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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended December 31, 1998
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
Commission File Number: 0-20045
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WATSON PHARMACEUTICALS, INC.
(Exact name of registrant as specified in its charter)
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Nevada 95-3872914
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
311 Bonnie Circle, Corona, CA 91720
(Address of principal executive offices)
(909) 270-1400
(Registrant's telephone number, including area code)
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Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $0.0033 Par Value
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Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes [X] No [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [_]
Aggregate market value, as of March 15, 1999, of Common Stock held by non-
affiliates of the registrant: $3,717,276,908 based on the last reported sale
price on the New York Stock Exchange.
Number of shares of Common Stock outstanding on March 15, 1999: 95,592,406
DOCUMENTS INCORPORATED BY REFERENCE
The registrant intends to file a definitive Proxy Statement pursuant to
Regulation 14A within 120 days after the close of the fiscal year ended
December 31, 1998. Portions of such Proxy Statement are incorporated by
reference in Part III of this report.
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PART I
ITEM 1. BUSINESS
Unless otherwise specified, reference to "Watson" or the "Company" refers to
Watson Pharmaceuticals, Inc. and its subsidiaries as of December 31, 1998, and
unless otherwise indicated excludes TheraTech, Inc., which was acquired in
January 1999 (as discussed below). Eldepryl(R) and Zarontin(R) are registered
trademarks of Somerset Pharmaceuticals, Inc. ("Somerset") and Warner-Lambert
Company, respectively. All other marks are trademarks of the Company. For full
prescribing information for any Watson Product, please contact the Company at
(800) 272-5525.
CAUTIONARY STATEMENT FOR PURPOSES OF THE SAFE HARBOR PROVISIONS OF THE PRIVATE
SECURITIES LITIGATION REFORM ACT OF 1995
This report contains forward-looking statements. The Company desires to take
advantage of the safe harbor provisions of the Private Securities Litigation
Reform Act of 1995 and is including this statement for the express purpose of
availing itself of the protections of the safe harbor with respect to all
forward-looking statements. Several important factors, in addition to the
specific factors discussed in connection with such forward-looking statements
individually, could affect the future results of the Company and could cause
those results to differ materially from those expressed in the forward-looking
statements contained herein.
The Company's estimated or anticipated future results, product performance
or other non-historical facts are forward-looking and reflect Watson's current
perspective of existing trends and information. These statements involve risks
and uncertainties that cannot be predicted or quantified and, consequently,
actual results may differ materially from those expressed or implied by such
forward-looking statements. Such risks and uncertainties include, among
others, the success of Watson's product development activities and the
timeliness with which regulatory authorizations and product roll-out may be
achieved, market acceptance of Watson's products and the impact of competitive
products and pricing, the availability on commercially reasonable terms of raw
materials and other third party sourced products, dependence on sole source
suppliers, successful compliance with extensive, costly, complex and evolving
governmental regulations and restrictions, the ability to timely and cost
effectively integrate acquisitions, exposure to product liability and other
lawsuits and contingencies, the successful and timely implementation of the
Company's Year 2000 Compliance Program, and other risks and uncertainties
detailed in this report and from time to time in Watson's other Securities and
Exchange Commission ("SEC") filings.
Therefore, the Company wishes to caution each reader of this report to
consider carefully these factors as well as the specific factors that may be
discussed with each forward-looking statement in this report or disclosed in
the Company's filings with the SEC as such factors, in some cases, could
affect the ability of the Company to implement its business strategy and may
cause actual results to differ materially from those contemplated by the
statements expressed herein.
OVERVIEW
Watson Pharmaceuticals, Inc., incorporated in 1985, is engaged in the
development, production, marketing and distribution of branded and off-patent
pharmaceutical products. The Company's products include therapeutic and
preventive agents generally sold by prescription or over-the-counter (OTC) for
the treatment of human diseases and disorders.
Branded Pharmaceutical Products
New pharmaceutical products are often patented and, as a result, generally
are offered by a single provider when first introduced to the market. In
addition to patented products, certain trademarked off-patent products which
are promoted directly to healthcare professionals are treated by Watson as
branded pharmaceutical products.
2
The Company's branded pharmaceutical business operates primarily in the
following specialty areas: Dermatology, Women's Health, Neurology/Psychiatry
and Primary Care. Watson has strategically focused on these markets due to
their anticipated growth opportunities. The Company believes that the nature
of these markets and the identifiable base of physician prescribers provide it
with the opportunity to achieve significant market penetration through its
specialized sales forces. The Company believes its branded pharmaceutical
products tend to generate more stable earnings over a longer period, in large
part through higher margins. The Company intends to continue to expand its
branded product portfolio through internal product development and acquisition
or may also choose to enter into collaborative or licensing agreements with
third parties at various stages of product development.
Off-Patent Pharmaceutical Products
When the relevant patents no longer protect a branded product (either due to
the patent's expiration or otherwise), opportunities exist for third parties
to introduce generic counterparts to the branded product. Such generic or off-
patent pharmaceutical products are therapeutically equivalent to their brand-
name counterparts and are generally sold at prices significantly less than the
branded product. Accordingly, off-patent pharmaceuticals provide a safe,
effective and cost-efficient alternative to users of branded products.
The Company is recognized as a leader in the development, manufacture and
sale of off-patent pharmaceutical products. With respect to off-patent
products, the Company's strategy is to enter markets where it enjoys
competitive advantages. In this regard, the Company targets for development
drugs that are difficult to formulate or manufacture, or that will complement
its existing portfolio, or that will otherwise assist it in making its product
line more complete.
Revenues From Pharmaceutical Sales
Company revenues for the last three fiscal years were derived as follows:
For the Years Ended December 31,
----------------------------------------------
1998 1997 1996
------------ --------------- ---------------
$ % $ % $ %
-------- --- -------- --- -------- ---
($ in thousands)
Off-patent product sales... $329,805 59% $200,890 59% $189,275 75%
Branded product sales...... 226,343 41 123,125 37 34,364 14
Royalty income from branded
sales..................... 0 0 14,249(1) 4 27,162(1) 11
-------- --- -------- --- -------- ---
Total revenues........... $556,148 100% $338,264 100% $250,801 100%
======== === ======== === ======== ===
- --------
(1) Following Watson's acquisition of the U.S. rights to Dilacor XR(R) from
Rhone-Poulenc Rorer Pharmaceuticals, Inc. ("RPR") as of June 30, 1997, no
further royalty income was earned.
SUMMARY OF RECENT TRANSACTIONS
Several acquisitions have contributed to the Company's growth over the past
year. In February 1998, the Company acquired from Hoechst Marion Roussel, Inc.
("HMR") The Rugby Group, Inc. ("Rugby"), a developer and marketer of off-
patent pharmaceutical products, for approximately $67.5 million in cash
(exclusive of certain contingent payments). The Company also entered into a
supply agreement with HMR under which Watson currently purchases certain off-
patent products.
In November 1998, the Company acquired three branded oral contraceptive
products from G. D. Searle & Co. ("Searle"), Norinyl(R), Brevicon(R), and Tri-
Norinyl(R), for $120.0 million cash. The Company and Searle also entered into
a supply agreement under which the Company is currently purchasing these
products. Under the supply agreement with Searle, the Company has the right to
purchase these products from Searle for three years; the first two years in
finished packaged form and the third year in bulk tablet form.
3
In January 1999, Watson acquired TheraTech, Inc. ("TheraTech"), a leading
drug-delivery company, in a share for share exchange for approximately 5.8
million Watson common shares. TheraTech develops advanced, controlled-release
and other drug-delivery products which administer drugs through the skin, by
oral delivery to
the gastrointestinal tract, through tissues in the oral cavity, through
absorption in the lungs and by other means. TheraTech believes its products
provide advantages over existing controlled-released drug-delivery products
and conventional oral, injectable, inhalation and continuous infusion methods
by increasing efficacy, safety, bioavailability and/or patient compliance and
comfort. TheraTech focuses its research and development efforts on the design
and development of improved delivery systems for off-patent and proprietary
drugs.
The U.S. Food and Drug Administration ("FDA") has approved for marketing
three of TheraTech's developed products. Two of these products, the
Androderm(R) two and one half milligram (2.5 mg) testosterone transdermal
system for men and the Alora(R) estradiol transdermal system for women,
received marketing approval within one year of their respective initial
submissions.
As of March 15, 1999, TheraTech had 208 full-time and 9 part-time employees.
Of the total number, 92 employees were engaged in research and development
activities, 59 employees were in manufacturing, and 66 employees were in
administrative capacities. TheraTech's management team consists of
pharmaceutical industry specialists, including individuals with experience
ranging from project conception and design to regulatory approval process and
commercial production.
TheraTech's principal facilities are located in Salt Lake City, Utah. These
facilities include approximately 76,000 square feet of research and
development, pilot manufacturing and packaging, and administrative space under
one lease. The lease expires in May 1999 and has two, one-year renewal
options. TheraTech has also entered into a 40-year lease, with an option to
renew for an additional ten years, on approximately seven acres of land
located in the University of Utah Research Park for its commercial
manufacturing facility. TheraTech also maintains approximately 3,000 square
feet of leased space for business development and related purposes in Tokyo,
Japan.
The Rugby, Searle and TheraTech transactions are more fully described in
Note 2 to the consolidated financial statements.
PRODUCTS
Branded pharmaceutical products
The Company markets its branded products to physicians through its four
principal sales groups: Dermatology, Women's Health, Neurology/Psychiatry and
Primary Care. As of March 15, 1999, the Company marketed the following branded
products:
Dermatology
Watson markets several products for the prevention and treatment of skin
diseases. These products include Monodox(R) (doxycycline monohydrate), for the
treatment of severe acne; Cordran(R) (flurandrenolide) and Cormax(TM)
(clobetasol propionate), for the treatment of dermatoses; Condylox(R)
(podofilox), for the treatment of genital warts; and Cinobac(R) (cinoxacin),
for the treatment of urinary tract infections.
Women's Health
The Company markets a variety of oral contraceptive products. These products
include Zovia(TM) (ethynodiol diacetate & ethinyl estradiol), Levora(R)
(levonorgestrel), Nor QD(R) (norethindrone), Trivora(R) (levonorgestrel and
ethinyl estradiol tablets, USP--Triphasic Regimen), Norinyl(R) (norethindrone
and ethinyl estradiol), Brevicon(R) (norethindrone and ethinyl estradiol), and
Tri-Norinyl(R) (norethindrone and ethinyl estradiol).
4
Neurology/Psychiatry
Watson markets three central nervous system products: Loxitane(R) (loxapine
succinate), for the treatment of psychotic disorders, Zarontin(R)
(ethosuximide), for the treatment of pediatric epilepsy and Eldepryl(R)
(selegiline), a product of Somerset, for the treatment of Parkinson's disease.
These products are sold into this growing specialty market, exclusively to
psychiatrists and neurologists.
Primary Care
The Company markets three products directly to primary care physicians.
These products are Norco(TM) (hydrocodone bitartrate & acetaminophen), a
branded off-patent analgesic; and Microzide(R) (hydrochlorothiazide) and
Dilacor XR(R), which are both used in the treatment of hypertension and
angina. In 1997, sales of Dilacor XR(R) accounted for approximately 19% of
total revenues following Watson's June 1997 purchase of Dilacor XR(R). In
1998, sales of Dilacor XR(R) accounted for approximately 15% of total
revenues. The Company expects that the significance of Dilacor XR(R) as a
percentage of total revenues will continue to decline as a result of new
product introductions and acquisitions, increased revenues from existing
products and increased competition; and that Dilacor XR(R) will not represent
a significant portion of Watson's revenues in 1999.
Off-patent pharmaceutical products
Watson manufactures and markets more than 85 off-patent prescription
products in capsule or tablet forms in approximately 166 dosage strengths. The
Company markets its off-patent products to drug wholesalers, distributors and
retailers, including chain drug stores, hospitals, clinics, governmental
agencies, and managed healthcare providers such as health maintenance
organizations and other institutions.
Watson's sales of off-patent drugs have increased significantly in recent
years. The Company believes that this growth is attributable to a number of
factors, including (a) acquisitions by the Company in 1997 and 1998, (b)
modification of certain federal and state laws to permit or mandate
substitution of off-patent drugs by pharmacists, (c) the enactment of
abbreviated procedures for obtaining FDA approval to manufacture off-patent
prescription drugs, (d) changes in government and third-party payor
reimbursement policies to encourage cost containment by health care providers
and consumers, (e) increased acceptance of off-patent drugs by physicians,
pharmacists and consumers, and (f) an increasing number of products which have
lost patent protection.
During 1998, the hydrocodone bitartrate & acetaminophen off-patent product
group accounted for approximately 13% of total revenues. In 1997, the
hydrocodone bitartrate & acetaminophen off-patent product group accounted for
approximately 21% of total revenues and in 1996 this same product group
accounted for 29% of total revenues.
JOINT VENTURES
Watson has made substantial investments in pharmaceutical joint ventures and
may utilize this method of investment in the future. The Company does not
control these joint ventures or the commercial exploitation of the branded and
off-patent products they develop, manufacture and/or market, although Watson
does market Somerset's Eldepryl(R). Further, there is no assurance that such
joint ventures will be profitable, or if profitable currently, will continue
to be profitable.
The Company owns a 50% interest in Somerset, a joint venture with Mylan
Laboratories, Inc. Currently, Somerset's only marketed product is Eldepryl(R).
Somerset, however, is actively involved in research projects regarding
additional indications for Eldepryl(R) and other chemical compounds. In
addition, the Company owns a 50% interest in ANCIRC, a joint venture with
Andrx Corporation ("Andrx"), that is developing off-patent pharmaceutical
products utilizing Andrx's controlled-release technology. In 1998, ANCIRC
received one abbreviated new drug application ("ANDA") product approval from
the FDA and as of March 15, 1999, ANCIRC had one ANDA under review with the
FDA. At December 31, 1998, Watson owned approximately 17.7% of the outstanding
common stock of Andrx. The Company also has a warrant to purchase 337,079
shares of Andrx common stock (which represented approximately 2.2% of the
outstanding shares of Andrx common stock at December 31, 1998) at an exercise
price of $8.90 per share.
5
PRODUCT DEVELOPMENT
The Company devotes significant resources to the research and development of
branded and off-patent products. During the three years ended December 31,
1998, the Company incurred research and development expenditures of $30.8
million, $18.1 million and $22.9 million, respectively. There can be no
assurance that any of the products currently in development will receive the
required regulatory approvals from the FDA or be commercially successful if
ultimately approved.
Watson's research and development strategy focuses on the following product
development areas: (a) expansion of its existing oral immediate-release
products with respect to additional dosage strengths, (b) off-patent drugs
that are technically difficult to develop or make because of unusual factors
that affect their shelf life or bioequivalence or are sold in smaller
specialized markets, (c) the development of sustained-release technologies and
the application of these technologies to existing products, (d) the
application of proprietary drug-delivery technology for new product
development in specialty areas, and (e) medium-to-late stage new drug
opportunities.
Watson maintains research and development facilities in Corona, California,
Miami, Florida and Cincinnati, Ohio.
Branded product development
Watson continues to develop certain branded products, some of which utilize
novel drug-delivery systems. Such branded products generally require FDA
approval of a New Drug Application ("NDA") prior to marketing. The Company is
also developing proprietary products through a combination of internal and
collaborative programs, including joint ventures. Watson's proprietary product
development continues to emphasize mid-to-late-stage new drug opportunities
that can quickly be brought to market.
The Company is focusing its proprietary drug development efforts in the
three specialty areas where Watson has existing sales and marketing presence,
namely Women's Health, Neurology/Psychiatry and Dermatology. Products
currently in development include: a hormone replacement therapy, a dermatology
product, a central nervous system product, and an analgesic product.
In recent years, Somerset has increased its research and development
spending in order to (a) develop additional indications for selegiline (the
parent compound of Eldepryl(R)), using a transdermal delivery system and (b)
develop and evaluate different therapeutic areas using selegiline and other
compounds. Clinical studies using the selegiline transdermal system (STS) in
major depression were completed in 1998.
Off-patent product development
Watson intends to continue to concentrate its development activities in
areas that offer significant opportunity and that allow Watson to develop
competitive advantages. For instance, the Company has focused its development
efforts on technically difficult-to-formulate products, or products that
require advanced manufacturing technology. By so doing, the Company seeks to
secure a competitive advantage and increased profitability with these
products. In addition, when evaluating which drug development projects to
undertake, Watson considers whether the product, once developed, will
complement other products in its portfolio, or will otherwise assist in making
the Company's product line more complete.
The Company's acquisition of Royce Laboratories, Inc. ("Royce") in 1997 and
Rugby in 1998 has increased its resources in the area of off-patent product
development. The Company presently has submissions for approval pending before
the FDA representing 17 separate products of varying dosage strengths. During
1998 and through March 15, 1999, Watson received 10 off-patent product
approvals from the FDA.
6
As of March 15, 1999, the Company believed that it received the first ANDA
approval for approximately 40 products and/or dosage strengths. Also as of
March 15, 1999, the Company believed that it received the sole ANDA approval
for approximately 13 products and/or dosage strengths.
Over the next few years, patent protection on a relatively large number of
branded drugs will expire, thereby providing additional off-patent product
opportunities. The branded products targeted for off-patent development
include those with specialized or growing markets as well as those products
with U.S. sales exceeding $50 million.
SALES AND MARKETING
The Company sells its pharmaceutical products to drug wholesalers, retailers
and distributors, including large chain drug stores, hospitals, clinics,
government agencies and managed healthcare providers such as health
maintenance organizations and other institutions.
