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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 


 

ý QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

 

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2003

 

or

 

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                  to                 

 

Commission file number 0-20045

 


 

WATSON PHARMACEUTICALS, INC.

(Exact name of registrant as specified in its charter)

 

Nevada

 

95-3872914

(State or other jurisdiction of
incorporation or organization)

 

(I.R.S. Employer Identification No.)

 

311 Bonnie Circle
Corona, CA  92880-2882

(Address of principal executive offices, including zip code)

 

(909) 493-5300

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.   Yes ý   No o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).  Yes ý  No o

 

The number of shares outstanding of the Registrant’s only class of common stock as of October 31, 2003 was approximately 107,953,740.

 

 



 

WATSON PHARMACEUTICALS, INC.

TABLE OF CONTENTS

FORM 10-Q FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2003

 

Part I. FINANCIAL INFORMATION

 

Item 1.  Condensed Consolidated Financial Statements:

 

 

Condensed Consolidated Balance Sheets as of September 30, 2003 and December 31, 2002

 

 

 

Condensed Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2003 and 2002

 

 

 

Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2003 and 2002

 

 

 

Notes to Condensed Consolidated Financial Statements

 

Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Item 3.  Quantitative and Qualitative Disclosure about Market Risk

 

Item 4.  Controls and Procedures

 

Part II.  OTHER INFORMATION AND SIGNATURES

 

Item 1.  Legal Proceedings

 

Item 6.  Exhibits and Reports on Form 8-K

 

Signatures

 



 

WATSON PHARMACEUTICALS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited; in thousands, except share amounts)

 

 

 

September 30,
2003

 

December 31,
2002

 

ASSETS

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

610,018

 

$

230,155

 

Marketable securities

 

40,653

 

42,649

 

Accounts receivable, net

 

122,255

 

178,563

 

Inventories

 

399,588

 

348,773

 

Prepaid expenses and other current assets

 

29,967

 

35,895

 

Deferred tax assets

 

89,259

 

77,416

 

Total current assets

 

1,291,740

 

913,451

 

 

 

 

 

 

 

Property and equipment, net

 

384,620

 

304,667

 

Investments and other assets

 

72,623

 

75,435

 

Deferred tax assets

 

31,478

 

34,596

 

Product rights and other intangibles, net

 

1,014,059

 

889,027

 

Goodwill

 

446,288

 

446,288

 

Total assets

 

$

3,240,808

 

$

2,663,464

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable and accrued expenses

 

$

209,703

 

$

172,363

 

Income taxes payable

 

131,257

 

111,565

 

Current portion of long-term debt

 

 

83,360

 

Deferred revenue

 

10,965

 

8,177

 

Total current liabilities

 

351,925

 

375,465

 

 

 

 

 

 

 

Long-term debt

 

722,427

 

331,877

 

Deferred revenue

 

15,217

 

 

Other long-term liabilities

 

9,938

 

5,948

 

Deferred tax liabilities

 

145,494

 

151,890

 

Total liabilities

 

1,245,001

 

865,180

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Preferred stock; no par value per share; 2,500,000 shares authorized; none issued

 

 

 

Common stock; $0.0033 par value per share; 500,000,000 shares authorized; 107,933,504 and 106,878,900 shares outstanding

 

356

 

353

 

Additional paid-in capital

 

828,018

 

797,097

 

Retained earnings

 

1,148,853

 

998,850

 

Accumulated other comprehensive income

 

18,580

 

1,984

 

Total stockholders’ equity

 

1,995,807

 

1,798,284

 

Total liabilities and stockholders’ equity

 

$

3,240,808

 

$

2,663,464

 

 

See accompanying Notes to Condensed Consolidated Financial Statements.

 

1



 

WATSON PHARMACEUTICALS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Unaudited; in thousands, except per share amounts)

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2003

 

2002

 

2003

 

2002

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

358,756

 

$

307,860

 

$

1,051,558

 

$

893,624

 

Cost of sales

 

142,331

 

143,925

 

446,308

 

417,698

 

Gross profit

 

216,425

 

163,935

 

605,250

 

475,926

 

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Research and development

 

26,428

 

22,387

 

74,613

 

60,675

 

Selling, general and administrative

 

87,547

 

56,149

 

227,420

 

178,046

 

Amortization of intangibles

 

17,820

 

16,176

 

54,040

 

44,012

 

Total operating expenses

 

131,795

 

94,712

 

356,073

 

282,733

 

Operating income

 

84,630

 

69,223

 

249,177

 

193,193

 

 

 

 

 

 

 

 

 

 

 

Other income (expense):

 

 

 

 

 

 

 

 

 

Equity in earnings (losses) of joint ventures

 

(68

)

(1,945

)

137

 

(3,759

)

Impairment of securities

 

(1,605

)

 

(15,865

)

 

Gain on sale of securities

 

2,496

 

 

5,510

 

 

Gain on sale of subsidiary

 

 

 

15,676

 

 

Gain from legal settlement

 

 

 

 

32,000

 

Loss on early extinguishment of debt

 

 

 

(2,807

)

 

Interest income

 

1,603

 

1,869

 

4,287

 

5,146

 

Interest expense

 

(5,980

)

(5,747

)

(18,901

)

(16,690

)

Other income (expense)

 

(293

)

776

 

(1,731

)

791

 

Total other income (expense), net

 

(3,847

)

(5,047

)

(13,694

)

17,488

 

 

 

 

 

 

 

 

 

 

 

Income before income taxes

 

80,783

 

64,176

 

235,483

 

210,681

 

Provision for income taxes

 

29,324

 

23,519

 

85,480

 

77,983

 

Net income

 

$

51,459

 

$

40,657

 

$

150,003

 

$

132,698

 

 

 

 

 

 

 

 

 

 

 

Earnings per share:

 

 

 

 

 

 

 

 

 

Basic

 

$

0.48

 

$

0.38

 

$

1.40

 

$

1.24

 

Diluted

 

$

0.47

 

$

0.38

 

$

1.38

 

$

1.24

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding:

 

 

 

 

 

 

 

 

 

Basic

 

107,762

 

106,784

 

107,282

 

106,590

 

Diluted

 

109,658

 

107,199

 

108,459

 

107,284

 

 

See accompanying Notes to Condensed Consolidated Financial Statements.

 

2



 

WATSON PHARMACEUTICALS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited; in thousands)

 

 

 

Nine Months Ended
September 30,

 

 

 

2003

 

2002

 

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

 

Net income

 

$

150,003

 

$

132,698

 

Reconciliation to net cash provided by operating activites:

 

 

 

 

 

Depreciation

 

20,683

 

18,900

 

Amortization

 

54,040

 

44,012

 

Deferred income tax benefit

 

(15,460

)

(4,691

)

Equity in (earnings) losses of joint ventures

 

(137

)

3,467

 

Gain on sale of securities

 

(5,510

)

 

Gain on sale of subsidiary

 

(15,676

)

 

Loss on early extinguishment of debt

 

2,807

 

 

Charge for impairment of securities

 

15,865

 

 

Tax benefits related to exercises of stock options

 

4,750

 

1,240

 

Other

 

(826

)

977

 

Changes in assets and liabilities:

 

 

 

 

 

Accounts receivable

 

54,112

 

(8,095

)

Inventories

 

(51,789

)

(31,826

)

Prepaid expenses and other current assets

 

5,891

 

5,945

 

Accounts payable and accrued expenses

 

40,332

 

12,759

 

Deferred revenue

 

18,005

 

(227

)

Income taxes payable

 

19,713

 

97,181

 

Other assets

 

(933

)

9,892

 

Other liabilities

 

2,057

 

 

Total adjustments

 

147,924

 

149,534

 

Net cash provided by operating activities

 

297,927

 

282,232

 

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

 

Additions to property and equipment

 

(104,542

)

(56,220

)

Acquisitions of product rights

 

(179,303

)

(121,152

)

Proceeds from sales of securities

 

12,122

 

 

Proceeds from sale of subsidiary

 

16,368

 

 

Distributions from equity investments

 

13,500

 

 

Other investing activities, net

 

3,944

 

1,292

 

Net cash used in investing activities

 

(237,911

)

(176,080

)

CASH FLOWS FROM FINANCING ACTIVITIES:

 

 

 

 

 

Proceeds from issuance of debt, net of issuance costs of $14,375

 

560,625

 

 

Proceeds from borrowings under revolving credit facility

 

60,000

 

 

Principal payments on credit facility

 

(325,940

)

(48,581

)

Principal payments on acquisition liabilities

 

(1,012

)

(7,070

)

Proceeds from stock plans

 

26,174

 

4,803

 

Net cash provided by (used in) financing activities

 

319,847

 

(50,848

)

Net increase in cash and cash equivalents

 

379,863

 

55,304

 

Cash and cash equivalents at beginning of period

 

230,155

 

193,731

 

Cash and cash equivalents at end of period

 

$

610,018

 

$

249,035

 

 

See accompanying Notes to Condensed Consolidated Financial Statements.

 

3



 

WATSON PHARMACEUTICALS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

NOTE A – GENERAL

 

Watson Pharmaceuticals, Inc. (Watson or the Company) is primarily engaged in the development, manufacture, marketing, sale and distribution of branded and off-patent (generic) pharmaceutical products. The Company also develops advanced drug delivery systems designed to enhance the therapeutic benefits of existing drug forms.  Watson operates manufacturing, distribution, research and development and administrative facilities primarily in the United States of America.

