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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 AUGUST 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 SEPTEMBER 29, 2004, 19,785,408 SHARES OF THE COMPANY'S COMMON STOCK,
WITHOUT PAR VALUE, WERE OUTSTANDING.
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CHATTEM, INC.
-------------
INDEX
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PAGE NO.
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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of August 31, 2004 and
November 30, 2003 3
Condensed Consolidated Statements of Income for the Three and Nine
Months Ended August 31, 2004 and August 31, 2003 5
Condensed Consolidated Statements of Cash Flows for the Nine Months
Ended August 31, 2004 and August 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 39
Item 4. Controls and Procedures 39
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 40
Item 2. Changes in Securities and Use of Proceeds 40
Item 3. Defaults Upon Senior Securities 40
Item 4. Submission of Matters to a Vote of Security Holders 40
Item 5. Other Information 40
Item 6. Exhibits and Reports on Form 8-K 41
SIGNATURES 42
2
PART 1. FINANCIAL INFORMATION
-----------------------------
ITEM 1. FINANCIAL STATEMENTS
- ----------------------------
CHATTEM, INC. AND SUBSIDIARIES
------------------------------
CONDENSED CONSOLIDATED BALANCE SHEETS
-------------------------------------
(In thousands)
AUGUST 31, NOVEMBER 30,
ASSETS 2004 2003
- ------ ---------- ----------
(Unaudited)
CURRENT ASSETS:
Cash and cash equivalents $ 26,755 $ 26,931
Accounts receivable, less allowances of $3,310 at
August 31, 2004 and $3,594 at November 30, 2003 32,241 25,478
Inventories 19,549 17,559
Refundable income taxes 5,273 4,431
Deferred income taxes 1,635 3,441
Prepaid expenses and other current assets 3,369 3,376
---------- ----------
Total current assets 88,822 81,216
---------- ----------
PROPERTY, PLANT AND EQUIPMENT, NET 27,993 28,722
---------- ----------
OTHER NONCURRENT ASSETS:
Patents, trademarks and other purchased product rights, net 245,633 245,847
Debt issuance costs, net 5,348 5,504
Other 3,559 2,096
---------- ----------
Total other noncurrent assets 254,540 253,447
---------- ----------
TOTAL ASSETS $ 371,355 $ 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)
AUGUST 31, NOVEMBER 30,
LIABILITIES AND SHAREHOLDERS' EQUITY 2004 2003
- ------------------------------------ ---------- ----------
(Unaudited)
CURRENT LIABILITIES:
Current maturities of long-term debt $ -- $ 7,750
Accounts payable and other 10,396 10,924
Accrued liabilities 12,181 15,979
---------- ----------
Total current liabilities 22,577 34,653
---------- ----------
LONG-TERM DEBT, less current maturities 200,000 204,676
---------- ----------
DEFERRED INCOME TAXES 30,975 26,501
---------- ----------
OTHER NONCURRENT LIABILITIES 1,738 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 19,752 at August 31, 2004 and 19,161 at
November 30, 2003 83,425 77,815
Retained earnings 37,543 22,274
---------- ----------
120,968 100,089
Unamortized value of restricted common shares issued (2,668) (2,058)
Cumulative other comprehensive income, net of taxes:
Interest rate cap adjustment (259) --
Foreign currency translation adjustment (336) (525)
Minimum pension liability adjustment (1,640) (1,640)
---------- ----------
Total shareholders' equity 116,065 95,866
---------- ----------
TOTAL LIABILITIES AND SHAREHOLDERS'
EQUITY $ 371,355 $ 363,385
========== ==========
The accompanying notes are an integral part of these condensed
consolidated financial statements.
4
CHATTEM, INC. AND SUBSIDIARIES
------------------------------
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
-------------------------------------------
(Unaudited and in thousands, except per share amounts)
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED AUGUST 31, ENDED AUGUST 31,
------------------------ ------------------------
2004 2003 2004 2003
--------- --------- --------- ---------
REVENUES:
Net sales $ 66,096 $ 58,972 $ 196,909 $ 180,366
Royalties 39 210 555 874
--------- --------- --------- ---------
Total revenues 66,135 59,182 197,464 181,240
--------- --------- --------- ---------
COSTS AND EXPENSES:
Cost of sales 19,135 15,995 56,643 51,399
Advertising and promotion 18,666 17,075 56,278 54,009
Selling, general and administrative 11,525 10,234 32,831 30,445
Litigation settlement 834 -- 4,491 --
--------- --------- --------- ---------
Total costs and expenses 50,160 43,304 150,243 135,853
--------- --------- --------- ---------
INCOME FROM OPERATIONS 15,975 15,878 47,221 45,387
--------- --------- --------- ---------
OTHER INCOME (EXPENSE):
Interest expense (3,284) (5,057) (11,678) (15,431)
Investment and other income, net 45 32 205 119
Loss on early extinguishment of debt -- -- (12,958) --
--------- --------- --------- ---------
Total other income (expense) (3,239) (5,025) (24,431) (15,312)
--------- --------- --------- ---------
INCOME BEFORE INCOME TAXES 12,736 10,853 22,790 30,075
PROVISION FOR INCOME TAXES 4,002 4,016 7,521 11,128
--------- --------- --------- ---------
NET INCOME $ 8,734 $ 6,837 $ 15,269 $ 18,947
========= ========= ========= =========
NUMBER OF COMMON SHARES:
Weighted average outstanding-basic 19,498 19,148 19,295 19,178
========= ========= ========= =========
Weighted average and potential dilutive outstanding 20,308 19,905 20,148 19,897
========= ========= ========= =========
NET INCOME PER COMMON SHARE:
Basic $ .45 $ .36 $ .79 $ .99
========= ========= ========= =========
Diluted $ .43 $ .34 $ .76 $ .95
========= ========= ========= =========
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 NINE MONTHS ENDED
--------------------------
AUGUST 31, AUGUST 31,
2004 2003
---------- ----------
OPERATING ACTIVITIES:
Net income $ 15,269 $ 18,947
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization 4,609 4,565
Deferred income taxes 6,280 6,104
Tax benefit realized from stock option exercises 4,036 1,240
Loss on early extinguishment of debt 12,958 --
Other, net 53 (94)
Changes in operating assets and liabilities:
Accounts receivable (6,763) (2,867)
Inventories (1,990) (1,009)
Refundable income taxes (842) (256)
Prepaid expenses and other current assets 54 (768)
Accounts payable and accrued liabilities (4,326) (1,749)
---------- ----------
Net cash provided by operating activities 29,338 24,113
---------- ----------
INVESTING ACTIVITIES:
Purchases of property, plant and equipment (1,763) (3,933)
Purchases of patents, trademarks and other product rights (8) (373)
Increase in other assets, net (594) (285)
---------- ----------
Net cash used in investing activities (2,365) (4,591)
---------- ----------
FINANCING ACTIVITIES:
Repayment of long-term debt (212,288) (10,000)
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 5,139 1,533
Repurchase of common shares (5,015) (5,351)
Increase in debt issuance costs (5,729) (25)
Retirement of debt issuance costs (7,861) --
Premium on interest rate cap agreement (1,375) --
---------- ----------
Net cash used in financing activities (27,129) (13,843)
---------- ----------
EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS
(20) 118
---------- ----------
CASH AND CASH EQUIVALENTS:
(Decrease) increase for the period (176) 5,797
At beginning of period 26,931 15,924
---------- ----------
At end of period $ 26,755 $ 21,721
========== ==========
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 nine months
ended August 31, 2004 and 2003, respectively $ 1,399 $ 1,000
PAYMENTS FOR:
Interest $ 8,737 $ 9,916
Taxes $ 228 $ 2,680
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 U.S. generally accepted accounting
principles for interim financial information and the instructions to Form
10-Q and Rule 10-01 of Regulation S-X. Accordingly, these condensed
consolidated financial statements do not include all of the information and
footnotes required by U.S. generally accepted accounting principles 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. As of August 31, 2004, the application of
SFAS 146 resulted in recording $35 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
fourth quarter 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 59% and 64%, respectively, risk-free interest rates of 4.12% and 4.47%,
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 nine months ended August 31, 2004 and
2003, respectively, as indicated below:
For the Three Months Ended For the Nine Months Ended
August 31, August 31,
------------------------- -------------------------
2004 2003 2004 2003
---------- ---------- ---------- ----------
Net income:
As reported $ 8,734 $ 6,837 $ 15,269 $ 18,947
Fair value method compensation cost, net 1,348 516 3,228 1,552
---------- ---------- ---------- ----------
Pro forma $ 7,386 $ 6,321 $ 12,041 $ 17,395
========== ========== ========== ==========
Net income per share, basic:
As reported $ .45 $ .36 $ .79 $ .99
Pro forma $ .38 $ .33 $ .62 $ .91
Net income per share, diluted:
As reported $ .43 $ .34 $ .76 $ .95
Pro forma $ .36 $ .32 $ .60 $ .87
8
6. EARNINGS PER SHARE
------------------
The following table presents the computation of per share earnings for
the three and nine months ended August 31, 2004 and 2003, respectively:
For the Three Months Ended For the Nine Months Ended
August 31, August 31,
------------------------- -------------------------
2004 2003 2004 2003
---------- ---------- ---------- ----------
NET INCOME $ 8,734 $ 6,837 $ 15,269 $ 18,947
========== ========== ========== ==========
NUMBER OF COMMON SHARES:
Weighted average outstanding 19,498 19,148 19,295 19,178
Issued upon assumed exercise of
outstanding stock options 735 647 795 617
Effect of issuance of restricted
common shares 75 110 58 102
---------- ---------- ---------- ----------
Weighted average and potential 20,308 19,905 20,148 19,897
========== ========== ========== ==========
dilutive outstanding (1)
NET INCOME PER COMMON SHARE:
Basic $ .45 $ .36 $ .79 $ .99
========== ========== ========== ==========
Diluted $ .43 $ .34 $ .76 $ .95
========== ========== ========== ==========
(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: 5 and 85 shares for the three months ended
August 31, 2004 and 2003, respectively, and 247 and 87 shares for the
nine months ended August 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 $2,036 and $1,602 are included in selling
expenses for the three months ended August 31, 2004 and 2003, respectively,
and $5,469 and $4,647 for the nine months ended August 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 $244,797 and $244,790 as of August 31, 2004 and November
30, 2003, respectively. After reviewing pertinent information relating to the
revaluation of these intangible assets and performing the impairment test as
prescribed by SFAS 142 as of August 31, 2004, we determined that the
revaluation of these intangible assets was not required. The gross carrying
amount of finite-lived intangible assets subject to amortization at both
August 31, 2004 and November 30, 2003, which consist primarily of non-compete
agreements, was $2,400. The related accumulated amortization of finite-lived
intangible assets at August 31, 2004 and November 30, 2003 was $1,564 and
$1,343, respectively. Amortization of our finite-lived intangible assets
subject to amortization under the provisions of
9
SFAS 142 for the three months ended August 31, 2004 and 2003 was $73 and
$85, respectively, and for the nine months ended August 31, 2004 and 2003
was $222 and $255, 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.
