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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT
PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MAY 31, 2004
COMMISSION FILE NUMBER 0-5905
CHATTEM, INC.
A TENNESSEE CORPORATION
I.R.S. EMPLOYER IDENTIFICATION NO. 62-0156300
1715 WEST 38TH STREET
CHATTANOOGA, TENNESSEE 37409
TELEPHONE: 423-821-4571
Registrant 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, and has been
subject to such filing requirements for the past 90 days.
The registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange
Act).
As of June 30, 2004, 19,715,078 shares of the Company's common stock, without
par value, were outstanding.
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CHATTEM, INC.
INDEX
PAGE NO.
--------
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of May 31, 2004 and
November 30, 2003 3
Condensed Consolidated Statements of Income for the Three and Six
Months Ended May 31, 2004 and May 31, 2003 5
Condensed Consolidated Statements of Cash Flows for the Six Months
Ended May 31, 2004 and May 31, 2003 6
Notes to Condensed Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 25
Item 3. Quantitative and Qualitative Disclosures About Market Risks 38
Item 4. Controls and Procedures 38
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 39
Item 2. Changes in Securities and Use of Proceeds 39
Item 3. Defaults Upon Senior Securities 39
Item 4. Submission of Matters to a Vote of Security Holders 39
Item 5. Other Information 39
Item 6. Exhibits and Reports on Form 8-K 40
SIGNATURES 41
2
PART 1. FINANCIAL INFORMATION
-----------------------------
ITEM 1. FINANCIAL STATEMENTS
- ----------------------------
CHATTEM, INC. AND SUBSIDIARIES
------------------------------
CONDENSED CONSOLIDATED BALANCE SHEETS
-------------------------------------
(In thousands)
MAY 31, NOVEMBER 30,
ASSETS 2004 2003
---------- ----------
(Unaudited)
CURRENT ASSETS:
Cash and cash equivalents $ 10,890 $ 26,931
Accounts receivable, less allowances of $4,034 at
May 31, 2004 and $3,594 at November 30, 2003 39,057 25,478
Inventories 18,839 17,559
Refundable income taxes 6,569 4,431
Deferred income taxes 1,152 3,441
Prepaid expenses and other current assets 1,095 3,376
---------- ----------
Total current assets 77,602 81,216
---------- ----------
PROPERTY, PLANT AND EQUIPMENT, NET 28,288 28,722
---------- ----------
OTHER NONCURRENT ASSETS:
Patents, trademarks and other purchased product rights, net 245,717 245,847
Debt issuance costs, net 5,532 5,504
Other 4,059 2,096
---------- ----------
Total other noncurrent assets 255,308 253,447
---------- ----------
TOTAL ASSETS $ 361,198 $ 363,385
========== ==========
The accompanying notes are an integral part of these condensed
consolidated financial statements.
3
CHATTEM, INC. AND SUBSIDIARIES
------------------------------
CONDENSED CONSOLIDATED BALANCE SHEETS
-------------------------------------
(In thousands)
MAY 31, NOVEMBER 30,
LIABILITIES AND SHAREHOLDERS' EQUITY 2004 2003
---------- ----------
(Unaudited)
CURRENT LIABILITIES:
Current maturities of long-term debt $ -- $ 7,750
Accounts payable and other 9,805 10,924
Accrued liabilities 14,995 15,979
---------- ----------
Total current liabilities 24,800 34,653
---------- ----------
LONG-TERM DEBT, less current maturities 200,000 204,676
---------- ----------
DEFERRED INCOME TAXES 29,725 26,796
---------- ----------
OTHER NONCURRENT LIABILITIES 1,746 1,689
---------- ----------
COMMITMENTS AND CONTINGENCIES (Note 18)
SHAREHOLDERS' EQUITY:
Preferred shares, without par value, authorized 1,000,
none issued -- --
Common shares, without par value, authorized 50,000,
issued 19,557 at May 31, 2004 and 19,161 at
November 30, 2003 81,410 77,815
Retained earnings 28,809 22,274
---------- ----------
110,219 100,089
Unamortized value of restricted common shares issued (2,951) (2,058)
Cumulative other comprehensive income:
Foreign currency translation adjustment (701) (820)
Minimum pension liability adjustment, net of income taxes (1,640) (1,640)
---------- ----------
Total shareholders' equity 104,927 95,571
---------- ----------
TOTAL LIABILITIES AND SHAREHOLDERS'
EQUITY $ 361,198 $ 363,385
========== ==========
The accompanying notes are an integral part of these condensed
consolidated financial statements.
4
CHATTEM, INC. AND SUBSIDIARIES
------------------------------
CONSOLIDATED STATEMENTS OF INCOME
---------------------------------
(Unaudited and in thousands, except per share amounts)
FOR THE THREE MONTHS FOR THE SIX MONTHS
ENDED MAY 31, ENDED MAY 31,
-------------------------- --------------------------
2004 2003 2004 2003
---------- ---------- ---------- ----------
REVENUES:
Net sales $ 69,886 $ 63,269 $ 130,813 $ 121,394
Royalties 206 364 516 664
---------- ---------- ---------- ----------
Total revenues 70,092 63,633 131,329 122,058
---------- ---------- ---------- ----------
COSTS AND EXPENSES:
Cost of sales 20,556 17,713 37,508 35,404
Advertising and promotion 19,080 18,529 37,612 36,934
Selling, general and administrative 10,671 10,397 21,306 20,211
Settlement and administrative costs of PPA litigation 3,463 -- 3,657 --
---------- ---------- ---------- ----------
Total costs and expenses 53,770 46,639 100,083 92,549
---------- ---------- ---------- ----------
INCOME FROM OPERATIONS 16,322 16,994 31,246 29,509
---------- ---------- ---------- ----------
OTHER INCOME (EXPENSE):
Interest expense (3,639) (5,227) (8,394) (10,374)
Investment and other income, net 115 53 160 87
Loss on early extinguishment of debt (1,649) -- (12,958) --
---------- ---------- ---------- ----------
Total other income (expense) (5,173) (5,174) (21,192) (10,287)
---------- ---------- ---------- ----------
INCOME BEFORE INCOME TAXES 11,149 11,820 10,054 19,222
PROVISION FOR INCOME TAXES 3,902 4,299 3,519 7,112
---------- ---------- ---------- ----------
NET INCOME $ 7,247 $ 7,521 $ 6,535 $ 12,110
========== ========== ========== ==========
NUMBER OF COMMON SHARES:
Weighted average outstanding-basic 19,286 19,052 19,193 19,177
========== ========== ========== ==========
Weighted average and potential dilutive outstanding 20,176 19,751 20,038 19,966
========== ========== ========== ==========
NET INCOME PER COMMON SHARE:
Basic $ .38 $ .39 $ .34 $ .63
========== ========== ========== ==========
Diluted $ .36 $ .38 $ .33 $ .61
========== ========== ========== ==========
The accompanying notes are an integral part of these condensed
consolidated financial statements.
5
CHATTEM, INC. AND SUBSIDIARIES
------------------------------
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
-----------------------------------------------
(Unaudited and in thousands, except per share amounts)
FOR THE SIX MONTHS ENDED
--------------------------
MAY 31, MAY 31,
2004 2003
---------- ----------
OPERATING ACTIVITIES:
Net income $ 6,535 $ 12,110
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization 3,072 3,021
Deferred income taxes 5,218 3,774
Tax benefit realized from stock option exercises 2,504 199
Loss on early extinguishment of debt 12,958 --
Other, net 49 (116)
Changes in operating assets and liabilities:
Accounts receivable (13,579) (6,524)
Inventories (1,280) (1,648)
Refundable income taxes (2,138) 242
Prepaid expenses and other current assets 2,295 1,236
Accounts payable and accrued liabilities (2,103) 82
---------- ----------
Net cash provided by operating activities 13,531 12,376
---------- ----------
INVESTING ACTIVITIES:
Purchases of property, plant and equipment (1,240) (2,566)
Purchases of patents, trademarks and other product rights (19) (308)
(Increase) decrease in other assets, net (701) 289
---------- ----------
Net cash used in investing activities (1,960) (2,585)
---------- ----------
FINANCING ACTIVITIES:
Repayment of long-term debt (212,288) (8,250)
Proceeds from long-term debt 200,000 --
Proceeds from borrowings under revolving credit facility 25,000 --
Repayments of revolving credit facility (25,000) --
Proceeds from exercise of stock options 2,880 275
Repurchase of common shares (3,234) (3,900)
Increase in debt issuance costs (5,718) (25)
Retirement of debt issuance costs (7,861) --
Premium on interest rate cap agreement (1,375) --
---------- ----------
Net cash used in financing activities (27,596) (11,900)
---------- ----------
EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH
EQUIVALENTS (16) 146
---------- ----------
CASH AND CASH EQUIVALENTS:
Decrease for the period (16,041) (1,963)
At beginning of period 26,931 15,924
---------- ----------
At end of period $ 10,890 $ 13,961
========== ==========
SCHEDULE OF NON-CASH INVESTING AND FINANCING ACTIVITIES:
Issuance of 70 and 69 shares of restricted common stock at a value of $19.98 and
$14.50 per share for the six months ended May 31, 2004 and 2003, respectively $ 1,399 $ 1,000
PAYMENTS FOR:
Interest $ 7,807 $ 9,656
Taxes $ 196 $ 2,599
The accompanying notes are an integral part of these condensed
consolidated financial statements.
6
CHATTEM, INC. AND SUBSIDIARIES
------------------------------
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
----------------------------------------------------
(UNAUDITED)
All monetary and share amounts are expressed in thousands.
1. BASIS OF PRESENTATION
---------------------
The accompanying unaudited condensed consolidated financial statements
have been prepared in accordance with accounting principles generally
accepted in the United States for interim financial information and the
instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly,
they do not include all of the information and footnotes required by
accounting principles generally accepted in the United States for complete
financial statements. These condensed consolidated financial statements
should be read in conjunction with the audited consolidated financial
statements and related notes thereto included in our Annual Report on Form
10-K for the year ended November 30, 2003. The accompanying unaudited
condensed consolidated financial statements, in the opinion of management,
include all adjustments necessary for a fair presentation. All such
adjustments are of a normal recurring nature.
2. CASH AND CASH EQUIVALENTS
-------------------------
We consider all short-term deposits and investments with original
maturities of three months or less to be cash equivalents.
3. RECLASSIFICATIONS
-----------------
Certain amounts have been reclassified to conform to the current
period's presentation.
4. RECENT ACCOUNTING PRONOUNCEMENTS
--------------------------------
In April 2002, the Financial Accounting Standards Board ("FASB")
issued Statement of Financial Accounting Standards ("SFAS") No. 145,
"Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB
Statement No. 13, and Technical Corrections" ("SFAS 145"). We adopted SFAS
145 on December 1, 2002. SFAS 145 requires us to classify gains and losses
on extinguishments of debt as income or loss from continuing operations
rather than as extraordinary items as previously required under SFAS No. 4,
"Reporting Gains and Losses from Extinguishment of Debt". We are also
required to reclassify any gain or loss on extinguishment of debt
previously classified as an extraordinary item in prior periods presented.
SFAS 145 also provides accounting standards for certain lease modifications
that have economic effects similar to sale-leaseback transactions and
various other technical corrections. The application of SFAS 145 resulted
in recording a loss on early extinguishment of debt of $12,958 in the first
and second quarters of fiscal 2004, which was classified in the condensed
consolidated financial statements in accordance with the provisions of SFAS
145.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities" ("SFAS 146"). We adopted SFAS
146 on January 1, 2003. SFAS 146 supercedes Emerging Issues Task Force
("EITF") Issue No. 94-3. SFAS 146 requires that the liability for a cost
associated with an exit or disposal activity be recognized when the
liability is incurred, not at the date of an entity's commitment to an exit
or disposal plan. SFAS 146 is to be applied prospectively to exit or
disposal activities initiated after December 31, 2002. The application of
SFAS 146 resulted in recording $40 of accrued liabilities related to the
restructuring of the United Kingdom ("U.K.") operations. We expect to
record additional charges related to the restructuring of the U.K.
operations in the third and fourth quarters of fiscal 2004.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation
of Variable Interest Entities" ("FIN 46"). FIN 46 requires a company to
consolidate a variable interest entity ("VIE"), as defined, when the
company will absorb a majority of the VIE's expected losses, receives a
majority of the VIE's expected residual returns or both. FIN 46 also
requires consolidation of existing, non-controlled affiliates if the VIE is
unable to finance its operations without investor support, or where the
other investors do not have exposure to the significant risks and rewards
of ownership. FIN 46 applies immediately to a VIE created or acquired after
January 31, 2003. For a VIE created before February 1, 2003, FIN 46 applies
in the first fiscal year or interim period beginning after March 15, 2004,
our third fiscal quarter beginning June 1, 2004. Application of FIN 46 is
also required in financial statements that have interests in structures
that are commonly referred to as special-purpose entities for periods
ending after December 15, 2003. The adoption of FIN 46 did not have an
impact on our financial position, results of operations or cash flows.
7
In December 2003, the FASB issued SFAS No. 132 (revised 2003),
"Employers' Disclosure about Pensions and Other Postretirement Benefits"
("SFAS 132"). The revision of SFAS 132 provides for additional disclosures
including the description of the types of plan assets, investment strategy,
measurement date(s), plan obligations, cash flows and components of net
periodic benefit cost recognized in interim periods. The revisions of SFAS
132 are effective for financial statements with fiscal years ending after
December 15, 2003 and interim periods beginning after December 15, 2003.
The adoption of the revised SFAS 132 did not have an impact on our
financial position, results of operations or cash flows.
5. STOCK-BASED COMPENSATION
------------------------
Our 1998 Non-Statutory Stock Option Plan provides for the issuance of
up to 1,400 shares of common stock to key employees, while the 1999
Non-Statutory Stock Option Plan for Non-Employee Directors allows for the
issuance of up to 200 shares of common stock. Our 2000 Non-Statutory Stock
Option Plan provides for the issuance of up to 1,500 shares of common
stock. Our 2003 Stock Incentive Plan provides for the issuance of up to
1,500 shares of common stock. Options granted under the plans vest ratably
over four years and are exercisable for a period of up to ten years from
the date of grant.
For SFAS No. 123, "Accounting for Stock-Based Compensation" ("SFAS
123") purposes, as amended by SFAS No. 148, "Accounting for Stock Based
Compensation-Transition and Disclosure", the fair value of each option
grant has been estimated as of the date of grant using the Black-Scholes
option-pricing model with the following weighted average assumptions for
grants in 2004 and 2003: expected dividend yield of 0%, expected volatility
of 60% and 64%, respectively, risk-free interest rates of 4.65% and 3.95%,
respectively, and expected lives of approximately five and six years,
respectively.
Had compensation expense for stock option grants been determined based
on the fair value at the grant dates consistent with the method prescribed
by SFAS 123, our net income and net income per share would have been
adjusted to the pro forma amounts for the three and six months ended May
31, 2004 and 2003, respectively, as indicated below:
For the Three Months Ended For the Six Months Ended
May 31, May 31,
------------------------- -------------------------
2004 2003 2004 2003
---------- ---------- ---------- ----------
Net income:
As reported $ 7,247 $ 7,521 $ 6,535 $ 12,110
Fair value method compensation cost, net 1,110 472 1,999 1,033
---------- ---------- ---------- ----------
Pro forma $ 6,137 $ 7,049 $ 4,536 $ 11,077
========== ========== ========== ==========
Net income per share, basic:
As reported $ .38 $ .39 $ .34 $ .63
Pro forma $ .32 $ .37 $ .24 $ .58
Net income per share, diluted:
As reported $ .36 $ .38 $ .33 $ .61
Pro forma $ .30 $ .36 $ .23 $ .55
8
6. EARNINGS PER SHARE
------------------
The following table presents the computation of per share earnings for
the three and six months ended May 31, 2004 and 2003, respectively:
For the Three Months Ended For the Six Months Ended
May 31, May 31,
------------------------- -------------------------
2004 2003 2004 2003
---------- ---------- ---------- ----------
NET INCOME $ 7,247 $ 7,521 $ 6,535 $ 12,110
========== ========== ========== ==========
NUMBER OF COMMON SHARES:
Weighted average outstanding 19,286 19,052 19,193 19,177
Issued upon assumed exercise of
outstanding stock options 814 612 783 694
Effect of issuance of restricted
common shares 76 87 62 95
---------- ---------- ---------- ----------
Weighted average and potential
dilutive outstanding (1) 20,176 19,751 20,038 19,966
========== ========== ========== ==========
NET INCOME PER COMMON SHARE:
Basic $ .38 $ .39 $ .34 $ .63
========== ========== ========== ==========
Diluted $ .36 $ .38 $ .33 $ .61
========== ========== ========== ==========
(1) Because their effects are anti-dilutive, excludes shares issuable
under stock option plans and restricted stock issuance whose grant
price was greater than the average market price of common shares
outstanding as follows: 199 and 1,042 shares for the three months ended
May 31, 2004 and 2003, respectively, and 100 and 96 shares for the six
months ended May 31, 2004 and 2003, respectively.