Branded products
The Company markets its branded products through its specialty sales groups:
Dermatology, Women's Health, Neurology/Psychiatry and Primary Care. Each of
these sales groups focuses on physicians who specialize in the diagnosis and
treatment of different medical conditions and each offers products to satisfy
the needs of these specialty physicians. The Company believes that this
focused marketing approach enables it to develop highly knowledgeable and
dedicated sales representatives and to foster close professional relationships
with physicians.
During 1998, the Company continued to develop the sales forces for each
therapeutic area as well as the marketing infrastructure to support sales
efforts in these specialty areas. The Company's branded products sales group
had grown to include more than 350 sales representatives by the end of 1998.
Off-patent products
Customer service activities are an integral part of the Company's sales and
marketing operations. The Company endeavors to maintain adequate inventories,
make timely delivery of its products and provide technical and other service
support to its customers. During 1998, Rugby's telemarketing organization and
other sales and marketing personnel were integrated into the Company's
existing infrastructure, enhancing its sales and marketing efforts in the off-
patent product area.
Customers
The Company markets its products primarily to pharmaceutical wholesalers,
drug distributors, and chain drug stores that in turn market to retailers,
managed care entities, hospitals and government agencies. Watson sells its
dermatology products under the "Oclassen Pharmaceuticals" label. Watson has
witnessed a consolidation of its customers, as chain drug stores and
wholesalers merge or consolidate. In addition, a number of the Company's
customers have instituted source programs that limit the number of suppliers
of off-patent pharmaceutical products carried by that customer. As a result of
these developments, there is heightened competition among off-patent drug
producers for the business of this smaller and more selective customer base.
The Company ships products pursuant to purchase orders. In 1998, two
customers accounted for 17% and 12%, individually, of the Company's product
sales. In 1997, these same two customers accounted for 12% and 11%,
individually, of the Company's product sales. In 1996, one customer accounted
for 10% of product sales.
Competition
The pharmaceutical industry is highly competitive, and in many cases, highly
regulated. Watson's competitors vary depending upon categories, and within
each product category, upon dosage strengths and drug-delivery systems. Such
competitors include the major brand name and off-patent manufacturers of
7
pharmaceuticals, especially those doing business in the United States. Many
competitors have been in business for a longer period of time than Watson,
have a greater number of products on the market and have greater financial and
other resources. Watson competes principally through its targeted product
development strategies. In addition to product development, other competitive
factors in the pharmaceutical industry include product quality and price,
reputation and access to technical information.
Newly introduced off-patent products with limited or no off-patent
competition are typically sold at higher selling prices, often resulting in
increased gross profit margins. As competition from other manufacturers
intensifies selling prices typically decline. Consequently, the maintenance of
profitable operations depends, in part, on the Company's ability to maintain
efficient production capabilities and to develop and introduce new products in
a timely and cost-effective manner.
Revenues and gross profit derived from the sales of off-patent
pharmaceutical products tend to follow a pattern based on certain regulatory
and competitive factors. As patents for brand name products and related
exclusivity periods mandated by regulatory authorities expire, the first off-
patent manufacturer to receive regulatory approval for off-patent equivalents
of such products is generally able to achieve a relatively high market share.
As competing off-patent manufacturers receive regulatory approvals on similar
products, market share, revenues and gross profit typically decline.
Accordingly, the level of market share, revenues and gross profit attributable
to a particular off-patent product is normally related to (a) the number of
competitors in that product's market and (b) the timing of that product's
regulatory approval, in relation to competing approvals. In addition to
competition from other off-patent drug manufacturers, the Company faces
competition from brand name companies as they increasingly sell their products
into the off-patent market by establishing, acquiring or forming licensing or
business arrangements with other off-patent pharmaceutical companies.
With respect to its branded products, the competitive environment requires
an intensive search for technological innovations and the Company's ability to
market the products effectively, including its ability to communicate the
effectiveness, safety and value of the Company's branded products to
healthcare professionals in private practice, group practices and managed care
organizations.
SUPPLIERS AND MATERIALS
The principal components used in the Company's products are active and
inactive pharmaceutical ingredients and packaging materials. The Company
maintains its own manufacturing capabilities but also contracts with third
parties for the manufacture of a number of its finished products. Certain
third-party components and finished products (including certain products that
have historically accounted for a significant portion of Watson's revenues)
are currently available only from sole or limited suppliers. The FDA (and in
some cases, other regulatory agencies) must approve suppliers for the
Company's products. The Company's third-party suppliers are required by the
Federal Food, Drug and Cosmetic Act and by FDA regulations to follow current
Good Manufacturing Practices ("cGMP"). Accordingly, the Company is dependent
upon its suppliers to comply with such requirements or similar standards
imposed by foreign regulators. Arrangements with foreign suppliers are subject
to certain additional risks, including the availability of governmental
clearances, export duties, political instability, currency fluctuations and
restrictions on the transfer of funds. If any of the components or finished
products were no longer available from an existing approved source, a
qualified alternative would have to be located. This process could delay the
manufacture and sale of such products. In addition, there can be no assurance
that the Company will continue to be able to obtain such items on a timely
basis or at commercially reasonable prices. Any extended inability to timely
obtain components or finished products, or any significant price increases
that cannot be passed on to customers, could have a material adverse effect on
the Company. From time to time, certain outside suppliers have experienced
regulatory difficulties that have inhibited their ability to deliver products
to the Company. To the extent such regulatory difficulties cannot be resolved
within a reasonable time, the resulting delay could have a material adverse
effect on the Company.
8
PATENTS AND PROPRIETARY RIGHTS
Watson believes that protection of its patents, proprietary products,
technologies, processes and know-how is important to its business. The Company
maintains an active patent program and has numerous issued and pending United
States patents. The Company also seeks patent protection in major foreign
pharmaceutical markets, and has a number of foreign patents that are issued
and pending.
There can be no assurance that Watson's patents or those of its competitors
will be held valid by a court of competent jurisdiction. There also can be no
assurance that pending patents will result in issued patents, that patents
issued to or licensed by the Company will not be challenged or circumvented by
competitors, or that such patents will be found to be valid or sufficiently
broad to protect the Company's technology or to provide the Company with a
competitive advantage. Watson relies on non-disclosure agreements with certain
employees, consultants and other parties to protect, in part, trade secrets
and other proprietary technology. There can be no assurance that these
agreements will not be breached, that the Company will have adequate remedies
for any breach, or that others will not independently develop equivalent
proprietary information or that third parties will not otherwise gain access
to the Company's trade secrets and proprietary knowledge.
Watson may find it necessary to initiate litigation to enforce its patent
rights, to protect its trade secrets or know-how and to determine the scope
and validity of the proprietary rights of others. In addition, any time the
Company files an ANDA in which it certifies that its product is not infringing
or that the patent covering the NDA patent is invalid, the patent holder may
file suit against the Company for patent infringement. Patent litigation can
be costly and time-consuming, and there can be no assurance that the Company's
litigation expenses will not be significant in the future or that the outcome
of such litigation will ultimately be favorable to the Company.
GOVERNMENT REGULATION
All pharmaceutical manufacturers are subject to extensive regulation by the
federal government, principally the FDA and, to a lesser extent, by state and
local governments. The Federal Food, Drug and Cosmetic Act and other federal
statutes and regulations govern or influence the testing, manufacture, safety,
labeling, storage, record keeping, approval, advertising, promotion, sale and
distribution of pharmaceutical products. Noncompliance with applicable
requirements can result in fines, recall or seizure of products, total or
partial suspension of production and/or distribution, refusal of the
government to enter into supply contracts or to approve NDAs or ANDAs, civil
sanctions and criminal prosecution. The FDA also has the authority to revoke
previously granted drug approvals. From time to time, the FDA issues notices
and warning letters to pharmaceutical manufacturers that request or require
the manufacturer to modify certain activities with which the FDA finds fault.
To facilitate compliance, the Company from time to time may institute
voluntary compliance programs.
The FDA's cGMP standards have become more complex in recent years. The ANDA
drug development and approval process now averages approximately two to five
years. FDA approval is required before each dosage form of any new drug can be
marketed. Applications for FDA approval must contain information relating to
bioequivalency, product formulation, raw material suppliers, stability,
manufacturing processes, packaging, labeling and quality control. FDA
procedures require full-scale manufacturing equipment to be used to produce
test batches for FDA approval. Validation of manufacturing processes by the
FDA also is required before a Company can market new products. The FDA
conducts pre-approval and post-approval reviews and plant inspections to
enforce these rules. Supplemental filings are required for approval to
transfer products from one manufacturing site to another and may be under
review for a year or more. In addition, certain products may only be approved
for transfer once new bioequivalency studies are conducted.
The Company's manufacturing operations are required to comply with cGMP
standards as interpreted by the FDA. This concept encompasses all aspects of
the production process, including validation and record keeping, and involves
changing and evolving standards. In recent years, the FDA has increased the
number of
9
regular inspections to determine compliance with its cGMP standards. The
evolving and complex nature of regulatory requirements, the broad authority
and discretion of the FDA and the generally high level of regulatory oversight
results in a continuing possibility that from time to time the Company will be
adversely affected by regulatory actions despite its ongoing efforts and
commitment to achieve and maintain full compliance with all regulatory
requirements.
The Hatch-Waxman Act of 1984 extended the established ANDA application
procedure for obtaining FDA approval of generic forms of brand-name drugs,
which were originally marketed before 1962 or whose market exclusivity has
expired. Upon filing an ANDA application with the FDA, the Company must make
one of five certifications with respect to patents. If the Company certifies
that its product is not infringing or that the NDA patent is invalid, then a
NDA patent holder can file suit against the ANDA applicant. Once a suit is
filed, the FDA is prohibited from approving the ANDA for thirty months or
until the suit is litigated. The Hatch-Waxman Act also provides market
exclusivity provisions that could preclude the submission or delay the
approval of a competing ANDA. One such provision allows a five-year market
exclusivity period for NDAs involving new chemical compounds and a three-year
market exclusivity period for NDAs (including different dosage forms)
containing new clinical investigations essential to the approval of the
application. The market exclusivity provisions apply equally to patented and
non-patented products. Another provision of the Hatch-Waxman Act may extend
patents for up to five years as compensation for reduction of the effective
life of the patent as a result of time spent by the FDA reviewing a drug
application. In addition, recent changes to the patent law resulting from
passage of the Uruguay Round Agreements Act ("URAA") will lengthen the term of
some granted patents. Generally, patents have terms that are the longer of 17
years from patent grant or 20 years from patent application.
The Generic Drug Enforcement Act of 1992 establishes penalties for
wrongdoing in connection with the development or submission of an ANDA by
authorizing the FDA to permanently or temporarily debar companies or
individuals from submitting or assisting in the submission of an ANDA, and to
temporarily deny approval and suspend applications to market off-patent drugs.
The FDA may also suspend the distribution of all drugs approved or developed
in connection with certain wrongful conduct and/or withdraw approval of an
ANDA and seek civil penalties. The FDA can also significantly delay the
approval of any pending NDA or ANDA under the Fraud, Untrue Statements of
Material Facts, Bribery and Illegal Gratuities Policy Act.
Medicaid, Medicare and other reimbursement legislation or programs govern
reimbursement levels, including requiring that all pharmaceutical
manufacturers rebate to individual states a percentage of their revenues
arising from Medicaid-reimbursed drug sales. The required rebate is currently
11% of the average wholesale price for sales of Medicaid-reimbursed products
marketed under ANDAs. For sales of medicaid-reimbursed products marketed under
NDAs, manufacturers are required to rebate the greater of approximately 15.1%
of the average wholesale price or, the difference between the average net
sales price and the lowest net sales price during a specified period. The
federal and/or state governments may continue to enact measures in the future
aimed at reducing the cost of drugs to the public. The Company cannot predict
the nature of such measures or their impact on the Company's profitability.
Federal, state and local laws of general applicability, such as laws
regulating working conditions also govern Watson. In addition, the Company is
subject, as are all manufacturers generally, to various federal, state and
local environmental protection laws and regulations, including those governing
the discharge of material into the environment. Compliance with such
environmental provisions is not expected to have a material effect on the
earnings, cash requirements or competitive position of the Company in the
foreseeable future. However, no assurance can be given that changes to, or
compliance with, such environmental provisions will not have a material effect
on the Company's earnings, cash requirements or competitive position.
Continuing studies of the proper utilization, safety, and efficacy of
pharmaceuticals and other health care products are being conducted by
industry, government agencies and others. Such studies, which increasingly
employ sophisticated methods and techniques, can call into question the
utilization, safety and efficacy of
10
previously marketed products and in some cases have resulted, and may in the
future result, in the discontinuance of their marketing. In certain countries,
these studies gave rise to claims for damages from persons who believe they
have been injured through the use of particular pharmaceutical products.
It is impossible for the Company to predict the extent to which its
operations will be affected under regulations discussed above or any new
regulations that may be adopted by regulatory agencies.
SEASONALITY
The Company's business, taken as a whole, is not materially affected by
seasonal factors.
PERSONNEL
As of December 31, 1998, the Company had 1,510 full-time employees. Of the
Company's employees, 164 are engaged in research and development, 479 in
manufacturing, 214 in quality assurance and quality control, 498 in sales and
marketing, and 155 in administration. Employees are not represented by unions
and the Company believes its relations with its employees are good.
BUSINESS--RISK FACTORS
In addition to the other information in this Annual Report on Form 10-K, you
should carefully consider the following risk factors in evaluating Watson's
business.
Risks Associated with Investing in Watson Common Stock
Watson is dependent on product development and commercialization for continued
growth and development.
Watson's future results of operations will depend to a significant extent
upon its ability to successfully commercialize new proprietary and off-patent
pharmaceutical products in a timely manner. As a result, new products must be
continually developed, tested and manufactured and, in addition, must meet
regulatory standards and receive requisite regulatory approvals. Products
currently in development by the Company may or may not receive the regulatory
approvals necessary for marketing by Watson or other third-party partners.
Furthermore, the development and commercialization process is time-consuming
and costly, and we cannot assure you that any of Watson's products, if and
when developed and approved, can be successfully commercialized. Risk
particularly exists with respect to the development of proprietary products,
because of the uncertainties and higher costs associated with research and
development of such products and the unproven market acceptability of such
products. Delays or unanticipated costs in any part of the process or the
inability of Watson to obtain regulatory approval for its products, including
failure to maintain its manufacturing facilities in compliance with all
applicable regulatory requirements, could adversely affect Watson's operating
results.
The effect of future transactions on Watson's business or stock price is
uncertain.
Watson regularly reviews potential transactions related to technologies,
products or product rights and businesses complementary to its business. Such
transactions could include mergers, acquisitions, strategic alliances,
licensing agreements or co-promotion agreements. In the future, Watson may
choose to enter into such transactions at any time. The impact of transactions
on the market price of a company's stock is often uncertain, but may cause
substantial fluctuations to the market price. Consequently, you should be
aware that any announcement of any such transaction could have a material
adverse effect upon the market price of Watson's common stock. Moreover,
depending upon the nature of any transaction, Watson may experience a charge
to earnings, which could be material, and could possibly have an adverse
impact upon the market price of Watson common stock. In connection with the
TheraTech merger, Watson expects to record merger-related expenses of
11
approximately $20 million in the first quarter of 1999. In addition, any such
transaction could be disruptive to the management of Watson, and any such
disruption could also have a material adverse effect on its business or
financial condition.
Watson's stock price has experienced substantial volatility. Watson has not
paid and does not intend to pay dividends.
The market prices for securities of companies engaged primarily in the
pharmaceutical industry have been volatile, and the market price of Watson
common stock has been and may continue to be volatile. For example, the market
price of Watson common stock fluctuated during the past twelve months between
$30.50 per share and $63.00 per share and may continue to fluctuate. Generally
market price fluctuations in a company's stock may be due to acquisition or
other material public announcements, along with a variety of additional
factors including, without limitation:
(a) new product introductions,
(b) the purchasing practices of the Company's customers,
(c) changes in the degree of competition for a company's products,
(d) the announcement of technological innovations or new commercial
products by a company or its competitors,
(e) governmental regulation,
(f) regulatory approvals or regulatory issues,
(g) developments relating to patents or proprietary rights,
(h) publicity regarding actual or potential clinical results with respect
to products under development by a company or others and
(i) political developments or proposed legislation in the pharmaceutical or
healthcare industry.
Any of these factors, among others, could have a significant impact on the
market price of Watson's common stock.
The Company has not paid any cash dividends since inception, although
certain of its wholly-owned subsidiaries may have paid dividends prior to a
combination with Watson. Watson does not anticipate paying cash dividends in
the foreseeable future.
The Company's issued common stock could experience dilution as a result of
future transactions.
In April 1998, Watson filed a registration statement with the SEC which
allows Watson to raise up to $300 million from offerings of senior or
subordinated debt securities, common stock, preferred stock or a combination
thereof, at such times and in such amounts as Watson deems appropriate. To
date, Watson has issued $150 million in senior unsecured notes pursuant to
such registration statement. In addition, (a) Watson may engage in future
transactions, including the acquisition of technologies, products, product
rights and businesses, which could involve the issuance of its securities and
(b) Watson has commitments pursuant to existing option plans and free-standing
options and warrants which are likely to result in the issuance of additional
shares of Watson common stock. The issuance of any securities for these or
other reasons could result in dilution of existing shareholders' equity
interest in Watson. In addition, the Watson Board of Directors has the
authority to issue, without vote or action of shareholders, shares of
preferred stock, in one or more series, and to fix the rights, preferences,
privileges and restrictions thereof. Any such series of preferred stock could
contain dividend rights, conversion rights, voting rights, terms of
redemption, redemption prices, liquidation preferences or other rights
superior to the rights of holders of Watson common stock. The Watson Board of
Directors has no present intention of issuing any such preferred series, but
reserves the right to do so in the future.
12
Risks Associated with Investing in the Business of Watson
The pharmaceutical industry is extensively regulated by various government
agencies.