10. INVENTORIES
-----------
Inventories consisted of the following as of August 31, 2004 and
November 30, 2003:
2004 2003
---------- ----------
Raw materials and work in process $ 9,191 $ 9,740
Finished goods 12,046 9,507
Excess of current cost over LIFO values (1,688) (1,688)
---------- ----------
Total inventories $ 19,549 $ 17,559
========== ==========
11. ACCRUED LIABILITIES
-------------------
Accrued liabilities consisted of the following as of August 31, 2004 and
November 30, 2003:
2004 2003
---------- ----------
Interest $ 5,356 $ 3,115
Salaries, wages and commissions 3,669 3,604
Product advertising and promotion 118 5,348
Insurance 520 1,151
Pension 1,054 1,040
Other 1,464 1,721
---------- ----------
Total accrued liabilities $ 12,181 $ 15,979
========== ==========
12. LONG-TERM DEBT
--------------
Long-term debt consisted of the following as of August 31, 2004 and
November 30, 2003:
2004 2003
---------- ----------
Revolving Credit Facility due 2009
at a variable rate of 5.00% as of
August 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 4.31% as of
August 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 August 31, 2004, no amounts have been borrowed
under the Revolving Credit Facility, and the variable rate was 5.0%.
10
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 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 September 29, 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
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 first quarter of fiscal 2004. 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. These related tax
benefits were adjusted to reflect the annual estimated effective tax rate of
33% in the third quarter of fiscal 2004 to $3,732 and $544, respectively.
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 (4.31% as of August 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 $47 is
included in prepaid expenses and other current assets, and the long-term
portion of $922 is included in other noncurrent assets. The amortized value
of the premium on the interest rate cap was compared to its fair value as of
August 31, 2004, and a charge of $259, net of tax, was 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
11
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 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% 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 August 31,
2004 are as follows:
2005 $ --
2006 --
2007 --
2008 --
2009 --
Thereafter 200,000
----------
$ 200,000
==========
13. COMPREHENSIVE INCOME
--------------------
Comprehensive income, net of taxes, consisted of the following
components for the three and nine months ended August 31, 2004 and 2003,
respectively:
For the Three Months For the Nine Months
Ended August 31, Ended August 31,
----------------------- -----------------------
2004 2003 2004 2003
---------- ---------- ---------- ----------
Net income $ 8,734 $ 6,837 $ 15,269 $ 18,947
Other - interest rate cap
adjustment (259) -- (259) --
Other - foreign currency
translation adjustment 120 268 189 307
---------- ---------- ---------- ----------
Total $ 8,595 $ 7,105 $ 15,199 $ 19,254
========== ========== ========== ==========
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 nine months ended August 31, 2004, we repurchased 190
shares for $5,015. 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
indentures pursuant to which the Floating Rate Notes and 7.0% Subordinated
Notes were issued.
12
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 August 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.
Net periodic pension cost for the three and nine months ended August 31,
2004 and 2003 comprised the following components:
For the Three Months For the Nine Months
Ended August 31, Ended August 31,
------------------- -------------------
2004 2003 2004 2003
-------- -------- -------- --------
Service cost $ -- $ -- $ -- $ --
Interest cost on projected
benefit obligation 155 152 465 456
Actual return on plan assets (178) (157) (534) (471)
Net amortization and deferral 28 (36) 84 (108)
-------- -------- -------- --------
Net pension cost (benefit) $ 5 $ (41) $ 15 $ (123)
======== ======== ======== ========
No employer contributions were made for the nine months ended August 31,
2004 and August 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
nine months ended August 31, 2004 and August 31, 2003, included the following
components:
For the Three Months For the Nine Months
Ended August 31, Ended August 31,
------------------- -------------------
2004 2003 2004 2003
-------- -------- -------- --------
Service cost $ 16 $ 14 $ 48 $ 42
Interest cost on accumulated
postretirement benefit
obligation 20 20 60 60
Amortization of prior service
cost 4 4 12 12
Amortization of net gain (8) (7) (24) (21)
-------- -------- -------- --------
Net periodic postretirement
benefits cost $ 32 $ 31 $ 96 $ 93
======== ======== ======== ========
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
nine months ended August 31, 2004 was 31% and 33%, respectively, as compared
to 37% in the three and nine months ended August 31, 2003, respectively. The
lower rates for the three and nine months ended August 31, 2004 reflect the
implementation of a number of foreign and state tax planning initiatives,
which include our determination during the third quarter of fiscal 2004 to
reinvest indefinitely all undistributed earnings of Chattem (Canada), a
wholly-owned subsidiary.
13
Undistributed earnings of Chattem (Canada) amounted to approximately
$496 and $1,441 for the three and nine months ended August 31, 2004,
respectively. These earnings are considered to be reinvested indefinitely
and, accordingly, no provision for U.S. federal and state income taxes has
been provided thereon. Upon distribution of those earnings in the form of
dividends or otherwise, we would be subject to U.S. income taxes (subject to
an adjustment for foreign tax credits).
17. PRODUCT SEGMENT INFORMATION
---------------------------
Net sales of our domestic product categories within our single
healthcare business segment for the three and nine months ended August 31,
2004 and 2003 are as follows:
For the Three Months For the Nine Months
Ended August 31, Ended August 31,
------------------- -------------------
2004 2003 2004 2003
-------- -------- -------- --------
Topical analgesics $ 20,118 $ 14,540 $ 53,964 $ 42,738
Medicated skin care products 17,257 16,926 47,920 44,988
Dietary supplements 7,774 9,664 26,654 30,232
Medicated dandruff shampoos
and conditioner 6,480 6,116 23,107 20,928
Other OTC and toiletry products 8,210 6,490 27,485 23,711
-------- -------- -------- --------
Total $ 59,839 $ 53,736 $179,130 $162,597
======== ======== ======== ========
18. COMMITMENTS AND CONTINGENCIES
-----------------------------
GENERAL LITIGATION
As of September 29, 2004, we were named as a defendant in approximately
345 lawsuits 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.
In an effort to achieve a global settlement of all DEXATRIM PPA product
liability claims, 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
Washington (the "Memorandum of Understanding"). The Memorandum of
Understanding memorialized certain settlement terms concerning lawsuits
relating to our DEXATRIM products containing PPA.
On April 13, 2004, we entered into a class action settlement agreement
with representatives of the plaintiffs' settlement class. The class action
settlement agreement was generally consistent with the terms of and
superceded the Memorandum of Understanding and provided for a national class
action settlement of all DEXATRIM PPA claims. The court granted preliminary
approval of the class action settlement on April 23, 2004.
