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SECURITIES AND EXCHANGE COMMISSION
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WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
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SECURITIES EXCHANGE ACT OF 1934
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FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004
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COMMISSION FILE NUMBER 1-9601
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K-V PHARMACEUTICAL COMPANY
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(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 43-0618919
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(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER IDENTIFICATION NO.)
INCORPORATION OR ORGANIZATION)
2503 SOUTH HANLEY ROAD, ST. LOUIS, MISSOURI 63144
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(ADDRESS OR PRINCIPAL EXECUTIVE OFFICES)
(ZIP CODE)
(314) 645-6600
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(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 SUCH SHORTER PERIOD
THAT THE REGISTRANT WAS REQUIRED TO FILE SUCH REPORTS) AND (2) HAS BEEN
SUBJECT TO SUCH FILING REQUIREMENTS FOR THE PAST 90 DAYS. YES X NO
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INDICATE BY CHECK MARK WHETHER THE REGISTRANT IS AN ACCELERATED FILER (AS
DEFINED IN EXCHANGE ACT RULE 12b-2). YES X NO
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TITLE OF CLASS OF NUMBER OF SHARES
COMMON STOCK OUTSTANDING AS OF JULY 31, 2004
------------ -------------------------------
CLASS A COMMON STOCK, PAR VALUE $.01 PER SHARE 33,063,051
CLASS B COMMON STOCK, PAR VALUE $.01 PER SHARE 16,104,374
PART I. - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
K-V PHARMACEUTICAL COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited; in thousands, except per share data)
THREE MONTHS ENDED
JUNE 30,
----------------------------
2004 2003
------- -------
Net revenues................................ $66,087 $59,379
Cost of sales............................... 23,734 20,990
------- -------
Gross profit................................ 42,353 38,389
------- -------
Operating expenses:
Research and development................ 4,624 5,542
Selling and administrative.............. 24,131 17,723
Amortization of intangible assets....... 1,122 1,111
------- -------
Total operating expenses.................... 29,877 24,376
------- -------
Operating income............................ 12,476 14,013
------- -------
Other expense (income):
Interest expense........................ 1,446 1,085
Interest and other income............... (513) (363)
------- -------
Total other expense, net.................... 933 722
------- -------
Income before income taxes.................. 11,543 13,291
Provision for income taxes.................. 3,982 4,718
------- -------
Net income.................................. $ 7,561 $ 8,573
======= =======
Net income per common share-basic........... $0.15 $0.16
===== =====
Net income per common share-diluted......... $0.15 $0.17
===== =====
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2
K-V PHARMACEUTICAL COMPANY AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
JUNE 30, MARCH 31,
2004 2004
---- ----
(unaudited)
ASSETS
------
CURRENT ASSETS:
Cash and cash equivalents............................................................ $218,769 $226,911
Receivables, less allowance for doubtful accounts of $402 and $402
at June 30, 2004 and March 31, 2004, respectively................................... 67,935 65,872
Inventories, net..................................................................... 53,217 50,697
Prepaid and other assets............................................................. 6,261 6,591
Deferred tax asset................................................................... 6,720 8,037
-------- --------
Total Current Assets.............................................................. 352,902 358,108
Property and equipment, less accumulated depreciation................................ 87,685 75,777
Intangible assets and goodwill, net.................................................. 80,127 80,809
Other assets......................................................................... 13,454 13,744
-------- --------
TOTAL ASSETS......................................................................... $534,168 $528,438
======== ========
LIABILITIES
-----------
CURRENT LIABILITIES:
Accounts payable..................................................................... $ 12,259 $ 12,650
Accrued liabilities.................................................................. 29,029 30,917
Current maturities of long-term debt................................................. 7,976 7,909
-------- --------
Total Current Liabilities......................................................... 49,264 51,476
Long-term debt....................................................................... 210,497 210,741
Other long-term liabilities.......................................................... 3,197 3,122
Deferred tax liability............................................................... 5,644 5,350
-------- --------
TOTAL LIABILITIES.................................................................... 268,602 270,689
-------- --------
COMMITMENTS AND CONTINGENCIES
SHAREHOLDERS' EQUITY
--------------------
7% cumulative convertible Preferred Stock, $.01 par value; $25.00 stated and
liquidation value; 840,000 shares authorized; issued and outstanding --
40,000 shares at June 30, 2004 and March 31, 2004 (convertible into
Class A shares at a ratio of 8.4375 to one)......................................... -- --
Class A and Class B Common Stock, $.01 par value;150,000,000 and
75,000,000 shares authorized, respectively;