All pharmaceutical manufacturers are subject to extensive, complex, costly
and evolving governmental regulations and restrictions administered by the
FDA, other federal and state agencies, and numerous governmental authorities
in other countries. Moreover, Watson and certain of its vendors are subject to
the periodic inspection of their facilities and operations and/or the testing
of their products by the FDA, the U.S. Drug Enforcement Agency ("DEA"), the
U.S. Environmental Protection Agency ("EPA") and similar state, local and
foreign regulatory authorities. Each of these organizations conducts periodic
inspections to confirm continued compliance with its regulations. In
connection with such an inspection by FDA of the Company's Corona, California
facility, the FDA issued to the Company a Warning Letter in January 1999. The
Warning Letter related to the Company's cGMP compliance in areas such as
documentation, training and laboratory controls. The Company has responded to
the FDA and has adopted certain improvements to its procedures. Watson intends
to implement certain additional corrective improvements and anticipates that
these activities will be substantially completed within the next few months.
The Company does not expect that expenditures for these improvements will be
material. Product production at Watson's Corona facility has not been
interrupted, and the Company expects that production will continue, while it
implements the improvements.
Failure to comply with governmental regulations could result in fines,
unanticipated compliance expenditures, interruption of production and criminal
prosecution. Although Watson has instituted internal compliance programs, we
cannot assure you that such programs will meet regulatory agency standards and
that any lack of compliance will not have a material adverse effect on Watson.
The process for obtaining governmental approval to manufacture and market
pharmaceutical products is rigorous, time-consuming and costly, and Watson
cannot predict the extent to which it may be affected by legislative and
regulatory developments. Watson is dependent on receiving FDA and other
governmental approvals prior to manufacturing, marketing and shipping its
products. Consequently, there is always the chance that the FDA or other
applicable agency will not approve products, or that the rate, timing and cost
of such approvals will adversely affect Watson's product introduction plans or
results of operations. The URAA, which became effective June 8, 1994,
lengthens the term of existing and future patents by changing the patent term
to the longer of 17 years from the date of patent grant or 20 years from the
date of patent application. These URAA changes could postpone approval
eligibility of some products.
Watson is dependent on key personnel for its continued growth and development.
The success of Watson's present and future operations will depend, to a
great extent, upon the experience, abilities and continued services of certain
executive officers of Watson, including Allen Chao, Ph.D. The loss of the
services of any of these officers could have a material adverse effect on the
Company. Watson has entered into employment agreements with certain of its
executive officers, including Dr. Chao. Watson does not carry key-man life
insurance on any of its officers. Watson's success also will depend upon its
ability to attract and retain other highly qualified scientific, managerial,
sales and manufacturing personnel. However, there is a risk of departure of
employees due to certain factors, including factors relating to the
integration process following mergers. Competition for such personnel is
intense. In this respect, Watson competes with numerous pharmaceutical and
healthcare companies, as well as universities and nonprofit research
organizations. We cannot assure you that Watson will continue to attract and
retain qualified personnel.
Watson may not be able to obtain patent coverage or otherwise protect
proprietary technology.
Watson's success with its proprietary products will depend in part on its
ability to obtain patent protection for its products. Watson has a number of
U.S. and foreign patents issued and pending. However, we cannot assure you
that Watson's patent applications will be approved, or if approved will be
upheld in a court of law. We also cannot assure you that such patents will
provide competitive advantages for their respective products or will not be
challenged or circumvented by competitors.
13
Watson also relies on trade secrets and proprietary know-how which it seeks
to protect, in part, through confidentiality agreements with its partners,
customers, employees and consultants. It is possible that these agreements
will be breached or that they won't be enforceable in every instance, and that
Watson will not have adequate remedies for any such breach. It is also
possible that Watson's trade secrets will become known or independently
developed by competitors.
Watson may be required or may desire to obtain licenses to patents and other
proprietary rights held by third parties to develop, manufacture and market
products. We cannot assure you that Watson will be able to obtain these
licenses on commercially reasonable terms, if at all, or that any licensed
patents or proprietary rights will be valid or enforceable. In addition,
intellectual property law is subject to change by the courts and other
governmental bodies. For example, a 1997 Supreme Court ruling could impact a
party's ability to enforce its patents and to defend against potential patent
infringement claims by third parties. Watson's ability to commercialize its
products will depend on it not infringing the valid patent rights of others.
Litigation concerning patents and proprietary technologies can be protracted
and expensive and brand companies are increasingly suing competitors as a way
of delaying the introduction of competitors' products. Any such litigation may
be costly and time consuming, and could result in a substantial delay in a new
product introduction, any of which could have a material adverse effect on
Watson's business, financial condition or results of operations.
Increased competition may cause reduced revenues and gross margins.
Due to introduction of products from time to time that may compete with
Watson's products, Watson may continue to experience increased price
competition. Consequently, Watson may experience a reduction in future sales
or gross margin of such products which, absent additional offsetting revenues,
could have a material adverse effect on the financial condition and results of
operations of Watson.
Watson is dependent on certain suppliers that in some cases may be the only
source of finished products or raw materials.
Some materials used in Watson's manufactured products, and some products
sold by Watson, are currently available only from sole or limited suppliers.
This includes products that have historically accounted for a significant
portion of Watson's revenues. In addition, sources for materials for Watson's
products must be approved by the FDA, the DEA and/or other governmental
agencies or bodies. For some products sold by Watson, only one or very few
suppliers have been approved for certain materials or products used in
Watson's products. Any interruption or delay in supply of materials or
products from sole or limited source suppliers, or delays in the applicable
governmental approval of new suppliers, or delay in approving Watson as the
manufacturer of such products, could have a material adverse effect on
Watson's business.
The Year 2000 issue may affect Watson's operations.
Watson has assessed and continues to assess the potential impact of the
situation commonly referred to as the "Year 2000 Issue." The Year 2000 Issue
concerns the inability of information systems and computer software programs
to properly recognize and process date sensitive information relating to the
Year 2000 and beyond. Watson has several information system improvement
initiatives underway which management believes will adequately address the
Year 2000 Issue. However, if third party payors, suppliers, distributors,
transporters or joint venture partners do not adequately address their Year
2000 Issues or if Watson fails to successfully complete its Year 2000
initiative, it could be adversely affected in the future. For a discussion of
the Company's Year 2000 readiness see Item 7--Management's Discussion and
Analysis of Financial Condition and Results of Operations.
Watson may not receive anticipated income from its existing or future joint
ventures.
A portion of Watson's net income is derived from joint ventures. In
addition, a substantial portion of Watson's efforts in developing controlled-
release technology prior to the TheraTech merger was primarily
14
conducted through joint ventures. These arrangements involve various partners.
Watson does not control the joint ventures or the commercial exploitation of
the licensed products, and we cannot assure you that such joint ventures will
be, or, if profitable, will continue to be profitable. Although restrictions
contained in certain of Watson's joint venture arrangements have not in the
past had a material adverse impact on Watson's marketing of its products, any
such marketing restriction could affect future revenues and have a material
adverse effect on its operations. Watson's earnings may be negatively impacted
if existing collaborative or joint venture partners withdraw or if these
products are not timely developed, approved or successfully commercialized.
Product liability claims are a risk and insurance is expensive.
The design, development and manufacture of Watson's products involve an
inherent risk of product liability claims and associated adverse publicity.
Insurance coverage is expensive and may be difficult to obtain, and may not be
available in the future on acceptable terms, or at all. Although Watson
currently maintains product liability insurance for its products in the
amounts Watson believes to be commercially reasonable, we cannot assure you
that the coverage limits of Watson's insurance policies will be adequate. A
claim brought against Watson, whether fully covered by insurance or not, could
have a material adverse effect upon Watson.
Risks Associated With Investing in the Pharmaceutical Industry
The pharmaceutical industry is highly competitive.
The pharmaceutical industry is intensely competitive. Watson's competitors
vary depending upon product categories, and within each product category, upon
dosage strengths and drug-delivery systems. Such competitors include the major
brand name and off-patent manufacturers of pharmaceuticals, especially those
doing business in the United States. Many competitors have been in business
for a longer period of time than Watson, have a greater number of products on
the market and have greater financial and other resources. Newly introduced
off-patent products with limited or no off-patent competition are typically
sold at higher selling prices, often resulting in increased gross profit
margins. As competition from other manufacturers intensifies, selling prices
typically decline. Consequently, the maintenance of profitable operations will
depend, in part, on Watson's ability to maintain efficient production
capabilities and to develop and introduce new products in a timely and cost-
effective manner. It is possible that developments by others will make
Watson's products or technologies noncompetitive or obsolete.
15
ITEM 2. PROPERTIES
Watson conducts its operations using a combination of owned and leased
properties. The Company believes that its facilities are well maintained and
in good condition. Properties owned by the Company consist of research and
development, manufacturing, warehouse, distribution and administrative
facilities, containing approximately 697,000 square feet in Corona,
California, Copiague, New York, Salt Lake City, Utah and Dayton, Ohio. In
addition, the Company has a majority interest in a 90,000 square foot
manufacturing plant in Changzhou City, People's Republic of China.
Leased properties are located throughout the U.S. and include a distribution
center, research and development, manufacturing, administrative and sales and
marketing facilities. The facilities currently leased by the Company contain
approximately 484,000 square feet and are subject to lease terms that expire,
subject to renewal options, between 1999 and 2005. In addition, the Company
has leased through 2001, a 32,000 square foot manufacturing facility in
Corona, California from a trust in which Watson's Chairman, Chief Executive
Officer and President and the Company's Senior Vice President, Scientific
Affairs have a beneficial interest. 1998 rent expense under this related party
lease was $345,000.
The Company believes that while it currently has sufficient facilities to
conduct its operations during 1999, it will continue to acquire and lease
additional properties as its business requires.
ITEM 3. LEGAL PROCEEDINGS
In November 1997, a suit was filed against Royce and Watson naming them as
defendants, along with five other corporations, in an action captioned Michael
D. Hardy, Individually and Michael D. Hardy as Executor of the Estate of
Judith Marie Hardy v. Royce Laboratories, Inc., et al. in the Western District
of Kentucky at Louisville. The plaintiff alleges that his wife suffered
personal injuries due to her ingestion of the drug quinine for leg cramps in
June 1995, and personal injuries leading to death due to its ingestion in
April 1997. The plaintiff seeks actual damages in the amount of six million
dollars for personal injuries suffered by his wife, actual damages in the
amount of ten million dollars for wrongful death and additional punitive
damages. In June 1998, the Federal District Court for the Western District of
Kentucky dismissed all claims against Watson in this action. Royce remains a
defendant in the action and has filed its response denying all relevant
claims. The case is still in discovery. It is contemplated that any material
liability and defense costs will be covered by the Company's product liability
insurance.
Beginning in late 1997, a number of product liability suits were filed
against Rugby and numerous manufacturing defendants for personal injuries
arising out of the use of phentermine hydrochloride. The plaintiffs allege
various injuries, ranging from memory loss and anxiety to heart damage and
death. As of March 15, 1999, 517 cases have been filed against Rugby in state
and federal courts in twenty-one different states. Most of the cases involve
multiple plaintiffs, and six of the complaints were filed as class actions.
The Company believes that it will be fully indemnified by Hoechst Marion
Roussel, Inc. for the defense of all such cases and for any liability which
may arise out of these cases. HMR is currently controlling the defense of all
these matters as the indemnifying party under its agreements with Rugby.
Additionally, it is Rugby's position that it has recourse for liability from
the manufacturing defendants in these cases.
The Company is involved in various other disputes, governmental and/or
regulatory inspections, investigations and proceedings, and litigation matters
that arise from time to time in the ordinary course of business. The process
of resolving matters through litigation or other means is inherently uncertain
and it is possible that the resolution of these matters may adversely affect
the Company. In management's opinion, however, Watson is not currently
involved in any legal proceedings which, individually or in the aggregate,
would likely have a material adverse effect on the Company.
16
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth
quarter of the Company's fiscal year ended December 31, 1998.
ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT
Below are the Company's executive officers as of March 31, 1999.
Name Age Principal Position with Registrant
---- --- ----------------------------------
Michael E. Boxer........ 37 Chief Financial Officer
Allen Y. Chao, Ph.D..... 53 Chairman, President and Chief Executive Officer
Robert C. Funsten....... 39 Vice President, General Counsel and Secretary
David C. Hsia, Ph.D..... 54 Senior Vice President, Scientific Affairs.
G. Frederick Wilkinson.. 42 Vice President
Michael E. Boxer
Michael E. Boxer, age 37, has served as Chief Financial Officer of the
Company since July 1998. Before joining Watson, Mr. Boxer was President of The
Enterprise Group, a financial advisory firm, which provided consulting
services to the Company. From 1991 to 1997, he was Vice President of the
Health Care Group at Furman Selz, LLC, a New-York-based investment bank. While
at Furman Selz, Mr. Boxer participated in Watson's public financings and its
acquisition of Oclassen Pharmaceuticals, Inc. Mr. Boxer received a M.B.A. from
the University of Chicago in 1991.
Allen Y. Chao, Ph.D.
Allen Chao, age 53, a co-founder of the Company, has been Chief Executive
Officer of the Company since 1985, Chairman of the Company since May 1996 and
President of the Company since February 1, 1998. Dr. Chao also serves on the
Board of Directors of Somerset. Dr. Chao served as Director of Pharmaceutical
Technology and Packaging Development at Searle Laboratories, Inc. from
September 1979 to August 1983, where he had overall responsibility for new
product implementation and new pharmaceutical technology development. He
received a Ph.D. in industrial and physical pharmacy from Purdue University in
1973.
Robert C. Funsten
Robert C. Funsten, age 39, has served as Vice President, General Counsel and
Secretary of the Company since December 1998. Mr. Funsten was the Vice
President, Legal Affairs of the Company from July 1998 to December 1998.
Before joining the Company, Mr. Funsten was the Vice President and General
Counsel of Chiron Vision Corporation, an ophthalmic surgical device company,
from August 1995 to June 1998 and previously served as its Vice President and
Corporate Counsel from November 1993 to August 1995. Prior to joining Chiron
Vision Corporation, Mr. Funsten was in private practice at Stradling, Yocca,
Carlson & Rauth. Mr. Funsten received a J.D. from Stanford School of Law in
1986.
David C. Hsia
David Hsia, age 54, has served as Watson's Senior Vice President of
Scientific Affairs since May 1995 and has been a Vice President of Watson
since 1985. Dr. Hsia is also co-founder of the Company. He has been involved
in the development of pharmaceutical formulations for oral contraceptives,
sustained-release products and novel dosage forms. Dr. Hsia received a Ph.D.
in industrial and physical pharmacy from Purdue University in 1975. Dr. Hsia
is Dr. Chao's brother-in-law.
17
G. Frederick Wilkinson
G. Frederick Wilkinson, age 42, has been Vice President of Watson
Pharmaceuticals, Inc. since July, 1997 and Executive Vice President Sales &
Marketing of Watson Laboratories, Inc. since July 1996. Mr. Wilkinson also
serves as a director of Somerset. Prior to his employment with Watson, Mr.
Wilkinson was the President and General Manager of Creighton Pharmaceuticals,
a wholly owned subsidiary of Sandoz Pharmaceuticals, Inc. ("Sandoz") from 1994
to 1996. Prior to that, he held various marketing management positions at
Sandoz since 1980. Mr. Wilkinson received his M.B.A. from Capital University
in 1984 and his B.S. in Pharmacy from Ohio Northern University in 1979.
The executive officers of the Company are appointed annually by the Board of
Directors, hold office until their successors are chosen and qualify, and may
be removed at any time by the affirmative vote of a majority of the Board. The
Company has employment agreements with each of the executive officers except
Mr. Wilkinson. David C. Hsia is the brother-in-law of Allen Chao. There are no
other family relationships between any director and executive officer of the
Company.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's common stock began trading on the New York Stock Exchange on
September 17, 1997 under the symbol "WPI". Previously, the Company's common
stock traded on the Nasdaq National Market under the symbol "WATS". The
following table sets forth the quarterly high and low share price information
for the years ended December 31, 1997 and 1998, as adjusted to retroactively
reflect the October 1997 two-for-one stock split in the form of a 100% stock
dividend:
1997, by quarter High Low
---------------- ------ ------
First...................................................... $23.06 $17.69
Second..................................................... $22.25 $16.00
Third...................................................... $30.38 $21.63
Fourth..................................................... $34.13 $27.00
1998, by quarter
----------------
First...................................................... $42.94 $30.50
Second..................................................... $49.50 $36.25
Third...................................................... $52.88 $40.25
Fourth..................................................... $63.00 $42.00
As of March 15, 1999, there were approximately 11,000 holders of record of
the Company's common stock, which does not include those who held in street or
nominee name.
Since its initial public offering in February 1993, the Company has not paid
a cash dividend on its common stock and does not anticipate paying dividends
in the foreseeable future.