On August 26, 2004, a fairness hearing to consider final approval of the
settlement was held before Judge Rothstein. At the conclusion of the hearing,
Judge Rothstein stated that the court would prepare and enter an order
certifying the class and granting approval of the settlement. We expect that
the order will be entered in October 2004.
The settlement includes claims against us involving alleged injuries by
DEXATRIM products containing PPA that were alleged to have occurred after
December 21, 1998, the date we acquired the DEXATRIM brand. In accordance
with the terms of the class action settlement agreement, we previously
published notice of the settlement and details as to the manner in which
claims could be submitted. The deadline for submission of claims was July 7,
2004. A total of 391 claims were submitted prior to the claims deadline. Of
these 391 claims, 173 alleged stroke as an injury and 218 alleged other
non-stroke injuries. These claims will be valued pursuant to the agreed upon
settlement matrix that is designed to evaluate and determine the settlement
value of each claim. A total of 16 claimants elected to opt out of the class
settlement and may continue to pursue claims for damages against us in
separate lawsuits.
In accordance with the terms of the class action settlement agreement,
$60,885 has been funded into a settlement trust from our first three layers
of insurance coverage, as described below. In addition, on July 14, 2004, we
entered into a settlement agreement with Sidmak Laboratories, Inc.
("Sidmak"), the manufacturer of DEXATRIM products containing PPA, pursuant to
which Sidmak agreed to contribute $10,000 into the settlement trust within 30
days after final court approval of
14
the settlement. To the extent the amount in the 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 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 settlement trust, either
pursuant to the terms of the settlement, as a result of the opt out cases or
otherwise, we will have significantly fewer sources of funds with which to
satisfy such liabilities, and we may be unable to do so.
We recorded a $3,463 charge in the second quarter of fiscal 2004 and an
$834 charge in the third quarter of fiscal 2004 relating to settlement and
administrative costs and expenses associated with the PPA litigation.
Although we believe that an additional liability existed as of August 31,
2004 related to the PPA litigation, due to the significant assumptions and
uncertainty involved in estimating the value of cases included in the final
settlement under the settlement matrix, as well as the opt out cases, we are
not able to reasonably estimate if any additional payments by us will be
required in excess of our insurance coverage and third party payments. As a
result, we are not able to reasonably estimate the amount of such liability
as of August 31, 2004 and have made no provision for this liability in the
August 31, 2004 financial statements.
We believe that approximately 206 or approximately 60% of the existing
lawsuits in which we are named as a defendant relating to DEXATRIM containing
PPA involve alleged injuries by DEXATRIM products containing PPA manufactured
and sold prior to our acquisition of DEXATRIM on December 21, 1998. In these
lawsuits, we are being defended on the basis of indemnification obligations
assumed by The DELACO Company ("DELACO"), successor to Thompson Medical
Company, Inc., which owned DEXATRIM prior to December 21, 1998. 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 on
December 21, 1998. However, DELACO is seeking to resolve all DEXATRIM cases
with injury dates prior to December 21, 1998 as part of a liquidating Chapter
11 bankruptcy plan. We understand that DELACO's product liability insurance
carriers and other sources are expected to fund this plan. As part of
DELACO's bankruptcy plan, if finally approved, we expect the bankruptcy court
to release us from liability in DEXATRIM cases with injury dates prior to
December 21, 1998, although there can be no assurances in this regard.
On December 19, 2003, DELACO also entered into a Memorandum of
Understanding with the PSC. If DELACO achieves resolution of the pre-December
21, 1998 cases 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.
Our product liability insurance, as described below, would not apply to
claims arising from products manufactured and sold prior to our acquisition
of DEXATRIM. Although we expect the DELACO bankruptcy plan to resolve these
cases, 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 21, 1998. In the approximately 206 cases that have been filed
against us for products manufactured and sold prior to December 21, 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. Even in these cases,
although there can be no assurances, we do not believe that successor
liability would be imposed against us. 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 21, 1998; we did
not cause DELACO's bankruptcy; and many plaintiffs included in cases filed in
states that in some circumstances impose successor liability are actually
residents of other states.
We have reached an agreement with Kemper Indemnity Insurance Company
("Kemper") to settle its 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 a 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 $25,000 of excess coverage
for product liability and pursue our available remedies at law against
Interstate. We cannot ensure 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 settlement trust and the $10,000 to be contributed by Sidmak, the
manufacturer of the product, 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 $83,500
coverage point for the Interstate policy.
15
We maintain a significantly lower level of insurance coverage for all
other potential claims relating to our products including DEXATRIM products
containing ephedrine. For the current policy period, 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 $5,019 is currently
funded, and a total of $40,000 of excess coverage through third party
insurers.
We have been named as a defendant in three lawsuits alleging that the
plaintiff was injured as a result of the ingestion of DEXATRIM containing
ephedrine. In addition, three individuals who allege injury caused by
DEXATRIM containing ephedrine filed opt out notices in the PPA class action
settlement. These three individuals have not filed lawsuits against us as of
September 29, 2004. We intend to vigorously defend 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. These plaintiffs have not refiled this
lawsuit as of September 29, 2004.
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.
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
16
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. We discontinued the
manufacturing and shipment of DEXATRIM containing ephedrine in September
2002.
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 the 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 January 2006. If neither action described above
is successful and the final monograph excludes such products, we would have
to file and receive approval of 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 an 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. In a letter dated January 22, 2004, the FDA wrote the
boards of pharmacy in each state regarding the FDA's concern about products
(both OTC and prescription) that contain acetaminophen. In that letter the
FDA expressed 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.
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
17
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 August 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 August 31, 2004 is $200,000.
18
Note 19
CHATTEM, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATING BALANCE SHEETS
August 31, 2004
(Unaudited and in thousands)
GUARANTOR NON-GUARANTOR
SUBSIDIARY SUBSIDIARY
CHATTEM COMPANIES COMPANIES ELIMINATIONS CONSOLIDATED
--------- --------- --------- --------- ---------
ASSETS
- ------
CURRENT ASSETS:
Cash and cash equivalents $ 15,849 $ 2,523 $ 8,383 $ -- $ 26,755
Accounts receivable, less allowances of $3,310 26,929 9,677 5,312 (9,677) 32,241
Interest receivable -- 619 -- (619) --
Inventories 13,358 3,783 2,408 -- 19,549
Refundable income taxes 5,258 -- 15 -- 5,273
Deferred income taxes 1,635 -- -- -- 1,635
Prepaid expenses and other current assets 3,224 -- 145 -- 3,369
--------- --------- --------- --------- ---------
Total current assets 66,253 16,602 16,263 (10,296) 88,822
--------- --------- --------- --------- ---------
PROPERTY, PLANT AND EQUIPMENT, NET 26,896 775 322 -- 27,993
--------- --------- --------- --------- ---------
OTHER NONCURRENT ASSETS:
Patents, trademarks and other purchased
product rights, net 836 307,087 -- (62,290) 245,633
Debt issuance costs, net 5,348 -- -- -- 5,348
Investment in subsidiaries 261,034 33,000 66,024 (360,058) --
Note receivable -- 33,000 -- (33,000) --
Other 3,159 -- 400 -- 3,559
--------- --------- --------- --------- ---------
Total other noncurrent assets 270,377 373,087 66,424 (455,348) 254,540
--------- --------- --------- --------- ---------
TOTAL ASSETS $ 363,526 $ 390,464 $ 83,009 $(465,644) $ 371,355