Class A - issued 36,122,687 and 36,080,583 at June 30, 2004
and March 31, 2004, respectively................................................ 362 362
Class B - issued 16,148,214 and 16,148,739 at June 30, 2004 and March 31, 2004,
respectively (convertible into Class A shares on a one-for-one basis)........... 162 162
Additional paid-in capital........................................................... 126,526 123,828
Retained earnings.................................................................... 192,124 184,580
Less: Treasury stock, 3,108,727 shares of Class A and 92,902 shares of Class B
Common Stock at June 30, 2004, respectively, and 3,035,948 shares of Class A and
80,142 shares of Class B Common Stock at March 31, 2004, respectively, at cost...... (53,608) (51,183)
-------- --------
TOTAL SHAREHOLDERS' EQUITY........................................................... 265,566 257,749
-------- --------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY........................................... $534,168 $528,438
======== ========
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3
K-V PHARMACEUTICAL COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited; in thousands)
THREE MONTHS ENDED
JUNE 30,
-------------------------
2004 2003
-------- --------
OPERATING ACTIVITIES:
Net income......................................................... $ 7,561 $ 8,573
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation, amortization and other non-cash charges........... 3,341 2,954
Deferred income tax provision................................... 1,611 2,551
Deferred compensation........................................... 75 75
Changes in operating assets and liabilities:
(Increase) decrease in receivables, net......................... (2,063) 11,193
Increase in inventories, net.................................... (2,520) (9,510)
Increase in prepaid and other assets............................ (123) (1,183)
Decrease in accounts payable and accrued........................
liabilities.................................................... (2,279) (4,271)
-------- --------
Net cash provided by operating activities.......................... 5,603 10,382
-------- --------
INVESTING ACTIVITIES:
Purchase of property and equipment, net......................... (13,757) (3,552)
Product acquisition............................................. - (14,300)
-------- --------
Net cash used in investing activities.............................. (13,757) (17,852)
-------- --------
FINANCING ACTIVITIES:
Principal payments on long-term debt............................ (244) (194)
Dividends paid on preferred stock............................... (17) (384)
Proceeds from issuance of convertible notes..................... - 194,467
Purchase of common stock for treasury........................... (2,425) (50,000)
Proceeds from exercise of common stock options.................. 2,698 1,202
-------- --------
Net cash provided by financing activities.......................... 12 145,091
-------- --------
(Decrease) increase in cash and cash equivalents................... (8,142) 137,621
Cash and cash equivalents:
Beginning of year............................................... 226,911 96,288
-------- --------
End of period................................................... $218,769 $233,909
======== ========
SUPPLEMENTAL INFORMATION:
Interest paid................................................... $ 2,677 $ 195
Income taxes paid............................................... 663 6,651
NON-CASH FINANCING ACTIVITY:
Term loan to finance building purchase.......................... - 8,800
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
4
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(Dollars in thousands, except per share data)
1. BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements of K-V
Pharmaceutical Company ("KV" or the "Company") have been prepared in
accordance with accounting principles generally accepted in the United
States for interim financial information and with the instructions to Form
10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all
of the information and footnotes required by accounting principles generally
accepted in the United States for complete financial statements. However, in
the opinion of management, all adjustments (consisting of only normal
recurring accruals) considered necessary for a fair presentation have been
included. The results of operations and cash flows for the three-month
period ended June 30, 2004 are not necessarily indicative of the results of
operations and cash flows that may be expected for the fiscal year ending
March 31, 2005. The interim consolidated financial statements should be read
in conjunction with the consolidated financial statements and footnotes
thereto included in the Company's Annual Report on Form 10-K for the fiscal
year ended March 31, 2004. The balance sheet information as of March 31,
2004 has been derived from the Company's audited consolidated balance sheet
as of that date.
On July 6, 2004, the Company was advised by its independent accountant, BDO
Seidman, LLP, that it resigned as the Company's independent accountant
effective immediately. On July 13, 2004, the Company filed a Form 8-K
disclosing the resignation under Item 4, Change in Registrant's Certifying
Accountant. The Company is actively seeking to engage a new independent
accountant to serve as its auditor. The accompanying condensed consolidated
financial statements have not been reviewed by a successor independent
accountant, as required by Rule 10-01(d) of Regulation S-X. The Company will
engage its new auditor to review the accompanying condensed consolidated
financial statements upon engagement. If the review results in any material
change to the condensed consolidated financial statements, the Company will
file an amendment to this report reflecting such change.