18
PART II
ITEM 6. SELECTED FINANCIAL DATA
SELECTED CONSOLIDATED FINANCIAL DATA(1)
For the Years Ended December 31,
--------------------------------------------------
1998 1997 1996 1995 1994
---------- -------- -------- -------- --------
(In Thousands, Except Earnings Per Share)
CONSOLIDATED INCOME
STATEMENT DATA:
Product sales, net......... $ 556,148 $324,015 $223,639 $170,227 $127,894
Cost of sales.............. 208,657 125,057 101,921 81,417 62,495
---------- -------- -------- -------- --------
Gross profit............ 347,491 198,958 121,718 88,810 65,399
---------- -------- -------- -------- --------
Royalty income............. -- 14,249 27,162 22,247 1,209
---------- -------- -------- -------- --------
Operating expenses:
Research and
development............. 30,825 18,055 22,895 24,562 23,525
Selling, general and
administrative.......... 88,435 50,937 38,891 34,873 30,368
Amortization of product
rights and goodwill..... 22,469 7,213 386 306 --
Charge for acquired in-
process research and
development(2).......... 13,000 -- -- -- --
Merger expenses(3)....... -- 14,718 -- 13,939 --
---------- -------- -------- -------- --------
Total operating
expenses............... 154,729 90,923 62,172 73,680 53,893
---------- -------- -------- -------- --------
Operating income........ 192,762 122,284 86,708 37,377 12,715
---------- -------- -------- -------- --------
Other income (expense):
Equity in earnings of
joint ventures.......... 6,789 10,694 17,909 22,766 24,968
Investment and other
income(4)............... 6,588 11,967 10,282 13,387 8,421
Interest expense......... (7,063) (347) (421) (482) (525)
Gain from legal
settlement(5)........... -- -- -- -- 2,299
---------- -------- -------- -------- --------
Total other income,
net.................... 6,314 22,314 27,770 35,671 35,163
---------- -------- -------- -------- --------
Income before income tax
provision.............. 199,076 144,598 114,478 73,048 47,878
Provision for income
taxes..................... 78,247 54,414 35,916 24,867 10,853
---------- -------- -------- -------- --------
Net income.............. $ 120,829 $ 90,184 $ 78,562 $ 48,181 $ 37,025
========== ======== ======== ======== ========
Basic earnings per
share.................. $ 1.36 $ 1.04 $ 0.92 $ 0.58 $ 0.45
========== ======== ======== ======== ========
Diluted earnings per
share.................. $ 1.32 $ 1.01 $ 0.89 $ 0.56 $ 0.44
========== ======== ======== ======== ========
Weighted average shares
outstanding, no dilution.. 89,078 86,991 85,028 83,317 81,849
========== ======== ======== ======== ========
Weighted average shares
outstanding, diluted
basis..................... 91,593 89,325 88,081 85,515 83,563
========== ======== ======== ======== ========
AS OF DECEMBER 31,
--------------------------------------------------
1998 1997 1996 1995 1994
---------- -------- -------- -------- --------
(In Thousands)
CONSOLIDATED BALANCE SHEET
DATA:
Current assets............. $ 293,255 $246,789 $326,930 $235,398 $207,467
Working capital............ 198,474 146,949 293,675 195,735 179,132
Total assets............... 1,070,043 755,005 473,581 364,879 299,121
Long-term debt and other... 149,872 2,385 3,864 4,464 20,782
Liability from acquisition
of product rights......... 50,000 95,000 -- -- --
Deferred tax liabilities... 54,512 36,887 12,226 -- --
Total stockholders'
equity.................... 750,478 565,034 423,835 320,752 250,004
19
- --------
(1) The Company merged with Circa Pharmaceuticals, Inc. ("Circa"), in July
1995, with Oclassen Pharmaceuticals, Inc. ("Oclassen"), in February 1997,
and with Royce, in April 1997. These transactions were accounted for as
poolings of interests, and accordingly, the consolidated financial data
include Circa, Oclassen, and Royce for all periods presented.
In October 1997, the Company effected a two-for-one stock split in the form
of a 100% stock dividend. Share and per share amounts for all reported
periods have been restated to reflect the stock split.
(2) The charge for acquired in-process research and development relates to
the Company's February 1998 acquisition of Rugby. This charge is
discussed further in Note 2 to the consolidated financial statements.
(3) Merger expenses of $13.9 million in 1995 and $14.7 million in 1997 relate
to the Company's acquisitions of Circa in 1995 and Oclassen and Royce in
1997.
(4) Included in investment and other income for the years ended December 31,
1995 and 1994 were gains from the sale of common stock of Marsam
Pharmaceuticals, Inc. ("Marsam") of $6.2 million and $3.2 million,
respectively. The Company has no remaining investment in Marsam.
(5) The gain from legal settlement resulted from the settlement of certain
lawsuits which Circa was a defendant. All of these lawsuits were settled
by the first quarter of 1996.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Except for the historical information contained herein, this report,
including the following discussion, contains forward-looking statements that
involve risks and uncertainties. Such risks and uncertainties are discussed in
this report and in the cautionary statement on page 2 of this Form 10-K.
GENERAL
The Company derives its revenues from the development, manufacture and sale
of pharmaceutical products. From the Company's founding in 1983 until 1996,
revenues were generated primarily from sales of off-patent versions of branded
pharmaceutical products. Since 1997, Watson has made significant investments
in branded pharmaceutical businesses and products. The Company believes that
branded pharmaceutical products generally offer stronger proprietary positions
and provide more consistent profit margins than off-patent pharmaceutical
products. Although the Company has diversified its product portfolio with
branded products, off-patent products remain an integral component of its
overall business strategy. Through internal product development and
acquisitions, the Company continues to expand its off-patent product
offerings. Watson will continue to consider acquisitions of complementary
products and businesses as a means of broadening its off-patent and branded
product portfolio.
ACQUISITIONS IN 1999 AND 1998
Acquisition of TheraTech, Inc. ("TheraTech")--Watson completed its
acquisition of TheraTech in January 1999. TheraTech is a leading drug-delivery
company that developed, manufactured and marketed innovative products based on
its patented and proprietary technologies and systems. Under the terms of the
TheraTech merger agreement, each share of TheraTech common stock was converted
into the right to receive 0.2663 of a share of the Company's common stock.
Accordingly, the Company issued approximately 5.8 million common shares with a
market value on the date of acquisition of approximately $329.0 million in
exchange for all of the outstanding common shares of TheraTech. The
acquisition qualified as a tax-free merger for federal income tax purposes and
will be accounted for as a pooling of interests. The Company's 1998
consolidated financial statements do not reflect the 1999 acquisition of
TheraTech. In the first quarter of 1999, Watson expects to incur a one-time
charge related to this acquisition of approximately $20.0 million. This charge
will include investment banking fees, professional fees and other acquisition
and consolidation-related costs.
20
1998 acquisition of oral contraceptive products from Searle--In November
1998, Watson acquired from Searle the U.S. rights to three oral contraceptive
products, Tri-Norinyl(R), Norinyl(R) and Brevicon(R), for $120.0 million in
cash. In connection with the acquisition, Watson and Searle entered into a
supply agreement whereby Watson has the right to purchase the products from
Searle in finished form for two years and in bulk form for an additional one-
year period.
Acquisition of Rugby--In February 1998, Watson acquired Rugby from Hoechst
Marion Roussel, Inc. Rugby developed, manufactured, and marketed a wide array
of off-patent pharmaceutical products. Under the terms of the acquisition
agreement, the Company acquired Rugby and its abbreviated new drug
applications, which included several licensed products, plus Rugby's sales and
marketing operations for U.S. off-patent and over-the-counter pharmaceutical
products. Rugby's product development group and product development pipeline
were also acquired in the transaction. The Company paid approximately $67.5
million in cash at closing and agreed to contingent payments based on future
sales and operating results. The acquisition was accounted for as a purchase
and Rugby's results of operations have been recorded in the Company's
consolidated financial statements since the date of acquisition. A charge of
$13.0 million for acquired in-process research and development was recorded in
the Rugby acquisition. This charge is discussed further in Note 2 to the
consolidated financial statements.
ACQUISITIONS IN 1997 AND EARLIER YEARS
1997 acquisition of oral contraceptive products from Searle--In October
1997, the Company acquired the U.S. rights to certain existing and future
Searle branded off-patent oral contraceptive products. In accordance with this
agreement, cash payments of $51.5 million and $85.0 million were made to
Searle in 1998 and 1997, respectively. Watson and Searle entered into a supply
agreement whereby Watson has the right to purchase the products for two years
from the date of acquisition and, at the Company's election, for an additional
two-year period. Payment for future products is contingent and due upon
receipt of FDA approval. If the FDA approves these future products, the
maximum aggregate acquisition cost for the remaining future products will be
approximately $33.8 million plus certain contingent payments based on the
technology transfer and net aggregate annual sales of certain acquired
products.
Acquisition of product rights to Dilacor XR(R)--In June 1997, the Company
acquired from Rhone-Poulenc Rorer Pharmaceuticals, Inc. ("RPR") the exclusive
U.S. and certain worldwide marketing, sales, and distribution rights to
Dilacor XR(R) for $190.0 million in cash and future royalties. Watson and RPR
entered into a supply agreement whereby Watson has the right to purchase
finished products from RPR through June 1999 and for an additional one-year
period under certain conditions. Prior to the acquisition of the rights to
Dilacor XR(R), the Company earned royalties from RPR sales of Dilacor XR(R).
The Company earned royalties from this product of $14.2 million for the first
six months of 1997 and $27.2 million for the full year of 1996. Dilacor XR(R)
has been available in the U.S. for the treatment of hypertension since June
1992 and was approved for the treatment of chronic stable angina in March
1995. Due to off-patent competition, the Company's product sales and gross
profit from Dilacor XR(R) are likely to continue to decline in future periods.
Acquisition of Royce--In April 1997, the Company acquired Royce for
approximately 5.2 million shares of its common stock having a market value of
approximately $98.0 million at the date of acquisition. Royce developed and
manufactured off-patent prescription drugs in solid dosage forms (tablets and
capsules). The acquisition was accounted for as a pooling of interests and
qualified as a tax-free merger for federal income tax purposes.
Acquisition of Oclassen--In February 1997, the Company acquired Oclassen for
approximately 6.6 million shares of its common stock having a market value of
approximately $135.0 million at the date of acquisition. The acquisition was
accounted for as a pooling of interests for accounting purposes and qualifies
as a tax-free merger for federal income tax purposes. Oclassen marketed
dermatology products used to prevent and treat skin diseases. In connection
with the acquisition, the Company obtained the rights to the following five
Oclassen products: Monodox(R) (doxycycline monohydrate), Condylox(R)
(podofilox 0.5%), Cordran(R) (flurandrenolide), Cinobac(R) (cinoxacin) and
Cormax(TM) (clobetasol propionate).
21
Acquisition of Circa--In July 1995, the Company acquired Circa for
approximately 37.4 million shares of its common stock having a market value of
approximately $698.0 million at the date of acquisition. Circa manufactured
off-patent pharmaceutical products and held investments in Somerset
Pharmaceuticals, Inc. ("Somerset") and Andrx Corporation ("Andrx"). The
acquisition qualified as a tax-free merger for federal income tax purposes and
was accounted for as a pooling of interests.
OTHER SIGNIFICANT INVESTMENTS AND JOINT VENTURES
Somerset joint venture--The Company owns 50% of the outstanding shares of
Somerset, which markets the product Eldepryl(R) used for the treatment of
Parkinson's disease. Somerset is also developing additional indications for
selegiline (the active compound of Eldepryl(R)), using a transdermal delivery
system. The Company recorded equity in earnings from this joint venture of
$7.4 million in 1998, $12.7 million in 1997 and $20.1 million in 1996. The
introduction of off-patent competition and Somerset's increased research and
development spending in support of various clinical trials have significantly
reduced Somerset's earnings. Management expects the Company's earnings from
Somerset to continue to decline.
Investment in Andrx--In 1994, the Company acquired a 7.5% interest in Andrx
(Nasdaq:ADRX), a drug-delivery company utilizing controlled-release
technologies to develop oral pharmaceutical products. Watson increased its
ownership of Andrx in October 1995 and in June 1997. At December 31, 1998, the
Company owned 2.7 million common shares of Andrx, which represented
approximately 17.7% of the total Andrx common shares outstanding. The Company
also has a warrant to acquire 337,100 shares of Andrx, exercisable in whole or
in part until July 8, 1999 at an exercise price of $8.90 per share. Watson
accounts for its investment in Andrx using the cost method, adjusted to fair
value. See Item 7A--Quantitative and Qualitative Disclosures About Market Risk
and Note 4 to the consolidated financial statements for further discussion.
QUARTERLY FLUCTUATIONS
Watson's quarterly earnings have fluctuated in the past, and may continue to
fluctuate. The Company believes such fluctuations are primarily due to new-
product introductions and to a variety of additional factors including, but
not limited to, purchasing practices of the Company's customers, market
acceptance of Watson's products, the impact of competitive products and
pricing and the timeliness with which regulatory authorizations and product
roll-out may be achieved.
22
CONSOLIDATED STATEMENTS OF INCOME
The following table presents the Company's consolidated statements of income
for each of the three years ended December 31, 1998, 1997 and 1996, in
thousands of dollars and as percentages of product sales:
For the Years Ended December 31,
-------------------------------------------------
1998 1997 1996
--------------- --------------- ---------------
$ % $ % $ %
-------- ----- -------- ----- -------- -----
Product sales, net $556,148 100.0% $324,015 100.0% $223,639 100.0%
Cost of sales............... 208,657 37.5 125,057 38.6 101,921 45.6
-------- ----- -------- ----- -------- -----
Gross profit.............. 347,491 62.5 198,958 61.4 121,718 54.4
-------- ----- -------- ----- -------- -----
Royalty income.............. -- -- 14,249 4.4 27,162 12.1
-------- ----- -------- ----- -------- -----
Operating expenses:
Research and development... 30,825 5.6 18,055 5.6 22,895 10.2
Selling, general and
administrative............ 88,435 15.9 50,937 15.8 38,891 17.3
Amortization............... 22,469 4.0 7,213 2.2 386 0.2
Charge for acquired in-
process
research and development.. 13,000 2.3 -- -- -- --
Merger expenses............ -- -- 14,718 4.5 -- --
-------- ----- -------- ----- -------- -----
Total operating expenses.. 154,729 27.8 90,923 28.1 62,172 27.7
-------- ----- -------- ----- -------- -----
Operating income.......... 192,762 34.7 122,284 37.7 86,708 38.8
-------- ----- -------- ----- -------- -----
Other income (expense):
Equity in earnings of joint
ventures.................. 6,789 1.2 10,694 3.3 17,909 8.0
Investment and other
income.................... 6,588 1.2 11,967 3.7 10,282 4.6
Interest expense........... (7,063) (1.3) (347) (0.1) (421) (0.2)
-------- ----- -------- ----- -------- -----
Total other income, net... 6,314 1.1 22,314 6.9 27,770 12.4
-------- ----- -------- ----- -------- -----
Income before income tax
provision................ 199,076 35.8 144,598 44.6 114,478 51.2
Provision for income taxes.. 78,247 14.1 54,414 16.8 35,916 16.1
-------- ----- -------- ----- -------- -----
Net income................ $120,829 21.7% $ 90,184 27.8% $ 78,562 35.1%
======== ===== ======== ===== ======== =====
YEARS ENDED DECEMBER 31, 1998 AND 1997
Product sales for the year ended December 31, 1998 were $556.1 million
compared to $324.0 million for the year ended December 31, 1997, an increase
of $232.1 million or 72%. This sales increase was due primarily to i)
increased sales of certain core off-patent and branded products, ii) increased
sales of off-patent products obtained through the Rugby acquisition, and iii)
increased sales of branded products, primarily as a result of the Dilacor
XR(R) acquisition in June 1997 and the Searle oral contraceptive products
which were purchased in October 1997.
The Company earned royalties of $14.2 million in 1997 from RPR sales of
Dilacor XR(R). Subsequent to Watson's June 1997 purchase of the Dilacor XR(R)
product rights, no further royalties were earned.
Research and development expenses increased to $30.8 million in 1998 from
$18.1 million in 1997. This increase was due primarily to the 1998 acquisition
of Rugby's off-patent product development group and increased spending by the
Company's existing development groups.
Selling, general and administrative expenses increased to $88.4 million in
1998 from $50.9 million in 1997. The increase consists of a $30.6 million
increase in sales and marketing expenses and a $6.9 million increase in
general and administrative costs. The increased sales and marketing expenses
were primarily the result of increased sales force personnel costs,
advertising and other promotional expenses incurred in support of the
Company's branded products. General and administrative costs increased during
1998 as a result of increased staffing in certain administrative areas to
support the Company's growth. However, as a percentage of net sales, general
and administrative costs decreased to 3.6% in 1998 from 4.1% in 1997.
23
Amortization expense increased to $22.5 million in 1998 from $7.2 million in
1997 due to the product right acquisitions (Dilacor XR(R) and Searle oral
contraceptive products) and goodwill recorded in the Rugby acquisition.
In connection with the acquisition of Rugby during the first quarter of
1998, the Company recorded a special charge of $13.0 million for the write-off
of in-process research and development associated with Rugby's wholly owned
subsidiary, Chelsea Laboratories, Inc. Watson, in conjunction with an
independent valuation firm, based this charge on an assessment of the value of
purchased research and development at Rugby. This charge is discussed further
in Note 2 to the consolidated financial statements. No such charge was
incurred in 1997.
In 1997, the Company recorded one-time charges of $14.7 million for costs
incurred in connection with the mergers of Royce and Oclassen. These costs
included investment banking fees and other merger-related expenses.
Equity in earnings from joint ventures decreased $3.9 million to $6.8
million in 1998 from $10.7 million in 1997, due primarily to lower earnings
from Somerset. The decrease in Somerset earnings is due in part to increased
competition with respect to Eldepryl(R) (Somerset's sole product) and
increased research and development spending in support of various clinical
trials. Management expects the Company's earnings from Somerset to continue to
decline.
Investment and other income decreased to $6.6 million in 1998 from $12.0
million in 1997 due to lower average cash and marketable securities balances
in 1998. The lower average cash and marketable securities balances in 1998
were due to the Company's acquisition-related activities.
Interest expense during 1998 increased to $7.1 million from $347,000 in 1997
as a result of the Company's $150.0 million senior debt issuance in May 1998.
These notes have a stated annual interest rate of 7 1/8% and were sold at a
discount to yield an effective annual interest rate of 7 1/4% to the Company.