7. ADVERTISING EXPENSES
--------------------
We incur significant expenditures on television, radio and print
advertising to support our nationally branded over-the-counter ("OTC")
health care products and toiletries. Customers purchase products from us
with the understanding that the brands will be supported by our extensive
media advertising. This advertising supports the retailers' sales effort
and maintains the important brand franchise with the consuming public.
Accordingly, we consider our advertising program to be clearly implicit in
our sales arrangements with our customers. Therefore, we believe it is
appropriate to allocate a percentage of the necessary supporting
advertising expenses to each dollar of sales by charging a percentage of
sales on an interim basis based upon anticipated annual sales and
advertising expenditures (in accordance with Accounting Principles Board
Opinion No. 28, "Interim Financial Reporting") and adjusting that accrual
to the actual expenses incurred at the end of the year.
8. SHIPPING AND HANDLING
---------------------
Shipping and handling costs of $1,999 and $1,588 are included in
selling expenses for the three months ended May 31, 2004 and 2003,
respectively, and $3,434 and $3,045 for the six months ended May 31, 2004
and 2003, respectively.
9. PATENTS, TRADEMARKS AND OTHER PURCHASED PRODUCT RIGHTS
------------------------------------------------------
The carrying value of trademarks, which are not subject to
amortization under the provisions of SFAS No. 142, "Goodwill and Other
Intangible Assets" ("SFAS 142"), was $244,809 and $244,790 as of May 31,
2004 and November 30, 2003, respectively. The gross carrying amount of
intangible assets subject to amortization at both May 31, 2004 and November
30, 2003, which consist primarily of non-compete agreements, was $2,400.
The related accumulated amortization of intangible assets at May 31, 2004
and November 30, 2003 was $1,492 and $1,343, respectively. Amortization of
our intangible assets subject to amortization under the provisions of SFAS
142 for the three months ended May 31, 2004 and 2003 was $73 and $85,
respectively, and for the six months ended May 31, 2004 and 2003 was $149
and $170, respectively. Estimated annual amortization expense for these
assets for the years ended November 30, 2005, 2006, 2007, 2008 and 2009 is
$290, $290, $123, $40 and $20, respectively.
9
10. INVENTORIES
-----------
Inventories consisted of the following as of May 31, 2004 and November
30, 2003:
2004 2003
---------- ----------
Raw materials and work in process $ 8,091 $ 9,740
Finished goods 12,436 9,507
Excess of current cost over LIFO values (1,688) (1,688)
---------- ----------
Total inventories $ 18,839 $ 17,559
========== ==========
11. ACCRUED LIABILITIES
-------------------
Accrued liabilities consisted of the following as of May 31, 2004 and
November 30, 2003:
2004 2003
---------- ----------
Interest $ 3,219 $ 3,115
Salaries, wages and commissions 3,133 3,604
Product advertising and promotion 5,806 5,348
Insurance 480 1,151
Pension 956 1,040
Other 1,401 1,721
---------- ----------
Total accrued liabilities $ 14,995 $ 15,979
========== ==========
12. LONG-TERM DEBT
--------------
Long-term debt consisted of the following as of May 31, 2004 and
November 30, 2003:
2004 2003
---------- ----------
Revolving Credit Facility due 2009 at a
variable rate of 4.75% as of
May 31, 2004 $ -- $ --
Term loan payable to banks at variable
rates of 3.42% and 3.39% as of
February 26, 2004 (termination date) and
November 30, 2003, respectively -- 7,750
8.875% Senior Subordinated Notes, plus
unamortized premium of $138
for 2003 -- 204,676
Floating Rate Senior Notes due 2010
at a variable rate of 4.12% as of
May 31, 2004 75,000 --
7.0% Senior Subordinated Notes due 2014 125,000 --
---------- ----------
Total long-term debt 200,000 212,426
Less: current maturities -- 7,750
---------- ----------
Total long-term debt, net of current maturities $ 200,000 $ 204,676
========== ==========
On February 26, 2004, we entered into a new Senior Secured Revolving
Credit Facility that matures February 26, 2009 (the "Revolving Credit
Facility") with Bank of America, N.A. that provided an initial borrowing
capacity of $25,000 and an additional $25,000, subject to successful
syndication. On March 9, 2004, we entered into a new commitment agreement
with a syndicate of commercial banks led by Bank of America, N.A., as
agent, that enables us to borrow up to a total of $50,000 under the
Revolving Credit Facility. Borrowings under our Revolving Credit Facility
bear interest at LIBOR plus applicable percentages of 1.75% to 2.50% or a
base rate (the higher of the federal funds rate plus 0.5% or the prime
rate) plus applicable percentages of 0.25% to 1.0%. The applicable
percentages are calculated based on our leverage ratio. As of May 31, 2004,
no amounts have been borrowed under the Revolving Credit Facility, and the
variable rate was 4.75%. Borrowings under our Revolving Credit Facility are
secured by substantially all of our assets, except real property, and
shares of capital stock of our domestic subsidiaries held by us and by the
assets of the guarantors (our domestic subsidiaries). The Revolving Credit
Facility contains covenants, representations, warranties and other
agreements by us that are customary in credit
10
agreements and security instruments relating to financings of this type.
The significant financial covenants include fixed charge coverage ratio,
leverage ratio, senior secured leverage ratio, net worth and brand value
calculations. On June 30, 2004, we had no borrowings outstanding under our
Revolving Credit Facility.
On March 28, 2002, we obtained a $60,000 senior secured credit
facility from a syndicate of commercial banks led by Bank of America, N.A.,
as agent (the "Credit Facility"). The Credit Facility included a $15,000
revolving credit line and a $45,000 term loan. The remaining balance of the
term loan under the Credit Facility was repaid as part of the refinancing
transactions discussed herein, and the revolving credit line under the
Credit Facility was terminated on February 26, 2004.
On February 10, 2004, we commenced a cash tender offer and consent
solicitation for the $204,538 outstanding principal amount of our 8.875%
Senior Subordinated Notes due 2008 (the "8.875% Subordinated Notes"). The
consent solicitation expired on February 24, 2004, and a total of
approximately $174,530, or approximately 85.3% of the 8.875% Subordinated
Notes, were tendered and accepted for payment on February 26, 2004. The
remaining principal outstanding, call premium, accrued interest and
interest to call date amounting to $32,227 was placed in escrow with the
indenture trustee to fund the purchase of additional 8.875% Subordinated
Notes tendered prior to March 9, 2004, the expiration date of the tender
offer, and the redemption of the remaining 8.875% Subordinated Notes not
tendered. The redemption of the remaining 8.875% Subordinated Notes not
tendered in such offer were called in accordance with their terms on April
1, 2004 at a redemption price of 102.9583% of their aggregate principal
amount. On April 1, 2004, the remaining amount held in escrow was released
for payment and all outstanding 8.875% Subordinated Notes were redeemed.
The completion of our refinancing of the Credit Facility and purchase
of approximately $174,530 of our 8.875% Subordinated Notes that were
tendered on February 26, 2004 resulted in a loss on early extinguishment of
debt of $11,309 and a tax benefit of $3,958. In the second quarter of
fiscal 2004, we recorded a loss on early extinguishment of debt of $1,649
and a related tax benefit of $577 related to the redemption of the
remaining $30,008 of our 8.875% Subordinated Notes.
Also on February 26, 2004, we issued and sold $75,000 of Floating Rate
Senior Notes due March 1, 2010 (the "Floating Rate Notes") and $125,000 of
7.0% Senior Subordinated Notes due March 1, 2014 (the "7.0% Subordinated
Notes"), the proceeds of which were used to purchase our 8.875%
Subordinated Notes and refinance the Credit Facility as discussed above.
The Floating Rate Notes bear interest at a three-month LIBOR plus
3.00% per year (4.12% as of May 31, 2004). Interest payments are due
quarterly in arrears commencing on June 1, 2004. On March 8, 2004, we
entered into an interest rate cap agreement effective June 1, 2004 with
decreasing notional principal amounts and cap rates ranging from 4.0% to
5.0% over the life of the agreement. We paid a $1,375 premium to enter into
the interest rate cap agreement, which will be amortized over the life of
the agreement. The current portion of the premium on the interest rate cap
agreement of $14 is included in prepaid expenses and other current assets,
and the long-term portion of $1,361 is included in other noncurrent assets.
The amortized value of the premium on the interest rate cap will be
compared to its fair value quarterly. If the fair value is lower than the
carrying value of the premium on the interest rate cap, a charge will be
recorded to other comprehensive income. The interest rate cap agreement
terminates on March 1, 2010. Our domestic subsidiaries are guarantors of
the Floating Rate Notes. The guarantees of the Floating Rate Notes are
unsecured senior obligations of the guarantors and rank equally with all of
the current and future unsecured senior debt of the guarantors. The
guarantees of the Floating Rate Notes effectively rank junior to any
secured debt of the guarantors, including the guarantors' guarantee of our
indebtedness under the Revolving Credit Facility. At any time after March
1, 2005, we may redeem any of the Floating Rate Notes upon not less than 30
nor more than 60 days' notice at redemption prices (expressed in
percentages of principal amount), plus accrued and unpaid interest, if any,
and liquidated damages, if any, to the applicable redemption rate, if
redeemed during the twelve-month periods beginning March 1, 2005 at 102.0%,
March 1, 2006 at 101.0% and March 1, 2007 and thereafter at 100.0%. At any
time prior to March 1, 2005, we may redeem up to 35.0% of the aggregate
principal amount of the Floating Rate Notes (including any additional
Floating Rate Notes) at a redemption price of 100.0% of the principal
amount thereof, plus a premium equal to the interest rate per annum on the
Floating Rate Notes applicable on the date on which notice of the
redemption is given, together with accrued and unpaid interest and
liquidated damages, if any, with the net cash proceeds of one or more
qualified equity offerings; provided, that (i) at least 65.0% of the
aggregate principal amount of Floating Rate Notes remains outstanding
immediately after the occurrence of each redemption (excluding Floating
Rate Notes held by us and our subsidiaries); and (ii) the redemption must
occur within 90 days of the date of the closing of such qualified equity
offering.
Interest payments on the 7.0% Subordinated Notes are due semi-annually
in arrears on March 1 and September 1, commencing on September 1, 2004. Our
domestic subsidiaries are guarantors of the 7.0% Subordinated Notes. The
guarantees of the 7.0% Subordinated Notes are unsecured senior subordinated
obligations of the guarantors. At any time after March 1, 2009, we may
redeem any of the 7.0% Subordinated Notes upon not less than 30 nor more
than 60 days' notice at redemption prices (expressed in percentages of
principal amount), plus accrued and unpaid interest, if any, and
liquidation
11
damages, if any, to the applicable redemption rate, if redeemed during the
twelve-month periods beginning March 1, 2009 at 103.500%, March 1, 2010 at
102.333%, March 1, 2011 at 101.167% and March 1, 2012 and thereafter at
100.000%. At any time prior to March 1, 2007, we may redeem up to 35.0% of
the aggregate principal amount of the 7.0% Subordinated Notes (including
any additional 7.0% Subordinated Notes) at a redemption price of 107.0% of
the principal amount thereof, plus accrued and unpaid interest and
liquidated damages, if any, thereon to the applicable redemption rate, with
the net cash proceeds of one or more qualified equity offerings; provided,
that (i) at least 65.0% of the aggregate principal amount of the 7.0%
Subordinated Notes remains outstanding immediately after the occurrence of
such redemption (excluding 7.0% Subordinated Notes held by us and our
subsidiaries); and (ii) the redemption must occur within 90 days of the
date of the closing of such qualified equity offering.
The indentures governing the Floating Rate Notes and 7.0% Subordinated
Notes, among other things, limit our ability and the ability of our
restricted subsidiaries to: (i) borrow money or sell preferred stock, (ii)
create liens, (iii) pay dividends on or redeem or repurchase stock, (iv)
make certain types of investments, (v) sell stock in our restricted
subsidiaries, (vi) restrict dividends or other payments from restricted
subsidiaries, (vii) enter into transactions with affiliates, (viii) issue
guarantees of debt and (ix) sell assets or merge with other companies. In
addition, if we experience specific kinds of changes in control, we must
offer to purchase the Floating Rate Notes and 7.0% Subordinated Notes at
101.0% of their principal amount plus accrued and unpaid interest.
The future maturities of long-term debt outstanding as of May 31, 2004
are as follows:
2005 $ --
2006 --
2007 --
2008 --
2009 --
Thereafter 200,000
--------
$200,000
========
13. COMPREHENSIVE INCOME
--------------------
Comprehensive income consisted of the following components for the
three and six months ended May 31, 2004 and 2003, respectively:
For the Three Months Ended For the Six Months Ended
May 31, May 31,
-------------------------- -------------------------
2004 2003 2004 2003
---------- ---------- ---------- ----------
Net income $ 7,247 $ 7,521 $ 6,535 $ 12,110
Other - foreign currency
translation adjustment (151) (47) 119 317
---------- ---------- ---------- ----------
Total $ 7,096 $ 7,474 $ 6,654 $ 12,427
========== ========== ========== ==========
14. STOCK BUYBACK
-------------
In January 2004, our board of directors increased the total
authorization to repurchase our common stock under our stock buyback
program to $20,000. During the six months ended May 31, 2004, we
repurchased 129 shares for $3,234. All repurchased shares were retired and
returned to unissued. We are limited in our ability to repurchase shares
due to restrictions under the terms of our Revolving Credit Facility and
the indenture pursuant to which Floating Rate Notes and 7.0% Subordinated
Notes were issued.
15. RETIREMENT PLANS AND POSTRETIREMENT HEALTH CARE BENEFITS
--------------------------------------------------------
RETIREMENT PLANS
We have a noncontributory defined benefit pension plan ("the Plan"),
which covers substantially all employees. The Plan provides benefits based
upon years of service and the employee's compensation. Our contributions
are based on computations by independent actuaries. Plan assets at May 31,
2004 and November 30, 2003 were invested primarily in United States
government and agency securities and corporate debt and equity securities.
In October 2000, our board of directors adopted an amendment to the Plan
that freezes benefits of the Plan and prohibits new entrants to the Plan
effective December 31, 2000.
12
Net periodic pension cost for the three and six months ended May 31,
2004 and 2003 comprised the following components:
For the Three Months Ended For the Six Months Ended
May 31, May 31,
---------------------- ----------------------
2004 2003 2004 2003
-------- -------- -------- --------
Service cost $ -- $ -- $ -- $ --
Interest cost on projected benefit
obligation 155 152 310 304
Actual return on plan assets (178) (157) (356) (314)
Net amortization and deferral 28 (36) 56 (72)
-------- -------- -------- --------
Net pension cost (benefit) $ 5 $ (41) $ 10 $ (82)
======== ======== ======== ========
No employer contributions were made for the six months ended May 31,
2004 and May 31, 2003, and no employer contributions are required to be
made in fiscal 2004.
POSTRETIREMENT HEALTH CARE BENEFITS
We maintain certain postretirement health care benefits for eligible
employees. Employees become eligible for these benefits if they meet
certain age and service requirements. We pay a portion of the cost of
medical benefits for certain retired employees over the age of 65.
Effective January 1, 1993, our contribution is a service-based percentage
of the full premium. We pay these benefits as claims are incurred. Employer
contributions expected for fiscal 2004 are approximately $70.
Net periodic postretirement health care benefits cost for the three
and six months ended May 31, 2004 and May 31, 2003, included the following
components:
For the Three Months Ended For the Six Months Ended
May 31, May 31,
---------------------- ----------------------
2004 2003 2004 2003
-------- -------- -------- --------
Service cost $ 16 $ 14 $ 32 $ 28
Interest cost on accumulated
postretirement benefit obligation 20 20 40 40
Amortization of prior service cost 4 4 8 8
Amortization of net gain (8) (7) (16) (14)
-------- -------- -------- --------
Net periodic postretirement benefits cost $ 32 $ 31 $ 64 $ 62
======== ======== ======== ========
16. INCOME TAXES
------------
We account for income taxes using the asset and liability approach as
prescribed by SFAS No. 109, "Accounting for Income Taxes". This approach
requires recognition of deferred tax assets and liabilities for the
expected future tax consequences of events that have been included in the
consolidated financial statements or tax returns. Using the enacted tax
rates in effect for the year in which the differences are expected to
reverse, deferred tax assets and liabilities are determined based on the
differences between the financial reporting and the tax basis of an asset
or liability. We record income tax expense in our consolidated financial
statements based on an estimated annual effective income tax rate. Our tax
rate for the three and six months ended May 31, 2004 was 35%, respectively,
as compared to 36% in the corresponding quarter of fiscal 2003 and 37% for
the six months ended May 31, 2003. The lower rate in fiscal 2004 reflects
the implementation of a number of foreign and state tax planning
initiatives.