========= ========= ========= ========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
- ------------------------------------
CURRENT LIABILITIES:
Accounts payable and other $ 8,560 $ -- $ 1,836 $ -- $ 10,396
Accrued liabilities 19,320 1,306 1,851 (10,296) 12,181
--------- --------- --------- --------- ---------
Total current liabilities 27,880 1,306 3,687 (10,296) 22,577
--------- --------- --------- --------- ---------
LONG-TERM DEBT 200,000 -- 33,000 (33,000) 200,000
--------- --------- --------- --------- ---------
DEFERRED INCOME TAXES (786) 31,808 (47) -- 30,975
--------- --------- --------- --------- ---------
OTHER NONCURRENT LIABILITIES 1,738 -- -- -- 1,738
--------- --------- --------- --------- ---------
INTERCOMPANY ACCOUNTS 18,629 (19,627) 998 -- --
--------- --------- --------- --------- ---------
SHAREHOLDERS' EQUITY:
Preferred shares, without par value,
authorized 1,000, none issued -- -- -- -- --
Common shares, without par value,
authorized 50,000, issued 19,752 83,425 -- -- -- 83,425
Share capital of subsidiaries -- 330,586 38,647 (369,233) --
Retained earnings 37,543 46,391 6,749 (53,140) 37,543
--------- --------- --------- --------- ---------
Total 120,968 376,977 45,396 (422,373) 120,968
--------- --------- --------- --------- ---------
Unamortized value of restricted common
shares issued (2,668) -- -- -- (2,668)
Cumulative other comprehensive income,
net of taxes:
Interest rate cap adjustment (259) -- -- -- (259)
Foreign currency translation adjustment (336) -- (25) 25 (336)
Minimum pension liability adjustment (1,640) -- -- -- (1,640)
--------- --------- --------- --------- ---------
Total shareholders' equity 116,065 376,977 45,371 (422,348) 116,065
--------- --------- --------- --------- ---------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 363,526 $ 390,464 $ 83,009 $(465,644) $ 371,355
========= ========= ========= ========= =========
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 236,053 -- -- (236,053) --
Other 1,596 -- 500 -- 2,096
--------- --------- --------- --------- ---------
Total other noncurrent assets 244,210 307,080 500 (298,343) 253,447
--------- --------- --------- --------- ---------
TOTAL ASSETS $ 337,162 $ 318,948 $ 13,874 $(306,599) $ 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 (239) 26,788 (48) -- 26,501
--------- --------- --------- --------- ---------
OTHER NONCURRENT LIABILITIES 1,689 -- -- -- 1,689
--------- --------- --------- --------- ---------
INTERCOMPANY ACCOUNTS (3,801) 3,469 332 -- --
--------- --------- --------- --------- ---------
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, net
of taxes:
Foreign currency translation adjustment (525) -- (222) 222 (525)
Minimum pension liability adjustment (1,640) -- -- -- (1,640)
--------- --------- --------- --------- ---------
Total shareholders' equity 95,866 288,063 10,280 (298,343) 95,866
--------- --------- --------- --------- ---------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 337,162 $ 318,948 $ 13,874 $(306,599) $ 363,385
========= ========= ========= ========= =========
20
Note 19
CHATTEM, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATING STATEMENTS OF INCOME
FOR THE NINE MONTHS ENDED AUGUST 31, 2004
(Unaudited and in thousands)
GUARANTOR NON-GUARANTOR
SUBSIDIARY SUBSIDIARY
CHATTEM COMPANIES COMPANIES ELIMINATIONS CONSOLIDATED
--------- --------- --------- --------- ---------
TOTAL REVENUES $ 158,569 $ 55,984 $ 13,360 $ (30,449) $ 197,464
--------- --------- --------- --------- ---------
COSTS AND EXPENSES:
Cost of sales 45,211 7,701 5,401 (1,670) 56,643
Advertising and promotion 44,765 8,089 3,424 -- 56,278
Selling, general and administrative 31,711 339 781 -- 32,831
Litigation settlement 4,491 -- -- -- 4,491
Equity in subsidiary income (24,783) -- -- 24,783 --
--------- --------- --------- --------- ---------
Total costs and expenses 101,395 16,129 9,606 23,113 150,243
--------- --------- --------- --------- ---------
INCOME FROM OPERATIONS 57,174 39,855 3,754 (53,562) 47,221
--------- --------- --------- --------- ---------
OTHER INCOME (EXPENSE):
Interest expense (11,678) -- (1,856) 1,856 (11,678)
Investment and other income, net 100 1,859 1,352 (3,106) 205
Loss on early extinguishment of debt (12,958) -- -- -- (12,958)
Royalties (24,359) (4,420) -- 28,779 --
Corporate allocations 2,631 (2,545) (86) -- --
--------- --------- --------- --------- ---------
Total other income (expense) (46,264) (5,106) (590) 27,529 (24,431)
--------- --------- --------- --------- ---------
INCOME BEFORE INCOME TAXES 10,910 34,749 3,164 (26,033) 22,790
--------- --------- --------- --------- ---------
(BENEFIT FROM) PROVISION FOR INCOME TAXES (4,359) 11,467 413 -- 7,521
--------- --------- --------- --------- ---------
NET INCOME $ 15,269 $ 23,282 $ 2,751 $ (26,033) $ 15,269
========= ========= ========= ========= =========
21
Note 19
CHATTEM, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATING STATEMENTS OF INCOME
FOR THE NINE MONTHS ENDED AUGUST 31, 2003
(Unaudited and in thousands)
GUARANTOR NON-GUARANTOR
SUBSIDIARY SUBSIDIARY
CHATTEM COMPANIES COMPANIES ELIMINATIONS CONSOLIDATED
--------- --------- --------- --------- ---------
TOTAL REVENUES $ 138,026 $ 53,896 $ 14,225 $ (24,907) $ 181,240
--------- --------- --------- --------- ---------
COSTS AND EXPENSES:
Cost of sales 39,530 8,113 5,873 (2,117) 51,399
Advertising and promotion 41,218 8,333 4,458 -- 54,009
Selling, general and administrative 28,510 208 1,727 -- 30,445
Equity in subsidiary income (22,792) -- -- 22,792 --
--------- --------- --------- --------- ---------
Total costs and expenses 86,466 16,654 12,058 20,675 135,853
--------- --------- --------- --------- ---------
INCOME FROM OPERATIONS 51,560 37,242 2,167 (45,582) 45,387
--------- --------- --------- --------- ---------
OTHER INCOME (EXPENSE):
Interest expense (15,431) -- -- -- (15,431)
Investment and other income, net 69 3 47 -- 119
Royalties (20,951) (1,561) (278) 22,790 --
Corporate allocations 2,951 (2,870) (81) -- --
--------- --------- --------- --------- ---------
Total other income (expense) (33,362) (4,428) (312) 22,790 (15,312)
--------- --------- --------- --------- ---------
INCOME BEFORE INCOME TAXES 18,198 32,814 1,855 (22,792) 30,075
(BENEFIT FROM) PROVISION FOR INCOME TAXES
(749) 11,435 442 -- 11,128
--------- --------- --------- --------- ---------
NET INCOME $ 18,947 $ 21,379 $ 1,413 $ (22,792) $ 18,947
========= ========= ========= ========= =========
22
Note 19
CHATTEM, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS
FOR THE NINE MONTHS ENDED AUGUST 31, 2004
(Unaudited and in thousands)
GUARANTOR NON-GUARANTOR
SUBSIDIARY SUBSIDIARY
CHATTEM COMPANIES COMPANIES ELIMINATIONS CONSOLIDATED
--------- --------- --------- --------- ---------
OPERATING ACTIVITIES:
Net income $ 15,269 $ 23,282 $ 2,751 $ (26,033) $ 15,269
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 4,549 -- 60 -- 4,609
Deferred income taxes 1,260 5,020 -- -- 6,280
Tax benefit realized from stock option exercises 4,036 -- -- -- 4,036
Loss on early extinguishment of debt 12,958 -- -- -- 12,958
Other, net 33 -- 20 -- 53
Equity in subsidiary income (26,033) -- -- 26,033 --
Changes in operating assets and liabilities:
Accounts receivable (5,200) (2,588) (1,563) 2,588 (6,763)
Interest receivable -- (619) -- 619 --
Inventories (688) (1,743) 441 -- (1,990)
Refundable income taxes (844) -- 2 -- (842)
Prepaid expenses and other current assets 1,223 -- (2) (1,167) 54
Accounts payable and accrued liabilities (3,341) 678 377 (2,040) (4,326)
--------- --------- --------- --------- ---------
Net cash provided by operating activities 3,222 24,030 2,086 -- 29,338
--------- --------- --------- --------- ---------
INVESTING ACTIVITIES:
Purchases of property, plant and equipment (1,753) -- (10) -- (1,763)
Purchases of patents, trademarks and other
product rights -- (8) -- -- (8)
Increase in note receivable -- (33,000) -- 33,000 --
(Increase) decrease in other assets, net (998) -- 404 -- (594)
--------- --------- --------- --------- ---------
Net cash (used in) provided by investing
activities (2,751) (33,008) 394 33,000 (2,365)
--------- --------- --------- --------- ---------
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 credit
facility 25,000 -- -- -- 25,000
Payments of revolving credit facility (25,000) -- -- -- (25,000)
Proceeds from exercise of stock options 5,139 -- -- -- 5,139
Repurchase of common shares (5,015) -- -- -- (5,015)
Increase in debt issuance costs (5,729) -- -- -- (5,729)
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 23,805 10,787 (34,592) -- --
Dividends paid -- (1,250) 1,250 -- --
--------- --------- --------- --------- ---------
Net cash (used in) provided by financing
activities (3,324) 9,537 (342) (33,000) (27,129)
--------- --------- --------- --------- ---------
EFFECT OF EXCHANGE RATE CHANGES ON CASH
AND CASH EQUIVALENTS -- -- (20) -- (20)
--------- --------- --------- --------- ---------
CASH AND CASH EQUIVALENTS:
(Decrease) increase for the period (2,853) 559 2,118 -- (176)
At beginning of period 18,702 1,964 6,265 -- 26,931
--------- --------- --------- --------- ---------
At end of period $ 15,849 $ 2,523 $ 8,383 $ -- $ 26,755