 

The accompanying condensed consolidated financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2002.  Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted from the accompanying consolidated financial statements.  The year end balance sheet was derived from the audited financial statements.  The accompanying interim financial statements are unaudited, but reflect all adjustments which are, in the opinion of management, necessary to present fairly Watson’s consolidated financial position, results of operations and cash flows for the periods presented.  Unless otherwise noted, all such adjustments are of a normal, recurring nature.  Certain reclassifications, none of which affected net income or retained earnings, have been made to prior period amounts to conform to current period presentation.  The Company’s results of operations and cash flows for the interim periods are not necessarily indicative of the results of operations and cash flows that it may achieve in future periods or for the full year.

 

Comprehensive income

 

Comprehensive income includes all changes in equity during a period except those that resulted from investments by or distributions to the Company’s stockholders.  Other comprehensive income refers to revenues, expenses, gains and losses that, under generally accepted accounting principles, are included in comprehensive income, but excluded from net income as these amounts are recorded directly as an adjustment to stockholders’ equity.  Watson’s other comprehensive income (loss) is comprised of unrealized gains (losses) on its holdings of publicly traded equity securities, net of realized gains included in net income.  The components of comprehensive income and related income taxes consisted of the following (in thousands):

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2003

 

2002

 

2003

 

2002

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

51,459

 

$

40,657

 

$

150,003

 

$

132,698

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive income (loss):

 

 

 

 

 

 

 

 

 

Unrealized holding gain (loss) on securities

 

1,598

 

(16,368

)

16,670

 

(84,049

)

Less related income taxes

 

(641

)

6,547

 

(6,670

)

33,620

 

Total unrealized gain (loss) on securities, net

 

957

 

(9,821

)

10,000

 

(50,429

)

 

 

 

 

 

 

 

 

 

 

Reclassification for (gains) losses included in net income

 

(891

)

 

10,355

 

 

Less related income taxes

 

323

 

 

(3,759

)

 

Total reclassification, net

 

(568

)

 

6,596

 

 

Total other comprehensive income (loss)

 

389

 

(9,821

)

16,596

 

(50,429

)

Total comprehensive income

 

$

51,848

 

$

30,836

 

$

166,599

 

$

82,269

 

 

4



 

Earnings per share

 

Basic earnings per share is computed by dividing net income by the weighted average common shares outstanding.  Diluted earnings per share is based on the treasury stock method and is computed by dividing net income by the weighted average number of common shares and dilutive potential common shares outstanding, assuming the exercise of all in-the-money stock options. A reconciliation of the numerators and denominators of basic and diluted earnings per share consisted of the following (in thousands, except per share amounts):

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2003

 

2002

 

2003

 

2002

 

 

 

 

 

 

 

 

 

 

 

Numerator:

 

 

 

 

 

 

 

 

 

Net income

 

$

51,459

 

$

40,657

 

$

150,003

 

$

132,698

 

Denominator:

 

 

 

 

 

 

 

 

 

Basic weighted average common shares outstanding

 

107,762

 

106,784

 

107,282

 

106,590

 

Effect of dilutive stock options

 

1,896

 

415

 

1,177

 

694

 

Diluted weighted average common shares outstanding

 

109,658

 

107,199

 

108,459

 

107,284

 

 

 

 

 

 

 

 

 

 

 

Basic earnings per share

 

$

0.48

 

$

0.38

 

$

1.40

 

$

1.24

 

 

 

 

 

 

 

 

 

 

 

Diluted earnings per share

 

$

0.47

 

$

0.38

 

$

1.38

 

$

1.24

 

 

Excluded from the computation of diluted earnings per share are outstanding common stock options with an exercise price greater than the average market price of the common shares for the period reported.  For the three month periods ended September 30, 2003 and 2002, excluded from the computation of diluted earnings per share were stock options to purchase 4.4 million and 10.8 million common shares, respectively. For the nine month periods ended September 30, 2003 and 2002, excluded from the computation of diluted earnings per share were stock options to purchase 6.3 million and 10.4 million common shares, respectively.

 

The effect of approximately 14.4 million shares related to the assumed conversion of the $575 million convertible contingent debentures (as described in Note I) has been excluded from the computation of diluted earnings per share for the three and nine month periods ended September 30, 2003 as the conditions that would permit conversion have not been satisfied.

 

Stock-based compensation

 

The Company accounts for its stock-based employee compensation plans using the recognition and measurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations.  No stock-based employee compensation expense has been recognized for the options in the accompanying condensed consolidated statements of income, as all options granted under the plans had an exercise price equal to the market value of the underlying common stock on the date of grant.

 

5



 

Had the Company determined compensation expense for all prior periods using the fair value method prescribed by Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation,” the Company’s net income and earnings per share would have been as follows (in thousands, except per share amounts):

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2003

 

2002

 

2003

 

2002

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

51,459

 

$

40,657

 

$

150,003

 

$

132,698

 

Total stock-based employee compensation expense determined under fair value based method for all awards

 

8,525

 

11,230

 

22,942

 

36,323

 

Tax effect of compensation expense

 

(3,095

)

(4,116

)

(8,328

)

(13,445

)

Pro forma net income

 

$

46,029

 

$

33,543

 

$

135,389

 

$

109,820

 

 

 

 

 

 

 

 

 

 

 

Earnings per share:

 

 

 

 

 

 

 

 

 

Basic - as reported

 

$

0.48

 

$

0.38

 

$

1.40

 

$

1.24

 

Basic - pro forma

 

$

0.43

 

$

0.31

 

$

1.26

 

$

1.03

 

 

 

 

 

 

 

 

 

 

 

Diluted - as reported

 

$

0.47

 

$

0.38

 

$

1.38

 

$

1.24

 

Diluted - pro forma

 

$

0.42

 

$

0.31

 

$

1.25

 

$

1.02

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding:

 

 

 

 

 

 

 

 

 

Basic

 

107,762

 

106,784

 

107,282

 

106,590

 

Diluted

 

109,658

 

107,199

 

108,459

 

107,284

 

 

The weighted average fair value of the options has been estimated on the date of grant using the Black-Scholes option-pricing model.  Weighted averages are used because of varying assumed exercise dates.  The following weighted average assumptions were used for options granted during the three and nine months ended September 30, 2003 and 2002:

 

 

 

2003

 

2002

 

 

 

 

 

 

 

Dividend yield

 

None

 

None

 

Expected volatility

 

38

%

38

%

Risk-free interest rate

 

3.38

%

4.21

%

Expected term

 

5.3 years

 

5.1 years

 

 

Recent accounting pronouncements

 

In July 2002, the Financial Accounting Standards Board (FASB) issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.”  SFAS No. 146 requires recognition of a liability for a cost associated with an exit or disposal activity when the liability is incurred, as opposed to when the entity commits to an exit plan as provided under previous guidance. This statement is effective for exit or disposal activities initiated after December 31, 2002. The Company adopted SFAS No. 146 on January 1, 2003, which had no material impact on the Company’s condensed consolidated financial statements.

 

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.”  SFAS No. 148 amends SFAS No. 123, “Accounting for Stock-Based

 

6



 

Compensation,” to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation.  In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results.  The Company adopted SFAS No. 148 on January 1, 2003, which had no material impact on the Company’s condensed consolidated financial statements.

 

In January 2003, the FASB issued Interpretation No. (FIN) 46, “Consolidation of Variable Interest Entities” an interpretation of Accounting Research Bulletin No. 51, “Consolidated Financial Statements.”  FIN 46 addresses consolidation by business enterprises of variable interest entities (VIE).  Under current practice, consolidation occurs when one enterprise controls the other through voting interests.  FIN 46 explains how to identify VIE and how an enterprise assesses its interest in VIE to decide whether to consolidate the VIE.  FIN 46 requires existing unconsolidated VIE to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among the parties involved.  VIE that effectively disperse risks will not be consolidated unless a single party holds an interest or combination of interests that effectively recombines risks that were previously dispersed.  FIN 46 applies immediately to VIE created after January 31, 2003 and to VIE in which an enterprise obtains an interest after that date.  It applies in the first interim period beginning after December 15, 2003 to VIE in which an enterprise holds a variable interest that it acquired before February 1, 2003.  The Company is in the process of identifying our interest in VIE to determine which, if any such entities, require consolidation under FIN 46.  If we determine we should consolidate these entities, we would recognize certain assets and debt on our condensed consolidated balance sheets and a cumulative adjustment for the accounting change in our condensed consolidated statements of income.

 

In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133. SFAS No. 149 is generally effective for contracts entered into or modified after June 30, 2003 (with a few exceptions) and for hedging relationships designated after June 30, 2003. The guidance is to be applied prospectively.  The Company adopted SFAS No. 149 on June 30, 2003, which had no material impact on its condensed consolidated financial statements.

 

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” SFAS No. 150 improves the accounting for certain financial instruments that, under previous guidance, issuers could account for as equity.  SFAS No. 150 requires that those instruments be classified as liabilities in statements of financial position.  SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003.  The Company adopted SFAS No. 150 during the third quarter of 2003, which had no material impact on its condensed consolidated financial statements.

 

NOTE B – ACQUISITIONS OF PRODUCT RIGHTS

 

In February 2003, Watson acquired the U.S. rights to the Fioricetâ and Fiorinalâ product lines from Novartis Pharmaceuticals Corporation (Novartis).  These products are indicated for the treatment of tension headaches.  The Company paid approximately $178 million in cash for the rights to these products.