The provision for income taxes increased to $78.2 million in 1998, compared
to $54.4 million in 1997. The effective income tax rate was 39% and 38% for
the years ended December 31, 1998 and 1997, respectively. The increase in the
Company's effective income tax rate was due primarily to the non-deductibility
for income tax purposes of the $13.0 million in-process research and
development charge incurred as a result of Watson's acquisition of Rugby.
YEARS ENDED DECEMBER 31, 1997 AND 1996
Revenues for the year ended December 31, 1997 were $338.3 million compared
to $250.8 million for the year ended December 31, 1996, an increase of $87.5
million or 34.9%. The increase in revenues was composed of a $100.4 million
increase in product sales, partially offset by a $12.9 million decrease in
royalty income. The increase in product sales was largely due to sales of
Dilacor XR(R), which was purchased from RPR in June 1997. The Company also
experienced increased sales of dermatology products, oral contraceptives, core
off-patent products and new products approved or acquired during the year.
These sales increases were partially offset by decreased sales of certain
strengths in the Company's hydrocodone product line.
Royalty income decreased $12.9 million or 47.5% in 1997 as compared with
1996 due to the Company's June 1997 acquisition from RPR of the Dilacor XR(R)
product rights. Following this acquisition, no further royalties were earned.
Gross profit margins increased to 61.4% in 1997 from 54.4% in 1996. The
increase in gross profit margins was due largely to sales of Dilacor XR(R),
higher sales of branded dermatology products and sales of products introduced
in 1997. The increased gross profit margins from these products was partially
offset by reduced gross profit margins of certain core off-patent products.
Research and development expenses decreased to $18.1 million in 1997 from
$22.9 million in 1996. Following the mergers with Royce and Oclassen, the
Company consolidated certain research and development functions and eliminated
duplicate programs.
24
Selling, general and administrative expenses increased to $50.9 million in
1997 from $38.9 million in 1996. The increase consists of a $16.8 million
increase in sales and marketing expenses and a $4.8 million decrease in
general and administrative costs. The Company incurred increased sales and
marketing costs as it expanded its marketing efforts for branded products. The
Company increased its sales force from approximately 20 representatives in
late 1996 to more than 300 at December 31, 1997.
As a result of the mergers of Royce and Oclassen with Watson, and the
subsequent consolidation of many of the administrative functions, the Company
has experienced a decrease in its general and administrative expenses. As a
percentage of net sales, general and administrative costs decreased from 8.1%
in 1996 to 4.1% in 1997. This decrease reflects efficiencies achieved
following the mergers and the fact that the Company's sales growth outpaced
the growth in administrative costs.
Amortization expense in 1997 increased to $7.2 million from $386,000 due to
several significant product right acquisitions during the year. The Company
amortizes these acquired product rights over 17 years.
In 1997, the Company recorded one-time charges of $14.7 million for costs
incurred in connection with the mergers with Royce and Oclassen. These costs
included investment banking fees and other merger-related expenses. No such
expenses were incurred in 1996.
Equity in earnings from joint ventures decreased $7.2 million or 40.2% to
$10.7 million in 1997 compared to $17.9 million in 1996, due primarily to
lower earnings from Somerset. The decrease in Somerset earnings is due in part
to the loss of exclusivity for Eldepryl(R) in June 1996. During 1997 and 1996,
a number of competitors introduced off-patent tablets to compete with
Eldepryl(R) capsules. Increased competition and research and development
spending in support of various clinical trials have significantly reduced
Somerset's contribution to the Company's operating results.
Investment and other income increased 16.5% to $12.0 million in 1997 from
$10.3 million in 1996 due to higher average cash and marketable securities
balances in 1997.
The provision for income taxes increased to $54.4 million in 1997, compared
to $35.9 million in 1996. The effective income tax rate was 38% and 31% for
the years ended December 31, 1997 and 1996, respectively. The increase in the
Company's effective income tax rate was due primarily to the non-deductibility
of a significant portion of merger expenses incurred in 1997 and lower
earnings from Somerset which are partially exempt from tax.
LIQUIDITY AND CAPITAL RESOURCES
The Company's working capital increased to $198.5 million at December 31,
1998 from $146.9 million at December 31, 1997. This $51.6 million increase was
primarily due to cash flows from operations ($117.7 million) and proceeds from
the offering of senior notes ($148.4 million), offset by the acquisition of
women's health products ($120.0 million), the acquisition of Rugby ($67.5
million) and capital expenditures ($26.5 million). The Company's $26.5 million
of capital investment in 1998 consisted primarily of additions to land,
buildings and manufacturing and laboratory equipment. Watson expects to invest
approximately $40.0 million in capital expenditures during 1999.
In April 1998, the Company filed a registration statement with the
Securities and Exchange Commission which allows Watson to raise up to $300.0
million from offerings of senior or subordinated debt securities, common
stock, preferred stock or a combination thereof, at such times and in such
amounts as Watson deems appropriate. In May 1998, pursuant to this
registration statement, the Company issued $150.0 million of 7 1/8% senior
unsecured notes (the "Senior Notes"). The Company had notes payable
outstanding of approximately $150.9 million at December 31, 1998. These notes
consist of the Senior Notes and other notes payable of approximately $2.4
million. The Senior Notes are due May 2008, with interest-only payments due
semi-annually in November and May.
25
In January 1999, the Company made a scheduled payment of $30.0 million
pursuant to the purchase of the product rights to Dilacor XR(R). Additional
payments of $15.0 million and $5.0 million will be due in January 2000 and
January 2001, respectively.
The Company's cash and marketable securities totaled $72.7 million at
December 31, 1998. Management believes that the Company's cash and marketable
securities, plus cash flow from operations will be sufficient to meet its
normal operating requirements during the coming year.
The Company continues to review additional opportunities to acquire or
invest in companies, technologies, product rights and other investments that
are compatible with its existing business. Watson could use sources other than
cash, such as offerings under the registration statement discussed herein or
other such registration statements, to fund additional acquisitions or
investments. If any such acquisition or investment is completed, the Company's
operating results and financial condition could change materially in future
periods.
Management believes inflation does not have, and has not had, a significant
impact on the Company's revenues or operations.
YEAR 2000 COMPLIANCE PROGRAM
Watson has instituted a multi-phase program to (a) evaluate whether its
computerized information systems are able to interpret dates beyond the year
1999, (b) to respond to and remedy any inadequacies which may emerge from the
evaluation process, (c) to investigate the Year 2000 readiness of third
parties having material relationships with the Company and (d) to develop a
contingency plan for any Year 2000 date sensitive systems of the Company,
which may not be immediately remedied (the "Year 2000 Compliance Program"). An
inability to interpret dates beyond 1999 could cause computer system errors or
system failure, potentially leading to disruptions in operations. The
aggregate cost of Watson's Year 2000 Compliance Program is expected to be
approximately $500,000. The scope of the Company's Year 2000 Compliance
Program was initially focused on Watson's primary business application
systems, including manufacturing, sales, distribution and finance. The
evaluation and remedy phases have been completed for these business units and
management believes that these systems are currently Year 2000 compliant.
Additionally, the Company is evaluating all internal network systems, personal
computers and telecommunications systems. These systems are expected to be
Year 2000 compliant by approximately April 1999. In the third quarter of 1998,
Watson began the third phase in its Year 2000 Compliance Program, which is a
review of external entities having material relationships with the Company.
Communications with these entities is underway and the Company expects this
phase to be completed by June 1999.
Watson is developing a contingency plan for unanticipated Year 2000 exposure
as part of its overall efforts to ensure that its systems are Year 2000
compliant on a timely basis. This contingency plan includes the procurement of
additional raw material, packaging material and finished goods inventory, the
installation of back-up power generation systems and the implementation of
parallel procedures in key operating areas, among other measures.
The Company's management believes that an adequate program is in place in
order to be Year 2000 compliant, however, there can be no assurance that this
program ultimately will be successful. Any unanticipated failure in the
Company's internal systems to be Year 2000 compliant, or any failure by a
material third party to bring its own systems into compliance, could have a
material adverse effect on Watson's business, its financial position and its
results of operations.
The foregoing represents a Year 2000 readiness disclosure entitled to
protection as provided in the Year 2000 Information and Readiness Disclosure
Act.
26
NEW ACCOUNTING PRONOUNCEMENTS
In 1998, the Company adopted Financial Accounting Standards No. 131,
"Disclosures about Segments of an Enterprise and Related Information," (FAS
131). FAS 131 supercedes FAS 14, "Financial Reporting for Segments of a
Business Enterprise," and replaces the "industry segment" approach with the
"management" approach. The management approach designates the internal
organization that is used by management for making operating decisions and
assessing performance as the source of the Company's reportable segments.
Watson has one reportable segment, pharmaceutical products.
In 1998, the Company adopted Financial Accounting Standards No. 130,
"Reporting Comprehensive Income," (FAS 130). FAS 130 established new rules for
the reporting and display of comprehensive income and its components in the
financial statements. Comprehensive income includes all changes in equity
during a period except those resulting from investments by and distributions
to the Company's stockholders. Watson's comprehensive income is comprised of
net income and the unrealized gain on equity securities. The adoption of FAS
130 had no effect on the Company's consolidated results of operations,
financial position or cash flows.
In March 1998, the American Institute of Certified Public Accountants issued
Statement of Position (SOP) 98-1, "Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use." This SOP provides guidance
on accounting for certain costs in connection with obtaining or developing
computer software for internal use and requires that entities capitalize such
costs once certain criteria are met. The Company is required to adopt SOP 98-1
as of January 1, 1999.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Substantially all of the Company's cash equivalents and marketable
securities are at fixed interest rates and, as such, the fair value of these
instruments is affected by changes in market interest rates. However, all of
the Company's cash equivalents and marketable securities mature within one
year. As a result, the Company believes that the market risk arising from its
holding of these financial instruments is minimal.
The Company's investment in Andrx, which was stated on Watson's balance
sheet at a fair value of $138.0 million at December 31, 1998, is composed of
2.7 million shares of Andrx common stock. Andrx' common stock is a publicly
traded equity security, and therefore, has exposure to price risk. The
following table sets forth the Andrx quarterly high and low share price
information for 1997 and 1998:
1997, by quarter High Low
---------------- ------ ------
First...................................................... $26.75 $15.25
Second..................................................... $38.75 $20.50
Third...................................................... $45.63 $31.75
Fourth..................................................... $47.00 $28.75
1998, by quarter
----------------
First...................................................... $38.25 $24.50
Second..................................................... $42.63 $28.13
Third...................................................... $43.00 $25.88
Fourth..................................................... $51.69 $24.63
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by this item is contained in the financial
statements set forth in Item 14(a) under the caption "Consolidated Financial
Statements" as a part of this report.
27
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
There have been no changes in or disagreements with accountants on
accounting or financial disclosure matters during the Company's fiscal years
ended December 31, 1998, 1997 and 1996.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Directors
The information concerning directors of the Company required under this Item
is incorporated herein by reference to the Company's definitive proxy
statement pursuant to Regulation 14A, to be filed with the Commission not
later than 120 days after the close of the Company's fiscal year ended
December 31, 1998.
Executive Officers
The information concerning executive officers of the Company required under
this Item is provided under Item 4A.
ITEM 11. EXECUTIVE COMPENSATION
The information required under this Item is incorporated herein by reference
to the Company's definitive proxy statement pursuant to Regulation 14A, to be
filed with the Commission not later than 120 days after the close of the
Company's fiscal year ended December 31, 1998.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required under this Item is incorporated herein by reference
to the Company's definitive proxy statement pursuant to Regulation 14A, to be
filed with the Commission not later than 120 days after the close of the
Company's fiscal year ended December 31, 1998.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required under this Item is incorporated herein by reference
to the Company's definitive proxy statement pursuant to Regulation 14A, filed
with the Commission within 120 days after the close of the Company's fiscal
year ended December 31, 1998.
28
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a)(1) Consolidated Financial Statements
The following are included herein under Item 8:
Page
----
Reports of Independent Accountants....................................... F-2
Consolidated Balance Sheets as of December 31, 1998 and 1997............. F-5
Consolidated Statements of Income for each of the three years in the
period ended December 31, 1998.......................................... F-6
Consolidated Statements of Stockholders' Equity for each of the three
years in the period ended December 31, 1998............................. F-7
Consolidated Statements of Cash Flows for each of the three years in the
period ended December 31, 1998.......................................... F-8
Notes to Consolidated Financial Statements............................... F-10
(a)(2) Financial Statement Schedules
None.
All financial statement schedules are omitted because they are not
applicable or the required information is included in the Consolidated
Financial Statements or notes thereto.
(a)(3) Exhibits
Exhibit No. Description
----------- -----------
2.1 Agreement and Plan of Merger, among Watson Pharmaceuticals, Inc., TheraTech, Inc.
and the Jazz Merger Corp. dated as of October 23, 1998, incorporated by
reference to Appendix A of the Proxy Statement/Prospectus included in the
Registration Statement on Form S-4 (Reg. No. 333-68007) dated November 25, 1998,
and hereby incorporated by reference.
3.1 Articles of Incorporation of the Company and all amendments thereto, filed as
Exhibit 3.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended
June 30, 1995 and Exhibit 3.1(A) to the Company's Quarterly Report on Form 10-Q
for the quarter ended June 30, 1996 and hereby incorporated by reference.
3.2 Registrant's By-laws, as amended as of December 11, 1998, filed as Exhibit 3.2 to
the Registrant's Registration Statement on Form S-8 (Reg. No. 333-70933) on
January 19, 1999 and hereby incorporated by reference.
4.1 Trust Indenture dated May 18, 1998 between the Company and First Union National
Bank, as Trustee for the issuance of the Company's Senior Unsecured Notes, filed
as Exhibit 4.1 to the Company's Registration Statement on Form S-3/A (Reg. No.
333-49079) on April 30, 1999 and hereby incorporated by reference.
4.2 Credit Agreement dated February 3, 1999 between Watson Pharmaceuticals, Inc. and
Mellon Bank N.A.
10.1 Lease between Westgate Associates and the Company dated October 1991 and
addendums thereto, filed as Exhibit 10.5 to the Company's Registration Statement
on Form S-1, Reg. No. 33-46229 ("33-46229") and hereby incorporated by
reference.
10.2 Industrial Real Estate Lease, as amended, dated August 8, 1995, between Hsi-
Hsiung Hsu Hwa Chao (Chao Family) Trust I and the Company, filed as Exhibit 10.1
to the Company's Quarterly Report on Form 10-Q for the quarter ended September
30, 1995 and hereby incorporated by reference.
29
Exhibit No. Description
----------- -----------
10.3 Third Amendment to Industrial Real Estate Lease dated August 31, 1998, between
Hsi-Hsiung and Hsu Hwa Chao (Chao Family) Trust 1 and the Company.
10.4 Lease Agreement dated January 4, 1984 between LaSalle National Bank, as Trustee
under Trust Agreement dated March 2, 1997 and Modern Wholesale Drug Midwest,
Inc. d/b/a Rugby Laboratories, as amended.
10.5 Lease Agreement dated April 27, 1995 between Palmetto Lakes Realty Associates,
Inc. and Royce Laboratories, Inc., filed as Exhibit 10.7 to Royce Laboratories,
Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1995
and hereby incorporated by reference.
*10.6 1991 Stock Option Plan of the Company as revised, filed as Exhibit 10.1 to the
Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1995 and
hereby incorporated by reference.
*10.6(a) Amendment to the 1991 Stock Option Plan of the Company, filed as Exhibit 10.6(a)
to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30,
1996 and hereby incorporated by reference.
*10.6(b) Amendment to the 1991 Stock Option Plan of the Company, filed as Exhibit 10.6(a)
to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31,
1997 and hereby incorporated by reference.
*10.7 1995 Non-Employee Directors' Stock Option Plan, as amended, filed as Exhibit 10.2
to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30,
1995 and hereby incorporated by reference.
*10.8 Senior Executive Employment Agreement dated as of May 29, 1995 between the
Company and Allen Chao, filed as Exhibit 10.1 to 33-60211 and hereby
incorporated by reference.
*10.9 Senior Executive Employment Agreement dated as of May 29, 1995 between the
Company and David C. Hsia, filed as Exhibit 10.2 to 33-60211 and hereby
incorporated by reference.
*10.10 Employment Agreement dated as of July 27, 1998 between the Company and Michael E.
Boxer.
10.11 Release, Exit and Consulting Agreement between Alec D. Keith Ph.D. and the
Company, dated July 18, 1996, filed as Exhibit 10.15 to the Company's Quarterly
Report on Form 10-Q for the quarter ended September 30, 1996 and hereby
incorporated by reference.
10.12 Intellectual Property Agreement between Alec D. Keith, Ph.D. and the Company
dated as of July 18, 1996, filed as Exhibit 10.15 to the Company's Annual Report
on Form 10-K for the fiscal year ended December 31, 1996 and hereby incorporated
by reference.
*10.13 Consulting Agreement between Patrick J. McEnany and the Company dated January 31,
1998, and filed as Exhibit 10.20(a) to the Company's Annual Report on Form 10-K
for the fiscal year ended December 31, 1997 and hereby incorporated by
reference.
*10.14s Amendment to Stock Option Agreement between Patrick J. McEnany and the Company
dated January 29, 1998, and filed as Exhibit 10.20(b) to the Company's Annual
Report on Form 10-K for the fiscal year ended December 31, 1997 and hereby
incorporated by reference.
10.15 License Agreement between the Company and Rorer Pharmaceutical Products, Inc.,
dated June 30, 1997, filed as Exhibit 10.1 to the Company's Current Report 8-K
dated June 30, 1997 and hereby incorporated by reference.
10.16 Inventory Purchase Agreement between the Company and Rhone-Poulenc Rorer
Pharmaceuticals, Inc., dated June 30, 1997, filed as Exhibit 10.2 to the
Company's Current Report 8-K dated June 30, 1997 and hereby incorporated by
reference.