13
17. PRODUCT SEGMENT INFORMATION
---------------------------
Net sales of our domestic product categories within our single
healthcare business segment for the three and six months ended May 31, 2004
and 2003 are as follows:
For the Three Months Ended For the Six Months Ended
May 31, May 31,
--------------------- ---------------------
2004 2003 2004 2003
-------- -------- -------- --------
Topical analgesics $ 18,134 $ 14,626 $ 33,846 $ 28,198
Medicated skin care products 17,330 14,912 30,663 28,062
Dietary supplements 10,369 10,963 18,880 20,568
Medicated dandruff shampoos and conditioner 7,406 6,641 16,627 14,812
Other OTC and toiletry products 10,445 9,039 19,275 17,221
-------- -------- -------- --------
Total $ 63,684 $ 56,181 $119,291 $108,861
======== ======== ======== ========
18. COMMITMENTS AND CONTINGENCIES
-----------------------------
GENERAL LITIGATION
As of June 30, 2004, we were named as a defendant in approximately 345
lawsuits involving claims by approximately 680 plaintiffs alleging that the
plaintiffs were injured as a result of ingestion of products containing
phenylpropanolamine ("PPA"), which was an active ingredient in most of our
DEXATRIM products until November 2000. Most of the lawsuits seek an
unspecified amount of compensatory and exemplary damages or punitive
damages. The lawsuits that are federal cases have now been transferred to
the United States District Court for the Western District of Washington
before United States District Judge Barbara Jacobs Rothstein (In Re
Phenylpropanolamine ("PPA") Products Liability Litigation, MDL No. 1407).
The remaining cases are state court cases that have been filed in a number
of different states.
We believe that approximately 203 or approximately 59% of the existing
lawsuits in which we are named as a defendant represent cases involving
alleged injuries by products manufactured and sold prior to our acquisition
of DEXATRIM in December 1998. We have been defended in these lawsuits on
the basis of indemnification obligations assumed by The DELACO Company,
Inc. ("DELACO"), successor to Thompson Medical Company, Inc., which owned
DEXATRIM prior to December 1998. DELACO maintains product liability
insurance coverage for products manufactured and sold prior to December
1998 with annual limits of coverage and has an excess liability policy but
otherwise has only nominal assets. We understand that DELACO's insurance
carriers are disputing their responsibility for such coverage and are
engaged in settlement discussions with DELACO. On February 12, 2004, DELACO
filed a Chapter 11 bankruptcy petition in the United States Bankruptcy
Court for the Southern District of New York. Accordingly, it is uncertain
whether DELACO will be able to indemnify us for claims arising from
products manufactured and sold prior to our acquisition of DEXATRIM in
December 1998 and even if it is able to do so, it is unlikely that DELACO
will be able to indemnify us beyond its insurance coverage. In addition, we
cannot assure you that the insurance maintained by DELACO will be
sufficient to cover these claims or that ultimately we will not be held
liable for these claims. Our product liability insurance, as described
below, would not apply to claims arising from products manufactured and
sold prior to our acquisition of DEXATRIM. In addition to indemnification
from DELACO, we will also seek to defend ourselves in these lawsuits on the
basis that we did not manufacture and sell products containing PPA prior to
December 1998.
In the approximately 203 cases that have been filed against us for
products manufactured and sold prior to December 1998, approximately half
of the plaintiffs are in cases filed in states that we believe do not under
current law impose liability upon a successor. The remaining plaintiffs are
in cases filed in states that may in some circumstances permit liability
against a successor. However, although there can be no assurances, we do
not believe that successor liability would be imposed against us in these
cases. The reasons for our belief, among others, are that we did not
purchase all of DELACO's assets and DELACO continued to operate its
remaining business after December 1998; we did not cause DELACO's
bankruptcy; many plaintiffs included in cases filed in states that in some
circumstances impose successor liability are actually residents of other
states; and we believe that a remedy will be available to plaintiffs who
file claims in the DELACO bankruptcy.
As of June 30, 2004, in the approximately 142 lawsuits we are
defending, approximately 173 plaintiffs specifically allege ingestion of
DEXATRIM. The remaining plaintiffs either do not specifically allege
ingestion of DEXATRIM or have sued multiple manufacturers or sellers of
products containing PPA without identifying the products they ingested.
On December 19, 2003, we entered into a memorandum of understanding
with the Plaintiffs' Steering Committee ("PSC") in IN RE
PHENYLPROPANOLAMINE ("PPA") PRODUCTS LIABILITY LITIGATION, MDL 1407,
pending before the United States
14
District Court for the Western District of Washington (the "Memorandum of
Understanding"). The Memorandum of Understanding memorialized certain
settlement terms concerning lawsuits relating to DEXATRIM products
containing PPA.
On April 13, 2004, we entered into a class action settlement agreement
with representatives of the plaintiffs' settlement class. The court granted
preliminary approval of the class action settlement on April 23, 2004. The
class action settlement agreement is generally consistent with the terms of
and supercedes the Memorandum of Understanding and provides for a national
class action settlement of all DEXATRIM PPA claims. The class action
settlement is subject to final approval by the court at a fairness hearing
currently scheduled for August 26, 2004.
In accordance with the terms of the DEXATRIM class action settlement
agreement, $60,885 has been funded into an initial settlement trust from
our first three layers of insurance coverage, as described below. We have
published notice of the final settlement and details as to the manner in
which claims can be submitted. The deadline for submission of all claims is
July 7, 2004. If the final settlement is approved by the court, claims
submitted in the class settlement would be valued pursuant to an agreed
upon settlement matrix that is designed to evaluate and determine the
settlement value of each claim. To the extent the amount in the initial
settlement trust is ultimately insufficient to fully fund the settlement,
we will be required to make additional contributions to the settlement
trust in the future.
Based upon the Memorandum of Understanding and the settlement matrix,
Judge Rothstein entered a stay of discovery in all federal court DEXATRIM
PPA cases which allowed us to negotiate the class action settlement
agreement and file our class action settlement. Approximately 70% of our
cases are included in the multi-district litigation, or MDL. We expect most
of our cases pending in state courts will join in the settlement discussed
above.
On December 19, 2003, DELACO also entered into a Memorandum of
Understanding with the PSC. We understand that DELACO intends to implement
its contemplated settlement with the PSC through a liquidating Chapter 11
bankruptcy plan. If DELACO pursues the settlement through its bankruptcy
plan, we expect that the administrative process for DELACO's settlement
will be similar to the process in our class action. We have filed a claim
in DELACO's bankruptcy case in order to preserve our claims for
indemnification against DELACO. As part of this Chapter 11 plan, we expect
that after resolution of creditors' claims, DELACO will seek to liquidate
and distribute all of its assets and will dissolve as a company.
We cannot assure you that the terms of the class action settlement
agreement will be approved by the court. If the settlement is not approved,
we will continue to defend individual cases in a number of different state
and federal jurisdictions. If the final settlement is approved, we believe
that the settlement will include a substantial majority of the claims by
users of DEXATRIM products containing PPA, but that some claims may elect
to "opt out" of any class settlement and will continue to pursue claims for
damages against us in separate lawsuits. We cannot estimate at this time
how many claims may opt out or whether such claims will result in
significant additional liability for us. To the extent the number or
settlement value of opt out claims exceeds certain levels as specified in
the class action settlement agreement, we reserve the right to terminate
the settlement.
In the second quarter of fiscal 2004, we took a $3,463 charge relating
to settlement and administrative costs associated with the DEXATRIM PPA
litigation. Although we believe that an additional liability existed as of
May 31, 2004 related to our PPA litigation, because the final terms of the
settlement are still uncertain and have not been approved, we are not able
to estimate reasonably the amount of such liability at May 31, 2004 and
have made no provision for this liability in our condensed consolidated
financial statements.
As indicated above, $60,885 from our first three layers of our product
liability insurance coverage available for the PPA litigation has been
funded into an initial settlement trust. To the extent the amount in the
initial settlement trust is insufficient to fully fund the settlement, we
will be required to make additional contributions to the settlement trust
in the future. We currently expect to use certain of our cash on hand to
fund any required additional contributions to the settlement trust. If we
are required to fund significant other liabilities related to the PPA
litigation beyond the initial settlement trust, either pursuant to the
terms of the settlement, as a result of litigation or otherwise, we will
have significantly fewer sources of funds with which to satisfy such
liabilities, and we may be unable to do so. Moreover, if the settlement is
not approved, we may not have sufficient funds to satisfy all claims
against us.
We have reached an agreement with Kemper Indemnity Insurance Company
("Kemper") to settle Kemper's lawsuit that sought to rescind our policy for
$50,000 of excess coverage for product liability claims. After giving
effect to the settlement with Kemper, we have available for the claims
against us related to the PPA litigation, through our first three layers of
insurance coverage, approximately $60,885 of the $77,000 of product
liability coverage provided by these insurance policies. The $60,885 of
available coverage consists of $37,500 of insurance under the Kemper policy
and approximately $23,385 under policies with two other insurance
companies. As indicated above, this $60,885 of coverage has been funded
into an initial settlement trust in accordance with the terms of the class
action settlement agreement.
15
We continue to aggressively defend an action brought by Interstate
Fire & Casualty Company ("Interstate") to rescind its $25,000 of excess
coverage for product liability and pursue our available remedies at law
against Interstate. We cannot assure you that we will be successful in
retaining such excess coverage. The Interstate policy is in excess of the
product liability insurance available from Kemper and the two other
insurance companies referred to above. In the event the $60,885 of
insurance funds available in the initial settlement trust are exhausted
under the PPA settlement or otherwise, coverage under the Interstate policy
would not be available until we have paid $12,615 toward the settlement of
PPA claims to reach the $73,500 coverage point for the Interstate policy.
We maintain a significantly lower level of insurance coverage for all
other potential claims relating to our products including DEXATRIM products
containing ephedrine. As of June 1, 2004, our product liability insurance
coverage for all of our other products, including DEXATRIM products
containing ephedrine, consists of $10,000 of self-insured coverage through
our captive insurance subsidiary, of which approximately $4,250 is
currently funded, and a total of $40,000 of excess coverage through third
party insurers.
We have been named as a defendant in one lawsuit alleging that the
plaintiff was injured as a result of the ingestion of DEXATRIM containing
ephedrine. We have been named in an additional lawsuit alleging that the
plaintiff was injured as a result of the ingestion of DEXATRIM Natural, but
the allegations do not indicate whether the DEXATRIM Natural contained
ephedrine. We intend to vigorously defend both of these lawsuits.
We previously were named in a class action filed in the United States
District Court for the Southern District of New York seeking certification
of a class consisting of New York residents who have purchased DEXATRIM
Results or DEXATRIM Natural since January 2000. The class action lawsuit
sought compensatory and punitive damages arising out of allegedly false
advertising in connection with the sale of DEXATRIM Results and DEXATRIM
Natural products. None of the plaintiffs in this action alleged personal
injury as a result of the ingestion of a DEXATRIM product. On March 29,
2004, a stipulation was submitted to the court dismissing the case on
jurisdictional grounds. Pursuant to the stipulation, the plaintiffs may
re-file the class action in New York state court.
On December 30, 2003, the United States Food and Drug Administration
("FDA") issued a consumer alert on the safety of dietary supplements
containing ephedrine alkaloids and on February 6, 2004 published a final
rule with respect to these products. The final rule prohibits the sale of
dietary supplements containing ephedrine alkaloids because such supplements
present an unreasonable risk of illness or injury. The final rule became
effective on April 11, 2004. Although we discontinued the manufacturing and
shipment of DEXATRIM containing ephedrine in September 2002, the FDA's
final rule may result in additional lawsuits being filed against us
alleging damages related to the use or purchase of DEXATRIM containing
ephedrine.
We have been named as a defendant in a putative class action suit
filed in the Superior Court of the State of California for the County of
Los Angeles. The lawsuit seeks certification of classes consisting of
residents of the United States, or residents of the State of California,
who have purchased our BULLFROG sun care products during the past four
years. The lawsuit seeks injunctive relief and compensatory damages under
the California Business and Professions Code against us arising out of
alleged deceptive, untrue or misleading advertising, and breach of
warranty, in connection with the manufacturing, labeling, advertising,
promotion and sale of BULLFROG products. The plaintiff has stipulated that
the amount in controversy with respect to plaintiffs' individual claim and
each member of the proposed class does not exceed $75. We filed an answer
on June 28, 2004 and intend to defend vigorously the lawsuit.
Other claims, suits and complaints arise in the ordinary course of our
business involving such matters as patents and trademarks, product
liability, environmental matters and other alleged injuries or damage. The
outcome of such litigation cannot be predicted, but, in the opinion of
management, based in part upon assessments from counsel, all such other
pending matters are without merit or are of such kind or involve such other
amounts as would not have a material adverse effect on our financial
position, results of operations or cash flows if disposed of unfavorably.
REGULATORY
The FDA, the Drug Enforcement Administration and a number of state and
local governments have enacted or proposed restrictions or prohibitions on
the sale of products that contain ephedrine. Ephedrine can refer to the
herbal substance derived from the plant ephedra or the plant heart leaf,
which, until September 2002, was used in the manufacturing of some forms of
DEXATRIM Natural and DEXATRIM Results, or synthetic ephedrine, an FDA
regulated ingredient used in some OTC drug products, which has not been
used in our products. These restrictions include the prohibition of OTC
sales, required warnings or labeling statements, record keeping and
reporting requirements, the prohibition of sales to minors, per transaction
limits on the quantity of product that may be purchased and limitations on
advertising and promotion.
16
In 1997, the FDA published a proposed rule on the use of dietary
supplements containing ephedrine alkaloids. In June 2002, the United States
Department of Health and Human Services ("HHS") proposed an expanded
scientific evaluation of ephedra which led to the issuance of a report by
the RAND-based Southern California Evidence-Based Practice Center (the
"RAND Report"). The RAND Report concluded that ephedrine, ephedrine plus
caffeine and ephedra-containing dietary supplements with or without herbs
containing caffeine all promote modest amounts of weight loss over the
short term and use of ephedra or ephedrine plus caffeine is associated with
an increased risk of gastrointestinal, psychiatric and autonomic symptoms.
The adverse event reports contained a smaller number of more serious
adverse events. Given the small number of such events, the RAND Report
concluded that further study would be necessary to determine whether
consumption of ephedra or ephedrine may be causally related to these
serious adverse events. In connection with the RAND Report, HHS sought
public comment on whether additional measures are required concerning the
sale and distribution of dietary supplements containing ephedrine
alkaloids.
On December 30, 2003, the FDA issued a consumer alert on the safety of
dietary supplements containing ephedrine alkaloids and on February 6, 2004
published a final rule with respect to these products. The final rule
prohibits the sale of dietary supplements containing ephedrine alkaloids
because such supplements present an unreasonable risk of illness or injury.
The final rule became effective on April 11, 2004. Although we discontinued
the manufacturing and shipment of DEXATRIM containing ephedrine in
September 2002, the FDA's final rule may result in additional lawsuits
being filed against us alleging damages related to the use or purchase of
DEXATRIM containing ephedrine.
We were notified in October 2000 that the FDA denied a citizen
petition submitted by Thompson Medical Company, Inc., the previous owner of
SPORTSCREME and ASPERCREME. The petition sought a determination that 10%
trolamine salicylate, the active ingredient in SPORTSCREME and ASPERCREME,
was clinically proven to be an effective active ingredient in external
analgesic OTC drug products and should be included in the FDA's yet-to-be
finalized monograph for external analgesics. We have met with the FDA and
submitted a proposed protocol study to evaluate the efficacy of 10%
trolamine salicylate as an active ingredient in OTC external analgesic drug
products. We are working to develop alternate formulations for SPORTSCREME
and ASPERCREME in the event that the FDA does not consider the available
clinical data to demonstrate conclusively the efficacy of trolamine
salicylate when the OTC external analgesic monograph is finalized. If 10%
trolamine salicylate is not included in the final monograph, we would
likely be required to discontinue these products as currently formulated
and remove them from the market after expiration of an anticipated grace
period. If this occurred, we believe we could still market these products
as homeopathic products and could also reformulate them using ingredients
included in the FDA monograph.