 

7



 

NOTE C – EQUITY INVESTMENTS

 

Watson’s equity investments in publicly traded companies are classified as available-for-sale and are recorded at fair value based on quoted market prices using the specific identification method.  These investments are classified as either current or non-current, as appropriate, on the Company’s Condensed Consolidated Balance Sheets.

 

Current investments

 

The Company’s current investments are comprised of the common stock of Andrx Corporation – Andrx Group (Andrx), publicly traded on the Nasdaq Stock Market under the symbol ADRX, and Dr. Reddy’s Laboratories, Limited (Dr. Reddy), traded on the Bombay Stock Exchange.  These investments are included in “Marketable securities” on the Company’s Condensed Consolidated Balance Sheets at September 30, 2003 and December 31, 2002.

 

During the three and nine month periods ended September 30, 2003, Watson sold a portion of its shares of its Andrx and Dr. Reddy common stock investments.  The Company did not sell any of its shares of Andrx and Dr. Reddy during the nine month period ended September 30, 2002.  The following table provides a summary of the Company’s sales of its Andrx and Dr. Reddy holdings during the periods reported.  Realized gains are computed using the specific identification method to determine the cost basis for each investment (in thousands except share amounts):

 

 

 

Three Months
Ended
September 30, 2003

 

Nine Months
Ended
September 30, 2003

 

 

 

 

 

 

 

Andrx:

 

 

 

 

 

Shares sold

 

47,000

 

117,000

 

Proceeds from sale

 

$

1,004

 

$

2,376

 

Gross realized gain

 

$

875

 

$

2,054

 

 

 

 

 

 

 

Dr. Reddy:

 

 

 

 

 

Shares sold

 

146,228

 

436,228

 

Proceeds from sale

 

$

3,729

 

$

9,746

 

Gross realized gain

 

$

1,621

 

$

3,456

 

 

Non-current investments

 

The Company’s non-current investments include its investment in the common stock of Genelabs Technologies, Inc. (Genelabs), NovaDel Pharma Inc., and Amarin Corporation plc (Amarin), and warrants to purchase shares of common stock of Halsey Drug Co., Inc. (Halsey).  These investments are included in “Investments and other assets” on the Company’s Condensed Consolidated Balance Sheets at September 30, 2003 and December 31, 2002.

 

8



 

The following table provides a summary of the fair value and unrealized holding gain (loss) related to Watson’s available-for-sale securities (in thousands):

 

 

 

September 30,
2003

 

December 31,
2002

 

 

 

 

 

 

 

Equity securities:

 

 

 

 

 

Cost basis

 

$

32,535

 

$

49,669

 

Gross unrealized holding gain

 

29,553

 

24,530

 

Gross unrealized holding loss

 

(252

)

(13,625

)

Fair value of securities

 

$

61,836

 

$

60,574

 

 

Gross unrealized gains primarily relate to our holdings in shares of Andrx and Dr. Reddy common stock.  The gross unrealized holding loss at September 30, 2003 is attributable to adjustments, included in other comprehensive income, for the decline in fair value in the Company’s investment in Amarin.  Additionally, the Company recorded $1.6 million asset impairment charge during the quarter on the Halsey warrants (as described in Note K).  As of September 30, 2003, the fair value of the Halsey warrants was $9.2 million. The gross unrealized holding loss at December 31, 2002 is primarily attributable to the Company’s investment in Genelabs.

 

The Company’s net unrealized holding gain related to its available-for-sale securities, increased $0.4 million and $16.6 million for the three and nine month periods ended September 30, 2003, respectively.  During the three and nine month periods ended September 30, 2002, the Company’s net unrealized holding gain decreased $9.8 million and $50.4 million, respectively.  These changes in the Company’s net unrealized holding gain are included in other comprehensive income.

 

NOTE D – OPERATING SEGMENTS

 

Watson has two reportable operating segments: branded and generic pharmaceutical products.  The branded products segment includes the Company’s lines of Women’s Health, Urology/General Products and Nephrology products. Watson has aggregated its branded product lines in a single segment because of similarities in regulatory environment, manufacturing processes, methods of distribution and types of customer.  This segment includes patent-protected products and trademarked generic products that Watson sells and promotes directly to healthcare professionals as branded pharmaceutical products.  The generic products segment includes off-patent pharmaceutical products that are therapeutically equivalent to proprietary products.  The Company sells its branded and generic products primarily to pharmaceutical wholesalers, drug distributors and chain drug stores.

 

The accounting policies of the segments are described in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002.  Watson primarily evaluates the performance of its segments based on net revenues and gross profit.  The “other” classification consists primarily of contingent payments received from the settlement of a legal dispute, profit sharing revenues, and revenues from research, development and licensing fees.  The Company does not report depreciation expense, total assets, and capital expenditures by segment as such information is not used by management, or accounted for at the segment level.  Net revenues and gross profit information for the Company’s segments consisted of the following (in thousands):

 

9



 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2003

 

2002

 

2003

 

2002

 

 

 

 

 

 

 

 

 

 

 

Net revenues:

 

 

 

 

 

 

 

 

 

Branded pharmaceutical products

 

$

184,640

 

$

162,359

 

$

554,302

 

$

479,913

 

Generic pharmaceutical products

 

154,208

 

136,291

 

458,674

 

387,383

 

Other

 

19,908

 

9,210

 

38,582

 

26,328

 

Total net revenues

 

$

358,756

 

$

307,860

 

$

1,051,558

 

$

893,624

 

Gross profit:

 

 

 

 

 

 

 

 

 

Branded pharmaceutical products

 

$

143,907

 

$

124,145

 

$

428,644

 

$

365,373

 

Generic pharmaceutical products

 

52,610

 

30,580

 

138,024

 

84,226

 

Other

 

19,908

 

9,210

 

38,582

 

26,328

 

Total gross profit

 

$

216,425

 

$

163,935

 

$

605,250

 

$

475,927

 

 

NOTE E – INVENTORIES

 

Inventories consist of finished goods held for distribution, raw materials and work-in-process. At September 30, 2003, inventories included approximately $45.4 million of inventory, net of reserve, relating to products that are pending approval by the Food and Drug Administration (FDA) or have not been launched due to contractual restrictions.

 

Inventories are stated at the lower of cost (first-in, first-out method) or market (net realizable value) and consisted of the following (in thousands):

 

 

 

September 30,
2003

 

December 31,
2002

 

 

 

 

 

 

 

Raw materials

 

$

127,444

 

$

116,806

 

Work-in-process

 

76,439

 

80,062

 

Finished goods

 

195,705

 

151,905

 

Total inventories

 

$

399,588

 

$

348,773

 

 

NOTE F – NOTE RECEIVABLE

 

As part of a strategic alliance, in March 2000, the Company entered into a loan agreement with Halsey.  The loan consisted of principal of $17.5 million and bore interest at prime plus 2% with a maturity date of March 31, 2003.  During December 2002, Watson and Halsey amended the terms of this loan agreement.  As amended, the loan now consists of principal of $21.4 million and bears interest at prime plus 4.5% maturing on March 31, 2006.  In consideration for the amendment, Halsey issued to Watson warrants to purchase common stock.  The warrants were valued at fair value of $10.8 million and the related carrying value of the note was reduced by the fair value of the warrants (See Note K).  As of September 30, 2003, the book value of the note, net of reserve, was $10.0 million.  The note is collateralized by a first lien on all of Halsey’s assets and is senior to all other indebtedness incurred by Halsey.

 

Halsey’s ability to repay the note is dependent upon its ability to obtain funding for its ongoing operations.  If Halsey is unable to obtain adequate funding to support its operations, it may cease to operate as a going concern.  If Halsey were to cease operations, recovery of the net book value of the note would be dependent upon there being sufficient net proceeds generated from the sale of the operating assets of Halsey as Watson holds a first lien on all of Halsey’s assets.  The Company will continue to monitor Halsey’s activities to ascertain the recoverability of the note balance.

 

10



 

NOTE G – ASSETS HELD FOR DISPOSITION

 

In connection with the acquisition of Schein Pharmaceutical, Inc. (Schein), Watson acquired two injectable pharmaceutical manufacturing facilities, Steris Laboratories, Inc. (Steris), located in Phoenix, Arizona and Marsam Pharmaceuticals, Inc. (Marsam), located in Cherry Hill, New Jersey.  Upon acquisition, Watson intended to dispose of these facilities and, accordingly, these assets were reported as assets held for disposition in the Company’s Condensed Consolidated Balance Sheets.  Watson recorded these assets held for disposition at estimated fair value.  The operating expenses associated with the facilities were recorded separately in the Company’s Condensed Consolidated Statements of Income as loss on assets held for disposition.

 

At December 31, 2002, the Company had approximately $6 million of property related to Marsam and approximately $22 million of inventories and approximately $1 million of fixed assets related to Steris.

 

On January 1, 2003 Watson reclassified its assets held for disposition as held and used.  This reclassification was made as a result of the absence of a completed sale transaction or binding offer for either of the facilities, in accordance with SFAS No. 144.  The related assets were reclassified as inventories and property and equipment, as appropriate, in the Company’s Condensed Consolidated Balance Sheets.  For the three and nine months ended September 30, 2002, $8.1 million and $21.8 million of operating expenses related to the Steris facility were reclassified to cost of sales, research and development expenses and selling, general and administrative expenses, as appropriate.

 

Although the assets were reclassified as held and used, the Company continues its efforts to dispose of the Marsam property and continues to evaluate divestiture or other alternatives related to the Steris facility.