10.17 Manufacturing and Supply Agreement between the Company and Rhone-Poulenc Rorer
Pharmaceuticals, Inc., dated June 30, 1997, filed as Exhibit 10.3 to the
Company's Current Report on Form 8-K dated June 30, 1997 and hereby incorporated
by reference.
30
Exhibit No. Description
----------- -----------
10.18 Agreement Regarding Partnership Termination by and among Rhone-
Poulenc Rorer Inc., Rhone-Poulenc Rorer Pharmaceuticals, Inc.,
Watson Pharmaceuticals, Inc., Circa Pharmaceuticals, Inc., and
BOL, Inc., dated June 30, 1997, filed as Exhibit 10.4 to the
Company's Current Report on Form 8-K dated June 30, 1997 and
hereby incorporated by reference.
10.19 Asset Purchase Agreement among the Company, G. D. Searle & Co. and
SCS Pharmaceuticals, dated September 30, 1997, filed as Exhibit
10.1 to the Company's Current Report on Form 8-K dated October
16, 1997 and hereby incorporated by reference.
10.20 Supply Agreement between the Company and G. D. Searle & Co., dated
October 16, 1997, filed as Exhibit 10.2 to the Company's Current
Report on Form 8-K dated October 16, 1997 and hereby incorporated
by reference.
10.21 Stock Purchase Agreement among the Company, Hoechst Marion
Roussel, Inc. and Marisub, Inc. dated August 25, 1997, filed as
Exhibit 10.27.
10.21(a) Amendment to Stock Purchase Agreement among the Company, Hoechst
Marion Roussel, Inc. and Marisub, Inc. dated November 26, 1997,
filed as Exhibit 10.27(a) to the Company's Annual Report on Form
10-K for the fiscal year ended December 31, 1997 are hereby
incorporated by reference.
10.21(b) Second Amendment to Stock Purchase Agreement by and among the
Company, Hoechst Marion Roussel, Inc. and Marisub, Inc. dated
February 27, 1998, filed as Exhibit 10.27(b) to the Company's
Annual Report on Form 10-K for the fiscal year ended December 31,
1997 are hereby incorporated by reference.
10.22 Supply and License Agreement by and between Hoechst Marion
Roussel, Inc. and The Rugby Group, Inc. dated February 27, 1998,
filed as Exhibit 10.28 to the Company's Annual Report on Form 10-
K for the fiscal year ended December 31, 1997 are hereby
incorporated by reference.
10.23 Contract Manufacturing Agreement by and between Hoechst Marion
Roussel, Inc. and The Rugby Group, Inc., dated February 27, 1998,
filed as Exhibit 10.29 to the Company's Annual Report on Form 10-
K for the fiscal year ended December 31, 1997, and hereby
incorporated by reference.
10.24 Asset Purchase Agreement by and between Watson Laboratories, Inc.
and G. D. Searle & Co. dated September 18, 1998 and filed as
Exhibit 10.1 to the Company's Report on Form 8-K dated November
18, 1998.
10.25 Supply Agreement by and between the Company and G. D. Searle & Co.
dated November 18, 1998 filed as Exhibit 10.2 to the Company's
Report on Form 8-K dated November 18, 1998.
22.1 Subsidiaries of the Company
23.1 Consent of PricewaterhouseCoopers LLP.
23.2 Consent of Deloitte & Touche LLP.
23.3 Consent of Arthur Andersen LLP.
27.1 Financial Data Schedule (EDGAR version only).
- --------
* Compensation Plan or Agreement
(b)Reports on Form 8-K:
1. On December 3, 1998, the Company filed a Form 8-K Report dated
November 18, 1998 to disclose its acquisition from G. D. Searle & Co. of
the U.S. rights to three branded oral contraceptives, Tri-Norinyl(R),
Brevicon(R) and Norinyl(R) for $120 million cash.
2. Subsequent to the end of the fiscal year, on January 29, 1999 the
Company filed a Form 8-K Report dated January 15, 1999 to announce
consummation of the Company's merger with TheraTech, Inc.
31
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.
WATSON PHARMACEUTICALS, INC.
(Registrant)
/s/ Allen Y. Chao
By: _________________________________
Allen Y. Chao, Ph.D.
Chairman, President and Chief
Executive Officer
(Principal Executive Officer)
/s/ Michael E. Boxer
By: _________________________________
Michael E. Boxer
Chief Financial Officer
(Principal Financial Officer)
/s/ R. Chato Abad
By: _________________________________
R. Chato Abad
Vice President-Finance
(Principal Accounting Officer)
Date: March 30, 1999
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
Signature Title Date
--------- ----- ----
/s/ Allen Y. Chao Chairman, President and March 30, 1999
____________________________________ Chief Executive Officer
Allen Y. Chao, Ph.D.
/s/ Michael J. Fedida Director March 30, 1999
____________________________________
Michael J. Fedida
/s/ Michel J. Feldman Director March 30, 1999
____________________________________
Michel J. Feldman
/s/ Albert F. Hummel Director March 30, 1999
____________________________________
Albert F. Hummel
/s/ Alec D. Keith Director March 30, 1999
____________________________________
Alec D. Keith, Ph.D.
/s/ Ronald R. Taylor Director March 30, 1999
____________________________________
Ronald R. Taylor
/s/ Andrew L. Turner Director March 30, 1999
____________________________________
Andrew L. Turner
32
INDEX TO FINANCIAL STATEMENTS
Page
----
Reports Of Independent Accountants........................................ F-2
Consolidated Balance Sheets as of December 31, 1998 and 1997.............. F-5
Consolidated Statements of Income for each of the three years in the
period ended
December 31, 1998........................................................ F-6
Consolidated Statements of Stockholders' Equity for each of the three
years in the period
ended December 31, 1998.................................................. F-7
Consolidated Statements of Cash Flows for each of the three years in the
period ended
December 31, 1998........................................................ F-8
Notes to Consolidated Financial Statements................................ F-10
All financial statement schedules are omitted because they are not applicable
or the required information is included in the Consolidated Financial
Statements or notes thereto.
F-1
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders
of Watson Pharmaceuticals, Inc.
In our opinion, based upon our audits and the reports of other auditors, the
consolidated financial statements listed in the accompanying index on page F-1
present fairly, in all material respects, the financial position of Watson
Pharmaceuticals, Inc. and its subsidiaries at December 31, 1998 and 1997, and
the results of their operations and their cash flows for each of the three
years in the period ended December 31, 1998, in conformity with generally
accepted accounting principles. These financial statements are the
responsibility of the Company's management; our responsibility is to express
an opinion on these financial statements based on our audits. We did not audit
the financial statements of Somerset Pharmaceuticals, Inc. (Somerset), an
entity which is 50% owned by the Company, as of December 31, 1997 and for the
years ended December 31, 1997 and 1996. The Company's investment in Somerset
aggregated $27,643,000 at December 31, 1997, and its equity in the earnings of
Somerset totaled $12,672,000 and $20,100,000 for the years ended December 31,
1997 and 1996, respectively. In addition, we did not audit the financial
statements of Oclassen Pharmaceuticals, Inc. (Oclassen), a wholly owned
subsidiary, for the year ended December 31, 1996, which statements reflect
total revenues of $34,421,000 for the year ended December 31, 1996. Those
statements were audited by other auditors whose reports thereon have been
furnished to us, and our opinion expressed herein, insofar as it relates to
the amounts included for Somerset and Oclassen, is based solely on the reports
of each of the respective other auditors. We conducted our audits of these
statements in accordance with generally accepted auditing standards which
require that we plan and perform the audit to obtain reasonable assurance
about whether the financial statements are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits and the
respective reports of other auditors provide a reasonable basis for the
opinion expressed above.
PRICEWATERHOUSECOOPERS LLP
Los Angeles, California
February 17, 1999
F-2
INDEPENDENT AUDITORS' REPORT
To the Board of Directors of
Somerset Pharmaceuticals, Inc.:
We have audited the accompanying consolidated balance sheets of Somerset
Pharmaceuticals, Inc. and subsidiaries as of December 31, 1997 and 1996, and
the related consolidated statements of income, stockholders' equity, and cash
flows for each of the three years in the period ended December 31, 1997 (not
presented separately herein). These financial statements are the
responsibility of the Company's management. Our responsibility is to express
an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, such consolidated financial statements present fairly, in
all material respects, the financial position of Somerset Pharmaceuticals,
Inc. and subsidiaries as of December 31, 1997 and 1996, and the results of
their operations and their cash flows for each of the years in the period
ended December 31, 1997 in conformity with generally accepted accounting
principles.
DELOITTE & TOUCHE LLP
Pittsburgh, Pennsylvania
February 4, 1998
F-3
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Oclassen Pharmaceuticals, Inc.:
We have audited the balance sheet of Oclassen Pharmaceuticals, Inc. (a
Delaware corporation) as of December 31, 1996, and the related statements of
income, stockholders' equity (deficit) and cash flows for the year then ended
(not presented herein). These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audit provides a reasonable basis
for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Oclassen Pharmaceuticals,
Inc. as of December 31, 1996, and the results of its operations and its cash
flows for the year then ended in conformity with generally accepted accounting
principles.
ARTHUR ANDERSEN LLP
Oakland California
January 17, 1997
F-4
WATSON PHARMACEUTICALS, INC.
CONSOLIDATED BALANCE SHEETS
(In Thousands, Except Share Data)
December 31,
-------------------
1998 1997
---------- --------
ASSETS
Current assets:
Cash and cash equivalents.................................. $ 45,728 $ 82,837
Marketable securities...................................... 26,923 32,102
Accounts receivable, net of allowances for doubtful
accounts of $3,902 and $2,140............................. 97,227 65,068
Inventories................................................ 78,781 46,967
Prepaid expenses and other current assets.................. 14,962 416
Deferred tax assets........................................ 29,634 19,399
---------- --------
Total current assets...................................... 293,255 246,789
Property and equipment, net................................. 109,136 88,004
Investments and other assets................................ 193,151 131,083
Product rights and other intangibles, net................... 474,501 289,129
---------- --------
$1,070,043 $755,005
========== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses...................... $ 63,792 $ 44,423
Income taxes payable....................................... -- 9,553
Current portion of long-term debt.......................... 989 864
Current liability from acquisition of product rights....... 30,000 45,000
---------- --------
Total current liabilities................................. 94,781 99,840
Long-term debt.............................................. 149,872 2,385
Long-term liability from acquisition of product rights...... 20,000 50,000
Deferred tax liabilities.................................... 54,512 36,887
---------- --------
Total liabilities......................................... 319,165 189,112
---------- --------
Commitments and contingencies
Minority interest........................................... 400 859
---------- --------
Stockholders' equity:
Preferred stock; no par value per share, 2,500,000 shares
authorized; none outstanding
Common stock; par value of $0.0033 per share, 500,000,000
shares authorized; issued: 89,508,079 shares in 1998 and
87,882,233 shares in 1997.................................. 295 290
Additional paid-in capital.................................. 293,672 256,682
Retained earnings........................................... 395,866 275,037
Accumulated other comprehensive income...................... 60,645 33,025
---------- --------
Total stockholders' equity................................ 750,478 565,034
---------- --------
$1,070,043 $755,005
========== ========
See accompanying notes to consolidated financial statements.
F-5
WATSON PHARMACEUTICALS, INC.
CONSOLIDATED STATEMENTS OF INCOME
(In Thousands, Except Earnings per Share)
For The Years Ended
December 31,
----------------------------
1998 1997 1996
-------- -------- --------
Product sales, net............................... $556,148 $324,015 $223,639
Cost of sales.................................... 208,657 125,057 101,921
-------- -------- --------
Gross profit................................. 347,491 198,958 121,718
-------- -------- --------
Royalty income................................... -- 14,249 27,162
-------- -------- --------
Operating expenses:
Research & development......................... 30,825 18,055 22,895
Selling, general & administrative.............. 88,435 50,937 38,891
Amortization................................... 22,469 7,213 386
Charge for acquired in-process research and
development................................... 13,000 -- --
Merger expenses................................ -- 14,718 --
-------- -------- --------
Total operating expenses..................... 154,729 90,923 62,172
-------- -------- --------
Operating income............................. 192,762 122,284 86,708
-------- -------- --------
Other income (expense):
Equity in earnings of joint ventures........... 6,789 10,694 17,909
Investment and other income.................... 6,588 11,967 10,282
Interest expense............................... (7,063) (347) (421)
-------- -------- --------
Total other income, net...................... 6,314 22,314 27,770
-------- -------- --------
Income before income tax provision........... 199,076 144,598 114,478
Provision for income taxes....................... 78,247 54,414 35,916
-------- -------- --------
Net income................................... $120,829 $ 90,184 $ 78,562
======== ======== ========
Basic earnings per share..................... $ 1.36 $ 1.04 $ 0.92
======== ======== ========
Diluted earnings per share................... $ 1.32 $ 1.01 $ 0.89
======== ======== ========
Weighted average shares outstanding, no
dilution........................................ 89,078 86,991 85,028
======== ======== ========
Weighted average shares outstanding, diluted
basis........................................... 91,593 89,325 88,081
======== ======== ========
See accompanying notes to consolidated financial statements.
F-6
WATSON PHARMACEUTICALS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(In Thousands)
Accumulated
Additional Other Total
Common Stock Paid-in Comprehensive Retained Comprehensive Stockholders'
Shares Amount Capital Income Earnings Income Equity
------ ------ ---------- ------------- -------- ------------- -------------
Balance at December 31,
1995................... 84,174 $278 $214,418 $ -- $106,291 $ (235) $320,752
Exercise of
options/warrants....... 1,259 4 9,331 -- -- -- 9,335
Tax benefits related to
exercise of options.... -- -- 7,762 -- -- -- 7,762
Net income.............. -- -- -- 78,562 78,562 -- 78,562
Other comprehensive
income:
Amortization of
unearned
compensation.......... -- -- -- 856 -- -- --
Unrealized gains on
securities............ -- -- -- 6,568 -- -- --
-------
Other comprehensive
income................ -- -- -- 7,424 -- 7,424 7,424
-------
Comprehensive income... -- -- -- 85,986 -- -- --
------ ---- -------- ------- -------- ------- --------
Balance at December 31,
1996................... 85,433 282 231,511 -- 184,853 7,189 423,835
Exercise of
options/warrants....... 2,449 8 14,289 -- -- -- 14,297
Tax benefits related to
exercise of options.... -- -- 10,882 -- -- -- 10,882
Net income.............. -- -- -- 90,184 90,184 -- 90,184
Unrealized gains on
securities............ -- -- -- 25,836 -- 25,836 25,836
-------
Comprehensive income... -- -- -- 116,020 -- -- --
------ ---- -------- ------- -------- ------- --------
Balance at December 31,
1997................... 87,882 290 256,682 -- 275,037 33,025 565,034
Exercise of
options/warrants....... 1,626 5 23,397 -- -- -- 23,402
Tax benefits related to
exercise of options.... -- -- 13,593 -- -- -- 13,593
Net income.............. -- -- -- 120,829 120,829 -- 120,829
Unrealized gains on
securities............ -- -- -- 27,620 -- 27,620 27,620
-------
Comprehensive income... -- -- -- 148,449 -- -- --
------ ---- -------- ------- -------- ------- --------
Balance at December 31,
1998................... 89,508 $295 $293,672 $ -- $395,866 $60,645 $750,478
====== ==== ======== ======= ======== ======= ========
See accompanying notes to consolidated financial statements.
F-7
WATSON PHARMACEUTICALS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousands)
For The Years Ended December
31,
------------------------------
1998 1997 1996
--------- --------- --------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income................................... $ 120,829 $ 90,184 $ 78,562
--------- --------- --------
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation............................... 8,848 7,381 7,283
Amortization............................... 22,469 7,213 1,342
Charge for acquired in-process research and
development............................... 13,000 -- --
Deferred income tax provision (benefit).... 1,593 (1,948) 20,399
Dividends received from Somerset........... -- 8,000 18,000
Equity in earnings of joint ventures....... (5,706) (9,012) (14,684)
Provision for (recovery of) doubtful
accounts and allowances................... 762 (66) 604
Tax benefits related to exercise of
options................................... 13,593 10,882 7,752
Changes in assets and liabilities, net of
acquisitions:
Accounts receivable....................... (16,955) (32,133) (1,857)
Royalty receivable........................ -- 5,554 2,651
Inventories............................... (18,311) (14,538) (2,332)
Prepaid expenses and other current
assets................................... (10,848) 5,965 (1,053)
Other assets.............................. (1,855) (2,155) (2,386)
Accounts payable and accrued expenses..... (133) 12,665 (4,867)
Income taxes payable...................... (9,553) 9,081 (2,512)
--------- --------- --------
Total adjustments....................... (3,096) 6,889 28,340
--------- --------- --------
Net cash provided by operating
activities........................... 117,733 97,073 106,902
--------- --------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Additions to property and equipment.......... (26,467) (13,640) (12,375)
Purchase of marketable securities............ (69,000) (130,321) (840,969)
Proceeds from maturities of marketable
securities.................................. 73,192 179,118 801,179
Acquisitions of product rights............... (177,322) (144,171) --
Acquisitions of businesses................... (71,559) -- --
Investment in Andrx.......................... -- (15,307) --
Additions to investment in joint ventures.... (9,701) (6,496) ( 3,090)
--------- --------- --------
Net cash used in investing
activities........................... $(280,857) $(130,817) $(55,255)
--------- --------- --------
See accompanying notes to consolidated financial statements.