Certain of our topical analgesic products are currently marketed under
an FDA tentative final monograph. The FDA has proposed that the final
monograph exclude external analgesic products in patch, plaster, or
poultice form, unless the FDA receives additional data supporting the
safety and efficacy of these products. On October 14, 2003, we submitted to
the FDA information regarding the safety of our ICY HOT patches and
arguments to support our product's inclusion in the final monograph. We
have also participated in an industry effort coordinated by the Consumer
Healthcare Products Association ("CHPA") to establish with the FDA a
protocol of additional research that will allow the patches to be marketed
under the final monograph even if the final monograph does not explicitly
allow them. The CHPA submission to FDA was made on October 15, 2003. This
additional research may require a considerable amount of expensive testing
and data analysis by expert consultants. Some of this cost may be shared
with other patch manufacturers. We believe that the monograph is unlikely
to become final and take effect before November 2005. If neither action
described above is successful and the final monograph excludes such
products, we will have to file a new drug application ("NDA") in order to
continue to market the ICY HOT Patch or similar delivery systems under our
other topical analgesic brands. In such case, we would have to remove the
existing product from the market as of one year from the effective date of
the final monograph, pending FDA review and approval of an NDA. The
preparation of an NDA would likely take us six to 18 months and would be
expensive. It typically takes the FDA at least 12 months to rule on the NDA
once it is submitted.
We have responded to certain questions with respect to efficacy
received from the FDA in connection with clinical studies for pyrilamine
maleate, one of the active ingredients used in certain of the PAMPRIN and
PREMSYN PMS products. While we addressed all of the FDA questions in
detail, the final monograph for menstrual drug products, which has not yet
been issued, will determine if the FDA considers pyrilamine maleate safe
and effective for menstrual relief products. We have been actively
monitoring the process and do not believe that either PAMPRIN or PREMSYN
PMS will be materially adversely affected by the FDA review. We believe
that any adverse finding by the FDA would likewise affect our principal
competitors in the menstrual product category. We are also aware of the
FDA's concern about the potential toxicity due to concomitant use of OTC
and prescription drugs that contain the ingredient acetaminophen, an
ingredient also found in PAMPRIN and PREMSYN PMS. We are participating in
an industry-wide effort to reassure the FDA that the current recommended
dosing regimen is safe and effective and that proper labeling and public
education by both OTC and prescription drug companies are the best policies
to abate the FDA's concern. There can be no assurance as to what action, if
any, the FDA may take with respect to acetaminophen.
17
Our business is also regulated by the California Safe Drinking Water
and Toxic Enforcement Act of 1986, known as Proposition 65. Proposition 65
prohibits businesses from exposing consumers to chemicals that the state
has determined cause cancer or reproduction toxicity without first giving
fair and reasonable warning unless the level of exposure to the carcinogen
or reproductive toxicant falls below prescribed levels. From time to time,
one or more ingredients in our products could become subject to an inquiry
under Proposition 65. If an ingredient is on the state's list as a
carcinogen, it is possible that a claim could be brought, in which case we
would be required to demonstrate that exposure is below a "no significant
risk" level for consumers. Any such claims may cause us to incur
significant expense, and we may face monetary penalties or injunctive
relief, or both, or be required to reformulate our product to acceptable
levels. The State of California under Proposition 65 is also considering
the inclusion of titantium dioxide on the state's list of suspected
carcinogens. Titantium dioxide has a long history of widespread use as an
excipient in prescription and OTC pharmaceuticals, cosmetics, dietary
supplements and skin care products and is an active ingredient in our
BULLFROG Superblock products. We have participated in an industry-wide
submission to the State of California, facilitated through the CHPA,
presenting evidence that titantium dioxide presents "no significant risk"
to consumers.
19. CONDENSED CONSOLIDATING FINANCIAL STATEMENTS
--------------------------------------------
The condensed consolidating financial statements, for the dates or
periods indicated, of Chattem, Inc. ("Chattem"), Signal Investment &
Management Co. ("Signal"), SunDex, LLC ("SunDex") and Chattem (Canada)
Holdings, Inc. ("Canada"), the guarantors of the long-term debt of Chattem,
and the non-guarantor direct and indirect wholly-owned subsidiaries of
Chattem are presented below. Signal is 89% owned by Chattem and 11% owned
by Canada. SunDex and Canada are wholly-owned subsidiaries of Chattem. The
guarantees of Signal, SunDex and Canada are full and unconditional and
joint and several. The guarantees of Signal, SunDex and Canada as of May
31, 2004 arose in conjunction with Chattem's issuance of the Revolving
Credit Facility, the Floating Rate Notes and the 7.0% Subordinated Notes
(See Note 12). The maximum amount of future payments the guarantors would
be required to make under the guarantees as of May 31, 2004 is $200,000.
18
Note 19
CHATTEM, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATING BALANCE SHEETS
MAY 31, 2004
(Unaudited and in thousands)
GUARANTOR NON-GUARANTOR
SUBSIDIARY SUBSIDIARY
CHATTEM COMPANIES COMPANIES ELIMINATIONS CONSOLIDATED
------------ ------------ ------------ ------------ ------------
ASSETS
- ------
CURRENT ASSETS:
Cash and cash equivalents $ 318 $ 2,574 $ 7,998 $ -- $ 10,890
Accounts receivable, less allowances of
$4,034 34,369 13,370 4,688 (13,370) 39,057
Interest receivable -- 619 -- (619) --
Inventories 13,854 2,291 2,694 -- 18,839
Refundable income taxes 6,533 -- 36 -- 6,569
Deferred income taxes 1,152 -- -- -- 1,152
Prepaid expenses and other current assets 1,098 -- 163 (166) 1,095
------------ ------------ ------------ ------------ ------------
Total current assets 57,324 18,854 15,579 (14,155) 77,602
------------ ------------ ------------ ------------ ------------
PROPERTY, PLANT AND EQUIPMENT, NET 27,182 775 331 -- 28,288
------------ ------------ ------------ ------------ ------------
OTHER NONCURRENT ASSETS:
Patents, trademarks and other purchased
product rights, net 908 307,099 -- (62,290) 245,717
Debt issuance costs, net 5,532 -- -- -- 5,532
Investment in subsidiaries 251,534 33,000 66,024 (350,558) --
Note receivable -- 33,000 -- (33,000) --
Other 3,559 -- 500 -- 4,059
------------ ------------ ------------ ------------ ------------
Total other noncurrent assets 261,533 373,099 66,524 (445,848) 255,308
------------ ------------ ------------ ------------ ------------
TOTAL ASSETS $ 346,039 $ 392,728 $ 82,434 $ (460,003) $ 361,198
============ ============ ============ ============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY
- ------------------------------------
CURRENT LIABILITIES:
Accounts payable and other $ 8,552 $ -- $ 1,253 $ -- $ 9,805
Accrued liabilities 25,398 1,795 1,957 (14,155) 14,995
------------ ------------ ------------ ------------ ------------
Total current liabilities 33,950 1,795 3,210 (14,155) 24,800
------------ ------------ ------------ ------------ ------------
LONG-TERM DEBT 200,000 -- 33,000 (33,000) 200,000
------------ ------------ ------------ ------------ ------------
DEFERRED INCOME TAXES 452 29,319 (46) -- 29,725
------------ ------------ ------------ ------------ ------------
OTHER NONCURRENT LIABILITIES 1,746 -- -- -- 1,746
------------ ------------ ------------ ------------ ------------
INTERCOMPANY ACCOUNTS 4,964 (7,309) 2,345 -- --
------------ ------------ ------------ ------------ ------------
SHAREHOLDERS' EQUITY:
Preferred shares, without par value,
authorized 1,000, none issued -- -- -- -- --
Common shares, without par value,
authorized 50,000, issued 19,557 81,410 -- -- -- 81,410
Share capital of subsidiaries -- 330,586 38,647 (369,233) --
Retained earnings 28,809 38,337 5,496 (43,833) 28,809
------------ ------------ ------------ ------------ ------------
Total 110,219 368,923 44,143 (413,066) 110,219
------------ ------------ ------------ ------------ ------------
Unamortized value of restricted common
shares issued (2,951) -- -- -- (2,951)
Cumulative other comprehensive income:
Foreign currency translation adjustment (701) -- (218) 218 (701)
Minimum pension liability adjustment,
net of income taxes (1,640) -- -- -- (1,640)
------------ ------------ ------------ ------------ ------------
Total shareholders' equity 104,927 368,923 43,925 (412,848) 104,927
------------ ------------ ------------ ------------ ------------
TOTAL LIABILITIES AND
SHAREHOLDERS' EQUITY $ 346,039 $ 392,728 $ 82,434 $ (460,003) $ 361,198
============ ============ ============ ============ ============
19
Note 19
CHATTEM, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATING BALANCE SHEETS
NOVEMBER 30, 2003
(In thousands)
GUARANTOR NON-GUARANTOR
SUBSIDIARY SUBSIDIARY
CHATTEM COMPANIES COMPANIES ELIMINATIONS CONSOLIDATED
------------ ------------ ------------ ------------ ------------
ASSETS
- ------
CURRENT ASSETS:
Cash and cash equivalents $ 18,702 $ 1,964 $ 6,265 $ -- $ 26,931
Accounts receivable, less allowances of
$3,594 21,729 7,089 3,749 (7,089) 25,478
Inventories 12,670 2,040 2,849 -- 17,559
Refundable income taxes 4,414 -- 17 -- 4,431
Deferred income taxes 3,441 -- -- -- 3,441
Prepaid expenses and other current assets 4,401 -- 142 (1,167) 3,376
------------ ------------ ------------ ------------ ------------
Total current assets 65,357 11,093 13,022 (8,256) 81,216
------------ ------------ ------------ ------------ ------------
PROPERTY, PLANT AND EQUIPMENT, NET 27,595 775 352 -- 28,722
------------ ------------ ------------ ------------ ------------
OTHER NONCURRENT ASSETS:
Patents, trademarks and other purchased
product rights, net 1,057 307,080 -- (62,290) 245,847
Debt issuance costs, net 5,504 -- -- -- 5,504
Investment in subsidiaries 235,928 -- -- (235,928) --
Other 1,596 -- 500 -- 2,096
------------ ------------ ------------ ------------ ------------
Total other noncurrent assets 244,085 307,080 500 (298,218) 253,447
------------ ------------ ------------ ------------ ------------
TOTAL ASSETS $ 337,037 $ 318,948 $ 13,874 $ (306,474) $ 363,385
============ ============ ============ ============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY
- ------------------------------------
CURRENT LIABILITIES:
Current maturities of long-term debt $ 7,750 $ -- $ -- $ -- $ 7,750
Accounts payable and other 9,804 -- 1,120 -- 10,924
Accrued liabilities 21,417 628 2,190 (8,256) 15,979
------------ ------------ ------------ ------------ ------------
Total current liabilities 38,971 628 3,310 (8,256) 34,653
------------ ------------ ------------ ------------ ------------
LONG-TERM DEBT, less current maturities 204,676 -- -- -- 204,676
------------ ------------ ------------ ------------ ------------
DEFERRED INCOME TAXES 56 26,788 (48) -- 26,796
------------ ------------ ------------ ------------ ------------
OTHER NONCURRENT LIABILITIES 1,689 -- -- -- 1,689
------------ ------------ ------------ ------------ ------------
INTERCOMPANY ACCOUNTS (3,926) 3,469 457 -- --
------------ ------------ ------------ ------------ ------------
SHAREHOLDERS' EQUITY:
Preferred shares, without par value,
authorized 1,000, none issued -- -- -- -- --
Common shares, without par value,
authorized 50,000, issued 19,161 77,815 -- -- -- 77,815
Share capital of subsidiaries -- 263,704 6,504 (270,208) --
Retained earnings 22,274 24,359 3,998 (28,357) 22,274
------------ ------------ ------------ ------------ ------------
Total 100,089 288,063 10,502 (298,565) 100,089
------------ ------------ ------------ ------------ ------------
Unamortized value of restricted common
shares issued (2,058) -- -- -- (2,058)
Cumulative other comprehensive income:
Foreign currency translation adjustment (820) -- (347) 347 (820)
Minimum pension liability adjustment,
net of income taxes (1,640) -- -- -- (1,640)
------------ ------------ ------------ ------------ ------------
Total shareholders' equity 95,571 288,063 10,155 (298,218) 95,571
------------ ------------ ------------ ------------ ------------
TOTAL LIABILITIES AND
SHAREHOLDERS' EQUITY $ 337,037 $ 318,948 $ 13,874 $ (306,474) $ 363,385
============ ============ ============ ============ ============
20
Note 19
CHATTEM, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATING STATEMENTS OF INCOME
FOR THE SIX MONTHS ENDED MAY 31, 2004
(Unaudited and in thousands)
GUARANTOR NON-GUARANTOR
SUBSIDIARY SUBSIDIARY
CHATTEM COMPANIES COMPANIES ELIMINATIONS CONSOLIDATED
------------ ------------ ------------ ------------ ------------
TOTAL REVENUES $ 104,264 $ 38,417 $ 8,942 $ (20,294) $ 131,329
------------ ------------ ------------ ------------ ------------
COSTS AND EXPENSES:
Cost of sales 29,428 5,698 3,574 (1,192) 37,508
Advertising and promotion 28,903 6,427 2,282 -- 37,612
Selling, general and administrative 20,234 216 856 -- 21,306
Settlement and administrative costs of
PPA litigation 3,657 -- -- -- 3,657
Equity in subsidiary income (15,476) -- -- 15,476 --
------------ ------------ ------------ ------------ ------------
Total costs and expenses 66,746 12,341 6,712 14,284 100,083
------------ ------------ ------------ ------------ ------------
INCOME FROM OPERATIONS 37,518 26,076 2,230 (34,578) 31,246
------------ ------------ ------------ ------------ ------------
OTHER INCOME (EXPENSE):
Interest expense (8,394) -- (1,238) 1,238 (8,394)
Investment and other income, net 94 1,240 689 (1,863) 160
Loss on early extinguishment of debt (12,958) -- -- -- (12,958)
Royalties (15,988) (3,114) -- 19,102 --
Corporate allocations 1,791 (1,731) (60) -- --
------------ ------------ ------------ ------------ ------------
Total other income (expense) (35,455) (3,605) (609) 18,477 (21,192)
------------ ------------ ------------ ------------ ------------
INCOME BEFORE INCOME TAXES 2,063 22,471 1,621 (16,101) 10,054
------------ ------------ ------------ ------------ ------------
(BENEFIT FROM) PROVISION FOR INCOME TAXES (4,472) 7,865 126 -- 3,519
------------ ------------ ------------ ------------ ------------
NET INCOME $ 6,535 $ 14,606 $ 1,495 $ (16,101) $ 6,535
============ ============ ============ ============ ============
21
Note 19
CHATTEM, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS
FOR THE SIX MONTHS ENDED MAY 31, 2003
(Unaudited and in thousands)
GUARANTOR NON-GUARANTOR
SUBSIDIARY SUBSIDIARY
CHATTEM COMPANIES COMPANIES ELIMINATIONS CONSOLIDATED
------------ ------------ ------------ ------------ ------------
TOTAL REVENUES $ 90,971 $ 26,973 $ 10,505 $ (6,391) $ 122,058
------------ ------------ ------------ ------------ ------------
COSTS AND EXPENSES:
Cost of sales 25,934 5,889 4,231 (650) 35,404
Advertising and promotion 28,824 4,816 3,294 -- 36,934
Selling, general and administrative 18,938 144 1,129 -- 20,211
Equity in subsidiary income (10,424) -- -- 10,424 --
------------ ------------ ------------ ------------ ------------
Total costs and expenses 63,272 10,849 8,654 9,774 92,549
------------ ------------ ------------ ------------ ------------
INCOME FROM OPERATIONS 27,699 16,124 1,851 (16,165) 29,509
------------ ------------ ------------ ------------ ------------
OTHER INCOME (EXPENSE):
Interest expense (10,374) -- -- -- (10,374)
Investment and other income, net 69 2 16 -- 87
Royalties (4,463) (1,069) (209) 5,741 --
Corporate allocations 1,974 (1,918) (56) -- --
------------ ------------ ------------ ------------ ------------
Total other income (expense) (12,794) (2,985) (249) 5,741 (10,287)
------------ ------------ ------------ ------------ ------------
INCOME BEFORE INCOME TAXES 14,905 13,139 1,602 (10,424) 19,222
PROVISION FOR INCOME TAXES 2,795 4,030 287 -- 7,112
------------ ------------ ------------ ------------ ------------
NET INCOME $ 12,110 $ 9,109 $ 1,315 $ (10,424) $ 12,110
============ ============ ============ ============ ============
22
Note 19
CHATTEM, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS
FOR THE SIX MONTHS ENDED MAY 31, 2004
(Unaudited and in thousands)
GUARANTOR NON-GUARANTOR
SUBSIDIARY SUBSIDIARY
CHATTEM COMPANIES COMPANIES ELIMINATIONS CONSOLIDATED
------------ ------------ ------------ ------------ ------------
OPERATING ACTIVITIES:
Net income $ 6,535 $ 14,606 $ 1,495 $ (16,101) $ 6,535
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation and amortization 3,028 -- 44 -- 3,072
Deferred income taxes 2,687 2,529 2 -- 5,218
Tax benefit realized from stock option
exercises 2,504 -- -- -- 2,504
Loss on early extinguishment of debt 12,958 -- -- -- 12,958
Other, net 33 -- 16 -- 49
Equity in subsidiary income (16,101) -- -- 16,101 --
Changes in operating assets and
liabilities:
Accounts receivable (12,640) (6,280) (939) 6,280 (13,579)