 

NOTE H – GOODWILL AND OTHER INTANGIBLE ASSETS

 

Watson tests its goodwill and intangible assets with indefinite lives by comparing the fair value of each of the Company’s reporting units to the respective carrying value of the reporting units.  The Company performs this impairment testing annually during the second quarter or when events occur or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount.  The Company’s reporting units have been identified by Watson as branded and generic pharmaceutical products.  The carrying value of each reporting unit is determined by assigning the assets and liabilities, including the existing goodwill and intangible assets, to those reporting units.  Goodwill is considered impaired if the carrying amount exceeds the fair value of the asset.

 

During the second quarter of 2003, Watson performed its annual test for the impairment of goodwill and determined there was no indication of impairment.  There were no additions to goodwill recorded during the nine months ended September 30, 2003.  At September 30, 2003, goodwill for the Company’s reporting units consisted of the following (in thousands):

 

Branded pharmaceutical products

 

$

358,798

 

Generic pharmaceutical products

 

87,490

 

Total goodwill

 

$

446,288

 

 

11



 

Other intangible assets consist primarily of product rights.  The original cost and accumulated amortization of these intangible assets are as follows (in thousands):

 

 

 

September 30,
2003

 

December 31,
2002

 

 

 

 

 

 

 

Product rights and related intangibles

 

$

1,286,273

 

$

1,107,200

 

Less accumulated amortization

 

(272,214

)

(218,173

)

Total product rights and related intangibles, net

 

$

1,014,059

 

$

889,027

 

 

Assuming no additions, disposals or adjustments are made to the carrying values and/or useful lives of the assets, annual amortization expense on product rights and related intangibles is estimated to be approximately $71.7 million in 2003, $71.5 million in 2004 and $71.8 million in each of 2005, 2006 and 2007.  The Company’s current product rights and related intangibles have a weighted average useful life of approximately 19 years.

 

NOTE I – LONG-TERM DEBT

Long-term debt consisted of the following (in thousands):

 

 

 

September 30,
2003

 

December 31,
2002

 

 

 

 

 

 

 

Senior unsecured notes, 7.125%, face amount of $150 million, due 2008

 

$

149,142

 

$

149,023

 

Term loan facility, due 2005

 

 

265,928

 

Convertible contingent debentures, face amount of $575 million due 2023, net of $1,772 unamortized discount

 

573,228

 

 

Other notes payable

 

57

 

286

 

Total debt

 

$

722,427

 

$

415,237

 

Less current portion

 

 

(83,360

)

Total long-term debt

 

$

722,427

 

$

331,877

 

 

In May 1998, Watson issued $150 million of its senior unsecured notes (1998 Senior Notes).  These notes are due in May 2008 but may be redeemed earlier under certain circumstances.  The Company is required to make interest only payments due semi-annually in May and November at an effective annual rate of 7.2%.

 

The 1998 Senior Notes were issued pursuant to a shelf registration statement authorizing up to $300 million in debt securities, preferred stock or common stock.  On April 2, 2003, the Company determined that it did not intend to offer any additional debt securities, preferred stock or common stock under the registration statement, and filed an amendment with the Securities and Exchange Commission deregistering the remaining unsold $150 million aggregate amount of debt securities, preferred stock and common stock covered by the registration statement.

 

In March 2003, the Company issued $575 million of convertible contingent senior debentures (CODES).  The CODES, which are convertible into shares of Watson’s common stock upon the occurrence of certain events, are due in March 2023, with interest payments due semi-annually in March and September at an effective annual interest rate of 2.1%.

 

The CODES are convertible into Watson’s common stock at a conversion price of approximately $40.05 per share (subject to certain adjustments).  The CODES may be converted, at the option of the holders, prior to maturity under any of the following circumstances:

 

12



 

                  during any quarterly conversion period (period from and including the thirtieth trading day in a fiscal quarter to, but not including, the thirtieth trading day in the immediately following fiscal quarter) if the closing sale price per share of Watson’s common stock for a period of at least 20 trading days during the 30 consecutive trading-day period ending on the first day of such conversion period is more than 125% of the conversion price in effect on that thirtieth day;

 

                  on or before March 15, 2018, during the five business-day period following any 10 consecutive trading-day period in which the daily average trading price for the CODES for such ten-day period was less than 105% of the average conversion value for the debentures during that period.  This conversion feature represents an embedded derivative.  However, based on the de minimis value associated with this feature, no value has been assigned at issuance and at September 30, 2003;

 

                  during any period, following the earlier of (a) the date the CODES are rated by both Standard & Poor’s Rating Services and Moody’s Investor Services, Inc., and (b) April 21, 2003, when the long-term credit rating assigned to the CODES by either Standard & Poor’s or Moody’s (or any successors to these entities) is lower than “BB” or “Ba3”, respectively, or when either of these rating agencies does not have a rating then assigned to the CODES for any reason, including any withdrawal or suspension of a rating assigned to the CODES.  This conversion feature represents an embedded derivative.  However, based on the de minimis value associated with this feature, no value has been assigned at issuance and at September 30, 2003;

 

                  if the CODES have been called for redemption; or

 

                  upon the occurrence of specified corporate transactions.

 

The Company may redeem some or all of the CODES for cash, on or after March 20, 2008, for a price equal to 100% of the principal amount of the CODES plus accrued and unpaid interest (including contingent interest) to, but excluding, the redemption date.

 

The CODES contain put options which may require the Company to repurchase for cash all or a portion of the CODES on March 15 of 2010, 2015 and 2018 at a repurchase price equal to 100% of the principal amount of the CODES plus any accrued and unpaid interest (including contingent interest) to, but excluding, the date of repurchase.

 

In addition, the holders of the CODES have the right to receive contingent interest payments during any six-month period from March 15 to September 14 and from September 15 to March 14, commencing on September 15, 2003, if the average trading price of the CODES for the five trading days ending on the second trading day immediately preceding the relevant six-month period equals 120% or more of the principal amount of the CODES.  The interest rate used to calculate the contingent interest is the greater of 5% of the Company’s then-current estimated per annum borrowing rate for senior non-convertible fixed-rate debt with a maturity date and other terms comparable to that of the CODES or 0.33% per annum.  This contingent interest payment feature is an embedded derivative and has been bifurcated and recorded separately in the Condensed Consolidated Balance Sheets in other long-term liabilities.  The initial fair value assigned to the embedded derivative was $1.9 million, which is recorded as a discount to the CODES (See Note J).

 

The Company used a portion of the proceeds from the issuance of the CODES to retire the outstanding balance of the Company’s term loan and revolving credit facility it entered into in July 2000 (2000 Facility).  The total outstanding balance of the 2000 Facility consisted of a $246 million term loan balance and a $60 million revolving credit balance. The Company terminated the 2000 Facility in March 2003 upon repayment of the outstanding balance.  As a result of the early retirement of the 2000 Facility, the Company incurred a charge

 

13



 

in the amount of $2.8 million for the unamortized bank fees associated with this debt.  This charge is reported separately in the Condensed Consolidated Statements of Income.

 

In May 2003, the Company entered into an agreement with a syndicate of lenders for a five-year, $300 million senior, unsecured revolving credit facility for working capital and other general corporate purposes. Watson’s assets generally are held by, and its operations generally are conducted through, its subsidiaries.  Within the meaning of Regulation S-X, Rule 3-10, the Company has no assets or operations independent of its subsidiaries.  The terms of the new credit facility require each subsidiary, other than minor subsidiaries, to provide full and unconditional guarantees on a joint and several basis. In order to provide subsidiary guarantees in connection with this credit facility, the Company was also required, by the terms of the Indenture for the 1998 Senior Notes, to grant similar subsidiary guarantees in favor of the 1998 Senior Note holders. The subsidiary guarantees related to both the new credit facility and the 1998 Senior Notes are full and unconditional, on a joint and several basis, and are given by all subsidiaries other than minor subsidiaries.  As of September 30, 2003, the Company had not drawn any funds from the revolving credit facility.

 

NOTE J – FINANCIAL INSTRUMENTS

 

Fair value of financial instruments

 

The Company’s financial instruments consist primarily of cash and cash equivalents, marketable securities, accounts and other receivables, investments, trade accounts payable, senior subordinated notes, CODES and embedded derivatives related to the issuance of the CODES.  The carrying amounts of cash and cash equivalents, marketable securities, accounts and other receivables and trade accounts payable are representative of their respective fair values due to their relatively short maturities.  The fair values of investments in companies that are publicly traded are based on quoted market prices.  The fair value of investments in privately held companies, or cost-method investments, are based on historical cost, adjusted for any write-down related to impairment.  The Company estimates the fair value of its fixed rate long-term obligations based on quoted market rates of interest and maturity schedules for similar issues.  The carrying value of these obligations approximates their fair value.  The fair value of the embedded derivatives related to the CODES is based on a present value technique using discounted expected future cash flows.

 

Derivative financial instruments

 

The Company’s derivative financial instruments consist of embedded derivatives related to its CODES.  These embedded derivatives include certain conversion features and a contingent interest feature.   See Note I for a more detailed description of these features of the CODES.  Although the conversion features represent embedded derivative financial instruments, based on the de minimis value of these features at the time of issuance and at September 30, 2003, no value has been assigned to these instruments.  The contingent interest feature provides unique tax treatment under the Internal Revenue Service’s Contingent Debt Regulations.  In essence, interest accrues, for tax purposes, on the basis of the instrument’s comparable yield (the yield at which the issuer would issue a fixed rate instrument with similar terms). This embedded derivative is reported on the Company’s Condensed Consolidated Balance Sheets at fair value and the changes in the fair value of the embedded derivative are reported as gains or losses in the Company’s Condensed Consolidated Statements of Income.