2. STOCK-BASED COMPENSATION
The Company grants stock options for a fixed number of shares to employees
with an exercise price greater than or equal to the fair value of the shares
at the date of grant. As permissible under Statement of Financial Accounting
Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, the
Company elected to continue to account for stock option grants to employees
in accordance with Accounting Principles Board (APB) Opinion No. 25,
Accounting for Stock Issued to Employees and related interpretations. APB 25
requires that compensation cost related to fixed stock option plans be
recognized only to the extent that the fair value of the shares at the grant
date exceeds the exercise price. Accordingly, no compensation expense is
recognized for stock option awards granted to employees at or above fair
value. Had the Company determined compensation expense using the fair value
method prescribed by SFAS 123, the Company's net income and earnings per
share would have been as follows:
THREE MONTHS ENDED
JUNE 30,
---------------------
2004 2003
---- ----
Net income, as reported................. $7,561 $8,573
Stock based employee
compensation expense, net of tax....... (157) (169)
------ ------
Pro forma net income.................... $7,404 $8,404
====== ======
Earnings per share:
Basic - as reported.................. $ 0.15 $ 0.16
Basic - pro forma.................... 0.15 0.16
Diluted - as reported................ 0.15 0.17
Diluted - pro forma.................. 0.15 0.16
5
The weighted average fair value of the options has been estimated on the
date of grant using the following weighted average assumptions for grants
during the three months ended June 30, 2004 and 2003, respectively: no
dividend yield; expected volatility of 41% and 44%; risk-free interest rate
of 3.70% and 2.57% per annum; and expected option terms ranging from 3 to
10 years for both periods. Weighted averages are used because of varying
assumed exercise dates.
3. EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted
earnings per share:
THREE MONTHS ENDED
JUNE 30,
-----------------------
2004 2003
---- ----
Numerator:
Net income......................................... $ 7,561 $ 8,573
Preferred stock dividends.......................... (17) (384)
------- -------
Numerator for basic earnings per
share - income available to common
shareholders...................................... 7,544 8,189
Effect of dilutive securities:
Preferred stock dividends....................... 17 384
------- -------
Numerator for diluted earnings per
share - income available to common
shareholders after assumed conversions............ $ 7,561 $ 8,573
======= =======
Denominator:
Denominator for basic earnings per
share - weighted-average shares................... 49,116 49,797
------- -------
Effect of dilutive securities:
Employee stock options.......................... 1,476 1,664
Convertible preferred stock..................... 338 338
------- -------
Dilutive potential common shares................... 1,814 2,002
------- -------
Denominator for diluted earnings per
share - adjusted weighted-average shares and
assumed conversions............................... 50,930 51,799
======= =======
Basic earnings per share(1) ....................... $ 0.15 $ 0.16
======= =======
Diluted earnings per share(1)(2)(3) ............... $ 0.15 $ 0.17
======= =======
(1) The two-class method for Class A and Class B common
stock is not presented because the earnings per share
are equivalent to the if converted method since
dividends were not declared or paid and each class of
common stock has equal ownership of the Company.
(2) Employee stock options to purchase 162,161 and 219,825
shares of common stock at June 30, 2004 and 2003,
respectively, were outstanding but not included in the
computation of diluted earnings per share because the
option exercise price was greater than the average
market price of the common shares.
(3) The effect of 8,691,880 shares related to the assumed
conversion of the $200,000 Convertible Subordinated
Notes (see Note 7) has been excluded from the
computation of diluted earnings per share as the
conditions that would permit conversion have not been
satisfied.
6
4. REVENUE RECOGNITION
Revenue from product sales is recognized when the merchandise is shipped to
an unrelated third party pursuant to Staff Accounting Bulletin No. 104,
Revenue Recognition. Accordingly, revenue is recognized when all of the
following occur: a purchase order is received from a customer; title and
risk of loss pass to the Company's customer upon shipment of the merchandise
under the terms of FOB shipping point; prices and estimated sales provisions
for product returns, sales rebates, payment discounts, chargebacks, and
other promotional allowances are reasonably determinable; and the customer's
payment ability has been reasonably assured.
Concurrently with the recognition of revenue, the Company records estimated
sales provisions for product returns, sales rebates, payment discounts,
chargebacks, and other sales allowances. Sales provisions are established
based upon consideration of a variety of factors, including but not limited
to, historical relationship to revenues, historical payment and return
experience, estimated customer inventory levels, customer rebate
arrangements, and current contract sales terms with wholesale and indirect
customers.