Interest receivable -- (619) -- 619 --
Inventories (1,183) (251) 154 -- (1,280)
Refundable income taxes (2,119) -- (19) -- (2,138)
Prepaid expenses and other current assets 3,317 -- (22) (1,000) 2,295
Accounts payable and accrued liabilities 2,729 1,167 (100) (5,899) (2,103)
------------ ------------ ------------ ------------ ------------
Net cash provided by operating activities 1,748 11,152 631 -- 13,531
------------ ------------ ------------ ------------ ------------
INVESTING ACTIVITIES:
Purchases of property, plant and equipment (1,232) -- (8) -- (1,240)
Purchases of patents, trademarks and other
product rights -- (19) -- -- (19)
Increase in note receivable -- (33,000) -- 33,000 --
(Increase) decrease in other assets, net (818) -- 117 -- (701)
------------ ------------ ------------ ------------ ------------
Net cash (used in) provided by
investing activities (2,050) (33,019) 109 33,000 (1,960)
------------ ------------ ------------ ------------ ------------
FINANCING ACTIVITIES:
Repayment of long-term debt (212,288) -- -- -- (212,288)
Proceeds from long-term debt 200,000 -- -- -- 200,000
Proceeds from borrowings under revolving 25,000 -- -- -- 25,000
credit facility
Payments of revolving credit facility (25,000) -- -- -- (25,000)
Proceeds from exercise of stock options 2,880 -- -- -- 2,880
Repurchase of common shares (3,234) -- -- -- (3,234)
Increase in debt issuance costs (5,718) -- -- -- (5,718)
Retirement of debt issuance costs (7,861) -- -- -- (7,861)
Premium on interest rate cap agreement (1,375) -- -- -- (1,375)
Intercompany debt proceeds, net -- -- 33,000 (33,000) --
Changes in intercompany accounts 9,514 23,102 (32,616) -- --
Dividends paid -- (625) 625 -- --
------------ ------------ ------------ ------------ ------------
Net cash (used in) provided by
financing activities (18,082) 22,477 1,009 (33,000) (27,596)
------------ ------------ ------------ ------------ ------------
EFFECT OF EXCHANGE RATE CHANGES ON CASH
AND CASH EQUIVALENTS -- -- (16) -- (16)
------------ ------------ ------------ ------------ ------------
CASH AND CASH EQUIVALENTS:
(Decrease) increase for the period (18,384) 610 1,733 -- (16,041)
At beginning of period 18,702 1,964 6,265 -- 26,931
------------ ------------ ------------ ------------ ------------
At end of period $ 318 $ 2,574 $ 7,998 $ -- $ 10,890
============ ============ ============ ============ ============
23
Note 19
CHATTEM, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS
FOR THE SIX MONTHS ENDED MAY 31, 2003
(Unaudited and in thousands)
GUARANTOR NON-GUARANTOR
SUBSIDIARY SUBSIDIARY
CHATTEM COMPANIES COMPANIES ELIMINATIONS CONSOLIDATED
------------ ------------ ------------ ------------ ------------
OPERATING ACTIVITIES:
Net income $ 12,110 $ 9,109 $ 1,315 $ (10,424) $ 12,110
Adjustments to reconcile net income to
net cash (used in) provided by
operating activities:
Depreciation and amortization 2,947 -- 74 -- 3,021
Deferred income taxes 177 3,597 -- -- 3,774
Tax benefit realized from stock
option exercises 199 -- -- -- 199
Other, net (119) -- 3 -- (116)
Equity in subsidiary income (10,424) -- -- 10,424 --
Changes in operating assets and
liabilities:
Accounts receivable (6,427) -- (97) -- (6,524)
Inventories (1,778) 337 (207) -- (1,648)
Refundable income taxes 242 -- -- -- 242
Prepaid expenses and other current
assets 1,031 -- 205 -- 1,236
Accounts payable and accrued
liabilities (43) -- 125 -- 82
------------ ------------ ------------ ------------ ------------
Net cash (used in) provided by
operating activities (2,085) 13,043 1,418 -- 12,376
------------ ------------ ------------ ------------ ------------
INVESTING ACTIVITIES:
Purchases of property, plant and equipment (2,446) -- (120) -- (2,566)
Purchase of patents, trademarks and other
product rights (8) (300) -- -- (308)
Decrease (increase) in other assets, net 599 -- (310) -- 289
------------ ------------ ------------ ------------ ------------
Net cash used in investing activities (1,855) (300) (430) -- (2,585)
------------ ------------ ------------ ------------ ------------
FINANCING ACTIVITIES:
Repayment of long-term debt (8,250) -- -- -- (8,250)
Proceeds from exercise of stock options 275 -- -- -- 275
Repurchase of common shares (3,900) -- -- -- (3,900)
Increase in debt issuance costs (25) -- -- -- (25)
Changes in intercompany accounts 8,517 (11,386) 2,869 -- --
Dividends paid 2,000 (2,000) -- -- --
------------ ------------ ------------ ------------ ------------
Net cash (used in) provided by
financing activities (1,383) (13,386) 2,869 -- (11,900)
------------ ------------ ------------ ------------ ------------
EFFECT OF EXCHANGE RATE CHANGES ON CASH
AND CASH EQUIVALENTS 21 -- 125 -- 146
------------ ------------ ------------ ------------ ------------
CASH AND CASH EQUIVALENTS:
(Decrease) increase for the period (5,302) (643) 3,982 -- (1,963)
At beginning of period 11,505 1,138 3,281 -- 15,924
------------ ------------ ------------ ------------ ------------
At end of period $ 6,203 $ 495 $ 7,263 $ -- $ 13,961
============ ============ ============ ============ ============
24
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
- -----------------------------------------------------------------------
RESULTS OF OPERATIONS
---------------------
The following discussion and analysis of our financial condition and
results of operations should be read in conjunction with the audited
consolidated financial statements and related notes thereto included in our 2003
Annual Report on Form 10-K filed with the Securities and Exchange Commission.
This discussion and analysis contains forward-looking statements that involve
risks, uncertainties and assumptions. The actual results may differ materially
from those anticipated in these forward-looking statements as a result of a
number of factors, including, but not limited to, those described in our filings
with the Securities and Exchange Commission.
OVERVIEW
- --------
We are a leading marketer and manufacturer of a broad portfolio of
branded over-the-counter ("OTC") healthcare products, toiletries and dietary
supplements including such categories as topical analgesics, medicated skin care
products, medicated dandruff shampoos and conditioner, dietary supplements, and
other OTC and toiletry products. Our portfolio of products includes
well-recognized brands such as:
o Topical analgesics such as ICY HOT, ASPERCREME and FLEXALL;
o Medicated skin care products such as GOLD BOND medicated skin care
powder, cream, lotion, first aid, and foot care products; and
PHISODERM medicated acne treatment products and skin cleansers;
o SELSUN BLUE medicated dandruff shampoos and conditioner;
o Dietary supplements including DEXATRIM, GARLIQUE and NEW PHASE; and
o Other OTC and toiletry products such as PAMPRIN and PREMSYN PMS,
menstrual analgesics; HERPECIN-L, a lip care product; BENZODENT, a
dental analgesic cream; and toiletries such as BULLFROG, a line of
sunblocks; ULTRASWIM, chlorine-removing shampoo; and SUN-IN, a hair
lightener.
Our products typically target niche markets that are often outside the
core product areas of larger companies where we believe we can achieve and
sustain significant market penetration through innovation and strong advertising
and promotion support. Many of our products are among the U.S. market leaders in
their respective categories. For example, our portfolio of topical analgesic
brands and our GOLD BOND medicated body powders have the leading U.S. market
share in these categories. We support our brands through extensive and
cost-effective advertising and promotion, the expenditures for which represented
approximately 29% of our total revenues in the six months ended May 31, 2004. We
sell our products nationally through mass merchandiser, drug and food channels
principally utilizing our own sales force.
Our strategy to achieve future growth is to generate new sales through
strong marketing and promotional programs, new product development, acquisitions
of new brands, development of strategic marketing alliances and expansion of our
international business. As previously high-growth brands mature, sales increases
will become even more dependent on the development of successful line
extensions, international expansion and acquisitions. During the first quarter
of fiscal 2004, we introduced the DEXATRIM All in One Bar, SELSUN BLUE
Conditioner, PAMPRIN All Day, BULLFROG SuperBlock Spray Lotion and PHISODERM
CLEAR CONFIDENCE Self Heating Daily Scrub and Herbal Astringent. In the second
quarter of fiscal 2004, we introduced the ICY HOT Medicated Sleeve. Line
extensions, product introductions and acquisitions require a significant amount
of introductory advertising and promotional support. For a period of time, these
products do not generate a commensurate amount of sales or earnings. As a
result, we may experience a short-term impact on our profitability due to line
extensions and acquisitions.
In March 2002, we acquired worldwide rights (except in India) to
manufacture, sell and market SELSUN BLUE, which is marketed internationally as
SELSUN, plus related intellectual property and certain manufacturing equipment
from Abbott Laboratories ("Abbott"). Abbott, or manufacturers under contract to
Abbott, manufactured SELSUN BLUE for us domestically until June 2003 and
internationally until the end of March 2004. We have entered into an amendment
to the manufacturing agreement with Abbott under which Abbott will continue to
manufacture SELSUN for us for the European, Middle East and several Latin
American markets for an additional period ending July 2005 at agreed upon rates,
which vary by market. Abbott will also continue to serve as our distributor for
SELSUN in certain foreign countries under separate distribution agreements. All
of our North American SELSUN BLUE product lines are presently being manufactured
at our Chattanooga facilities. During a transition period which ended March 28,
2004, Abbott also marketed, sold and distributed SELSUN products for us in
certain foreign countries until we could satisfy various foreign regulatory
requirements, new distributors were in place and any applicable marketing
permits were transferred. During the transition period, Abbott paid us an
initial royalty equal to 28% of international
25
sales of SELSUN in these countries with the royalty reduced to 14% of
international sales in certain countries if foreign regulatory requirements were
satisfied prior to our assumption of sales and marketing responsibility in such
countries. During the transition period, Abbott paid all costs and expenses
related to the manufacture, marketing and sales of SELSUN in these countries. As
we assumed responsibility for the sales and marketing effort in a country, the
royalty arrangement with respect to such country terminated. We then recorded
these international sales directly as well as the costs and expenses associated
with these sales. Abbott has agreed to extend the transition beyond March 28,
2004 in several countries where we are still awaiting regulatory approval of the
transfer. In certain international markets, we sell SELSUN through a distributor
and receive a royalty based on a percentage of distributor sales.
In January 2004, our board of directors increased the total
authorization to repurchase our common stock under our stock buyback program to
$20.0 million. For the six months ended May 31, 2004, we repurchased 129,000
shares for $3.2 million. The remaining availability under the board
authorization was $16.8 million as of May 31, 2004. We are limited in our
ability to repurchase shares due to restrictions under the terms of our Senior
Secured Revolving Credit Facility due February 26, 2009 (the "Revolving Credit
Facility") and the indenture pursuant to which Floating Rate Senior Notes due
2010 (the "Floating Rate Notes") and 7.0 % Senior Subordinated Fixed Rate Notes
due 2014 (the "7.0% Subordinated Notes") were issued.
Our net income margin (net income/total revenues) was 10.3% and 11.8%
for the second quarter of fiscal 2004 and 2003, respectively, and 5.0% and 9.9%
for the six months ended May 31, 2004 and 2003, respectively. Our net income
(excluding debt extinguishment charges and settlement and administrative costs
of PPA litigation) margin (net income (excluding debt extinguishment charges and
settlement and administrative costs of PPA litigation)/total revenues) was 15.1%
and 13.2% for the three and six months ended May 31, 2004, respectively. We
believe that disclosure of net income (excluding debt extinguishment charges and
settlement and administrative costs of PPA litigation) margin provides investors
with useful information regarding the Company's financial performance and allows
for easier comparison with net income margin without the effect of these charges
in prior periods. A reconciliation of net income (excluding debt extinguishment
charges and settlement and administrative costs of PPA litigation) to net income
for the three and six months ended May 31, 2004 is presented in the following
table:
For the For the
Three Months Six Months
Ended Ended
May 31, May 31,
2004 2004
---------- ----------
(dollars in thousands)
Net income $ 7,247 $ 6,535
Add:
Loss on early extinguishment of debt 1,649 12,958
Settlement and administrative costs of PPA litigation 3,463 3,657
Benefit from income taxes (1,789) (5,815)
---------- ----------
Net income (excluding debt extinguishment charges and
settlement and administrative costs of PPA litigation) $ 10,570 $ 17,335
========== ==========
Net income (excluding debt extinguishment charges and
settlement and administrative costs of PPA litigation)
margin 15.1% 13.2%
========== ==========
26
EBITDA, earnings before interest, taxes, depreciation and amortization,
is a key non-GAAP financial measure used by us to measure operating performance
but may not be comparable to a similarly titled measure reported by other
companies. The most directly comparable GAAP financial measure is net income.
EBITDA is used to supplement net income as an indicator of operating performance
and not as an alternative to measures defined and required by accounting
principles generally accepted in the United States. We consider EBITDA an
important indicator of our operational strength and performance, including our
ability to pay interest, service debt and fund capital expenditures. EBITDA is
also one measure used in the calculation of certain ratios to determine our
compliance with the terms of our Revolving Credit Facility.
A reconciliation of EBITDA and EBITDA (excluding settlement and
administrative costs of PPA litigation) to net income is presented in the
following table:
For the Three Months Ended
---------------------------------------------------
Dollar Percentage
May 31, May 31, Increase Increase
2004 2003 (Decrease) (Decrease)
-------- -------- -------- --------
(dollars in thousands)
Net income $ 7,247 $ 7,521 $ (274) (3.6%)
Add:
Provision for income taxes 3,902 4,299 (397) (9.2)
Interest expense, net (includes loss on
early extinguishment of debt in 2004) 5,173 5,174 (1) --
Depreciation and amortization less
amounts included in interest 1,349 1,018 331 32.5
-------- -------- --------
EBITDA $ 17,671 $ 18,012 $ (341) (1.9)
======== ======== ========
Settlement and administrative costs of
PPA litigation 3,463 -- 3,463 nm
-------- -------- --------
EBITDA (excluding settlement and
administrative costs of PPA litigation) $ 21,134 $ 18,012 $ 3,122 17.3
======== ======== ========
EBITDA margin (EBITDA/total revenues) 25.2% 28.3%
======== ========
EBITDA (excluding settlement and
administrative costs of PPA litigation)
margin (EBITDA (excluding settlement
and administrative costs of PPA
litigation)/total revenues) 30.2% 28.3%
======== ========
For the Three Months Ended
---------------------------------------------------
Dollar Percentage
May 31, May 31, Increase Increase
2004 2003 (Decrease) (Decrease)
-------- -------- -------- --------
(dollars in thousands)
Net income $ 6,535 $ 12,110 $ (5,575) (46.0%)
Add:
Provision for income taxes 3,519 7,112 (3,593) (50.5)
Interest expense, net (includes loss on
early extinguishment of debt in 2004) 21,192 10,287 10,905 106.0
Depreciation and amortization less
amounts included in interest 2,617 2,152 465 21.6
-------- -------- --------
EBITDA $ 33,863 $ 31,661 $ 2,202 7.0
======== ======== ========
Settlement and administrative costs of
PPA litigation 3,657 -- 3,657 nm
-------- -------- --------
EBITDA (excluding settlement and
administrative costs of PPA litigation) $ 37,520 $ 31,661 $ 5,859 18.5
======== ======== ========
EBITDA margin (EBITDA/total revenues) 25.8% 25.9%
======== ========
EBITDA (excluding settlement and
administrative costs of PPA
litigation) margin (EBITDA
(excluding settlement and
administrative costs of PPA
litigation)/total revenues) 28.6% 25.9%
======== ========
27
On December 19, 2003, we entered into a memorandum of understanding with
the Plaintiffs' Steering Committee ("PSC") in IN RE PHENYLPROPANOLAMINE ("PPA")
PRODUCTS LIABILITY LITIGATION, MDL 1407, pending before the United States
District Court for the Western District of Washingtion (the "Memorandum of
Understanding"). The Memorandum of Understanding memorialized certain settlement
terms concerning lawsuits relating to DEXATRIM products containing PPA.