 

At September 30, 2003, the carrying amount of $4.0 million approximates the estimated fair value of the Company’s derivative financial instruments.  Such financial instruments were not in place at September 30, 2002.

 

During the three and nine month periods ended September 30, 2003, the fair value of the Company’s derivative financial instruments increased $56,000 and $2 million, respectively.  These changes in fair value were recorded as a charge to interest expense during the respective periods.

 

14



 

NOTE K – IMPAIRMENT OF SECURITIES

 

At September 30, 2003, investments and other assets included an investment in three million shares of the common stock of Genelabs Technologies, Inc. (Genelabs), a publicly traded company, with an adjusted cost basis of $3.9 million.  This investment has been classified as available-for-sale, pursuant to SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.”  Available-for-sale securities are carried at fair value, based on quoted market prices, with unrealized gains and losses reported as a separate component of stockholders’ equity.  During the first quarter of 2003, management determined that an other than temporary decline in the fair value of Genelabs’ common stock existed and, as a result, wrote-down the initial cost basis of the investment to its fair value at March 31, 2003 of $3.9 million.  In connection with this write-down, an asset impairment charge of $13.0 million was recorded and recognized in earnings.  This impairment should have been recognized in the first quarter of 2002, as the investment had been in an unrealized loss position for an extended period.  Recognition of the impairment in the first quarter of 2003 was an error.  However, this charge would not have been material to the Company’s 2002 financial statements, and is not expected to be material to the Company’s 2003 earnings or trend of earnings.

 

At September 30, 2003, investments and other assets included an investment in 400,000 American Depository Receipts of Amarin, classified as an available-for-sale security, with a cost basis of $1.3 million.  During the second quarter of 2003, management determined that an other-than-temporary decline in fair value of its Amarin investment existed.  As a result, the Company wrote down the initial cost basis of the investment to its fair value at June 30, 2003.  In connection with this write-down, an asset impairment charge of $1.2 million was recorded and recognized in earnings.

 

At September 30, 2003, investment and other assets included an investment in 10,700,665 warrants to purchase shares of common stock of Halsey with a fair value at acquisition of $10.8 million.  During the third quarter of 2003, management determined that an other-than-temporary decline in fair value of its Halsey investment existed.  As a result, the Company wrote down the initial cost basis of the investment to its fair value of $9.2 million at September 30, 2003.  In connection with this write-down, an asset impairment charge of $1.6 million was recorded and recognized in earnings.

 

NOTE L – SALE OF SUBSIDIARY

 

During the first quarter of 2003, the Company completed the sale of its subsidiary located in the United Kingdom (UK).  The Company received proceeds from this sale of approximately $16.4 million and recorded a pre-tax gain of approximately $15.7 million.  During 2002, the subsidiary had net revenues, gross profit and net income of $10.8 million, $6.3 million and $3.2 million, respectively.

 

In connection with the sale, the Company has provided certain warranties and indemnifications to the buyer including an indemnification relating to website content. The buyer must give written notice to the Company within 18 months of the completion of the sale transaction of any claim arising out of these indemnifications.  The Company does not expect any liability arising out of a claim, if any, to have a material adverse impact on its results of operations, financial position or cash flows.  No liability has been recorded in relation to these indemnifications at September 30, 2003.

 

15



 

ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following discussion of our financial condition and the results of our operations should be read in conjunction with the condensed consolidated financial statements and notes thereto included elsewhere in this Quarterly Report.  This discussion contains forward-looking statements that are subject to known and unknown risks, uncertainties and other factors that may cause our actual results to differ materially from those expressed or implied by such forward-looking statements.  These risks, uncertainties and other factors include, among others, those identified under “Cautionary Note Regarding Forward-Looking Statements” and elsewhere in this Quarterly Report and under “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2002.

 

Results of Operations

 

Net Revenues

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

($ in thousands):

 

2003

 

2002

 

%
Change

 

2003

 

2002

 

%
Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net Revenues by Segment:

 

 

 

 

 

 

 

 

 

 

 

 

 

Branded pharmaceutical products

 

$

184,640

 

$

162,359

 

13.7

%

$

554,302

 

$

479,913

 

15.5

%

% of total product net revenues

 

54.5

%

54.4

%

 

 

54.7

%

55.3

%

 

 

Generic pharmaceutical products

 

154,208

 

136,291

 

13.1

%

458,674

 

387,383

 

18.4

%

% of total product net revenues

 

45.5

%

45.6

%

 

 

45.3

%

44.7

%

 

 

Other

 

19,908

 

9,210

 

116.2

%

38,582

 

26,328

 

46.5

%

Total net revenues

 

$

358,756

 

$

307,860

 

16.5

%

$

1,051,558

 

$

893,624

 

17.7

%

 

Total net revenues for the three and nine months ended September 30, 2003 increased compared to the corresponding 2002 periods due to increases in net revenues in both our branded and generic segments as well as other revenues.

 

Branded Pharmaceutical Products

 

The increase in net revenues from our branded pharmaceutical products segment for the three and nine month periods was primarily attributable to increases in product sales within our Urology/General Products division.  The acquisition of the Fioricet® and Fiorinal® product lines during the first quarter of 2003, and the launch of our OxytrolTM product during the second quarter of 2003 were the primary factors contributing to the increase.  In addition to the new products within our Urology/General Products division, higher unit sales of our Androderm® testosterone patch, resulting from focused product promotions and prescription growth, also contributed to the overall increase within the division.  Women’s Health also contributed approximately $20 million to the increase in net revenues for the nine month period as a result of new product launches such as our Necon® 7/7/7 and Mononessa™ products.  The increase in net revenues was partially offset by the decrease in Nephrology net revenues for the nine month period.

 

We expect net revenues from our branded segment to increase during the fourth quarter of 2003 at a slightly higher rate than the increase experienced in the third quarter of 2003, as a result of higher sales of Oxytrol® and the launch of an oral contraceptive product prior to year-end.

 

16



 

Generic Pharmaceutical Products

 

The increases in net revenues from our generic segment were related to new products launched and products reintroduced during, or subsequent to, the corresponding 2002 periods, as well as price increases on certain products.

 

We expect net revenues from our generic segment in the fourth quarter of 2003 to increase at a higher rate than the increase experienced in the third quarter of 2003, primarily as a result of anticipated product launches.

 

Other Revenues

 

Other revenues consist primarily of payments resulting from a legal settlement, royalty revenues, and revenues recognized as a result of partial completion of research and development activities for third parties.

 

The increase in other revenues from the prior year periods was primarily attributable to revenue received from Aventis Pharmaceuticals (Aventis) under a 1998 agreement entered into in connection with our acquisition of the Rugby Group, Inc.  Pursuant to the agreement, we are entitled to a portion of the proceeds received by Aventis in connection with Barr Laboratories, Inc.’s sales of ciprofloxacin tablets.

 

Additionally, revenues from research and development agreements increased slightly over prior year periods.  These revenues (typically milestone payments) are recorded under the “contingency-adjusted performance model,” which requires deferral of revenue until such time as contract milestone requirements, as specified in the individual agreement, have been met and cash has been received.  Thereafter, once contingencies have been removed, revenue is recognized based on the percentage of completion method.

 

Other revenues for the nine months ended September 30, 2003 include $21.0 million in payments from a 2001 legal settlement.  The payment received in the third quarter of 2003 represents the final payment from this settlement.  We expect other revenues to be approximately $45 million to $50 million for the full year 2003.

 

Net Revenue Mix

 

Net revenue mix is an important consideration in evaluating the profitability of our business.  Our branded products generally realize higher gross profit margins than our generic products.  Any significant change in our net revenue mix could substantially impact our gross profit, gross margin and the overall profitability of our business.

 

For the three and nine month periods ended September 30, 2003, our net revenue mix remained consistent with the corresponding 2002 periods. We expect the net revenue mix for the fourth quarter of 2003 to be consistent with that of the third quarter of 2003.

 

Gross Profit Margin on Product Net Revenues (Gross Margin)

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2003

 

2002

 

Change

 

2003

 

2002

 

Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross Margin by Segment:

 

 

 

 

 

 

 

 

 

 

 

 

 

Branded pharmaceutical products

 

77.9

%

76.5

%

1.4

%

77.3

%

76.1

%

1.2

%

Generic pharmaceutical products

 

34.1

%

22.4

%

11.7

%

30.1

%

21.7

%

8.4

%

Gross margin on product net revenues

 

58.0

%

51.8

%

6.2

%

55.9

%

51.8

%

4.1

%

 

17



 

Overall gross margin on product net revenues for the three and nine months ended September 30, 2003 increased compared to the same periods a year ago.

 

The increase in gross margin from our branded segment for the three and nine months ended September 30, 2003, was attributable to increased margins in our Urology/General Products division as a result of higher gross margins realized on the products that we introduced during 2003. The increase was partially offset by the decreased margin in Women’s Health due to lower margins realized on Necon® 7/7/7 and Mononessa™ products as a result of a profit sharing arrangement with the manufacturer.

 

The increase in the gross margin from our generic segment for the three and nine months ended September 30, 2003, was primarily attributable to price increases on certain products.

 

We expect our gross margins for the fourth quarter to remain consistent with the third quarter of 2003.