Actual product returns, chargebacks and other sales allowances incurred are,
however, dependent upon future events and may be different than the
Company's estimates. The Company continually monitors the factors that
influence sales allowance estimates and makes adjustments to these
provisions when management believes that actual product returns, chargebacks
and other sales allowances may differ from established allowances.
Accruals for sales provisions are presented in the consolidated financial
statements as reductions to net revenues and accounts receivable. Sales
provisions totaled $24,988 and $21,816 for the three months ended June 30,
2004 and 2003, respectively. The reserve balances related to the sales
provisions totaled $19,073 and $20,648 at June 30, 2004 and March 31, 2004,
respectively, and are included in "Receivables, less allowance for doubtful
accounts" in the accompanying consolidated balance sheets.
5. INVENTORIES
Inventories consist of the following:
JUNE 30, 2004 MARCH 31, 2004
------------- --------------
Finished goods..................... $31,582 $31,028
Work-in-process.................... 6,302 5,142
Raw materials...................... 16,770 15,529
------- -------
54,654 51,699
Reserves for obsolescence.......... (1,437) (1,002)
------- -------
$53,217 $50,697
======= =======
Management establishes reserves for potentially obsolete or slow moving
inventory based on an evaluation of inventory levels, forecasted demand, and
market conditions.
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6. INTANGIBLE ASSETS AND GOODWILL
Intangible assets and goodwill consist of the following:
JUNE 30, 2004 MARCH 31, 2004
-------------------------- --------------------------
GROSS GROSS
CARRYING ACCUMULATED CARRYING ACCUMULATED
AMOUNT AMORTIZATION AMOUNT AMORTIZATION
------ ------------ ------ ------------
Product rights - Micro-K(R).................. $36,140 $ (9,550) $36,140 $ (9,099)
Product rights - PreCare(R).................. 8,433 (2,073) 8,433 (1,968)
Trademarks acquired:
Niferex(R).............................. 14,834 (927) 14,834 (742)
Chromagen(R)/StrongStart(R)............... 27,642 (1,728) 27,642 (1,382)
License agreements......................... 4,125 - 3,825 -
Trademarks and patents..................... 3,120 (446) 2,980 (411)
------- -------- ------- --------
Total intangible assets.................. 94,294 (14,724) 93,854 (13,602)
Goodwill................................... 557 - 557 -
------- -------- ------- --------
$94,851 $(14,724) $94,411 $(13,602)
======= ======== ======= ========
As of June 30, 2004, the Company's intangible assets have a weighted average
useful life of approximately 20 years. Amortization expense for intangible
assets was $1,122 and $1,111 for the three months ended June 30, 2004 and
2003, respectively.
Assuming no additions, disposals or adjustments are made to the carrying
values and/or useful lives of the intangible assets, annual amortization
expense on product rights, trademarks acquired and other intangible assets
is estimated to be approximately $3,509 for the remainder of fiscal 2005 and
approximately $4,700 in each of the four succeeding fiscal years.
7. LONG-TERM DEBT
Long-term debt consists of the following:
JUNE 30, 2004 MARCH 31, 2004
------------- --------------
Industrial revenue bonds............... $ 205 $ 205
Notes payable.......................... 6,798 6,731
Building mortgages..................... 11,470 11,714
Convertible notes...................... 200,000 200,000
-------- --------
218,473 218,650
Less current portion................... (7,976) (7,909)
-------- --------
$210,497 $210,741
======== ========
As of June 30, 2004, the Company has a credit agreement with a bank that
provides for a revolving line of credit for borrowing up to $65,000. The
credit agreement provides for a $40,000 unsecured revolving line of credit
along with an unsecured supplemental credit line of $25,000 for financing
acquisitions. These credit facilities expire in October 2006 and December
2004, respectively. The revolving credit lines are unsecured and interest is
charged at the lower of the prime rate or the one-month LIBOR rate plus 150
basis points. At June 30, 2004, the Company had no cash borrowings
outstanding under either credit facility. The credit agreement includes
covenants that impose minimum levels of earnings before interest, taxes,
depreciation and amortization, a maximum funded debt ratio, a limit on
capital expenditures and dividend payments, a minimum fixed charge ratio and
a maximum senior leverage ratio. As of June 30, 2004, the Company was in
compliance with all of its covenants.
On May 16, 2003, the Company issued $200,000 of Convertible Subordinated
Notes (the "Notes") that are convertible, under certain circumstances, into
shares of Class A common stock at an initial conversion price of $23.01 per
share. The Notes, which are due May 16, 2033, bear interest that is payable
on May 16 and November
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16 of each year at a rate of 2.50% per annum. The Company also is obligated
to pay contingent interest at a rate equal to 0.5% per annum during any
six-month period from May 16 to November 15 and from November 16 to May 15,
with the initial six-month period commencing May 16, 2006, if the average
trading price of the Notes per $1,000 principal amount for the five trading
day period ending on the third trading day immediately preceding the first
day of the applicable six-month period equals $1,200 or more.