On April 13, 2004, we entered into a class action settlement agreement
with representatives of the plaintiffs' settlement class. The court granted
preliminary approval of the class action settlement on April 23, 2004. The class
action settlement agreement is generally consistent with the terms of and
supercedes the Memorandum of Understanding and provides for a national class
action settlement of all DEXATRIM PPA claims. The class action settlement is
subject to final approval by the court at a fairness hearing currently scheduled
for August 26, 2004.
In accordance with the terms of the DEXATRIM class action settlement
agreement, $60.9 million has been funded into an initial settlement trust from
our first three layers of insurance coverage, as described below. We have
published notice of the final settlement and details as to the manner in which
claims can be submitted. The deadline for submission of all claims is July 7,
2004. If the final settlement is approved by the court, claims submitted in the
class settlement would be valued pursuant to an agreed upon settlement matrix
that is designed to evaluate and determine the settlement value of each claim.
To the extent the amount in the initial settlement trust is ultimately
insufficient to fully fund the settlement, we will be required to make
additional contributions to the settlement trust in the future.
We cannot assure you that the terms of the class action settlement
agreement will be approved by the court. If the settlement is not approved, we
will continue to defend individual cases in a number of different state and
federal jurisdictions. If the final settlement is approved, we believe that the
settlement will include a substantial majority of the claims by users of
DEXATRIM products containing PPA, but that some claims may elect to "opt out" of
any class settlement and will continue to pursue claims for damages against us
in separate lawsuits. We cannot estimate at this time how many claims may opt
out or whether such claims will result in significant additional liability for
us. To the extent the number or settlement value of opt out claims exceeds
certain levels as specified in the class action settlement agreement, we reserve
the right to terminate the settlement.
If the settlement is approved based on the proposed terms and
information currently known to us about the pending cases, we estimate that we
may record, during fiscal 2004, a charge, net of insurance recovery, of
approximately $20.0-25.0 million, or an after tax charge of $13.0-16.3 million
(approximately $.65-.82 per share), for settlement costs, administrative
expenses and costs of defense related to resolving the PPA litigation. In the
second fiscal quarter ended May 31, 2004, we paid or accrued the first portion
of this charge, $3.5 million, or $2.3 million after tax ($.11 per share).
Although we believe an additional liability existed as of May 31, 2004 related
to our PPA litigation, because the final terms of the settlement are still
uncertain and have not been approved, we are not able to reasonably estimate the
amount of such liability at May 31, 2004 and have made no provision for this
liability in our condensed consolidated financial statements.
As indicated above, $60.9 million from our first three layers of our
product liability insurance coverage available for the PPA litigation has been
funded into an initial settlement trust. To the extent the amount in the initial
settlement trust is insufficient to fully fund the settlement, we will be
required to make additional contributions to the settlement trust in the future.
We currently expect to use certain of our cash on hand to fund any required
additional contributions to the settlement trust. If we are required to fund
significant other liabilities related to the PPA litigation beyond the initial
settlement trust, either pursuant to the terms of the settlement, as a result of
litigation or otherwise, we will have significantly fewer sources of funds with
which to satisfy such liabilities, and we may be unable to do so. Moreover, if
the settlement is not approved, we may not have sufficient funds to satisfy all
claims against us.
We have reached an agreement with Kemper Indemnity Insurance Company
("Kemper") to settle Kemper's lawsuit that sought to rescind our policy for
$50.0 million of excess coverage for product liability claims. After giving
effect to the settlement with Kemper, we have available for the claims against
us related to the PPA litigation, through our first three layers of insurance
coverage, approximately $60.9 million of the $77.0 million of product liability
coverage provided by these insurance policies. The $60.9 million of available
coverage consists of $37.5 million of insurance under the Kemper policy and
approximately $23.4 million under policies with two other insurance companies.
As indicated above, this $60.9 million of coverage has been funded into an
initial settlement trust in accordance with the terms of the class action
settlement agreement.
We continue to aggressively defend an action brought by Interstate Fire
& Casualty Company ("Interstate") to rescind its $25.0 million of excess
coverage for product liability and pursue our available remedies at law against
Interstate. We cannot assure you that we will be successful in retaining such
excess coverage. The Interstate policy is in excess of the product liability
insurance available from Kemper and the two other insurance companies referred
to above. In the event the $60.9 million of insurance funds available in the
initial settlement trust are exhausted under the PPA settlement or otherwise,
coverage under the Interstate policy would not be available until we have paid
$12.6 million toward the settlement of PPA claims to reach the $73.5 million
coverage point for the Interstate policy.
28
On December 30, 2003, the United States Food and Drug Administration
("FDA") issued a consumer alert on the safety of dietary supplements containing
ephedrine alkaloids and on February 6, 2004 published a final rule with respect
to these products. The final rule prohibits the sale of dietary supplements
containing ephedrine alkaloids because such supplements present an unreasonable
risk of illness or injury. The final rule became effective on April 11, 2004.
Although we discontinued the manufacturing and shipment of DEXATRIM containing
ephedrine in September 2002, the FDA's final rule may result in additional
lawsuits being filed against us alleging damages related to the use or purchase
of DEXATRIM containing ephedrine.
RESULTS OF OPERATIONS
- ---------------------
The following table sets forth, net income and for the periods
indicated, certain items from our Condensed Consolidated Statements of Income
expressed as a percentage of total revenues:
For the Three Months Ended For the Six Months Ended
--------------------------- ---------------------------
May 31, 2004 May 31, 2003 May 31, 2004 May 31, 2003
------------ ------------ ------------ ------------
TOTAL REVENUES 100.0% 100.0% 100.0% 100.0%
------ ------ ----- -----
COSTS AND EXPENSES:
Cost of sales 29.3 27.9 28.6 29.0
Advertising and promotion 27.2 29.1 28.6 30.3
Selling, general and administrative 15.2 16.3 16.2 16.5
Settlement and administrative costs of
PPA litigation 5.0 -- 2.8 --
------ ------ ----- -----
Total costs and expenses 76.7 73.3 76.2 75.8
------ ------ ----- -----
INCOME FROM OPERATIONS 23.3 26.7 23.8 24.2
------ ------ ----- -----
OTHER INCOME (EXPENSE):
Interest expense (5.2) (8.2) (6.4) (8.5)
Investment and other income, net 0.2 0.1 0.1 0.1
Loss on early extinguishment of debt (2.4) -- (9.8) --
------ ------ ----- -----
Total other income (expense) (7.4) (8.1) (16.1) (8.4)
------ ------ ----- -----
INCOME BEFORE INCOME TAXES 15.9 18.6 7.7 15.8
PROVISION FOR INCOME TAXES 5.6 6.8 2.7 5.9
------ ------ ----- -----
NET INCOME (1) 10.3% 11.8% 5.0% 9.9%
====== ====== ===== =====
- ------------
(1) For the net income (excluding debt extinguishment charges and settlement and
administrative costs of PPA litigation) margin, see the "Overview" in this
Management's Discussion and Analysis.
CRITICAL ACCOUNTING POLICIES
- ----------------------------
The preparation of financial statements in accordance with accounting
principles generally accepted in the United States requires management to use
estimates. Several different estimates or methods can be used by management that
might yield different results. The following are the significant estimates used
by management in the preparation of the May 31, 2004 condensed consolidated
financial statements:
ALLOWANCE FOR DOUBTFUL ACCOUNTS
As of May 31, 2004, an estimate was made of the collectibility of the
outstanding accounts receivable balances. This estimate requires the utilization
of outside credit services, knowledge about the customer and the customer's
industry, new developments in the customer's industry and operating results of
the customer as well as general economic conditions and historical trends. When
all these facts are compiled, a judgment as to the collectibility of the
individual account is made. Many factors can impact this estimate, including
those noted in this paragraph. The adequacy of the estimated allowance may be
impacted by the deterioration in the financial condition of a large customer,
weakness in the economic environment resulting in a higher level of customer
bankruptcy filings or delinquencies and the competitive environment in which the
customer operates.
29
REVENUE RECOGNITION
Revenue is recognized when our products are shipped to our customers.
It is generally our policy across all classes of customers that all sales are
final. As is common in the consumer products industry, customers return products
for a variety of reasons including products damaged in transit, discontinuance
of a particular size or form of product and shipping errors. As sales are
recorded, we accrue an estimated amount for product returns as a reduction of
these sales based upon our historical experience and any known specific events
that affect the accrual. We charge the allowance account resulting from this
accrual with any authorized deduction from remittance by the customer or product
returns upon receipt of the product.
In accordance with industry practice, we allow our customers to return
unsold sun care products (i.e. BULLFROG line of products) at the end of the sun
care season. We record the sales at the time the products are shipped and title
transfers. At the time of shipment, we also record a reduction in sales and an
allowance on our consolidated balance sheet for anticipated returns based upon
an estimated return level. The level of returns may fluctuate from our estimates
due to several factors including weather conditions, customer inventory levels
and competitive conditions. Each percentage point change in our return rate
would impact our net sales by approximately $0.1 million. For the three and six
months ended May 31, 2004, we revised our estimate of returns related to our
BULLFROG line of products by approximately $0.3 million and $0.6 million,
respectively, which were included as increases to net sales in the 2004
condensed consolidated financial statements.
We routinely enter into agreements with our customers to participate in
promotional programs. These programs generally take the form of coupons,
temporary price reductions, scan downs, display activity and participations in
advertising vehicles provided uniquely by the customer. The ultimate cost of
these programs is often variable based on the number of units actually sold.
Estimated unit sales of a product under a promotional program are used to
estimate the total cost of the program, which is recorded as a reduction of
sales. Actual results can differ from the original estimate. We also consider
customer delays in requesting promotional program payments when evaluating the
required accrual. Many customers audit programs significantly after the date of
performance to determine the actual amount due and make a claim for
reimbursement at that time. As a result, changes in the unit sales trends under
promotional programs as well as the timing of payments could result in changes
in the accrual. During the second quarter of fiscal 2004, we revised our
estimate by approximately $0.5 million, which was included as an increase to net
sales in the 2004 condensed consolidated financial statements.
INCOME TAXES
We account for income taxes using the asset and liability approach as
prescribed by Statement of Financial Accounting Standards ("SFAS") No. 109,
"Accounting for Income Taxes". This approach requires recognition of deferred
tax assets and liabilities for the expected future tax consequences of events
that have been included in the consolidated financial statements or tax returns.
Using the enacted tax rates in effect for the year in which the differences are
expected to reverse, deferred tax assets and liabilities are determined based on
the differences between the financial reporting and the tax basis of an asset or
liability. We record income tax expense in our consolidated financial statements
based on an estimated annual effective income tax rate. Our tax rate for the
three and six months ended May 31, 2004 was 35%, respectively, as compared to
36% in the corresponding quarter of fiscal 2003 and 37% for the six months ended
May 31, 2003. The lower rate in fiscal 2004 reflects the implementation of a
number of foreign and state tax planning initiatives.
For a summary of our significant accounting policies, see Note 2 of
Notes to Consolidated Financial Statements included in our Annual Report on Form
10-K for the year ended November 30, 2003 filed with the Securities and Exchange
Commission.
30
COMPARISON OF THREE MONTHS ENDED MAY 31, 2004 AND 2003
- ------------------------------------------------------
To facilitate discussion of our operating results for the three months
ended May 31, 2004 and 2003, we have included the following selected data from
our Condensed Consolidated Statements of Income:
Increase (Decrease)
------------------------
2004 2003 Amount Percentage
-------- -------- -------- ----------
(dollars in thousands)
Domestic net sales $ 63,684 $ 56,181 $ 7,503 13.4%
International revenues (including royalties) 6,408 7,452 (1,044) (14.0)
Total revenues 70,092 63,633 6,459 10.2
Cost of sales 20,556 17,713 2,843 16.1
Advertising and promotion expense 19,080 18,529 551 3.0
Selling, general and administrative expense 10,671 10,397 274 2.6
Settlement and administrative costs of PPA litigation 3,463 -- 3,463 nm
Interest expense 3,639 5,227 (1,588) (30.4)
Loss on early extinguishment of debt 1,649 -- 1,649 nm
Net income 7,247 7,521 (274) (3.6)
DOMESTIC NET SALES
Domestic net sales for the three months ended May 31, 2004 increased
$7.5 million or 13.4% as compared to the corresponding period of 2003. A
comparison of domestic net sales for the categories of products included in our
portfolio of OTC healthcare products is as follows:
Increase (Decrease)
------------------------
2004 2003 Amount Percentage
-------- -------- -------- ----------
(dollars in thousands)
Topical analgesics $ 18,134 $ 14,626 $ 3,508 24.0%
Medicated skin care products 17,330 14,912 2,418 16.2
Dietary supplements 10,369 10,963 (594) (5.4)
Medicated dandruff shampoos and conditioner 7,406 6,641 765 11.5
Other OTC and toiletry products 10,445 9,039 1,406 15.6
-------- -------- --------
Total $ 63,684 $ 56,181 $ 7,503 13.4
======== ======== ========
Domestic net sales increased in all product categories except for the
dietary supplements category. Net sales growth in the topical analgesics
category was led by a 67% increase in sales of ICY HOT, which was driven by the
continued strength of the ICY HOT Back Patch and better than expected initial
shipments of the ICY HOT Medicated Sleeve. Net sales growth in this category
also resulted from a 9% sales increase in CAPZASIN. The overall sales growth in
this category was partially offset by a decline in sales for the balance of the
topical analgesic brands as competition from inside and outside the category
increased. Net sales growth in the medicated skin care products category
resulted from a 32% increase in the GOLD BOND franchise. GOLD BOND sales growth
was attributable to 142%, 54% and 26% increases from the lotion, cream and foot
care lines, respectively, and was partially offset by declines in the first aid
portion of the business. The increase in the GOLD BOND lotion line of products
was attributable to the successful launch of GOLD BOND ULTIMATE Healing Skin
Therapy Lotion in the third quarter of fiscal 2003. Sales growth in the
medicated skin care products category was also offset by a 27% decrease in
PHISODERM sales. Domestic net sales of SELSUN BLUE medicated dandruff shampoo
increased due to an effective advertising campaign and initial shipments of
SELSUN BLUE conditioner, which was launched in the first quarter of fiscal 2004.
The increase in net sales for the other OTC and toiletry products category was
due primarily to sales increases of PAMPRIN, attributable to the introduction of
PAMPRIN All Day in the first quarter of fiscal 2004, and BULLFROG. The increase
in sales of BULLFROG was primarily attributable to expanded distribution and
increased sales of pre-pack displays. HERPECIN-L, SUN-IN and ULTRASWIM also
experienced net sales growth in the second fiscal quarter of 2004.
Net sales for the dietary supplements category declined primarily due to
a 55% decrease in DEXATRIM diet pill sales and a 12% decline in GARLIQUE sales
from the corresponding year-ago quarter. Sales of DEXATRIM were impacted by the
overall decline in the diet pill market resulting from negative ephedrine
publicity and the emergence of low carbohydrate diet products. The decline in
net sales of DEXATRIM diet pills and GARLIQUE was partially offset by better
than expected sales of the DEXATRIM All in One Bar, which was introduced in the
first quarter of fiscal 2004, as well as increased sales of NEW PHASE. The
increase in net sales of NEW PHASE was primarily attributable to effective media
campaigns and increased distribution. With the exception of PAMPRIN, PREMSYN
PMS, PHISODERM, FLEXALL, ASPERCREME, CAPZASIN and SPORTSCREME, domestic sales
variances were principally the result of changes in unit sales volumes. PAMPRIN,
PREMSYN PMS, PHISODERM, FLEXALL, ASPERCREME, CAPZASIN and SPORTSCREME
experienced a unit sales price increase.
31
INTERNATIONAL REVENUES
For the second quarter of fiscal 2004, international revenues decreased
$1.0 million or 14.0% as compared to the second quarter of fiscal 2003 due
principally to a 8.9% sales decrease in Canada and a 24.6% sales decrease in the
United Kingdom ("U.K."). Weaker sales in Canada are attributable to increased
competition, primarily in the medicated lotion category. The sales decrease in
the U.K. resulted primarily from the termination of certain European distributor
relationships. Other international revenues, including royalties from the sales
of SELSUN, increased 4.7% primarily as a result of increased SELSUN sales. Sales
variances for international operations were principally the result of changes in
unit sales volumes.