========= ========= ========= ========= =========
23
Note 19
CHATTEM, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS
FOR THE NINE MONTHS ENDED AUGUST 31, 2003
(Unaudited and in thousands)
GUARANTOR NON-GUARANTOR
SUBSIDIARY SUBSIDIARY
CHATTEM COMPANIES COMPANIES ELIMINATIONS CONSOLIDATED
--------- --------- --------- --------- ---------
OPERATING ACTIVITIES:
Net income $ 18,947 $ 21,379 $ 1,413 $ (22,792) $ 18,947
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 4,451 -- 114 -- 4,565
Deferred income taxes 713 5,401 (10) -- 6,104
Tax benefit realized from stock option exercises 1,240 -- -- -- 1,240
Other, net (101) -- 7 -- (94)
Equity in subsidiary income (22,792) -- -- 22,792 --
Changes in operating assets and liabilities:
Accounts receivable (3,293) (15,821) 426 15,821 (2,867)
Inventories (1,321) 809 (497) -- (1,009)
Refundable income taxes (256) -- -- -- (256)
Prepaid expenses and other current assets (664) -- (104) -- (768)
Accounts payable and accrued liabilities 12,640 1,235 197 (15,821) (1,749)
--------- --------- --------- --------- ---------
Net cash provided by operating activities 9,564 13,003 1,546 -- 24,113
--------- --------- --------- --------- ---------
INVESTING ACTIVITIES:
Purchases of property, plant and equipment (3,800) -- (133) -- (3,933)
Purchases of patents, trademarks and other
products rights -- (373) -- -- (373)
Increase in other assets, net (250) -- (35) -- (285)
--------- --------- --------- --------- ---------
Net cash used in investing activities (4,050) (373) (168) -- (4,591)
--------- --------- --------- --------- ---------
FINANCING ACTIVITIES:
Repayment of long-term debt (10,000) -- -- -- (10,000)
Proceeds from exercise of stock options 1,533 -- -- -- 1,533
Repurchase of common shares (5,351) -- -- -- (5,351)
Deferred debt issuance costs (25) -- -- -- (25)
Changes in intercompany accounts 7,541 (10,277) 2,736 -- --
Dividends paid 3,000 (3,000) -- -- --
--------- --------- --------- --------- ---------
Net cash (used in) provided by financing
activities (3,302) (13,277) 2,736 -- (13,843)
--------- --------- --------- --------- ---------
EFFECT OF EXCHANGE RATE CHANGES ON
CASH AND CASH EQUIVALENTS -- -- 118 -- 118
--------- --------- --------- --------- ---------
CASH AND CASH EQUIVALENTS:
Increase (decrease) for the period 2,212 (647) 4,232 -- 5,797
At beginning of period 11,505 1,138 3,281 -- 15,924
--------- --------- --------- --------- ---------
At end of period $ 13,717 $ 491 $ 7,513 $ -- $ 21,721
========= ========= ========= ========= =========
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 and ASPERCREME;
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, a menstrual
analgesic; HERPECIN-L, a lip care product; BENZODENT, a dental
analgesic cream; and toiletries such as BULLFROG, a line of sunblocks;
ULTRASWIM, a 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 nine months ended August 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 nine months ended August 31, 2004, we repurchased 190,100 shares for
$5.0 million. The remaining availability under the board authorization was $15.0
million as of August 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
indentures pursuant to which the 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 13.2% and 11.6% for
the third quarter of fiscal 2004 and 2003, respectively, and 7.7% and 10.5% for
the nine months ended August 31, 2004 and 2003, respectively. Our net income
(excluding debt extinguishment and litigation settlement charges) margin (net
income (excluding debt extinguishment and litigation settlement charges)/total
revenues) was 14.1% and 13.7% for the three and nine months ended August 31,
2004, respectively. We believe that disclosure of net income (excluding debt
extinguishment and litigation settlement charges) 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 and
litigation settlement charges) to net income for the three and nine months ended
August 31, 2004 is presented in the following table:
For the Three For the Nine
Months Ended Months Ended
August 31, 2004 August 31, 2004
--------------- ---------------
(dollars in thousands)
Net income $ 8,734 $ 15,269
Add:
Loss on early extinguishment of debt -- 12,958
Litigation settlement charges 834 4,491
Benefit from income taxes (275) (5,758)
--------- ---------
Net income (excluding debt extinguishment and
litigation settlement charges) $ 9,293 $ 26,960
========= =========
Net income (excluding debt extinguishment and
litigation settlement charges) margin 14.1% 13.7%
========= =========
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 similarly titled measures reported by other companies.
The most directly comparable GAAP financial measure is net income. EBITDA is
used by us to supplement net income as an indicator of operating performance and
not as an alternative to measures defined and required by U.S. generally
accepted accounting principles. 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 should be considered in
addition to, but not as a substitute for, operating income, net income and other
measures of financial performance reported in accordance with U.S. generally
accepted accounting principles. 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 litigation settlement
charges) to net income is presented in the following table:
For the Three Months Ended
-------------------------------------------------
Dollar Percentage
August 31, August 31, Increase Increase
2004 2003 (Decrease) (Decrease)
---------- ---------- ---------- ----------
(dollars in thousands)
Net income $ 8,734 $ 6,837 $ 1,897 27.7%
Add:
Provision for income taxes 4,002 4,016 (14) (0.3)
Interest expense, net (includes loss on
early extinguishment of debt in 2004) 3,239 5,025 (1,786) (35.5)
Depreciation and amortization less
amounts included in interest 1,341 1,153 188 16.3
---------- ---------- ----------
EBITDA $ 17,316 $ 17,031 $ 285 1.7
========== ========== ==========
Litigation settlement charges 834 -- 834 nm
---------- ---------- ----------
EBITDA (excluding litigation settlement
charges) $ 18,150 $ 17,031 $ 1,119 6.6
========== ========== ==========
EBITDA margin (EBITDA/total revenues) 26.2% 28.8%
========== ==========
EBITDA (excluding litigation settlement
charges) margin (EBITDA (excluding
litigation settlement charges)/total
revenues) 27.4% 28.8%
========== ==========
For the Nine Months Ended
-------------------------------------------------
Dollar Percentage
August 31, August 31, Increase Increase
2004 2003 (Decrease) (Decrease)
---------- ---------- ---------- ----------
(dollars in thousands)
Net income $ 15,269 $ 18,947 $ (3,678) (19.4%)
Add:
Provision for income taxes 7,521 11,128 (3,607) (32.4)
Interest expense, net (includes loss on
early extinguishment of debt in 2004) 24,431 15,312 9,119 59.6
Depreciation and amortization less
amounts included in interest 3,958 3,305 653 19.8
---------- ---------- ----------
EBITDA $ 51,179 $ 48,692 $ 2,487 5.1
========== ========== ==========
Litigation settlement charges 4,491 -- 4,491 nm
---------- ---------- ----------
EBITDA (excluding litigation settlement
charges) $ 55,670 $ 48,692 $ 6,978 14.3
========== ========== ==========
EBITDA margin (EBITDA/total revenues) 25.9% 26.9%
========== ==========
EBITDA (excluding litigation settlement
charges) margin (EBITDA (excluding
litigation settlement charges)/total
revenues) 28.2% 26.9%
========== ==========
In an effort to achieve a global settlement of all DEXATRIM PPA product
liability claims, 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
27
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 class action settlement
agreement was generally consistent with the terms of and superceded the
Memorandum of Understanding and provided for a national class action settlement
of all DEXATRIM PPA claims. The court granted preliminary approval of the class
action settlement on April 23, 2004.
On August 26, 2004, a fairness hearing to consider final approval of the
settlement was held before Judge Rothstein. At the conclusion of the hearing,
Judge Rothstein stated that the court would prepare and enter an order
certifying the class and granting approval of the settlement. We expect that the
order will be entered in October 2004.
The settlement includes claims against us involving alleged injuries by
DEXATRIM products containing PPA that were alleged to have occurred after
December 21, 1998, the date we acquired the DEXATRIM brand. In accordance with
the terms of the class action settlement agreement, we previously published
notice of the settlement and details as to the manner in which claims could be
submitted. The deadline for submission of claims was July 7, 2004. A total of
391 claims were submitted prior to the claims deadline. Of these 391 claims, 173
alleged stroke as an injury and 218 alleged other non-stroke injuries. These
claims will be valued pursuant to the case scoring system and settlement matrix
agreed upon as part of the class action settlement agreement that is designed to
evaluate and determine the settlement value of each claim. A total of 16
claimants elected to opt out of the class settlement and may continue to pursue
claims for damages against us in separate lawsuits.