The Company may redeem some or all of the Notes at any time on or after May
21, 2006, at a redemption price, payable in cash, of 100% of the principal
amount of the Notes, plus accrued and unpaid interest, including contingent
interest, if any. Holders may require the Company to repurchase all or a
portion of their Notes on May 16, 2008, 2013, 2018, 2023 and 2028 or upon a
change in control, as defined in the indenture governing the Notes, at a
purchase price, payable in cash, of 100% of the principal amount of the
Notes, plus accrued and unpaid interest, including contingent interest, if
any. The Notes are subordinate to all of our existing and future senior
obligations.
The Notes are convertible, at the holders' option, into shares of the
Company's Class A common stock prior to the maturity date under the
following circumstances:
o during any quarter commencing after June 30, 2003, if the
closing sale price of the Company's Class A common stock over
a specified number of trading days during the previous
quarter is more than 120% of the conversion price of the
Notes on the last trading day of the previous quarter. The
Notes are initially convertible at a conversion price of
$23.01 per share, which is equal to a conversion rate of
approximately 43.4594 shares per $1,000 principal amount of
Notes;
o if the Company has called the Notes for redemption;
o during the five trading day period immediately following any
nine consecutive day trading period in which the trading
price of the Notes per $1,000 principal amount for each day
of such period was less than 95% of the product of the
closing sale price of our Class A common stock on that day
multiplied by the number of shares of our Class A common
stock issuable upon conversion of $1,000 principal amount of
the Notes; or
o upon the occurrence of specified corporate transactions.
The Company has reserved 8,691,880 shares of Class A Common Stock for
issuance in the event the Notes are converted into the Company's common
shares.
The Notes, which are unsecured, do not contain any restrictions on the
payment of dividends, the incurrence of additional indebtedness or the
repurchase of the Company's securities, and do not contain any financial
covenants.
8. SEGMENT REPORTING
The reportable operating segments of the Company are branded products,
specialty generics and specialty materials. The operating segments are
distinguished by differences in products, marketing and regulatory approval.
Segment profits are measured based on income before taxes and are determined
based on each segment's direct revenues and expenses. The majority of
research and development expense, corporate general and administrative
expenses, amortization and interest expense, as well as interest and other
income, are not allocated to segments, but included in the "all other"
classification. Identifiable assets for the three reportable operating
segments primarily include receivables, inventory, and property and
equipment. For the "all other" classification, identifiable assets consist
of cash and cash equivalents, corporate property and equipment, intangible
and other assets and all income tax related assets. Accounting policies of
the segments are the same as the Company's consolidated accounting policies.
9
The following represents information for the Company's reportable operating
segments for the three months ended June 30, 2004 and 2003.
THREE MONTHS
ENDED BRANDED SPECIALTY SPECIALTY ALL
JUNE 30, PRODUCTS GENERICS MATERIALS OTHER ELIMINATIONS CONSOLIDATED
-------- -------- -------- --------- ----- ------------ ------------
Net revenues 2004 $15,919 $45,455 $4,131 $ 582 $ - $ 66,087
2003 14,781 39,455 3,902 1,241 - 59,379
Segment profit (loss) 2004 1,651 25,627 472 (16,207) - 11,543
2003 4,843 21,777 317 (13,646) - 13,291
Identifiable assets 2004 20,394 76,430 7,667 430,835 (1,158) 534,168
2003 12,328 59,410 8,526 421,787 (1,158) 500,893
Property and 2004 - - - 13,757 - 13,757
equipment additions 2003 117 - 5 12,230 - 12,352
Depreciation and 2004 105 30 35 3,171 - 3,341
amortization 2003 80 14 35 2,825 - 2,954
Consolidated revenues are principally derived from customers in North
America and substantially all property and equipment is located in the
St. Louis, Missouri metropolitan area.