COST OF SALES
Cost of sales as a percentage of total revenues was 29.3% for the second
quarter of fiscal 2004 as compared to 27.9% for the second quarter of fiscal
2003. Cost of sales in the second quarter of fiscal 2004 increased $2.8 million
due primarily to initial sales of the DEXATRIM All in One Bar and the ICY HOT
Medicated Sleeve, both of which have lower profit margins than most of our other
products.
ADVERTISING AND PROMOTION EXPENSE
Advertising and promotion expenses in the second quarter of fiscal 2004
increased $0.6 million or 3.0% as compared to the same quarter of fiscal 2003
and were 27.2% of total revenues for the three months ended May 31, 2004
compared to 29.1% for the comparable period of fiscal 2003. Support for new
product introductions drove an increase in advertising and promotion
expenditures in the current period for ICY HOT, PAMPRIN, DEXATRIM All in One
Bar, BULLFROG, SELSUN BLUE and the GOLD BOND cream, lotion and foot care lines.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSE
Selling, general and administrative expenses increased $0.3 million or
2.6% as compared to the same quarter of fiscal 2003. Selling, general and
administrative expenses were 15.2% and 16.3% of total revenues for the second
quarter of fiscal 2004 and 2003, respectively. An increase in sales was
primarily responsible for the increase in selling expense, which was offset by a
decrease in general and administrative expenses primarily attributable to a
decrease in compensation and benefit costs.
SETTLEMENT AND ADMINISTRATIVE COSTS OF PPA LITIGATION
Settlement and administrative costs of PPA litigation were $3.5 million
in the second quarter of fiscal 2004. This expense was attributable to
administrative costs of PPA litigation, advertising costs related to the PPA
settlement and reimbursement of legal and administrative costs in accordance
with a settlement with one of our insurance providers. No corresponding expenses
were recorded in the three months ended May 31, 2003.
INTEREST EXPENSE
Interest expense decreased $1.6 million or 30.4% in the second quarter
of fiscal 2004 as compared to the same quarter of fiscal 2003. The decrease was
largely the result of our debt refinancing completed during the first quarter of
fiscal 2004. Until our indebtedness is reduced substantially, interest expense
will continue to represent a significant percentage of our total revenues.
LOSS ON EARLY EXTINGUISHMENT OF DEBT
In the second quarter of fiscal 2004, we recorded a loss on early
extinguishment of debt of approximately $1.7 million and a related tax benefit
of $0.6 million related to the redemption of the remaining $30.0 million of our
8.875% Senior Subordinated Notes due 2009 ("8.875% Subordinated Notes").
32
COMPARISON OF SIX MONTHS ENDED MAY 31, 2004 AND 2003
- ----------------------------------------------------
To facilitate discussion of our operating results for the six months
ended May 31, 2004 and 2003, we have included the following selected data from
our Condensed Consolidated Statements of Income:
Increase (Decrease)
------------------------
2004 2003 Amount Percentage
-------- -------- -------- ----------
(dollars in thousands)
Domestic net sales $119,291 $108,861 $ 10,430 9.6%
International revenues (including royalties) 12,038 13,197 (1,159) (8.8)
Total revenues 131,329 122,058 9,271 7.6
Cost of sales 37,508 35,404 2,104 5.9
Advertising and promotion expense 37,612 36,934 678 1.8
Selling, general and administrative expense 21,306 20,211 1,095 5.4
Settlement and administrative costs of PPA litigation 3,657 -- 3,657 nm
Interest expense 8,394 10,374 (1,980) (19.1)
Loss on early extinguishment of debt 12,958 -- 12,958 nm
Net income 6,535 12,110 (5,575) (46.0)
DOMESTIC NET SALES
Domestic net sales for the six months ended May 31, 2004 increased $10.4
million or 9.6% as compared to the corresponding period of 2003. A comparison of
domestic net sales for the categories of products included in our portfolio of
OTC healthcare products is as follows:
Increase (Decrease)
------------------------
2004 2003 Amount Percentage
-------- -------- -------- ----------
(dollars in thousands)
Topical analgesics $ 33,846 $ 28,198 $ 5,648 20.0%
Medicated skin care products 30,663 28,062 2,601 9.3
Dietary supplements 18,880 20,568 (1,688) (8.2)
Medicated dandruff shampoos and conditioner 16,627 14,812 1,815 12.3
Other OTC and toiletry products 19,275 17,221 2,054 11.9
-------- -------- --------
Total $119,291 $108,861 $ 10,430 9.6
======== ======== ========
Domestic net sales increased in all product categories except for the
dietary supplements category. Net sales growth in the topical analgesics
category was led by a 51% increase in sales of ICY HOT, which was driven by the
continued strength of the ICY HOT Back Patch and better than expected initial
shipments of the ICY HOT Medicated Sleeve. Net sales growth in this category
also resulted from a 20% sales increase in CAPZASIN. The overall sales growth in
this category was partially offset by a decline in sales for the balance of the
topical analgesic brands as competition from inside and outside the category
increased. Net sales growth in the medicated skin care products category
resulted from an 18% increase in the GOLD BOND franchise. GOLD BOND sales growth
was attributable to 50%, 48% and 27% increases from the lotion, cream and foot
care lines, respectively, and was partially offset by declines in the first aid
portion of the business. The increase in the GOLD BOND lotion line of products
was attributable to the successful launch of GOLD BOND ULTIMATE Healing Skin
Therapy Lotion in the third quarter of fiscal 2003. Sales growth in this
category was further offset by a 16% decrease in PHISODERM sales. Domestic net
sales of SELSUN BLUE medicated dandruff shampoo increased due to an effective
advertising campaign and initial shipments of SELSUN BLUE conditioner. The
increase in net sales for the other OTC and toiletry products category was due
primarily to sales increases of PAMPRIN, attributable to the introduction of
PAMPRIN All Day in the first quarter of fiscal 2004, and BULLFROG. The increase
in sales of BULLFROG was primarily attributable to expanded distribution and
increased sales of pre-pack displays. HERPECIN-L also experienced net sales
growth in the six months ended May 31, 2004.
Net sales for the dietary supplements category declined primarily due to
a 52% decrease in DEXATRIM diet pill sales from the corresponding year-ago
period. Sales of DEXATRIM were impacted by the overall decline in the diet pill
market resulting from negative ephedrine publicity and the emergence of low
carbohydrate diet products. The decline in net sales of DEXATRIM diet pills was
partially offset by better than expected sales of the DEXATRIM All in One Bar,
which was introduced in the first quarter of fiscal 2004, as well as increased
sales of NEW PHASE. The increase in net sales of NEW PHASE was primarily
attributable to effective media campaigns and increased distribution. With the
exception of PAMPRIN, PREMSYN PMS, PHISODERM, FLEXALL, ASPERCREME, CAPZASIN and
SPORTSCREME, domestic sales variances were principally the result of changes in
unit sales volumes. PAMPRIN, PREMSYN PMS, PHISODERM, FLEXALL, ASPERCREME,
CAPZASIN and SPORTSCREME experienced a unit sales price increase.
33
INTERNATIONAL REVENUES
For the six months ended May 31, 2004, international revenues decreased
$1.2 million or 8.8% as compared to the same period in fiscal 2003 due
principally to a 3.3% sales decrease in Canada and a 22.6% sales decrease in the
U.K. The sales decrease in the U.K. primarily resulted from the termination of
certain European distributor relationships. Other international revenues,
including royalties from the sales of SELSUN, increased 15.0% primarily as a
result of SELSUN sales. Sales variances for international operations were
principally the result of changes in unit sales volumes.
COST OF SALES
Cost of sales as a percentage of total revenues was 28.6% for the six
months ended May 31, 2004 as compared to 29.0% for the comparable period of
fiscal 2003. Cost of sales in the six months ended May 31, 2004 increased $2.1
million due primarily to initial sales of the DEXATRIM All in One Bar and the
ICY HOT Medicated Sleeve, which are both lower margin products. The increase was
partially offset by a fiscal 2003 charge of approximately $0.7 million related
to DEXATRIM charges for product returns containing ephedrine.
ADVERTISING AND PROMOTION EXPENSE
Advertising and promotion expenses in the six months ended May 31, 2004
increased $0.7 million or 1.8% as compared to the same period in fiscal 2003 and
were 28.6% of total revenues for the six months ended May 31, 2004 compared to
30.3% for the comparable period of fiscal 2003. Support for new product
introductions drove an increase in advertising and promotion expenditures in the
current period for ICY HOT, PAMPRIN, DEXATRIM All in One Bar, BULLFROG, SELSUN
BLUE and the GOLD BOND cream, lotion and foot care lines.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSE
Selling, general and administrative expenses increased $1.1 million or
5.4% as compared to the same period of fiscal 2003. Selling, general and
administrative expenses were 16.2% and 16.5% of total revenues for the six
months ended May 31, 2004 and 2003, respectively. An increase in sales was
primarily responsible for the increase in selling expense. General and
administrative expenses remained flat compared to the corresponding period of
fiscal 2003.
SETTLEMENT AND ADMINISTRATIVE COSTS OF PPA LITIGATION
Settlement and administrative costs of PPA litigation were $3.7 million
for the six months ended May 31, 2004. This expense was attributable to
administrative costs of PPA litigation, advertising costs related to the PPA
settlement and reimbursement of legal and administrative costs in accordance
with a settlement with one of our insurance providers. No corresponding expenses
were recorded in the six months ended May 31, 2003.
INTEREST EXPENSE
Interest expense decreased $2.0 million or 19.1% in the six months ended
May 31, 2004 as compared to the same period in fiscal 2003. The decrease was
largely the result of our debt refinancing completed during the first quarter of
fiscal 2004. Until our indebtedness is reduced substantially, interest expense
will continue to represent a significant percentage of our total revenues.
LOSS ON EARLY EXTINGUISHMENT OF DEBT
During the six months ended May 31, 2004, we retired $204.5 million
principal amount of our 8.875% Subordinated Notes and the remaining outstanding
balance of our $60,000 senior secured credit facility from a syndicate of
commercial banks led by Bank of America, N.A., as agent ("Credit Facility"),
which resulted in a loss on early extinguishment of debt of $13.0 million and a
related tax benefit of $4.5 million.
LIQUIDITY AND CAPITAL RESOURCES
- -------------------------------
We have historically financed our operations with a combination of
internally generated funds and borrowings. Our principal uses of cash are for
operating expenses, servicing long-term debt, acquisitions, working capital,
repurchases of our common stock, payment of income taxes and capital
expenditures.
Cash of $13.5 million and $12.4 million was provided by operations for
the six months ended May 31, 2004 and 2003, respectively. Cash flows from
operations were impacted by an increase in working capital primarily
attributable to an increase in accounts receivable resulting from an increase in
sales of seasonal products, which have longer dated terms, as compared to the
34
corresponding period of fiscal 2003. In addition, a loss on early extinguishment
of debt of $13.0 million and a tax benefit of $4.5 million was recorded in the
six months ended May 31, 2004.
Investing activities used cash of $2.0 million and $2.6 million in the
six months ended May 31, 2004 and 2003, respectively. The decrease in usage of
cash was primarily due to reduced spending on capital expenditures in the first
half of fiscal 2004. Capital expenditures are anticipated to increase in the
second half of fiscal 2004.
Financing activities used cash of $27.6 million and $11.9 million in the
six months ended May 31, 2004 and 2003, respectively. The increase in cash used
in financing activities in the current period was attributable to a net
repayment of long-term debt of $12.3 million, an increase in and retirement of
debt issuance costs of $13.6 million related to the refinancing transactions, a
payment of $1.4 million for a premium on the interest rate cap agreement and
$3.2 million of repurchased shares offset by proceeds from the exercise of stock
options of $2.9 million.
As of May 31, 2004, total debt consisted of our Floating Rate Notes of
$75.0 million and 7.0 % Subordinated Notes of $125.0 million. As of May 31, 2004
and June 30, 2004, we had no borrowings outstanding under our Revolving Credit
Facility with available borrowings up to $50.0 million. Borrowings under our
Revolving Credit Facility bear interest at LIBOR plus applicable percentages of
1.75% to 2.50% or a base rate (the higher of the federal funds rate plus 0.5% or
the prime rate) plus applicable percentages of 0.25% to 1.0% ( 4.75% as of May
31, 2004). The applicable percentages are calculated based on our leverage
ratio. The Floating Rate Notes bear interest at a three-month LIBOR plus 3.00%
per year (4.12% as of May 31, 2004). On March 8, 2004, we entered into an
interest rate cap agreement effective June 1, 2004 with decreasing notional
principal amounts and cap rates ranging from 4.0% to 5.0% over the life of the
agreement. We paid a $1.4 million premium to enter into the interest rate cap
agreement, which will be amortized over the life of the agreement. The current
portion of the premium on the interest rate cap agreement of $14,000 is included
in prepaid expenses and other current assets, and the long-term portion of $1.4
million is included in other noncurrent assets. The amortized value of the
premium on the interest rate cap will be compared to its fair value quarterly.
If the fair value is lower than the carrying value of the premium on the
interest rate cap, a charge will be recorded to other comprehensive income. The
interest rate cap agreement terminates on March 1, 2010.
On December 19, 2003, we entered into a Memorandum of Understanding with
the PSC, which memorialized certain settlement terms concerning lawsuits
relating to DEXATRIM products containing PPA. On April 13, 2004, we entered into
a class action settlement agreement with representatives of the plaintiffs'
settlement class. The court granted preliminary approval of the class action
settlement on April 23, 2004. The class action settlement agreement is generally
consistent with the terms of and supercedes the Memorandum of Understanding and
provides for a national class action settlement of all DEXATRIM PPA claims. The
class action settlement is subject to final approval by the court at a fairness
hearing currently scheduled for August 26, 2004.
In accordance with the terms of the DEXATRIM class action settlement
agreement, $60.9 million has been funded into an initial settlement trust from
our first three layers of insurance coverage, as described below. We have
published notice of the final settlement and details as to the manner in which
claims can be submitted. The deadline for submission of all claims is July 7,
2004. If the final settlement is approved by the court, claims submitted in the
class settlement would be valued pursuant to an agreed upon settlement matrix
that is designed to evaluate and determine the settlement value of each claim.
To the extent the amount in the initial settlement trust is ultimately
insufficient to fully fund the settlement, we will be required to make
additional contributions to the settlement trust in the future.
We cannot assure you that terms of the class action settlement agreement
will be approved by the court. If the settlement is not approved, we will
continue to defend individual cases in a number of different state and federal
jurisdictions. If the final settlement is approved, we believe that the
settlement will include a substantial majority of the claims by users of
DEXATRIM products containing PPA, but that some claims may elect to "opt out" of
any class settlement and will continue to pursue claims for damages against us
in separate lawsuits. We cannot estimate at this time how many claims may opt
out or whether such claims will result in significant additional liability for
us. To the extent the number or settlement value of opt out claims exceeds
certain levels as specified in the class action settlement agreement, we reserve
the right to terminate the settlement.
DELACO filed a Chapter 11 bankruptcy petition on February 12, 2004 in
the United States Bankruptcy Court for the Southern District of New York. We
understand that DELACO intends to implement its contemplated settlement with the
PSC through a liquidating Chapter 11 bankruptcy plan. If DELACO pursues the
settlement through its bankruptcy plan, we expect that the administrative
process for DELACO's settlement will be similar to the process in our class
action. We have filed a claim in DELACO's bankruptcy case in order to preserve
our claims for indemnification against DELACO. As part of this Chapter 11 plan,
we expect that after resolution of creditors' claims, DELACO will seek to
liquidate and distribute all of its assets and will dissolve as a company.
If the settlement is approved based on the proposed terms and
information currently known to us about the pending cases, we estimate that we
may record, during fiscal 2004, a charge, net of insurance recovery, of
approximately $20.0-25.0
35
million, or an after tax charge of $13.0-16.3 million (approximately $.65-.82
per share), for settlement costs, administrative expenses and costs of defense
related to resolving the PPA litigation. In the second fiscal quarter ended May
31, 2004, we paid or accrued the first portion of this charge, $3.5 million, or
$2.3 million after tax ($.11 per share). Although we believe an additional
liability existed as of May 31, 2004 related to our PPA litigation, because the
final terms of the settlement are still uncertain and have not been approved, we
are not able to reasonably estimate the amount of such liability at May 31, 2004
and have made no provision for this liability in our condensed consolidated
financial statements.