In accordance with the terms of the class action settlement agreement,
$60.9 million has been funded into a settlement trust from our first three
layers of insurance coverage, as described below. In addition, on July 14, 2004,
we entered into a settlement agreement with Sidmak Laboratories, Inc.
("Sidmak"), the manufacturer of DEXATRIM products containing PPA, pursuant to
which Sidmak agreed to contribute $10.0 million into the settlement trust within
30 days after final court approval of the settlement. To the extent the amount
in the 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 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 settlement trust,
either pursuant to the terms of the settlement, as a result of the opt out cases
or otherwise, we will have significantly fewer sources of funds with which to
satisfy such liabilities, and we may be unable to do so.
Based upon the court's stated intention to approve the class action
settlement, the number of claims submitted in the settlement, the number of
claims which elected to opt out of the settlement and contributions from
insurers and other third parties, we currently expect to record pre-tax charges
totaling $10.0-15.0 million, or $7.0-10.0 million net of taxes (approximately
$.35-.50 per share), for settlement costs, administrative expenses and costs of
defense related to resolving the PPA litigation. We paid or accrued the first
portion of this charge, $3.5 million, or $2.3 million after tax ($.11 per share)
during the second fiscal quarter ended May 31, 2004, and $0.8 million, or $0.6
million after tax ($.03 per share), during the third fiscal quarter ended August
31, 2004. Although we believe an additional liability existed as of August 31,
2004 related to our PPA litigation, due to the significant assumptions and
uncertainty involved in estimating the value of cases included in the final
settlement under the settlement matrix, as well as the opt out cases, we are not
able to reasonably estimate if any additional payments by us will be required in
excess of our insurance coverage and third party payments. As a result, we are
not able to reasonably estimate the amount of such liability as of August 31,
2004 and have made no provision for this liability in the August 31, 2004
financial statements.
We have reached an agreement with Kemper Indemnity Insurance Company
("Kemper") to settle its 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 a 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
settlement trust and the $10.0 million to be contributed by Sidmak, the
manufacturer of the product, 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 $83.5
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 Nine Months Ended
-------------------------- -------------------------
August 31, August 31, August 31, August 31,
2004 2003 2004 2003
---------- ---------- ---------- ----------
TOTAL REVENUES 100.0% 100.0% 100.0% 100.0%
-------- -------- -------- --------
COSTS AND EXPENSES:
Cost of sales 28.9 27.0 28.7 28.4
Advertising and promotion 28.2 28.9 28.5 29.8
Selling, general and administrative 17.4 17.3 16.6 16.8
Litigation settlement 1.3 -- 2.3 --
-------- -------- -------- --------
Total costs and expenses 75.8 73.2 76.1 75.0
-------- -------- -------- --------
INCOME FROM OPERATIONS 24.2 26.8 23.9 25.0
-------- -------- -------- --------
OTHER INCOME (EXPENSE):
Interest expense (5.0) (8.5) (5.9) (8.5)
Investment and other income, net 0.1 0.1 0.1 0.1
Loss on early extinguishment of debt -- -- (6.6) --
-------- -------- -------- --------
Total other income (expense) (4.9) (8.4) (12.4) (8.4)
-------- -------- -------- --------
INCOME BEFORE INCOME TAXES 19.3 18.4 11.5 16.6
PROVISION FOR INCOME TAXES 6.1 6.8 3.8 6.1
-------- -------- -------- --------
NET INCOME (1) 13.2% 11.6% 7.7% 10.5%
======== ======== ======== ========
- --------
(1) For net income (excluding debt extinguishment and litigation settlement
charges) margin, see "Overview" in this Item 2, Management's Discussion and
Analysis of Financial Condition and Results of Operations.
CRITICAL ACCOUNTING POLICIES
- ----------------------------
The preparation of financial statements in accordance with U.S. generally
accepted accounting principles 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 August 31, 2004 condensed consolidated
financial statements:
ALLOWANCE FOR DOUBTFUL ACCOUNTS
As of August 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 (our 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 nine
months ended August 31, 2004, we reduced our estimate of returns related to our
BULLFROG line of products by approximately $0.6 million and $1.8 million,
respectively, which resulted in an increase to net sales in our condensed
consolidated financial statements. During the third quarter of fiscal 2004, we
also reduced our estimate of non-seasonal returns by approximately $0.3 million,
which resulted in an increase to net sales in our 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. For the three and nine months ended August 31, 2004, we reduced
our estimate of promotional accruals by approximately $0.6 million and $1.1
million, respectively, which resulted in an increase to net sales in our
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 nine months ended August 31, 2004 was 31% and 33%, respectively, as
compared to 37% in the three and nine months ended August 31, 2003,
respectively. The lower rates for the three and nine months ended August 31,
2004 reflect the implementation of a number of foreign and state tax planning
initiatives, which include our determination during the third quarter of fiscal
2004 to reinvest indefinitely all undistributed earnings of Chattem (Canada), a
wholly-owned subsidiary.
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 AUGUST 31, 2004 AND 2003
- ---------------------------------------------------------
To facilitate discussion of our operating results for the three months
ended August 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 $59,839 $53,736 $ 6,103 11.4%
International revenues (including
royalties) 6,296 5,446 850 15.6
Total revenues 66,135 59,182 6,953 11.7
Cost of sales 19,135 15,995 3,140 19.6
Advertising and promotion expense 18,666 17,075 1,591 9.3
Selling, general and administrative
expense 11,525 10,234 1,291 12.6
Litigation settlement charges 834 -- 834 nm
Interest expense 3,284 5,057 (1,773) (35.1)
Net income 8,734 6,837 1,897 27.7
DOMESTIC NET SALES
Domestic net sales for the three months ended August 31, 2004 increased
$6.1 million or 11.4% as compared to the corresponding period of 2003. Domestic
net sales increased in all product categories except for the dietary supplements
category. 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 $20,118 $14,540 $ 5,578 38.4%
Medicated skin care products 17,257 16,926 331 2.0
Dietary supplements 7,774 9,664 (1,890) (19.6)
Medicated dandruff shampoos and
conditioner 6,480 6,116 364 6.0
Other OTC and toiletry products 8,210 6,490 1,720 26.5
------- ------- -------
Total $59,839 $53,736 $ 6,103 11.4
======= ======= =======
Net sales growth in the topical analgesics category was led by a 70%
increase in sales of ICY HOT, which was primarily driven by the continued
strength of the ICY HOT Back Patch and the newly introduced ICY HOT Medicated
Sleeve. Net sales growth in this category also resulted from 33%, 22% and 8%
sales increases in CAPZASIN, ASPERCREME, and SPORTSCREME, respectively. 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 and media support was reduced.
Net sales growth in the medicated skin care products category resulted from
a 7% increase in the GOLD BOND franchise. GOLD BOND sales growth was
attributable to 60% and 18% increases from the lotion and foot care lines,
respectively, and was partially offset by declines in the first aid portion of
the business. The increase in sales from 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 17% decrease in
PHISODERM sales due to increased competition.
Net sales for the dietary supplements category declined primarily due to a
41% decrease in DEXATRIM diet pill sales and a 25% and 20% decline in GARLIQUE
and NEW PHASE sales, respectively, from the corresponding year-ago quarter.
Sales of DEXATRIM were impacted by the overall decline in the diet pill market
resulting in part from negative ephedrine publicity and the emergence of low
carbohydrate diet products. The decline in net sales of DEXATRIM diet pills,
GARLIQUE and NEW PHASE was partially offset by sales of the DEXATRIM All in One
Bar, which was introduced in the first quarter of fiscal 2004. The DEXATRIM All
in One Bar sales were lower than expected for the third fiscal quarter of 2004,
as the category has proved to be more promotional and seasonal than we expected.
If DEXATRIM sales continue to decline, the related intangible asset may be
subject to impairment based on the provisions of SFAS No. 142, "Goodwill and
Other Intangible Assets" ("SFAS 142").
Domestic net sales of SELSUN BLUE medicated dandruff shampoo increased due
to an effective advertising campaign and sales of SELSUN BLUE conditioner, which
was launched in the first quarter of fiscal 2004.
31
The increase in net sales for the other OTC and toiletry products category
was due primarily to sales increases of PAMPRIN and BULLFROG. The increase in
sales of PAMPRIN was primarily attributable to the introduction of PAMPRIN All
Day in the first quarter of fiscal 2004. The increase in sales of BULLFROG was
primarily attributable to expanded distribution and increased sales of pre-pack
displays.
Domestic sales variances were principally the result of changes in unit
sales volumes with the exception of PAMPRIN, PREMSYN PMS, PHISODERM, FLEXALL,
ASPERCREME, CAPZASIN and SPORTSCREME, which experienced a unit sales price
increase.
INTERNATIONAL REVENUES
For the third quarter of fiscal 2004, international revenues increased $0.9
million or 15.6% as compared to the third quarter of fiscal 2003 due principally
to increases in SELSUN sales in Canada, Europe and Latin America. International
sales variances were principally the result of changes in unit sales volumes.