9. CONTINGENCIES - RESERVE FOR POTENTIAL LEGAL DAMAGES
ETHEX Corporation (ETHEX), a subsidiary of the Company, is a defendant in a
lawsuit styled Healthpoint, Ltd. v. ETHEX Corporation, filed in federal
court in San Antonio, Texas. In general, the plaintiffs allege that ETHEX's
comparative promotion of its Ethezyme(TM) to Healthpoint's Accuzyme(R)
product resulted in false advertising and misleading statements under
various federal and state laws, and constituted unfair competition and
misappropriation of trade secrets. In September 2001, the jury returned
verdicts against ETHEX on certain false advertising, unfair competition, and
misappropriation claims. The jury awarded compensatory and punitive damages
totaling $16,500. On October 1, 2002, the U.S. District Court for the
Western District of Texas denied ETHEX's motion to set aside the jury's
verdict. On December 17, 2002, the court entered a judgment awarding
attorneys' fees to Healthpoint in an amount to be subsequently determined.
The Company believes that the jury award and the judgment is excessive and
is not sufficiently supported by the facts or the law. The Company is
vigorously prosecuting an appeal. The Company and its counsel believe it has
meritorious arguments to be raised during the appeal process; however, the
Company cannot give any assurance that it will prevail on appeal. As a
result of the court's earlier decisions, the Company's results of operations
for the quarter ended September 30, 2002 included a provision for potential
damages of $16,500, which was reflected in accrued liabilities on the
Company's consolidated balance sheet as of June 30, 2004. As discussed
above, Healthpoint also requested reimbursement for approximately $1,800 in
attorneys' fees in addition to the judgment. In September 2003, the court
entered an order specifying the amount of attorneys' fees to be awarded. As
a result of this decision, during the quarter ended September 30, 2003, the
Company recorded an additional provision of $1,825, which was reflected in
accrued liabilities on the Company's consolidated balance sheet as of June
30, 2004.
The Company and ETHEX are named as defendants in a second lawsuit brought by
Healthpoint and others styled Healthpoint Ltd. v. ETHEX Corporation, filed
in federal court in San Antonio, Texas. In general, the plantiffs allege
that ETHEX's comparative promotion of its Ethezyme(TM) 830 to Healthpoint's
Accuzyme(R) product resulted in false advertising and misleading statements
under various federal and state laws, and constituted unfair competition and
misappropriation of trade secrets. The case has been inactive for several
years. Discovery has
10
resumed and the case is expected to proceed to trial in August, 2004. The
Company believes it has meritorious defenses and will vigorously defend the
case; however, it cannot give any assurance that it will prevail.
The Company and ETHEX are named as defendants in a case brought by CIMA
LABS, Inc. and Schwarz Pharma, Inc. and styled CIMA LABS, Inc. et. al. v. KV
Pharmaceutical Company et. al. filed in federal court in Minnesota. It is
alleged that the Company and ETHEX infringe on a CIMA patent in connection
with the manufacture and sale of Hyoscyamine Sulfate Orally Dissolvable
Tablets, 0.125 mg. The court has denied the plaintiff's motion for a
preliminary injunction, which allows ETHEX to continue marketing the product
during the pendancy of the subject lawsuit and calls into question CIMA's
and Schwarz's ability to prevail in the lawsuit. Discovery is active. The
Company believes it has meritorious defenses and will vigorously defend the
case; however, it cannot give any assurance that it will prevail.
The Company and ETHEX are named as defendants in a case brought by Solvay
Pharmaceuticals, Inc. and styled Solvay Pharmaceuticals, Inc. v. ETHEX
Corporation, filed in federal court in Minnesota. In general, Solvay alleges
that ETHEX's comparative promotion of its Pangestyme(TM) CN 10 and
Pangestyme(TM) CN 20 products to Solvay's Creon(R) 10 and Creon(R) 20
products resulted in false advertising and misleading statements under
various federal and state laws, and constituted unfair and deceptive trade
practices. Discovery has recently become active. The Company believes it has
meritorious defenses and will vigorously defend the case; however, it cannot
give any assurance that it will prevail.
KV previously distributed several low volume pharmaceutical products that
contained phenylpropanolamine, or PPA, and that were discontinued in 2000
and 2001. The Company is presently named a defendant in a product liability
lawsuit in federal court in Mississippi involving PPA. The suit originated
out of a case, Virginia Madison, et al. v. Bayer Corporation, et al. The
original suit was filed on December 23, 2002, but was not served on KV until
February 2003. The case was originally filed in the Circuit Court of Hinds
County, Mississippi, and was removed to the United States District Court for
the Southern District of Mississippi by then co-defendant Bayer Corporation.