 

Research and Development (R&D) Expenses

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

($ in thousands):

 

2003

 

2002

 

%
Change

 

2003

 

2002

 

%
Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

R&D expenses

 

$

26,428

 

$

22,387

 

18.1

%

$

74,613

 

$

60,675

 

23.0

%

as % of net revenues

 

7.4

%

7.3

%

 

 

7.1

%

6.8

%

 

 

 

Research and development expenses increased from the corresponding prior year periods due to increased spending on clinical studies and expanded generic development programs.  The clinical studies relate to our anti-fungal nail patch, continued studies with Oxytrol® and additional indications for Ferrlecit®.  Expenses also increased due to biostudies and other expenses related to various generic products under different stages of development.

 

We expect research and development expenses for the remainder of 2003 to continue to increase slightly due to our efforts in both branded and generic product development.

 

Selling, General and Administrative (SG&A) Expenses

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

($ in thousands):

 

2003

 

2002

 

%
Change

 

2003

 

2002

 

%
Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

SG&A expenses

 

$

87,547

 

$

56,149

 

55.9

%

$

227,420

 

$

178,046

 

27.7

%

as % of net revenues

 

24.4

%

18.2

%

 

 

21.6

%

19.9

%

 

 

 

SG&A expenses increased from the corresponding prior year periods due to higher spending associated with the Oxytrolä product launch.  The third quarter of 2003 includes marketing expenses associated with our Oxytrol® product launch and additional costs related to expansion of our sales force through our relationship with Ventiv Health Inc., our contract sales organization.

 

18



 

Amortization Expense

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

($ in thousands):

 

2003

 

2002

 

%
Change

 

2003

 

2002

 

%
Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amortization expense

 

$

17,820

 

$

16,176

 

10.2

%

$

54,040

 

$

44,012

 

22.8

%

 

The increase in amortization expense was primarily due to amortization associated with the Fiorinalâ and Fioricetâ product lines acquired in February 2003.  See Note B in the accompanying Notes to Condensed Consolidated Financial Statements in this Quarterly Report. Assuming no additions, disposals or adjustments are made to the carrying values and/or useful lives of our product rights and other intangible assets, we expect amortization expense for the fourth quarter of 2003 to remain consistent with that of the third quarter of 2003.

 

Equity in Earnings (Losses) of Joint Ventures

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

($ in thousands):

 

2003

 

2002

 

%
Change

 

2003

 

2002

 

%
Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Equity in earnings (losses) of joint ventures

 

$

(68

)

$

(1,945

)

-96.5

%

$

137

 

$

(3,759

)

-103.6

%

 

The change from the prior year losses is attributable to income from our interest in ANCIRC Pharmaceuticals (ANCIRC), a joint venture with Andrx Corporation.  The income from ANCIRC substantially offset the losses from our interest in Somerset Pharmaceuticals, Inc. (Somerset), a joint venture with Mylan Laboratories, Inc.  During the fourth quarter, we expect our ANCIRC earnings to continue to offset Somerset losses, consistent with that of the third quarter of 2003.

 

Impairment of Securities

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

($ in thousands):

 

2003

 

2002

 

%
Change

 

2003

 

2002

 

%
Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Impairment of securities

 

$

1,605

 

$

 

n/a

 

$

15,865

 

$

 

n/a

 

 

During the third quarter of 2003, we recorded a $1.6 million impairment charge related to our investment in Halsey warrants. During the second quarter of 2003, we recorded a $1.2 million impairment charge related to our investment in Amarin. Additionally, we recorded a $13.0 million impairment charge during the first quarter of 2003, related to our investment in Genelabs.  See Note K in the accompanying Notes to Condensed Consolidated Financial Statements in this Quarterly Report.

 

At September 30, 2003, we had a total gross unrealized holding loss of $252,000 related to our investment in Amarin, which had a fair value less than its recorded cost for approximately three months.  Investments are considered to be impaired when a decline in fair value is judged to be other-than-temporary.  If a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded and a new cost basis in the investment is established.  We employ a systematic methodology that considers all available evidence in evaluating potential impairment of our investments.  In the event that the cost of an investment exceeds its fair

19



 

value, we evaluate, among other factors, general market conditions, the duration and extent to which the fair value is less than cost, as well as our intent and ability to hold the investment.  We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, operational and financing cash flow factors, and rating agency actions.  However, when the carrying value of an investment is greater than the realizable value for an extended period, unless sufficient positive, objective evidence exists to support such an extended period, the decline will be considered other-than-temporary.  Any decline in the market prices of our equity investments that are deemed to be other-than-temporary may require us to incur additional impairment charges.

 

Gain on Sale of Securities

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

($ in thousands):

 

2003

 

2002

 

%
Change

 

2003

 

2002

 

%
Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gain on sale of securities

 

$

2,496

 

$

 

n/a

 

$

5,510

 

$

 

n/a

 

 

Our gain on sale of securities resulted from the sale of shares of Dr. Reddy and Andrx common stock.  See Note C in the accompanying Notes to Condensed Consolidated Financial Statements in this Quarterly Report.

 

Gain on Sale of Subsidiary

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

($ in thousands):

 

2003

 

2002

 

%
Change

 

2003

 

2002

 

%
Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gain on sale of subsidiary

 

$

 

$

 

n/a

 

$

15,676

 

$

 

n/a

 

 

During the first quarter of 2003, we sold our subsidiary located in the United Kingdom.  As a result of the sale, we recorded a pre-tax gain of $15.7 million.   During 2002, the subsidiary had net revenues, gross profit and net income of $10.8 million, $6.3 million and $3.2 million, respectively.  See Note L in the accompanying Notes to Condensed Consolidated Financial Statements in this Quarterly Report.

 

Gain from Legal Settlement

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

($ in thousands):

 

2003

 

2002

 

%
Change

 

2003

 

2002

 

%
Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gain from legal settlement

 

$

 

$

 

n/a

 

$

 

$

32,000

 

-100

%

 

During the second quarter of 2002, we recorded a $32 million gain as a result of the settlement reached with Bristol-Myers Squibb (BMS) resolving all outstanding disputes between the companies related to buspirone.

 

20



 

Loss on Early Extinguishment of Debt

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

($ in thousands):

 

2003

 

2002

 

%
Change

 

2003

 

2002

 

%
Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loss on early extinguishment of debt

 

$

 

$

 

n/a

 

$

2,807

 

$

 

n/a

 

 

During the first quarter of 2003, as a result of the retirement of our previous credit facility, we incurred a $2.8 million charge for the unamortized bank fees associated with the credit facility.  See Note I in the accompanying Notes to Condensed Consolidated Financial Statements in this Quarterly Report.

 

Interest Expense

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

($ in thousands):

 

2003

 

2002

 

%
Change

 

2003

 

2002

 

%
Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest expense

 

$

5,980

 

$

5,747

 

4.1

%

$

18,901

 

$

16,690

 

13.2

%

 

Interest expense remained fairly consistent for the three month periods ended September 30, 2003 and 2002 as lower borrowing rates offset higher debt balances in the current year.  The increase in interest expense for the nine month period ended September 30, 2003 was primarily the result of the adjustments made to the fair value of our derivative financial instruments during the second and third quarters of 2003.  The changes in the fair value of $2 million and $56,000 for the three months ended June 30, 2003 and September 30, 2003, respectively, were recorded as interest expense.  See Note J in the accompanying Notes to Condensed Consolidated Financial Statements in this Quarterly Report.

 

Liquidity and Capital Resources

 

We assess liquidity by our ability to generate cash to fund our operations.  Significant factors that affect the management of our liquidity include: current balances of cash, cash equivalents and value of marketable securities; expected cash flows provided by operations; current levels of our accounts receivable, inventory and accounts payable balances; our expected investment in capital; access to financing sources, including credit and equity arrangements; and the financial flexibility to attract long-term capital on satisfactory terms.

 

We generated cash in excess of our working capital requirements for the nine months ended September 30, 2003.  Our cash flows provided by operations were $298 million, an increase of approximately $16 million from the previous year’s period.  This increase was primarily related to the increase in net income and changes from the prior year balances of accounts receivable and accounts payable and accrued expenses.  Additionally, during the third quarter of 2003, we received $17.5 million in upfront and milestone payments from our amended agreement for the development of certain hormonal therapies.  These increases were substantially offset by the changes, year over year, in balances of inventories and income taxes payable.

 

The increase in inventories is the result of supply chain initiatives to further improve customer service levels and to support recently launched products and products that have yet to be launched due to contractual restrictions.  Of the approximately $400 million of inventories at September 30, 2003, $45.4 million were in support of expected new product launches and marketing initiatives, including bupropion hydrochloride sustained-release tablets. Under a previously announced settlement with GlaxoSmithKline (GSK), we received rights in the U.S. market to distribute 100mg. and 150mg. bupropion hydrochloride sustained-release tablets, which are the generic versions of GSK’s

 

21



 

Wellbutrin® SR and Zyban® products and are manufactured by a GSK subsidiary, once a third party launches a fully substitutable generic equivalent of those products in the U.S. market.  As of September 30, 2003, we had a $5.0 million inventory reserve with respect to the potential expiration of a portion of our bupropion hydrochloride inventory.  In the event we do not launch this product during the fourth quarter of 2003, we expect to establish an additional inventory reserve of approximately $10 million due to the expiration dating of a portion of the product inventory.