COST OF SALES
Cost of sales as a percentage of total revenues was 28.9% for the third
quarter of fiscal 2004 as compared to 27.0% for the third quarter of fiscal
2003. Cost of sales in the third quarter of fiscal 2004 increased $3.1 million
due primarily to sales of the DEXATRIM All in One Bar, the ICY HOT Back Patch
and the ICY HOT Medicated Sleeve, all of which have lower profit margins than
most of our other products.
ADVERTISING AND PROMOTION EXPENSE
Advertising and promotion expenses in the third quarter of fiscal 2004
increased $1.6 million or 9.3% as compared to the same quarter of fiscal 2003
and were 28.2% of total revenues for the three months ended August 31, 2004
compared to 28.9% 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, SELSUN BLUE and the GOLD BOND lotion and foot care lines.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSE
Selling, general and administrative expenses increased $1.3 million or
12.6% as compared to the same quarter of fiscal 2003. Selling, general and
administrative expenses were 17.4% and 17.3% of total revenues for the third
quarter of fiscal 2004 and 2003, respectively. An increase in sales was
primarily responsible for the increase in selling expense. In addition, freight
expenses increased due to the increase in fuel costs. The increase in general
and administrative expenses was largely a result of increased incentive
compensation and new product development expenses as well as expenses related to
compliance with the Sarbanes-Oxley Act of 2002.
LITIGATION SETTLEMENT CHARGES
Litigation settlement charges were $0.8 million in the third quarter of
fiscal 2004. This expense was attributable to legal services related to our
DEXATRIM with PPA litigation. No corresponding expenses were recorded in the
three months ended August 31, 2003.
INTEREST EXPENSE
Interest expense decreased $1.8 million or 35.1% in the third quarter of
fiscal 2004 as compared to the same quarter of fiscal 2003. The decrease was
largely the result of lower interest rates and a reduction in outstanding debt
as a 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.
32
COMPARISON OF NINE MONTHS ENDED AUGUST 31, 2004 AND 2003
- --------------------------------------------------------
To facilitate discussion of our operating results for the nine months ended
August 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 $179,130 $162,597 $ 16,533 10.2%
International revenues (including
royalties) 18,334 18,643 (309) (1.7)
Total revenues 197,464 181,240 16,224 9.0
Cost of sales 56,643 51,399 5,244 10.2
Advertising and promotion expense 56,278 54,009 2,269 4.2
Selling, general and administrative
expense 32,831 30,445 2,386 7.8
Litigation settlement charges 4,491 - 4,491 nm
Interest expense 11,678 15,431 (3,753) (24.3)
Loss on early extinguishment of debt 12,958 - 12,958 nm
Net income 15,269 18,947 (3,678) (19.4)
DOMESTIC NET SALES
Domestic net sales for the nine months ended August 31, 2004 increased $16.5
million or 10.2% as compared to the corresponding period of 2003. Domestic net
sales increased in all product categories except for the dietary supplements
category. 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 $ 53,964 $ 42,738 $ 11,226 26.3%
Medicated skin care products 47,920 44,988 2,932 6.5
Dietary supplements 26,654 30,232 (3,578) (11.8)
Medicated dandruff shampoos and
conditioner 23,107 20,928 2,179 10.4
Other OTC and toiletry products 27,485 23,711 3,774 15.9
-------- -------- --------
Total $179,130 $162,597 $ 16,533 10.2
======== ======== ========
Net sales growth in the topical analgesics category was led by a 58%
increase in sales of ICY HOT, which was primarily driven by the continued
strength of the ICY HOT Back Patch and the newly introduced ICY HOT Medicated
Sleeve. Net sales growth in this category also resulted from a 24% and 5% sales
increase in CAPZASIN and ASPERCREME, respectively. 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 and media support was reduced.
Net sales growth in the medicated skin care products category resulted from
a 14% increase in the GOLD BOND franchise. GOLD BOND sales growth was
attributable to 52%, 28% and 23% 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 sales from 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 due to
increased competition.
Net sales for the dietary supplements category declined primarily due to a
48% decrease in DEXATRIM diet pill sales and an 8% decline in GARLIQUE sales
from the corresponding year-ago period. Sales of DEXATRIM were impacted by the
overall decline in the diet pill market resulting in part 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
sales of the DEXATRIM All in One Bar, which was introduced in the first quarter
of fiscal 2004. The DEXATRIM All in One Bar sales were lower than expected for
the nine months ended August 31, 2004, as the category has proved to be more
promotional and seasonal than we expected. If DEXATRIM sales continue to
decline, the related intangible asset may be subject to impairment based on the
provisions of SFAS 142.
Domestic net sales of SELSUN BLUE medicated dandruff shampoo increased due
to an effective advertising campaign and sales of SELSUN BLUE conditioner, which
was launched in the first quarter of fiscal 2004.
33
The increase in net sales for the other OTC and toiletry products category
was due primarily to sales increases of PAMPRIN and BULLFROG. The increase in
sales of PAMPRIN was primarily attributable to the introduction of PAMPRIN All
Day in the first quarter of fiscal 2004. 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 nine months ended
August 31, 2004 due primarily to effective advertising.
Domestic sales variances were principally the result of changes in unit
sales volumes with the exception of PAMPRIN, PREMSYN PMS, PHISODERM, FLEXALL,
ASPERCREME, CAPZASIN and SPORTSCREME, which experienced a unit sales price
increase.
INTERNATIONAL REVENUES
For the nine months ended August 31, 2004, international revenues decreased
$0.3 million or 1.7% as compared to the same period in fiscal 2003 due
principally to the termination of certain European distributor relationships and
a decrease in GOLD BOND sales in Canada. This decrease was offset by an increase
in SELSUN sales in Canada, Europe and Latin America. International sales
variances were principally the result of changes in unit sales volumes.
COST OF SALES
Cost of sales as a percentage of total revenues was 28.7% for the nine
months ended August 31, 2004 as compared to 28.4% for the comparable period of
fiscal 2003. Cost of sales in the nine months ended August 31, 2004 increased
$5.2 million due primarily to sales of the DEXATRIM All in One Bar, the ICY HOT
Back Patch and the ICY HOT Medicated Sleeve, which are 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 nine months ended August 31, 2004
increased $2.3 million or 4.2% as compared to the same period in fiscal 2003 and
were 28.5% of total revenues for the nine months ended August 31, 2004 compared
to 29.8% for the comparable period of fiscal 2003. Support for new product
introductions drove an increase in advertising and promotion expenditures in the
nine months ended August 31, 2004 for ICY HOT, PAMPRIN, DEXATRIM All in One Bar,
SELSUN BLUE and the GOLD BOND cream, lotion and foot care lines.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSE
Selling, general and administrative expenses increased $2.4 million or 7.8%
as compared to the same period of fiscal 2003. Selling, general and
administrative expenses were 16.6% and 16.8% of total revenues for the nine
months ended August 31, 2004 and 2003, respectively. An increase in sales was
primarily responsible for the increase in selling expense. In addition, freight
expenses increased due to the increase in fuel costs. The increase in general
and administrative expenses was largely a result of increased incentive
compensation and new product development expenses as well as expenses related to
compliance with the Sarbanes-Oxley Act of 2002.
LITIGATION SETTLEMENT CHARGES
Litigation settlement charges were $4.5 million for the nine months ended
August 31, 2004. This expense was attributable to legal and administrative costs
of our DEXATRIM with PPA litigation, costs of public notices 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 nine months ended August 31, 2003.
INTEREST EXPENSE
Interest expense decreased $3.8 million or 24.3% in the nine months ended
August 31, 2004 as compared to the same period in fiscal 2003. The decrease was
largely the result of lower interest rates and a reduction in outstanding debt
as a 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 first half of fiscal 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, which resulted in a loss on early
extinguishment of debt of $13.0 million and a related tax benefit of $4.3
million.
34
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 $29.3 million and $24.1 million was provided by operations for the
nine months ended August 31, 2004 and 2003, respectively. Cash flows from
operations were impacted by an increase in the tax benefit realized from stock
option exercises as compared to the corresponding period of fiscal 2003 offset
by an increase in working capital attributable to an increase in accounts
receivable and a decrease in accounts payable and accrued liabilities. The
increase in accounts receivable relates primarily to an increase in sales, an
increase in international receivables and a decrease in the allowance for
returns. The decrease in accounts payable and accrued liabilities relates
primarily to a decrease in accrued advertising offset by a lower increase in
interest payable as compared to the corresponding period of fiscal 2003. In
addition, a loss on early extinguishment of debt of $13.0 million and a tax
benefit of $4.3 million was recorded in the first half of fiscal 2004.