The case has been transferred to a Judicial Panel on Multi-District
Litigation for PPA claims sitting in the Western District of Washington. The
claims against the Company have now been segregated into a lawsuit brought
by Johnny Fulcher individually and on behalf of the wrongful death
beneficiaries of Linda Fulcher, deceased, against KV. It alleges bodily
injury, wrongful death, economic injury, punitive damages, loss of
consortium and/or loss of services from the use of the Company's distributed
pharmaceuticals containing PPA that have since been discontinued and/or
reformulated to exclude PPA. In May 2004, the case was dismissed with
prejudice by the U.S. District Court for the Western District of Washington
for a failure to timely file an individual complaint as required by certain
court orders. The plaintiff filed a request for reconsideration which was
opposed and subsequently denied by the court in June 2004. In July 2004, the
plaintiffs filed a notice of appeal of the dismissal. The Company intends to
oppose this appeal. Management believes that the Company may have
substantial defenses to the underlying claims, though the ultimate outcome
of this case and the potential effect cannot be determined.
KV's product liability coverage for PPA claims expired for claims made after
June 15, 2002. Although the Company renewed its product liability coverage
for coverage after June 15, 2002, that policy excludes future PPA claims in
accordance with the standard industry exclusion. Consequently, as of June
15, 2002, the Company has provided for legal defense costs and indemnity
payments involving PPA claims on a going forward basis, including the
Mississippi lawsuit that was filed after June 15, 2002. Moreover, the
Company may not be able to obtain product liability insurance in the future
for PPA claims with adequate coverage limits at commercially reasonable
prices for subsequent periods. From time to time in the future, KV may be
subject to further litigation resulting from products containing PPA that it
formerly distributed. The Company intends to vigorously defend any claims
that may be raised in the current and future litigation.
On September 25, 2003, the Commonwealth of Massachusetts filed Commonwealth
of Massachusetts v. Mylan Laboratories, Inc. et al in Massachusetts federal
court, against ETHEX Corp. and 12 other manufacturers of generic
pharmaceutical products. The complaint alleges, among other things, that
the defendants reported inflated pricing information for their drugs to data
reporting services, and that Massachusetts relied on this pricing data in
setting reimbursement rates under the Medicaid program. The complaint also
alleges that Massachusetts received rebates from the defendants under the
Medicaid Drug Rebate Program that were materially less than that to which
Massachusetts was entitled. Massachusetts seeks to recover from the
defendants the amount that it believes it
11
overpaid and the amount it is owed in rebates, based on claims under
Massachusetts and federal law. The case is in its early stages, and fact
discovery has not yet begun. ETHEX is vigorously defending the litigation.
On or about August 5, 2004, the City of New York filed a lawsuit in U.S.
District Court for the Southern District of New York against 44
manufacturers of pharmaceuticals, including ETHEX. The complaint alleges
that the defendants inflated the average wholesale prices used to calculate
Medicaid reimbursements and that by reporting inflated pricing information
they underpaid Medicaid rebates. The case is in its early stages and fact
discovery has not yet begun. ETHEX intends to vigorously defend its
interests.
It is possible that a number of jurisdictions may have commenced
investigations into the generic pharmaceutical industry, at large, regarding
pricing and price reporting practices that may or may not have an effect on
ETHEX. The Company is involved in various other legal proceedings in the
ordinary course of its business. These legal proceedings include various
patent infringement actions brought by potential competitors with respect to
products the Company proposes to market and for which it has filed
Abbreviated New Drug Applications and provided notice of certification
required under the provisions of the Hatch-Waxman Act. While it is not
feasible to predict the ultimate outcome of such other proceedings, the
Company believes that the ultimate outcome of such other proceedings will
not have a material adverse effect on its results of operations or financial
position. For additional information regarding legal proceedings in which
the Company or its subsidiaries are a party, see Item 1 of Part II of this
report.
There are uncertainties and risks associated with all litigation and there
can be no assurances that the Company will prevail in any particular
litigation.
10. RECENTLY ISSUED ACCOUNTING STANDARDS
In January 2003, the FASB issued Interpretation No. (FIN) 46, Consolidation
of Variable Interest Entities, an interpretation of ARB No. 51. The primary
objectives of FIN 46 are to provide guidance on the identification of
entities which the Company may control through means other than through
voting rights ("variable interest entities") and to determine when and which
business enterprise ("primary beneficiary") should consolidate the variable
interest entity. FIN 46 requires existing unconsolidated variable interest
entities to be consolidated by their primary beneficiaries if the entities
do not effectively disperse risks among the parties involved. Variable
interest entities 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. In addition,
FIN 46 requires that the primary beneficiary, as well as all other
enterprises with a significant variable interest in a variable interest
entity, make additional disclosures. Certain disclosure requirements of FIN
46 were effective for financial statements issued after January 31, 2003. In
December 2003, the FASB revised FIN 46 (FIN 46R) to address certain FIN 46
implementation issues. The revised provisions were applicable no later than
the first reporting period ending after March 15, 2004. The Company adopted
FIN 46 and FIN 46R on March 31, 2004 and, based upon the evaluation
performed of all interests, have determined the Company does not have any
variable interest entities that require consolidation.