 

In addition to the increase in inventories, other significant uses of cash for the nine months ended September 30, 2003, included the acquisition of product rights ($179.3 million), additions to property and equipment ($104.5 million) and principal payments on our previous credit facility ($325.9 million, of which $306.1 million was paid from the proceeds of the issuance of our convertible contingent debentures as discussed below).  We currently expect to spend between $130 million to $140 million for property and equipment additions in 2003, of which we expect approximately $35 million to be related to the installation and implementation of our new Enterprise Resource Planning system.

 

In May 1998, we issued $150 million of senior unsecured notes due May 2008 (1998 Senior Notes), with interest payable semi-annually in May and November at an effective rate of 7.2%, pursuant to a shelf registration statement authorizing up to $300 million in debt securities, preferred stock or common stock.  On April 2, 2003, we determined that we did not intend to offer any additional debt securities, preferred stock or common stock under the registration statement, and filed an amendment with the Securities and Exchange Commission deregistering the remaining unsold $150 million aggregate amount of debt securities, preferred stock and common stock covered by the registration statement.  In March 2003, we issued $575 million of convertible contingent senior debentures (CODES) due in 2023.  As of September 30, 2003, the entire amount of the CODES remained outstanding at an effective annual interest rate of approximately 2.1%.

 

We used a portion of the proceeds from the issuance of the CODES to repay the $306.1 million balance on our term loan and revolving credit facility we entered into in July 2000 (2000 Facility).  We terminated the 2000 Facility in March 2003 upon our repayment of this balance.

 

In May 2003, we entered into an agreement with a syndicate of lenders for a five-year, $300 million senior, unsecured revolving credit facility for working capital and other general corporate purposes.  As of September 30, 2003, the total $300 million under the revolving credit facility was available to us. Under the terms of the revolving credit facility, each of our subsidiaries, other than minor subsidiaries, entered into a full and unconditional guarantee on a joint and several basis.  In order to provide subsidiary guarantees in connection with the new credit facility, we were required to issue similar guarantees to the 1998 Senior Note holders.

 

Our cash and current marketable securities totaled $650.7 million at September 30, 2003.  The fair value of our current marketable securities may fluctuate significantly due to volatility of the stock market and changes in general economic conditions.  See Item 3 in this Quarterly Report on Form 10-Q.  We believe that our cash and marketable securities balance and our expected cash flows from operations will be sufficient to meet our normal operating requirements during the next twelve months.  However, we continue to review opportunities to acquire or invest in companies, technologies, product rights and other investments that are compatible with our existing business.  We could use cash and financing sources discussed herein, or financing sources that subsequently become available, to fund additional acquisitions or investments.  In addition, we may consider issuing additional debt or equity securities in the future to fund potential acquisitions or investment, to refinance existing debt, or for general corporate purposes.  If a material acquisition or investment is completed, our operating results and financial condition could change materially in future periods.  However, no assurance can be given that additional funds will be available on satisfactory terms, or at all, to fund such activities.

 

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

Any statements made in this report that are not statements of historical fact or that refer to estimated or anticipated future events are forward-looking statements.  We have based our forward-looking statements on our

 

22



 

management’s beliefs and assumptions based on information available to our management at the time these statements are made.  Such forward-looking statements reflect our current perspective of our business, future performance, existing trends and information as of the date of this filing.  These include, but are not limited to, our beliefs about future revenue and expense levels and growth rates, prospects related to our strategic initiatives and business strategies, express or implied assumptions about government regulatory action or inaction, anticipated product approvals and launches, business initiatives and product development activities, assessments related to clinical trial results, product performance and competitive environment, and anticipated financial performance. Without limiting the generality of the foregoing, words such as “may,” “will,” “expect,” “believe,” “anticipate,” “intend,” “could,” “would,” “estimate,” “continue,” or “pursue,” or the negative other variations thereof or comparable terminology, are intended to identify forward-looking statements.  The statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict.

 

We caution the reader that certain important factors may affect our actual operating results and could cause such results to differ materially from those expressed or implied by forward-looking statements.  We believe the following important risks, uncertainties and other factors, among others, may affect our actual results:

 

the success of our product development activities and uncertainties related to the timing or outcome of such activities;

 

the timing and unpredictability of regulatory authorizations and product launches, which is particularly sensitive in our generic business;

 

the outcome of our litigation (including, without limitation, patent, trademark and copyright litigation), and the costs, expenses and possible diversion of management’s time and attention arising from such litigation;

 

our ability to retain key personnel;

 

our ability to adequately protect our technology and enforce our intellectual property rights;

 

our ability to obtain and maintain a sufficient supply of products to meet market demand in a timely manner;

 

our dependence on sole source suppliers and the risks associated with a production interruption or supply delays at such third party

suppliers or at our own manufacturing facilities;

 

the scope, outcome and timeliness of any governmental, court or other regulatory action that may involve us (including, without limitation, the scope, outcome or timeliness of any inspection or other action of the FDA);

 

our success in divesting assets or facilities we intend to dispose of;

 

the increasing costs of insurance, and limitations on obtaining insurance coverage;

 

the scope, outcome and effect of investigations, actions or legislation related to our product pricing;

 

the availability to us, on commercially reasonable terms, of raw materials and other third party sourced products;

 

our exposure to product liability and other lawsuits and contingencies;

 

our mix of product sales between branded products, which typically have higher margins, and generic products;

 

23



 

our dependence on revenues from significant products, in particular, Ferrlecit®, for which 2003 net revenues are expected to be

approximately 10% of our total net revenues;

 

our dependence on revenues from significant customers;

 

the ability of third parties to assert patents or other intellectual property rights against us which, among other things, could cause a delay or disruption in the manufacture, marketing or sale of our products;

 

our ability to license patents or other intellectual property rights from third parties on commercially reasonable terms;

 

the expiration of patent and regulatory exclusivity on certain of our products that will result in competitive and pricing pressures;

 

difficulties and delays inherent in product development, manufacturing and sale, such as:

 

products that may appear promising in the development stage may fail to reach market for numerous reasons, including efficacy or safety concerns;

 

the inability to obtain necessary regulatory approvals and the difficulty or excessive cost to manufacture;

 

seizure or recall of products;

 

the failure to obtain, the imposition of limitations on the use of, or loss of patent and other intellectual property rights; and

 

manufacturing or distribution problems;

 

our successful compliance with extensive, costly, complex and evolving governmental regulations and restrictions;

 

market acceptance of and continued demand for our products and the impact of competitive products and pricing;

 

our ability to successfully compete in both the branded and generic pharmaceutical product sectors;

 

our timely and successful implementation of strategic initiatives, including integrating companies and products we acquire and new enterprise resource planning systems; and

 

other risks and uncertainties detailed herein and from time to time in our Securities and Exchange Commission filings.

 

We disclaim any obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise.  We also may make additional disclosures in our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K that we may file from time to time with the Securities and Exchange Commission (SEC).  Please also note that we provided a cautionary discussion of risks and uncertainties under the section entitled “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2002.  The factors identified above and those set forth in our SEC filings are the factors that we think could cause our actual results to differ materially from expected results.  Other factors besides those listed here could also adversely affect us.  This discussion is provided as permitted by the Private Securities Litigation Reform Act of 1995.

 

24



 

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

 

We are exposed to market risk for changes in the market values of our investments (Investment Risk) and the impact of interest rate changes (Interest Rate Risk).  We have not used derivative financial instruments in our investment portfolio.  The quantitative and qualitative disclosures about market risk are set forth below.

 

Investment Risk

 

As of September 30, 2003, our total investment in equity securities of other companies was $80.5 million.  Of this amount, we had equity-method investments of $24.0 million and publicly traded equity securities (available-for-sale securities) at fair value totaling $56.5 million ($40.7 million that was included in “Marketable securities” and $15.8 million that was included in “Investments and other assets”).  The fair values of these investments are subject to significant fluctuations due to volatility of the stock market and changes in general economic conditions.  Based on the fair value of the publicly traded equity securities we held at September 30, 2003, an assumed 25%, 40% and 50% adverse change in the market prices of these securities would result in a corresponding decline in total fair value of approximately $14 million, $23 million and $28 million, respectively.

 

At September 30, 2003, our investment in Andrx consisted of approximately 1.4 million shares of Andrx common stock with a fair market value of $26.5 million.  Because Andrx is a publicly traded equity security, our holdings of Andrx have exposure to investment risk.   The market price of Andrx common shares has been, and may continue to be, volatile as reflected in the table below.  On November 4, 2003, before the filing of this Form 10-Q, the closing price of Andrx common stock was $20.36.