Investing activities used cash of $2.4 million and $4.6 million in the nine
months ended August 31, 2004 and 2003, respectively. The decrease in usage of
cash was primarily due to reduced spending on capital expenditures. In fiscal
2003, capital expenditures related primarily to equipment and facility
modifications to produce SELSUN BLUE domestically and the construction of the
product development building. Capital expenditures are anticipated to increase
in the fourth quarter of fiscal 2004.
Financing activities used cash of $27.1 million and $13.8 million in the
nine months ended August 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
$5.0 million used to repurchase shares offset by proceeds from the exercise of
stock options of $5.1 million.
As of August 31, 2004, our total debt consisted of our Floating Rate Notes
of $75.0 million and 7.0% Subordinated Notes of $125.0 million. As of August 31,
2004 and September 29, 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% ( 5.00% as of August 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 (4.31% as of August 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 $47,000 is included in prepaid expenses and other current assets,
and the long-term portion of $0.9 million is included in other noncurrent
assets. The amortized value of the premium on the interest rate cap was compared
to its fair value as of August 31, 2004, and a charge of $0.3 million, net of
tax, was recorded to other comprehensive income. The interest rate cap agreement
terminates on March 1, 2010.
In an effort to achieve a global settlement of all DEXATRIM PPA product
liability claims, 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 class action settlement agreement was
generally consistent with the terms of and superceded the Memorandum of
Understanding and provided for a national class action settlement of all
DEXATRIM PPA claims. The court granted preliminary approval of the class action
settlement on April 23, 2004.
On August 26, 2004, a fairness hearing to consider final approval of the
settlement was held before Judge Rothstein. At the conclusion of the hearing,
Judge Rothstein stated that the court would prepare and enter an order
certifying the class and granting approval of the settlement. We expect that the
order will be entered in October 2004.
The settlement includes claims against us involving alleged injuries by
DEXATRIM products containing PPA that were alleged to have occurred after
December 21, 1998, the date we acquired the DEXATRIM brand. In accordance with
the terms of the class action settlement agreement, we previously published
notice of the settlement and details as to the manner in which claims could be
submitted. The deadline for submission of claims was July 7, 2004. A total of
391 claims were submitted prior to the claims deadline. Of these 391 claims, 173
alleged stroke as an injury and 218 alleged other non-stroke injuries. These
claims will be valued pursuant to the case scoring system and settlement matrix
agreed upon as part of the class action
35
settlement agreement that is designed to evaluate and determine the settlement
value of each claim. A total of 16 claimants elected to opt out of the class
settlement and may continue to pursue claims for damages against us in separate
lawsuits.
In accordance with the terms of the class action settlement agreement,
$60.9 million has been funded into a settlement trust from our first three
layers of insurance coverage, as described below. In addition, on July 14, 2004,
we entered into a settlement agreement with Sidmak Laboratories, Inc.
("Sidmak"), the manufacturer of DEXATRIM products containing PPA, pursuant to
which Sidmak agreed to contribute $10.0 million into the settlement trust within
30 days after final court approval of the settlement. To the extent the amount
in the 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
settlement trust, either pursuant to the terms of the settlement, as a result of
the opt out cases or otherwise, we will have significantly fewer sources of
funds with which to satisfy such liabilities, and we may be unable to do so.
In lawsuits in which we are named as a defendant relating to DEXATRIM
containing PPA involving alleged injuries by DEXATRIM containing PPA
manufactured and sold prior to our acquisition of DEXATRIM on December 21, 1998,
we are being defended on the basis of indemnification obligations assumed by the
DELACO Company ("DELACO"), successor to Thompson Medical Company, Inc., which
owned Dexatrim prior to December 21, 1998. 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 on December 21, 1998. However, DELACO is
seeking to resolve all DEXATRIM cases with injury dates prior to December 21,
1998 as part of a liquidating Chapter 11 bankruptcy plan. We understand that
DELACO's product liability insurance carriers and other sources are expected to
fund this plan. As part of DELACO's bankruptcy plan, if finally approved, we
expect the bankruptcy court to release us from liability in DEXATRIM cases with
injury dates prior to December 21, 1998, although there can be no assurances in
this regard. If DELACO achieves resolution of the pre-December 21, 1998 cases
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.
Based upon the court's stated intention to approve the class action
settlement, the number of claims submitted in the settlement, the number of
claims which elected to opt out of the settlement and contributions from
insurers and other third parties, we currently expect to record pre-tax charges
totaling $10.0-15.0 million, or $7.0-10.0 million net of taxes (approximately
$.35-.50 per share), for settlement costs, administrative expenses and costs of
defense related to resolving the PPA litigation. We paid or accrued the first
portion of this charge, $3.5 million, or $2.3 million after tax ($.11 per share)
during the second fiscal quarter ended May 31, 2004, and $0.8 million, or $0.6
million after tax ($.03 per share), during the third fiscal quarter ended August
31, 2004. Although we believe an additional liability existed as of August 31,
2004 related to our PPA litigation, due to the significant assumptions and
uncertainty involved in estimating the value of cases included in the final
settlement under the settlement matrix, as well as the opt out cases, we are not
able to reasonably estimate if any additional payments by us will be required in
excess of our insurance coverage and third party payments. As a result, we are
not able to reasonably estimate the amount of such liability as of August 31,
2004 and have made no provision for this liability in the August 31, 2004
consolidated financial statements.
We have reached an agreement with Kemper to settle its 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 a 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 settlement trust and the $10.0 million to be
contributed by Sidmak, the manufacturer of the product, 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 $83.5 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 nine months ended August 31, 2004, we repurchased 190,100 shares for
$5.0 million. The remaining availability under the board authorization was $15.0
million as of August 31, 2004. We are limited in
36
our ability to repurchase shares due to restrictions under the terms of our
Revolving Credit Facility and the indentures pursuant to which the 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 United Kingdom ("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
nine months ended August 31, 2004 and 2003, these subsidiaries accounted for 7%
and 8% of total revenues, respectively, and 3% of total assets for both periods,
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 nine 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. Gains of $7,000 and $0.2 million for
the nine months ended August 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.
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. As of August 31, 2004, the application of SFAS 146 resulted
in recording $35,000 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 fourth quarter 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
37
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.
38
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 August 31, 2004 was $75.0 million. The Floating
Rate Notes bear interest at a three-month LIBOR plus 3.00% per year (4.31% as of
August 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 August 31, 2004, no amounts had been borrowed under
the Revolving Credit Facility, and the variable rate on the Revolving Credit
Facility was 5.00%. 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 was compared to its fair value as of August
31, 2004, and a charge of $0.3 million, net of tax, was 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 $0.5 million, 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 nine months ended August 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 $1.0 million as of August 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 August 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.
39
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 third quarter of
fiscal 2004 is as follows:
Total Number of Maximum Dollar
Shares Purchased Value that may
Total Number Average as Part of Publicly yet be Purchased
of Shares Price Paid Announced Plans or under the Plans
Period Purchased Per Share(1) Programs(2) or Programs
- ------------------- --------- ------------ ----------- -----------
June 1-June 30 -- $ -- -- $16,765,825
July 1-July 31 61,100 $ 29.14 61,100 $14,985,202
August 1- August 31 -- $ -- -- $14,985,202
Total Third Quarter 61,100 $ 29.14 61,100 $14,985,202
(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
- -----------------------------------------------------------
None.
ITEM 5. OTHER INFORMATION
- -------------------------
None.
40
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 Settlement Agreement dated July 14, 2004 between Chattem,
Inc. and Sidmak Laboratories, Inc.
10.2 DEXATRIM Case Scoring System & Matrix for the Chattem
DEXATRIM Class Action Settlement
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
1350
(b) During the third quarter ended August 31, 2004, we filed the following Form
8-K reports with the Securities and Exchange Commission:
Form 8-K, filed June 17, 2004, containing a copy of our press release
announcing our financial results for the second quarter of fiscal 2004.
Form 8-K, filed August 27, 2004, containing a copy of our press release
regarding the phenylpropanolamine (PPA) litigation and announcing that the
Company expects to exceed prior guidance on financial results for the third
quarter of fiscal 2004.
41
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: October 1, 2004 /s/ A. Alexander Taylor II
------------------ --------------------------
A. Alexander Taylor II
President, Chief Operating Officer and
Director (Chief Operating Officer)
Dated: October 1, 2004 /s/ Richard D. Moss
------------------ ----------------------------
Richard D. Moss
Vice President and Chief Financial
Officer (Principal Financial Officer)
42
CHATTEM, INC. AND SUBSIDIARIES
------------------------------
EXHIBIT INDEX
-------------
Exhibit Number Description of Exhibit
- -------------- ----------------------
10.1 Settlement Agreement dated July 14, 2004 between Chattem,
Inc. and Sidmak Laboratories
10.2 DEXATRIM Case Scoring System & Matrix for the Chattem
DEXATRIM Class Action Settlement
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 1350
43