F-8
WATSON PHARMACEUTICALS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)
(In Thousands)
For the Years Ended
December 31,
-----------------------------
1998 1997 1996
-------- --------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of long-term debt..... $148,418 $ -- $ 743
Principal payments on long-term debt......... (806) (1,640) (886)
Payments on liability for acquisition of
product rights.............................. (45,000) (55,000) --
Proceeds from exercises of stock options and
warrants.................................... 23,403 15,000 9,210
-------- --------- --------
Net cash provided by (used in) financing
activities................................ 126,015 (41,640) 9,067
-------- --------- --------
Net (decrease) increase in cash and cash
equivalents................................... (37,109) (75,384) 60,714
Cash and cash equivalents at beginning of
year.......................................... 82,837 158,221 97,507
-------- --------- --------
Cash and cash equivalents at end of year....... $ 45,728 $ 82,837 $158,221
======== ========= ========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW
INFORMATION:
Cash paid during the years for:
Interest................................... $ 5,493 $ 336 $ 422
Income taxes............................... $ 82,917 $ 36,734 $ 10,376
SUPPLEMENTAL DISCLOSURES OF NONCASH INVESTING
AND FINANCING ACTIVITIES:
Acquisitions of product rights:
Fair value of assets acquired.............. $ -- $(294,171) $ --
Fair value of liabilities assumed.......... -- 150,000 --
-------- --------- --------
Net cash paid............................ $ -- $(144,171) $ --
-------- --------- --------
Acquisitions of businesses:
Fair value of assets acquired.............. $(97,323) $ -- $ --
Fair value of liabilities assumed.......... 25,764 -- --
-------- --------- --------
Net cash paid............................ $(71,559) $ -- $ --
-------- --------- --------
See accompanying notes to consolidated financial statements.
F-9
WATSON PHARMACEUTICALS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Description of Business and Significant Accounting Policies
Description of business and principles of consolidation
Watson Pharmaceuticals, Inc. ("Watson" or the "Company") is engaged in the
development, production, marketing and distribution of branded and off-patent
pharmaceutical products. The consolidated financial statements include the
accounts of wholly owned and majority-owned subsidiaries after elimination of
intercompany accounts and transactions. The preparation of consolidated
financial statements in conformity with generally accepted accounting
principles requires management to make estimates and assumptions that affect
the reported amounts in the financial statements and accompanying notes.
Actual results could differ from those estimates.
The Company's significant wholly owned subsidiaries include Watson
Laboratories, Inc., Circa Pharmaceuticals, Inc. ("Circa"), Oclassen
Pharmaceuticals, Inc. ("Oclassen"), Royce Laboratories, Inc. ("Royce") and The
Rugby Group, Inc. ("Rugby"). Watson acquired certain of these subsidiaries
through acquisitions in 1998 and earlier years. See Note 2 for further
information on the Company's merger and acquisition activities.
Investments are accounted for under the equity method where the Company can
exert significant influence and ownership does not exceed 50% (primarily
Somerset Pharmaceuticals, Inc.) Investments in which the Company holds less
than a 20% interest and does not exert significant influence are accounted for
under the cost method, adjusted to fair value. The Company's investment in
Andrx Corporation ("Andrx") is accounted for under the cost method.
Cash equivalents and marketable securities
Cash equivalents are highly liquid investments with original maturities of
three months or less at the date of acquisition. Marketable securities consist
primarily of time deposits, commercial paper, U.S. and state and local
government debt with original maturities between three and twelve months.
The Company accounts for investments in accordance with Financial Accounting
Standards No. 115 (FAS 115), "Accounting for Certain Investments in Debt and
Equity Securities." Under FAS 115, debt securities that the Company does not
have the positive intent and ability to hold to maturity and all marketable
equity securities are carried at fair market value and are classified as
either trading or available-for-sale securities. All of the Company's cash
equivalents and marketable securities are classified as available-for-sale
securities. Unrealized gains or losses on these securities are excluded from
earnings and are reported as a separate component of stockholders' equity, net
of applicable income taxes, until realized. Realized gains and losses are
determined on the specific identification method and are reported in
investment and other income. Realized gains and losses were not material for
the years ended December 31, 1998, 1997 and 1996.
The fair value of cash, cash equivalents and marketable securities is
summarized as follows:
December 31,
-----------------
1998 1997
-------- --------
(in thousands)
U.S. government debt..................................... $ 14,824 $ 27,996
State and local government debt.......................... 23,143 2,300
Corporate and other non-government debt.................. 7,317 45,972
Equity securities........................................ -- 3,006
Money market funds and cash.............................. 27,367 35,665
-------- --------
$ 72,651 $114,939
======== ========
F-10
WATSON PHARMACEUTICALS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Fair value of financial instruments
The carrying amounts of cash and cash equivalents, marketable securities,
accounts receivable, accounts payable and accrued expenses approximate fair
value. The fair value of cash equivalents, marketable securities and the
Company's investment in Andrx is based on quoted market prices at December 31,
1998 and 1997.
Inventories
Inventories are stated at the lower of cost (first-in, first-out method) or
market.
Property and equipment
Property and equipment are stated at cost, less accumulated depreciation.
Major renewals and improvements are capitalized, while routine maintenance and
repairs are expensed as incurred. At the time properties are retired from
service, the cost and accumulated depreciation are removed from the respective
accounts and the related gains or losses are reflected in income.
Depreciation expense is computed principally on the straight-line basis,
over estimated useful lives of two to ten years for furniture, fixtures and
equipment and thirty years for buildings and building improvements. Leasehold
improvements are amortized on the straight-line basis over the shorter of the
respective lease terms or the estimated useful life of the assets, and
generally range from five to thirty years.
Product rights and other intangible assets
Product rights are stated at cost, less accumulated amortization, and are
amortized on the straight-line basis over their estimated useful lives ranging
from seventeen to twenty five years. Goodwill is amortized on the straight-
line basis over twenty years or less and is primarily related to the Company's
acquisition of Rugby (Note 2). Accumulated amortization was $39.1 million and
$15.6 million at December 31, 1998 and 1997, respectively.
Potential impairment of long-lived assets
The Company annually evaluates its long-lived assets, including product
rights, for potential impairment. When circumstances indicate that the
carrying amount of the asset may not be recoverable, as demonstrated by
estimated future cash flows, an impairment loss would be recorded based on
fair value.
Revenue recognition
The Company recognizes revenue, net of sales discounts and allowances, from
the sale of its pharmaceutical products upon shipment.
Product sales to major customers
In 1998, two customers accounted for 17% and 12%, individually, of the
Company's product sales. In 1997, two customers accounted for 12% and 11%,
individually, of the Company's product sales. In 1996, one customer accounted
for 10% of product sales.
Research and development activities
The costs associated with the development, testing and approval of
pharmaceutical products are expensed as incurred.
F-11
WATSON PHARMACEUTICALS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Income taxes
Income taxes are accounted for using an asset and liability approach that
requires the recognition of deferred tax assets and liabilities for the
expected future tax consequences of temporary differences between the
financial statement and tax bases of assets and liabilities at the applicable
tax rates. A valuation allowance is provided when it is more likely than not
that some portion or all of the deferred tax assets will not be realized.
Earnings per share ("EPS")
Basic earnings per share is computed by dividing net income by the weighted
average number of common shares outstanding in each year. Diluted earnings per
share is computed by dividing net income by the weighted average number of
common shares outstanding plus any potential dilution that could occur if
options and warrants were converted into common stock in each year.
In 1997, the Company adopted Financial Accounting Standards No. 128,
"Earnings per Share," (FAS 128). In accordance with the implementation
provisions of FAS 128, the Company has restated earnings per share in its
consolidated statements of income for the year ended December 31, 1996. The
unaudited quarterly data for the first three quarters of 1997 presented in
Note 10 have also been restated to comply with the provisions ofFAS 128. A
reconciliation of the numerators and the denominators of basic and diluted
earnings per share for the years ended December 31, 1998, 1997, and 1996 is as
follows (in thousands, except for EPS):
For the Years Ended
December 31,
------------------------
1998 1997 1996
-------- ------- -------
Basic EPS Computation:
- ----------------------
Net income........................ (numerator) $120,829 $90,184 $78,562
Weighted average shares
outstanding...................... (denominator) 89,078 86,991 85,028
Basic EPS................... $ 1.36 $ 1.04 $ 0.92
======== ======= =======
Diluted EPS Computation:
- ------------------------
Net income........................ (numerator) $120,829 $90,184 $78,562
Weighted average shares
outstanding...................... 89,078 86,991 85,028
Assumed exercise of outstanding
stock options and warrants....... 2,515 2,334 3,053
-------- ------- -------
Weighted average shares
outstanding, diluted basis....... (denominator) 91,593 89,325 88,081
Diluted EPS................. $ 1.32 $ 1.01 $ 0.89
======== ======= =======
In October 1997, the Company effected a two-for-one stock split in the form
of a 100% stock dividend. All share and per share amounts for the reported
periods have been restated to reflect the stock split.
Concentration of credit risk
The Company is subject to a concentration of credit risk with respect to its
accounts receivable balance, all of which is due from service providers,
distributors, wholesalers and chain drug stores in the health care and
pharmaceutical industries throughout the United States. At December 31, 1998
and 1997, approximately 57% and 27%, respectively, of the trade receivable
balances represented amounts due from four customers in 1998 and two customers
in 1997. The Company performs ongoing credit evaluations of its customers and
maintains reserves for potential uncollectible accounts. Actual losses from
uncollectible accounts have been minimal.
F-12
WATSON PHARMACEUTICALS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Recent accounting pronouncements
In 1998, the Company adopted Financial Accounting Standards No.131,
"Disclosures about Segments of an Enterprise and Related Information," (FAS
131). FAS 131 supercedes FAS 14, "Financial Reporting for Segments of a
Business Enterprise," and replaces the "industry segment" approach with the
"management" approach. The management approach designates the internal
organization that is used by management for making operating decisions and
assessing performance as the source of the Company's reportable segments.
Watson has one reportable segment, pharmaceutical products.
In 1998, the Company adopted Financial Accounting Standards No. 130,
"Reporting Comprehensive Income," (FAS 130). FAS 130 established new rules for
the reporting and display of comprehensive income and its components in the
financial statements. Comprehensive income includes all changes in equity
during a period except those resulting from investments by and distributions
to the Company's stockholders. Watson's comprehensive income is comprised of
net income and the unrealized gain on equity securities. The adoption of FAS
130 had no effect on the Company's consolidated results of operations,
financial position or cash flows.
In March 1998, the American Institute of Certified Public Accountants issued
Statement of Position (SOP) 98-1, "Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use." This SOP provides guidance
on accounting for certain costs in connection with obtaining or developing
computer software for internal use and requires that entities capitalize such
costs once certain criteria are met. The Company is required to adopt SOP 98-1
as of January 1, 1999.
Reclassifications
Certain amounts in the 1996 and 1997 financial statements have been
reclassified to conform with the 1998 presentation. These reclassifications
had no effect on net income or retained earnings.
2. Mergers and Acquisitions
Subsequent event--acquisition of TheraTech
In January 1999, Watson's acquisition of TheraTech was completed. TheraTech
is a leading drug-delivery company that developed, manufactured and marketed
innovative products based on its patented and proprietary technologies and
systems. Under the terms of the TheraTech merger agreement, each share of
TheraTech common stock was converted into the right to receive 0.2663 of a
share of the Company's common stock. Accordingly, the Company issued
approximately 5.8 million common shares having a market value of approximately
$329 million on the date of acquisition in exchange for all of the outstanding
common shares of TheraTech. The acquisition qualified as a tax-free merger for
federal income tax purposes and will be accounted for as a pooling of
interests. The Company's 1998 consolidated financial statements do not reflect
the 1999 acquisition of TheraTech. In the first quarter of 1999, Watson
expects to incur a one-time charge related to this acquisition of
approximately $20.0 million. This charge will include investment banking fees,
professional fees and other costs related to consolidating the operations of
the two companies.
1998 acquisition of oral contraceptive products from Searle
In November 1998, Watson acquired the U.S. rights to three Searle oral
contraceptive products for $120.0 million in cash. Watson and Searle have
entered into a supply agreement whereby Watson has the right to purchase from
Searle the products in finished form for two years and in bulk form for an
additional one year period.
F-13
WATSON PHARMACEUTICALS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Acquisition of Rugby
In February 1998, Watson completed its acquisition of Rugby from Hoechst
Marion Roussel, Inc. Rugby developed, manufactured and marketed a wide array
of off-patent pharmaceutical products. Under the terms of the agreement, the
Company acquired Rugby and its abbreviated new drug applications, which
included several licensed products, plus Rugby's sales and marketing
operations for U.S. off-patent and over-the-counter pharmaceutical products.
The transaction also included Rugby's product development group and product
development pipeline. Under the terms of the acquisition agreement, the
Company paid approximately $67.5 million in cash at closing and agreed to
contingent payments based on future sales and operating results. The
acquisition was accounted for as a purchase and Rugby's results of operations
have been recorded in the Company's consolidated financial statements since
the date of acquisition. The excess of the aggregate purchase price over the
fair value of the assets acquired was approximately $30.9 million and is being
amortized over 20 years.
Under the purchase method of accounting, the purchase price is generally
allocated to the acquired assets and liabilities based on their estimated fair
values at the date of acquisition. However, the portion of the purchase price
that is allocated to in-process research and development (IPR&D) is not an
asset, but instead, represents the valuation of acquired, to-be-completed
research projects. As such, the amount that is determined to be IPR&D is
charged to expense at the date of acquisition. In the first quarter of 1998,
in connection with the Rugby acquisition, the Company charged $18.8 million to
IPR&D. This amount was subsequently adjusted to $13.0 million to reflect a
recently revised Securities and Exchange Commission-preferred methodology for
valuing IPR&D.
Watson acquired 13 separate IPR&D projects from Rugby, none of which were
material on an individual basis to the Company. Rugby commenced work on these
projects, all of which relate to the development of off-patent pharmaceutical
drugs, at various dates beginning in late 1994. The Company, in conjunction
with an independent valuation firm, determined the allocation of purchase
price to acquired IPR&D. At the acquisition date, it was estimated that the
acquired projects, on an overall basis, were approximately 70% complete and
would require approximately $8.8 million to complete. The primary factor
considered in determining the amount charged to IPR&D was the estimated future
cash flows of each project. Discount rates that ranged from 16% to 20% were
assigned to each project based on identified risk factor assumptions. The
discounted cash flows were then adjusted by the completion percentages of each
project, as of the acquisition date. The individual project completion
percentages were estimated by dividing project costs incurred through the
acquisition date by the costs expected to complete each project.
The development of pharmaceutical products is subject to numerous risks and
uncertainties including formulation and manufacturing issues, the FDA approval
and monitoring process and competitive risks in the marketplace, among others.
There can be no assurance that any of these projects will achieve full
development, receive the required regulatory approvals or contribute in any
significant manner to Watson's future sales.
Significant acquisitions in 1997 and earlier years are summarized below:
1997 acquisition of oral contraceptive products from Searle
In October 1997, the Company acquired the U.S. rights to certain existing
and future Searle branded off-patent oral contraceptive products. In
accordance with this agreement, cash payments of $51.5 million and
$85.0 million were made to Searle in 1998 and 1997, respectively. Watson and
Searle entered into a supply agreement whereby Watson has the right to
purchase the products for two years from the date of acquisition and,
F-14
WATSON PHARMACEUTICALS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
at the Company's election, for an additional two-year period. Payment for
future products is contingent and due upon receipt of FDA approval. If the FDA
approves these future products, the maximum aggregate acquisition cost for the
remaining future products will be approximately $33.8 million plus certain
contingent payments based on the technology transfer and net aggregate annual
sales of certain of the acquired products.
1997 acquisition of product rights to Dilacor XR(R)
In June 1997, the Company acquired from Rhone-Poulenc Rorer Pharmaceuticals,
Inc. ("RPR") the exclusive U.S. and certain worldwide marketing, sales, and
distribution rights to Dilacor XR(R) for $190.0 million in cash and future
royalties. Watson and RPR entered into a supply agreement whereby Watson has
the right to purchase finished product from RPR through June 1999 and for an
additional one-year period under certain conditions. Prior to the acquisition
of the rights to Dilacor XR(R), the Company earned royalties from RPR sales of
Dilacor XR(R). The Company earned royalties from this product of $14.2 million
for the first six months of 1997 and $27.2 million for the full year of 1996.
Dilacor XR(R) has been available in the U.S. for the treatment of hypertension
since June 1992 and was approved for the treatment of chronic stable angina in
March 1995.
1997 acquisition of Royce
In April 1997, the Company acquired Royce for approximately 5.2 million
shares of its common stock having a market value of approximately $98.0
million at the date of acquisition. Royce developed and manufactured off-
patent prescription drugs in solid dosage forms (tablets and capsules). The
acquisition was accounted for as a pooling of interests and the transaction
qualified as a tax-free merger.
1997 acquisition of Oclassen
In February 1997, the Company acquired Oclassen for approximately 6.6
million shares of its common stock having a market value of approximately
$135.0 million at the date of acquisition. The acquisition was accounted for
as a pooling of interests for accounting purposes and qualified as a tax-free
merger for federal income tax purposes. Oclassen marketed dermatology products
used to prevent and treat skin diseases. In connection with the acquisition,
the Company obtained the rights to the following five Oclassen products:
Monodox(R) (doxycycline monohydrate), Condylox(R) (podofilox 0.5%), Cordran(R)
(flurandrenolide), Cinobac(R) (cinoxacin) and Cormax(TM) (clobetasol
propionate).
1995 acquisition of Circa
In July 1995, the Company acquired Circa for approximately 37.4 million
shares of its common stock having a market value of approximately $698.0
million at the date of acquisition. Circa manufactured off-patent
pharmaceutical products and held investments in Somerset and Andrx. The
acquisition qualified as a tax-free merger for federal income tax purposes and
was accounted for as a pooling of interests.