 

The following table sets forth the Andrx high and low market price per share information, based on published financial sources, for 2003 and 2002:

 

 

 

High

 

Low

 

2003, by quarter

 

 

 

 

 

First

 

$

16.83

 

$

7.68

 

Second

 

$

24.20

 

$

11.10

 

Third

 

$

25.90

 

$

16.32

 

 

 

 

 

 

 

2002, by quarter

 

 

 

 

 

First

 

$

71.27

 

$

31.13

 

Second

 

$

48.20

 

$

25.80

 

Third

 

$

27.89

 

$

16.61

 

Fourth

 

$

23.19

 

$

10.75

 

 

In addition, our marketable securities include shares of common stock of Dr. Reddy’s Laboratories, Limited (Dr. Reddy).  As of September 30, 2003, Watson owned 603,772 common shares of Dr. Reddy with a market value of approximately $14.2 million.  Dr. Reddy’s shares trade on the Bombay Stock Exchange (BSE) and on the New York Stock Exchange in the form of American depositary shares.  However, the shares of Dr. Reddy common stock that we hold are currently tradable only on the BSE, since our shares are not presently in the form of American depositary shares.  The liquidity of our Dr. Reddy investment may be limited due to the current Dr. Reddy daily trading volume on the BSE, among other factors.  The following table sets forth the Dr. Reddy high and low market price per share information, based on published financial sources, for 2003 and 2002:

 

25



 

 

 

High

 

Low

 

2003, by quarter

 

 

 

 

 

First

 

$

21.00

 

$

18.03

 

Second

 

$

23.53

 

$

17.58

 

Third

 

$

27.90

 

$

21.85

 

 

 

 

 

 

 

2002, by quarter

 

 

 

 

 

First

 

$

23.76

 

$

18.91

 

Second

 

$

24.00

 

$

18.40

 

Third

 

$

21.64

 

$

16.00

 

Fourth

 

$

19.47

 

$

14.26

 

 

We regularly review the carrying value of our investments and identify and recognize losses, for income statement purposes, when events and circumstances indicate that any declines in the fair values of such investments, below our accounting basis, are other than temporary.  During 2003, we made such a determination with respect to our investments in Genelabs, Amarin and Halsey resulting in impairment charges of $13.0 million, $1.2 million, and $1.6 million, respectively (see Note K in the accompanying Notes to Condensed Consolidated Financial Statements in this Quarterly Report).

 

At September 30, 2003, our investment in warrants to purchase approximately 10.7 million shares of Halsey common stock (See Note C) had a fair market value of $9.2 million.  The market price of Halsey common shares has been, and may continue to be, volatile.  During the third quarter of 2003, the market price fluctuated between a low of $0.77 and a high of $1.65.  On November 4, 2003, the closing price of Halsey common stock was $0.68.  Due to the volatility of this investment, subsequent impairment charges may be required if they are determined to be other than temporary.

 

Interest Rate Risk

 

Our exposure to interest rate risk relates primarily to our non-equity investment portfolio.  Our cash is invested in A-rated money market mutual funds and short-term securities. Consequently, our interest rate and principal risk are minimal.

 

Based on quoted market rates of interest and maturity schedules for similar debt issues, we estimate that the fair values of our CODES and our fixed-rate senior unsecured notes approximated their carrying values September 30, 2003.  While changes in market interest rates may affect the fair value of our fixed-rate debt, we believe the effect, if any, of reasonably possible near-term changes in the fair value of such debt on our financial condition, results of operations or cash flows will not be material.

 

At this time, we are not party to any interest rate or derivative hedging contracts and have no material foreign exchange or commodity price risks.

 

26



 

ITEM 4.  CONTROLS AND PROCEDURES

 

The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including its Principal Executive Officer and Principal Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.  In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.  Also, the Company has investments in certain unconsolidated entities.  As the Company does not control or manage these entities, its disclosure controls and procedures with respect to such entities are necessarily substantially more limited than those it maintains with respect to its consolidated subsidiaries.

 

As required by SEC Rule 13a-15(b), the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Principal Executive Officer and Principal Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of the end of the quarter covered by this Report. Based on the foregoing, the Company’s Principal Executive Officer and Principal Financial Officer concluded that the Company’s disclosure controls and procedures were effective at the reasonable assurance level.

 

There have been no changes in the Company’s internal control over financial reporting, during the three months ended September 30, 2003, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting

 

27



 

PART II.  OTHER INFORMATION AND SIGNATURES

 

ITEM 1.  LEGAL PROCEEDINGS

 

The Company is party to certain lawsuits and legal proceedings, which are described in “Part I, Item 3. Legal Proceedings,” of our Annual Report on Form 10-K for the year ended December 31, 2002.  The following is a description of material developments during the period covered by this Quarterly Report and should be read in conjunction with the Annual Report referenced above.

 

Phen-fen Litigation.  With respect to the phentermine hydrochloride product liability lawsuits pending against the Company, certain of its subsidiaries, and others, additional actions raising similar issues have been filed, and some actions have been settled or otherwise dismissed.  As of October 15, 2003, approximately 389 actions were pending against the Company and other Company entities in a number of state and federal courts.  The Company believes that it will be fully indemnified by The Rugby Group’s former owner, Aventis Pharmaceuticals (Aventis, formerly known as Hoechst Marion Roussel, Inc.) for the defense of all such cases and for any liability that may arise out of these cases.  Aventis is currently controlling the defense of all these cases as the indemnifying party under its agreements with the Company.

 

Cipro Litigation.  On September 4, 2003, the court hearing the action pending in California Superior Court (Cipro Cases I & II, JCCP Proceeding Nos. 4154 and 4220) granted plaintiffs’ motion for class certification.  On September 19, 2003, the court hearing the action pending in Wisconsin Circuit Court (Barbara A. Meyers, et. al, v. Bayer AG, et. al., Case No. 00-CV-9347) granted the defendants’ motion to dismiss.  Plaintiffs have appealed.  On October 27, 2003, the court hearing the action pending in New York Supreme Court (Anne Cunningham, et. al. v. Bayer AG, et. al., Case No. 603820-00) granted the defendants’ motion to dismiss.  Other courts in which motions to dismiss are pending still have not ruled.  On October 3, 2003, the Rugby Group, Inc. responded to the complaint in the consolidated action pending in the United States District Court for the Eastern District of New York (In re: Ciprofloxacin Hydrochloride Antitrust Litigation, MDL Docket No. 001383).  Discovery is ongoing.  Aventis is currently controlling the defense of these matters as the indemnifying party under its agreements with the Company.

 

Government Reimbursement Investigations and Proceedings.  With regard to the consolidated actions alleging improper or fraudulent reporting practices related to the reporting of average wholesale prices of certain products pending in the United States District Court for the District of Massachusetts (In re: Pharmaceutical Industry Average Wholesale Price Litigation, MDL Docket No. 1456), the court has scheduled a hearing for November 21, 2003 to consider the motions to dismiss the Amended Master Consolidated Complaint filed by the Company and other defendants.  On October 1, 2003, an action was filed in the United States District Court for the District of Massachusetts by the Commonwealth of Massachusetts.  (The Commonwealth of Massachusetts v. Mylan Laboratories, Inc., et al., Civil Action No. 03-cv-11865 (PBS)).  This action names as defendants numerous pharmaceutical companies that are alleged to have sold generic pharmaceutical products, including the Company and its subsidiary, Schein Pharmaceutical, Inc. (now known as Watson Pharma, Inc.)  The complaint alleges, among other things, that the defendants inflated the reported prices for specified drug products, resulting in false and inflated claims being paid by Massachusetts under its Medicaid program.  The Company has not yet responded to this complaint.  With respect to other reimbursement inquiries, the Company has produced records in response to the request for records and information from the House of Representatives Committee on Energy and Commerce in connection with that Committee’s investigation into pharmaceutical reimbursements and rebates under Medicaid, and is reviewing additional documents to complete its response to the request.  In August 2003, the Company received a subpoena from the Attorney General for the State of California for production of additional records in connection with that State’s pending investigation into pharmaceutical pricing matters.  The Company has not yet responded to the subpoena.

 

FDA Matters.  On September 12, 2003, Steris Laboratories, Inc., which the Company acquired in connection with our acquisition of Schein Pharmaceutical, Inc. in August, 2000, completed its final independent expert

 

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inspection required pursuant to the terms of the October 1998 Consent Decree.  The inspection found the Steris facility to be in a satisfactory state of Good Manufacturing Practices control.  The Company is continuing to evaluate divestiture or other alternatives related to the Steris facility.

 

The Company and its affiliates are involved in various other disputes, governmental and/or regulatory inspections, investigations and proceedings, and litigation matters that arise from time to time in the ordinary course of business.  The process of resolving matters through litigation or other means is inherently uncertain and it is possible that the resolution of these matters will adversely affect the Company, its results of operations, financial position and/or cash flows.

 

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

 

(a) Exhibits:

 

Reference is hereby made to the Exhibit Index on page 31.

 

(b) Reports on Form 8-K filed during the quarter ended September 30, 2003:

 

On August 5, 2003, the Company filed a Current Report on Form 8-K with the Securities and Exchange Commission reporting, under Item 12, that it had issued a news release announcing its financial results for the quarter ended June 30, 2003.

 

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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.

 

 

 

 

WATSON PHARMACEUTICALS, INC.
(Registrant)

 

 

 

 

By:

/s/ Charles P. Slacik

 

 

Charles P. Slacik

 

 

Executive Vice President – Chief Financial Officer

 

 

(Principal Financial Officer)

 

 

 

 

 

 

 

By:

/s/ R. Todd Joyce

 

 

R. Todd Joyce

 

 

Vice President – Corporate Controller and
Treasurer

 

 

(Principal Accounting Officer)

 

 

 

Dated:  November 5, 2003

 

 

 

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WATSON PHARMACEUTICALS, INC.

 

EXHIBIT INDEX TO FORM 10-Q

For the Quarterly Period Ended September 30, 2003

 

 

Exhibit
No.

 

Description

 

 

 

*10.1

 

 

Third Amendment to the Watson Pharmaceuticals, Inc. 2001 Incentive Award Plan effective as of August 4, 2003.

 

 

 

 

31.1

 

 

Certification of Chairman and Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

 

 

 

31.2

 

 

Certification of Executive Vice President and Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

 

 

 

32.1

 

 

Certification of Chairman and Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

 

 

 

32.2

 

 

Certification of Executive Vice President and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 


*Compensation Plan or Agreement

 

31