As indicated above, $60.9 million from our first three layers of our
product liability insurance coverage available for the PPA litigation has been
funded into an initial settlement trust. To the extent the amount in the initial
settlement trust is insufficient to fully fund the settlement, we will be
required to make additional contributions to the settlement trust in the future.
We currently expect to use certain of our cash on hand to fund any required
additional contributions to the settlement trust. If we are required to fund
significant other liabilities related to the PPA litigation beyond the initial
settlement trust, either pursuant to the terms of the settlement, as a result of
litigation or otherwise, we will have significantly fewer sources of funds with
which to satisfy such liabilities, and we may be unable to do so. Moreover, if
the settlement is not approved, we may not have sufficient funds to satisfy all
claims against us.
We have reached an agreement with Kemper to settle Kemper's lawsuit that
sought to rescind our policy for $50.0 million of excess coverage for product
liability claims. After giving effect to the settlement with Kemper, we have
available for the claims against us related to the PPA litigation, through our
first three layers of insurance coverage, approximately $60.9 million of the
$77.0 million of product liability coverage provided by these policies. The
$60.9 million of available coverage consists of $37.5 million of insurance under
the Kemper policy and approximately $23.4 million under policies with two other
insurance companies. As indicated above, this $60.9 million of coverage has been
funded into an initial settlement trust in accordance with the terms of the
class action settlement agreement
We continue to aggressively defend an action brought by Interstate to
rescind its $25.0 million of excess coverage for product liability and pursue
our available remedies at law against Interstate. We cannot assure you that we
will be successful in retaining such excess coverage. The Interstate policy is
in excess of the product liability insurance available from Kemper and the two
other insurance companies referred to above. In the event the $60.9 million of
insurance funds available in the initial settlement trust are exhausted under
the PPA settlement or otherwise, coverage under the Interstate policy would not
be available until we have paid $12.6 million toward the settlement of PPA
claims to reach the $73.5 million coverage point for the Interstate policy.
In January 2004, our board of directors increased the total
authorization to repurchase our common stock under our stock buyback program to
$20.0 million. For the six months ended May 31, 2004, we repurchased 129,000
shares for $3.2 million. The remaining availability under the board
authorization was $16.8 million as of May 31, 2004. We are limited in our
ability to repurchase shares due to restrictions under the terms of our
Revolving Credit Facility and the indenture pursuant to which Floating Rate
Notes and 7.0% Subordinated Notes were issued.
We believe that cash provided by operating activities, our cash and cash
equivalents balance and funds available under our Revolving Credit Facility will
be sufficient to fund our capital expenditures, debt service and working capital
requirements for the foreseeable future as our business is currently conducted.
It is likely that any acquisitions we make in the future will require us to
obtain additional financing.
FOREIGN OPERATIONS
- ------------------
Historically, our primary foreign operations have been conducted through
our Canadian and U.K. subsidiaries. The functional currencies of these
subsidiaries are Canadian dollars and British pounds, respectively. Fluctuations
in exchange rates can impact operating results, including total revenues and
expenses, when translations of the subsidiary financial statements are made in
accordance with SFAS No. 52, "Foreign Currency Translation". For the six months
ended May 31, 2004 and 2003, these subsidiaries accounted for 7% and 9% of total
revenues, respectively, and 4% and 3% of total assets for each period,
respectively. It has not been our practice to hedge our assets and liabilities
in Canada and the U.K. or our intercompany transactions due to the inherent
risks associated with foreign currency hedging transactions and the timing of
payments between us and our foreign subsidiaries. Following our acquisition of
SELSUN BLUE, which is sold in more than 75 foreign countries, our international
business operations have expanded significantly, which will increase our
exposure to fluctuations in foreign exchange rates. During the first six months
of fiscal 2004, a portion of these foreign sales was reflected as royalties,
which have been paid to us in U.S. dollars. In addition, Abbott has continued to
supply a portion of our international product where appropriate and bill us in
U.S. dollars. Beginning April 1, 2004, we were billed in local currencies.
Historically, gains or losses from foreign currency transactions have not had a
material impact on our operating results. (Losses) and gains of ($3,000) and
$0.2 million for the six months ended May 31, 2004 and 2003, respectively,
resulted from foreign currency transactions and are included in selling, general
and administrative expenses in the Condensed Consolidated Statements of Income.
36
RECENT ACCOUNTING PRONOUNCEMENTS
- --------------------------------
In April 2002, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of
FASB Statement No. 13, and Technical Corrections" ("SFAS 145"). We adopted SFAS
145 on December 1, 2002. SFAS 145 requires us to classify gains and losses on
extinguishments of debt as income or loss from continuing operations rather than
as extraordinary items as previously required under SFAS No. 4, "Reporting Gains
and Losses from Extinguishment of Debt". We are also required to reclassify any
gain or loss on extinguishment of debt previously classified as an extraordinary
item in prior periods presented. SFAS 145 also provides accounting standards for
certain lease modifications that have economic effects similar to sale-leaseback
transactions and various other technical corrections. The application of SFAS
145 resulted in recording a loss on early extinguishment of debt of $13.0
million in fiscal 2004, which was classified in the condensed consolidated
financial statements in accordance with the provisions of SFAS 145.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities" ("SFAS 146"). We adopted SFAS 146
on January 1, 2003. SFAS 146 supercedes Emerging Issues Task Force ("EITF")
Issue No. 94-3. SFAS 146 requires that the liability for a cost associated with
an exit or disposal activity be recognized when the liability is incurred, not
at the date of an entity's commitment to an exit or disposal plan. SFAS 146 is
to be applied prospectively to exit or disposal activities initiated after
December 31, 2002. The application of SFAS 146 resulted in recording $40,000 of
accrued liabilities related to the restructuring of the U.K operations. We
expect to record additional charges related to the restructuring of the U.K.
operations in the third and fourth quarters of fiscal 2004.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation
of Variable Interest Entities" ("FIN 46"). FIN 46 requires a company to
consolidate a variable interest entity ("VIE"), as defined, when the company
will absorb a majority of the VIE's expected losses, receives a majority of the
VIE's expected residual returns or both. FIN 46 also requires consolidation of
existing, non-controlled affiliates if the VIE is unable to finance its
operations without investor support, or where the other investors do not have
exposure to the significant risks and rewards of ownership. FIN 46 applies
immediately to a VIE created or acquired after January 31, 2003. For a VIE
created before February 1, 2003, FIN 46 applies in the first fiscal year or
interim period beginning after March 15, 2004, our third fiscal quarter
beginning June 1, 2004. Application of FIN 46 is also required in financial
statements that have interests in structures that are commonly referred to as
special-purpose entities for periods ending after December 15, 2003. The
adoption of FIN 46 did not have an impact on our financial position, results of
operations or cash flows.
In December 2003, the FASB issued SFAS No. 132 (revised 2003),
"Employers' Disclosure about Pensions and Other Postretirement Benefits" ("SFAS
132"). The revision of SFAS 132 provides for additional disclosures including
the description of the types of plan assets, investment strategy, measurement
date(s), plan obligations, cash flows and components of net periodic benefit
cost recognized in interim periods. The revisions of SFAS 132 are effective for
financial statements with fiscal years ending after December 15, 2003 and
interim periods beginning after December 15, 2003. The adoption of the revised
SFAS 132 did not have an impact on our financial position, results of operations
or cash flows.
FORWARD LOOKING STATEMENTS
- --------------------------
Statements in this Quarterly Report on Form 10-Q which are not
historical facts are forward-looking statements within the meaning of the
Private Securities Litigation Reform Act of 1995. These forward-looking
statements involve risks, uncertainties and assumptions that could cause actual
outcomes and results to differ materially from those expressed or projected.
37
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS
- -------------------------------------------------------------------
We are exposed to market risk from changes in interest rates and foreign
currency exchange rates, which may adversely affect our results of operations
and financial condition. We seek to minimize the risks from these interest rates
and foreign currency exchange rate fluctuations through our regular operating
and financing activities.
Our exposure to interest rate risk currently consists of our Floating
Rate Notes and our Revolving Credit Facility. The aggregate balance outstanding
under the Floating Rate Notes as of May 31, 2004 was $75.0 million. The Floating
Rate Notes bear interest at a three-month LIBOR plus 3.00% per year (4.12% as of
May 31, 2004). Loans under our Revolving Credit Facility bear interest at LIBOR
plus applicable percentages of 1.75% to 2.50% or a base rate (the higher of the
federal funds rate plus 0.5% or the prime rate) plus applicable percentages of
0.25% to 1.0%. The applicable percentages are calculated based on our leverage
ratio. As of May 31, 2004, no amounts had been borrowed under the Revolving
Credit Facility, and the variable rate on the Revolving Credit Facility was
4.75%. The 7.0% Subordinated Notes are fixed interest rate obligations. On March
8, 2004, we entered into an interest rate cap agreement effective June 1, 2004
with decreasing notional principal amounts and cap rates ranging from 4.0% to
5.0% over the life of the agreement. The amortized value of the premium on the
interest rate cap will be compared to its fair value quarterly. If the fair
value is lower than the carrying value of the premium on the interest rate cap,
a charge will be recorded to other comprehensive income. The interest rate cap
agreement terminates on March 1, 2010. The impact on our results of operations
of a one-point rate change on the balance currently outstanding of our Floating
Rate Notes for the next twelve months would be approximately $488, net of tax.
We are subject to risk from changes in the foreign exchange rates
relating to our Canadian and U.K. subsidiaries. Assets and liabilities of these
subsidiaries are translated to U.S. dollars at year-end exchange rates. Income
and expense items are translated at average rates of exchange prevailing during
the year. Translation adjustments are accumulated as a separate component of
shareholders' equity. Gains and losses, which result from foreign currency
transactions, are included in the Condensed Consolidated Statements of Income.
During the six months ended May 31, 2004, pursuant to our manufacturing
agreement with Abbott, we were billed in U.S. dollars for purchases of SELSUN
for foreign markets. In many cases in the future, we will be billed in the
respective foreign currency. The potential loss resulting from a hypothetical
10.0% adverse change in the quoted foreign currency exchange rate amounts to
approximately $1.1 million as of May 31, 2004.
This market risk discussion contains forward-looking statements. Actual
results may differ materially from this discussion based upon general market
conditions and changes in financial markets.
ITEM 4. CONTROLS AND PROCEDURES
- -------------------------------
(a) Evaluation of Disclosure Controls and Procedures.
------------------------------------------------
Our Chief Executive Officer and Chief Financial Officer have evaluated
the effectiveness of our disclosure controls and procedures (as such terms are
defined in Rules 13(a)-15(e) and 15(d)-15(e)) under the Securities Exchange Act
of 1934, as amended (the "Exchange Act") as of May 31, 2004 of this Form 10-Q
(the "Evaluation Date"). Based on such evaluation, such officers have concluded
that, as of the Evaluation Date, our disclosure controls and procedures are
effective in alerting them on a timely basis to material information relating to
us (including our consolidated subsidiaries) required to be included in our
periodic filings under the Exchange Act.
(b) Changes in Internal Controls.
----------------------------
Since the Evaluation Date, there have not been any significant changes
in our internal controls or in other factors that could significantly affect
such controls.
38
PART II. OTHER INFORMATION
--------------------------
ITEM 1. LEGAL PROCEEDINGS
- --------------------------
See Note 18 of Notes to Condensed Consolidated Financial Statements
included in Part 1, Item 1 of this Report.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
- --------------------------------------------------
A summary of the common stock repurchase activity for our second quarter
of fiscal 2004 is as follows:
Total Number of Maximum Dollar
Shares Purchased as Value that may yet
Total Number Part of Publicly be Purchased under
of Shares Average Price Announced Plans or the Plans or
Period Purchased Paid Per Share(1) Programs(2) Programs
------ --------- ----------------- ----------- --------
March 1-March 31 -- -- -- $19,681,250
April 1-April 30 47,500 $27.08 47,500 $18,394,762
May 1-May 31 65,500 $24.87 65,500 $16,765,825
Total Second Quarter 113,000 $25.80 113,000 $16,765,825
(1) Average price paid per share includes broker commissions.
(2) Our stock buyback program authorizing the purchase of up to $10.0
million of our common stock was announced in January 2003. In January
2004, our board of directors increased the total authorization to
repurchase our common stock under our stock buyback program to $20.0
million. There is no expiration date specified for our stock buyback
program.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
- ----------------------------------------
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
- ------------------------------------------------------------
The annual meeting of shareholders was held on April 14, 2004 in
Chattanooga, Tennessee. At the meeting, the following persons were elected as
directors to serve for a three-year term: Bill W. Stacy (16,692,250 votes for
and 1,319,798 votes withheld) and Zan Guerry ( 14,169,354 votes for and
3,842,694 votes withheld). The following directors' terms of office continued
after the annual meeting: Samuel E. Allen, Philip H. Sanford, A. Alexander
Taylor II, Robert E. Bosworth and Richard E. Cheney.
The shareholders also ratified Ernst & Young as our independent auditors
for fiscal 2004 (16,785,414 votes for, 1,200,406 votes against and 26,228 votes
abstained).
ITEM 5. OTHER INFORMATION
- --------------------------
None.
39
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
- -----------------------------------------
(a) Exhibits (numbered in accordance with Item 601 of Regulation S-K):
Exhibit Number Description
-------------- -----------
10.1 New Commitment Agreement dated March 9, 2004 between
Chattem, Inc. and Bank of America, N.A., as
administrative agent
10.2 Rate Cap Transaction Agreement dated March 8, 2004
between Chattem, Inc. and JPMorgan Chase Bank
10.3 Class Action Settlement Agreement dated as of April 13,
2004 between Chattem, Inc. and Class Counsel on behalf
of Class Representatives In Re Phenylpropanolamine (PPA)
Products Liability Litigation
10.4 Initial Settlement Trust Agreement dated April 12, 2004
between Chattem, Inc. and AMSOUTH BANK
10.5 Settlement Agreement dated April 26, 2004 between
Chattem, Inc. and General Star Indemnity Company
10.6 Memorandum of Understanding dated December 13, 2003
between and among Chattem, Inc. and Kemper Indemnity
Insurance Company
10.7 Settlement Agreement dated December 30, 2003 between
Chattem, Inc. and Admiral Insurance Company
31.1 Certification required by Rule 13a-14(a) under the
Securities Exchange Act of 1934
31.2 Certification required by Rule 13a-14(a) under the
Securities Exchange Act of 1934
32 Certification required by Rule 13a-14(b) under the
Securities Exchange Act of 1934 and 18 U.S.C. Section 13
(b) During the second quarter ended May 31, 2004, we filed the
following Form 8-K reports with the Securities and Exchange
Commission:
Form 8-K, filed March 18, 2004, containing a copy of our press
release announcing our financial results for the first quarter of
fiscal 2004.
Form 8-K, filed May 25, 2004, announcing that the Company expects
to exceed prior guidance on financial results for the second
quarter of fiscal 2004.
40
CHATTEM, INC.
-------------
SIGNATURES
----------
Pursuant to the requirements 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.
CHATTEM, INC.
(Registrant)
Dated: July 2, 2004 \s\ A. Alexander Taylor II
-----------------------------------
A. Alexander Taylor II
President, Chief Operating Officer and Director
(Chief Operating Officer)
Dated: July 2, 2004 \s\ Richard D. Moss
-----------------------------------
Richard D. Moss
Vice President and Chief Financial Officer
(Principal Financial Officer)
41
CHATTEM, INC. AND SUBSIDIARIES
------------------------------
EXHIBIT INDEX
-------------
Exhibit Number Description
-------------- -----------
10.1 New Commitment Agreement dated March 9, 2004 between
Chattem, Inc. and Bank of America, N.A., as
administrative agent
10.2 Rate Cap Transaction Agreement dated March 8, 2004
between Chattem, Inc. and JPMorgan Chase Bank
10.3 Class Action Settlement Agreement dated as of April 13,
2004 between Chattem, Inc. and Class Counsel on behalf
of Class Representatives In Re Phenylpropanolamine (PPA)
Products Liability Litigation
10.4 Initial Settlement Trust Agreement dated April 12, 2004
between Chattem, Inc. and AMSOUTH BANK
10.5 Settlement Agreement dated April 26, 2004 between
Chattem, Inc. and General Star Indemnity Company
10.6 Memorandum of Understanding dated December 13, 2003
between and among Chattem, Inc. and Kemper Indemnity
Insurance Company
10.7 Settlement Agreement dated December 30, 2003 between
Chattem, Inc. and Admiral Insurance Company
31.1 Certification required by Rule 13a-14(a) under the
Securities Exchange Act of 1934
31.2 Certification required by Rule 13a-14(a) under the
Securities Exchange Act of 1934
32 Certification required by Rule 13a-14(b) under the
Securities Exchange Act of 1934 and 18 U.S.C. Section 13