F-15
WATSON PHARMACEUTICALS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
3. Balance Sheet Components
Selected balance sheet components consisted of the following:
December 31,
-----------------
1998 1997
-------- -------
(in thousands)
Inventories
Raw materials........................................... $ 23,937 $16,905
Work-in-progress........................................ 12,408 9,303
Finished goods.......................................... 42,436 20,759
-------- -------
$ 78,781 $46,967
======== =======
Property and equipment
Buildings and improvements.............................. $ 48,181 $48,206
Leasehold improvements.................................. 12,814 8,722
Land and land improvements.............................. 9,674 5,261
Machinery and equipment................................. 64,294 50,449
Research and laboratory equipment....................... 14,515 9,707
Furniture and fixtures.................................. 3,802 3,183
-------- -------
153,280 125,528
Less accumulated depreciation and amortization.......... (56,368) (47,681)
-------- -------
96,912 77,847
Construction in progress................................ 12,224 10,157
-------- -------
$109,136 $88,004
======== =======
Accounts payable and accrued expenses
Trade accounts payable.................................. $ 33,467 $22,754
Royalties payable....................................... 8,227 6,420
Accrued payroll and benefits............................ 7,120 5,755
Other accrued liabilities............................... 14,978 9,494
-------- -------
$ 63,792 $44,423
======== =======
4. Investments and Other Assets
Investments and other assets consisted of the following:
December 31,
-----------------
1998 1997
-------- --------
(in thousands)
Long-term investments..................................... $138,514 $ 92,233
Investments in joint ventures............................. 46,232 31,626
Other assets.............................................. 8,405 7,224
-------- --------
$193,151 $131,083
======== ========
Long-term investments
Long-term investments consist primarily of the Company's investment in
Andrx. Andrx is a drug-delivery company utilizing controlled-release
technologies to develop oral pharmaceutical products. Andrx' common
F-16
WATSON PHARMACEUTICALS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
stock trades on the Nasdaq Stock Market under the symbol ADRX. At December 31,
1998, the Company owned 2.7 million common shares of Andrx, which represents
approximately 17.7% of the total Andrx common shares outstanding. The Company
also has a warrant to acquire 337,100 shares of Andrx, exercisable in whole or
in part until July 8, 1999 at an exercise price of $8.90 per share. The
Company's unrealized gain on this investment was $60.6 million and $33.1
million (net of income taxes of $40.4 million and $22.1 million), at December
31, 1998 and 1997, respectively. The unrealized gain on Andrx is the primary
component of accumulated other comprehensive income in the stockholders'
equity section of Watson's consolidated balance sheets.
Investment in Somerset joint venture
The Company owns 50% of the outstanding common stock of Somerset and
utilizes the equity method to account for this investment. Somerset
manufactures and markets the product Eldepryl(R), which is used in the
treatment of Parkinson's disease. Earnings from Somerset were approximately
$7.4 million, $12.7 million, and $20.1 million in 1998, 1997, and 1996,
respectively. The Somerset joint venture earnings reported by Watson are
comprised of 50% of Somerset's earnings and management fees, offset by
amortization of goodwill. The net excess of the cost of this investment over
the fair value of net assets acquired was $5.4 million and $6.4 million at
December 31, 1998 and 1997, respectively. Such goodwill is amortized on the
straight-line basis over 15 years.
The Internal Revenue Service ("IRS") has notified Somerset that it may be
subject to additional income taxes and interest for its 1993, 1994, and 1995
tax years. The IRS has proposed adjustments relating to tax credits claimed
under Internal Revenue Code Section 936. The proposed adjustments amount to
approximately $14.0 million of additional income tax and interest charges, 50%
of which would be Watson's share. Management of Somerset believes that it has
met all of the requirements to qualify for the tax credits claimed and intends
to vigorously defend its position on this matter.
Combined results for unconsolidated investments in joint ventures
The following aggregate financial information is provided for unconsolidated
investments in joint ventures accounted for using the equity method:
For the Years Ended
December 31,
------------------------
1998 1997 1996
------- ------- --------
(in thousands)
Net revenues...................................... $51,564 $73,489 $101,512
======= ======= ========
Gross profit...................................... $43,108 $63,858 $ 88,840
======= ======= ========
Net income........................................ $13,108 $20,925 $ 31,564
======= ======= ========
December 31,
---------------
1998 1997
------- -------
(in thousands)
Current assets............................................ $79,155 $60,604
Other assets.............................................. 7,092 8,508
------- -------
Total assets............................................ $86,247 $69,112
======= =======
Current liabilities....................................... $20,893 $18,300
Other liabilities......................................... 723 1,309
Stockholders' equity...................................... 64,631 49,503
------- -------
Total liabilities and stockholders' equity.............. $86,247 $69,112
======= =======
F-17
WATSON PHARMACEUTICALS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
5. Debt
Long-term debt consisted of the following:
December 31,
----------------
1998 1997
-------- ------
(in thousands)
Senior unsecured notes, 7.125%, face amount of $150.0
million, due 2008 (effective rate of 7.25%).......... $148,489 $ --
Unsecured note, 8.1%, due August 2001................. 2,174 2,904
Other notes payable................................... 198 345
-------- ------
150,861 3,249
Less current portion.................................. (989) (864)
-------- ------
$149,872 $2,385
======== ======
In May 1998, the Company issued $150.0 million of 7.125% senior unsecured
notes. These notes are due in May 2008, with interest-only payments due semi-
annually in November and May. The Company must maintain specified financial
ratios and comply with certain restrictive covenants.
Annual maturities of notes payable, other than the senior unsecured notes,
are as follows: $1.0 million in 1999, $0.9 million in 2000 and $0.5 million in
2001.
6. Income Taxes
The provision for income taxes is summarized as follows:
For the Years Ended
December 31,
------------------------
1998 1997 1996
------- ------- -------
(in thousands)
Current provision:
Federal........................................ $67,314 $46,990 $11,059
State.......................................... 9,340 9,372 4,458
------- ------- -------
76,654 56,362 15,517
------- ------- -------
Deferred provision (benefit):
Federal........................................ 958 (2,228) 17,364
State.......................................... 635 280 3,035
------- ------- -------
1,593 (1,948) 20,399
------- ------- -------
Provision for income taxes..................... $78,247 $54,414 $35,916
======= ======= =======
The exercise of stock options represents a tax benefit and has been
reflected as a reduction of income taxes payable and an increase to additional
paid-in capital. Such benefits recorded were $13.6 million, $10.9 million and
$7.8 million for the years ended December 31, 1998, 1997 and 1996,
respectively. Income taxes of $2.3 million have been provided for the possible
distribution of approximately $29.0 million of undistributed earnings related
to the Company's investments in joint ventures.
F-18
WATSON PHARMACEUTICALS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Reconciliations between the statutory federal income tax rate and the
Company's effective income tax rate were as follows:
For the Years
Ended
December 31,
----------------
1998 1997 1996
---- ---- ----
Expected tax at federal statutory rate................... 35% 35% 35%
State income taxes, net of federal benefit............... 3 4 5
Research tax credits and other credits................... -- -- (1)
Dividends received deduction............................. -- (2) (4)
Non-deductible merger expenses........................... -- 2 --
Non-deductible IPR&D charge.............................. 2 -- --
Other.................................................... (1) (1) (4)
--- --- ---
39% 38% 31%
=== === ===
Deferred tax assets and liabilities are measured based on the difference
between the financial statement and tax bases of assets and liabilities at the
applicable tax rates. The significant components of the Company's net deferred
tax assets and liabilities were:
December 31,
------------------
1998 1997
-------- --------
(in thousands)
Benefits from NOL carryforwards........................ $ 3,085 $ 5,319
Differences in financial statement and tax accounting
for:
Inventory and receivables............................ 21,633 8,900
Research and development............................. 1,732 746
Property, equipment and intangible assets............ (11,487) (7,351)
Investments in joint ventures........................ (2,241) (1,590)
Unrealized gains--FAS 115.............................. (40,605) (22,093)
Valuation allowance.................................... (3,295) (5,529)
Other.................................................. 6,300 4,110
-------- --------
$(24,878) $(17,488)
======== ========
The Company had net operating loss ("NOL") carryforwards at December 31,
1998 of approximately $9.0 million and $6.0 million for federal and Florida
state income tax purposes, respectively. During 1998, the Company utilized NOL
carryforwards of approximately $7.0 million to offset federal income. Due to
restrictions imposed as a result of ownership changes to acquired
subsidiaries, the amount of the NOL carryforward available to offset future
taxable income is subject to limitation. The annual NOL utilization may be
further limited if additional changes in ownership occur. The Company's NOL
carryforwards will begin to expire in 2003.
7. Stockholders' Equity
Preferred stock
In 1992, the Company authorized 2.5 million shares of no par preferred
stock. The Board of Directors has the authority to fix the rights,
preferences, privileges and restrictions, including dividend rates, conversion
and voting rights, terms and prices of redemptions and liquidation preferences
without vote or action by the stockholders. At December 31, 1998, no preferred
stock was issued.
F-19
WATSON PHARMACEUTICALS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Stock option plans
The Company has adopted several stock option plans that authorize the
granting of options to purchase the Company's common stock subject to certain
conditions. At December 31, 1998, the Company had reserved 9.9 million shares
of its common stock for issuance upon exercise of options granted or to be
granted under these plans. The options are granted at the fair market value of
the shares underlying the options at the date of the grant, generally become
exercisable over a five-year period and expire in ten years. In conjunction
with certain of the Company's acquisitions, Watson assumed stock option and
warrant plans from the acquired companies. The options and warrants in these
plans were adjusted by the individual exchange ratios specified in each
transaction. No additional options or warrants will be granted under any of
the assumed plans.
The Company has elected to follow Accounting Principles Board Opinion No.
25, "Accounting for Stock Issued to Employees" (APB 25), and related
interpretations, which require compensation expense for options to be
recognized when the market price of the underlying stock exceeds the exercise
price on the date of the grant. Financial Accounting Standards No. 123,
"Accounting for Stock-Based Compensation" (FAS 123), permits companies to
apply existing accounting rules under APB 25 and provide pro forma disclosures
of net income and earnings per share as if the fair value method (as defined
in FAS 123) had been applied. Had compensation cost been determined using the
fair value method prescribed by FAS 123, the Company's net income and earnings
per share would have been as follows:
For the Years Ended
December 31,
------------------------
1998 1997 1996
-------- ------- -------
(in thousands, except
per share amounts)
Pro forma net income............................... $109,073 $82,182 $72,472
======== ======= =======
Pro forma basic earnings per share................. $ 1.22 $ 0.94 $ 0.85
======== ======= =======
Pro forma diluted earnings per share............... $ 1.19 $ 0.92 $ 0.82
======== ======= =======
The weighted average fair value of the options has been estimated on the
date of grant using the Black-Scholes option pricing model with the following
weighted average assumptions used for grants in 1998, 1997 and 1996,
respectively: no dividend yield; expected volatility of 41%, 49% and 51%,
risk-free interest rate of 5.14%, 6.15% and 6.18% per annum; and expected
terms ranging from approximately seven to eight years. Weighted averages are
used because of varying assumed exercise dates.
A summary of the Company's stock option plans as of December 31, 1998, 1997
and 1996, and for the years then ended is presented below (shares in
thousands):
For the Years Ended December 31,
--------------------------------------------------
1998 1997 1996
---------------- ---------------- ----------------
Weighted Weighted Weighted
Average Average Average
Exercise Exercise Exercise
Shares Price Shares Price Shares Price
------ -------- ------ -------- ------ --------
Outstanding-beginning of
year................... 6,809 $17.77 7,384 $12.39 8,064 $11.24
Granted............... 1,170 $43.06 2,388 $23.25 1,215 $17.88
Exercised............. (1,471) $14.01 (2,399) $ 5.97 (1,150) $ 7.56
Cancelled............. (421) $20.44 (564) $18.49 (745) $16.08
------ ------ ------
Outstanding-end of
year................... 6,087 $22.51 6,809 $17.77 7,384 $12.39
====== ====== ======
Weighted average fair
value
of options granted..... $21.06 $12.28 $ 8.42
====== ====== ======
F-20
WATSON PHARMACEUTICALS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The following table summarizes information about stock options outstanding
at December 31, 1998 (shares in thousands):
Options Outstanding Options Exercisable
---------------------------------------- -----------------------
Range of Weighted Average
Exercise Remaining Life Weighted Average Weighted Average
Prices Shares in Years Exercise Price Shares Exercise Price
-------- ------ ---------------- ---------------- ------ ----------------
$ 2.91 to
$12.75.. 1,118 4.4 $ 7.10 986 $ 7.11
$12.88 to
$18.63.. 2,164 7.2 $17.32 1,004 $17.37
$18.94 to
$33.00.. 1,635 8.3 $25.27 351 $24.58
$33.50 to
$56.75.. 1,170 9.5 $43.07 5 $33.50
----- -----
6,087 7.4 $22.51 2,346 $14.17
===== =====
8. Related Parties
The Company leases a portion of its facilities from a trust in which
Watson's Chairman and Senior Vice President, Scientific Affairs have
beneficial interests. The aggregate rent expense paid to related parties in
1998, 1997 and 1996 was $345,000, $332,000 and $432,000, respectively, and was
allocated to cost of sales, research and development and selling, general and
administrative expenses.
The Company had notes receivable due from executive officers in the amounts
of $600,000 and $2.0 million at December 31, 1998 and 1997, respectively. The
$600,000 note will mature in the third quarter of 1999. The $2.0 million note
was repaid in March 1998.
9. Commitments and Contingencies
Facility and equipment leases
The Company has entered into operating leases for certain facilities and
equipment. The terms of the operating leases for the Company's facilities
require the Company to pay property taxes, normal maintenance expenses and
maintain minimum insurance coverage. Total rental expense for operating leases
in 1998, 1997 and 1996, including rent paid to related parties, was $5.5
million, $2.6 million and $2.1 million, respectively.
At December 31, 1998, future minimum lease payments under all noncancelable
operating leases consisted of the following (in thousands):
For the Years Ending December 31,
1999.............................................................. $ 4,729
2000.............................................................. 3,962
2001.............................................................. 1,110
2002.............................................................. 263
2003 and after.................................................... 404
-------
$10,468
=======
Employee retirement plan
The Company maintains a 401(k) retirement plan covering substantially all
employees. The Company makes contributions to the plan based upon the employee
contributions. Watson contributed approximately $778,000, $398,000 and
$472,000 to the retirement plan for the years ended December 31, 1998, 1997,
and 1996, respectively.
F-21
WATSON PHARMACEUTICALS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Legal matters
The Company is involved in various disputes and litigation matters that
arise in the ordinary course of business. The litigation process is inherently
uncertain and it is possible that the resolution of these disputes and
lawsuits may adversely affect the Company. Management believes, however, that
the ultimate resolution of such matters will not have a material adverse
impact on the Company's consolidated financial position or results of
operations.
10. Quarterly Financial Data (Unaudited)
Unaudited quarterly financial and market price information follows (in
thousands, except per share data):
Fourth Third Second First
1998 Quarter Quarter Quarter Quarter
---- -------- -------- -------- --------
Product sales, net..................... $146,445 $145,946 $141,885 $121,872
Cost of sales.......................... 52,142 56,635 54,780 45,100
Gross profit......................... 94,303 89,311 87,105 76,772
-------- -------- -------- --------
Operating expenses..................... 36,461 37,044 37,202 44,022
Other income (expense), net............ (163) 1,595 2,267 2,615
Provision for income taxes............. 21,053 20,037 19,407 17,750
-------- -------- -------- --------
Net income........................... $ 36,626 $ 33,825 $ 32,763 $ 17,615
======== ======== ======== ========
Basic earnings per share............. $ 0.41 $ 0.38 $ 0.37 $ 0.20
======== ======== ======== ========
Diluted earnings per share........... $ 0.40 $ 0.37 $ 0.36 $ 0.19
======== ======== ======== ========
Market price per share: High......... $ 63.00 $ 52.88 $ 49.50 $ 42.94
Low............................. $ 42.00 $ 40.25 $ 36.25 $ 30.50
Fourth Third Second First
1997 Quarter Quarter Quarter Quarter
---- -------- -------- -------- --------
Product sales, net..................... $109,764 $ 91,817 $ 63,735 $ 58,699
Cost of sales.......................... 38,032 34,525 26,812 25,688
-------- -------- -------- --------
Gross profit......................... 71,732 57,292 36,923 33,011
-------- -------- -------- --------
Royalty income......................... -- -- 7,208 7,041
-------- -------- -------- --------
Operating expenses..................... 28,059 19,087 19,837 23,940
Other income, net...................... 3,058 4,230 7,376 7,650
Provision for income taxes............. 17,308 14,837 12,558 9,711
-------- -------- -------- --------
Net income........................... $ 29,423 $ 27,598 $ 19,112 $ 14,051
======== ======== ======== ========
Basic earnings per share............. $ 0.33 $ 0.32 $ 0.22 $ 0.16
======== ======== ======== ========
Diluted earnings per share........... $ 0.33 $ 0.31 $ 0.22 $ 0.16
======== ======== ======== ========
Market price per share: High......... $ 34.13 $ 30.38 $ 22.25 $ 23.06
Low............................. $ 27.00 $ 21.63 $ 16.00 $ 17.69
The quarterly data above were restated, as applicable, to reflect the
adoption of FAS 128 and for acquisitions in 1997 accounted for under the
pooling of interests method as further discussed in Note 2. In addition, a
first quarter 1998 charge for acquired in-process research and development
(IPR&D) was restated to reflect a recently revised Securities and Exchange
Commission-preferred methodology for valuing IPR&D. The restated amount is
$13.0 million, as compared to $18.8 million as originally reported, and was
determined in conjunction with an independent valuation firm.
F-22