In April 2004, the FASB issued FASB Staff Position No. 129-1 (FSP 129-1),
Disclosure Requirements under FASB Statement No. 129, Disclosure of
Information about Capital Structure, Relating to Contingently Convertible
Securities. This FSP requires the disclosure provisions of Statement 129 to
apply to all existing and newly created contingently convertible securities
and to their potentially dilutive effects on earnings per share. The
adoption of the disclosure provisions of FSP 129-1 did not have a material
impact on the Company's financial condition or results of operations.
12
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION
This Form 10-Q, including the documents that we incorporate herein by
reference, contains various forward-looking statements within the meaning of
the United States Private Securities Litigation reform Act of 1995
("PSLRA"), which may be based on or include assumptions, concerning our
operations, future results and prospects. Such statements may be identified
by the use of words like "plans," "expect", "aim", "believe", "projects",
"anticipate", "commit", "intend", "estimate", "will", "should", "could", and
other expressions tht indicate future events and trends.
All statements that address expectations or projections about the future,
including without limitation, statements about our strategy for growth,
product development, regulatory approvals, market position, expenditures and
financial results, are forward-looking statements.
All forward-looking statements are based on current expectations and are
subject to risk and uncertainties. In connection with the "safe harbor"
provisions, we provide the following cautionary statements identifying
important economic, political and technology factors which, among others,
could cause the actual results or events to differ materially from those set
forth or implied by the forward-looking statements and related assumptions.
Such factors include (but are not limited to) the following: (1) changes in
the current and future business environment, including interest rates and
capital and consumer spending; (2) the difficulty of predicting FDA
approvals; (3) acceptance and demand for new pharmaceutical products; (4)
the impact of competitive products and pricing; (5) new product development
and launch; (6) reliance on key strategic alliances; (7) the availability of
raw materials; (8) the regulatory environment; (9) fluctuations in operating
results; (1) the difficulty of predicting the pattern of inventory movements
by our customers; (11) the impact of competitive response to our efforts to
leverage our branded power with product innovation, promotional programs,
and new advertising; (12) risks that we may not ultimately prevail in our
Paragraph IV litigation and that any period of exclusivity may not in fact
be realized; and (13) the risks detailed from time to time in our filings
with the Securities and Exchange Commission.
This discussion is by no means exhaustive, but is designed to highlight
important factors that may impact the Company's outlook.
13
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND
FINANCIAL CONDITION
Except for the historical information contained herein, the following
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 those
forward-looking statements. These risks, uncertainties and other factors are
discussed above under the caption "Cautionary Statement Regarding
Forward-Looking Information." In addition, the following discussion and
analysis of financial condition and results of operations should be read in
conjunction with the consolidated financial statements, the related notes to
consolidated financial statements and "Management's Discussion and Analysis
of Results of Operations and Financial Condition" included in our Annual
Report on Form 10-K for the fiscal year ended March 31, 2004, and the
unaudited interim consolidated financial statements and related notes to
unaudited interim consolidated financial statements included in Item 1 of
this Quarterly Report on Form 10-Q.
BACKGROUND
We are a fully integrated specialty pharmaceutical company that develops,
acquires, manufactures, and markets technologically distinguished branded
and generic/non-branded prescription pharmaceutical products. We were
incorporated in 1971 and have become a leader in the development of advanced
drug delivery and formulation technologies that are designed to enhance
therapeutic benefits of existing drug forms. Through internal product
development and synergistic acquisitions of products, we have grown into a
fully integrated specialty pharmaceutical company. We also develop,
manufacture and market technologically advanced, value-added raw material
products for the pharmaceutical, nutritional, food and personal care
industries.
We have a broad portfolio of drug delivery technologies which we leverage to
create technologically distinguished brand name and specialty
non-branded/generic products. We have developed and patented 15 drug
delivery and formulation technologies primarily in four principal areas:
SITE RELEASE(R) bioadhesives, oral controlled release, tastemasking and
quick dissolving tablets. We incorporate these technologies in the products
we market to control and improve the absorption and utilization of active
pharmaceutical compounds. These technologies provide a number of benefits,
including reduced frequency of administration, reduced side effects,
improved drug efficacy, enhanced patient compliance and improved taste.
Our drug delivery technologies allow us to differentiate our products in the
marketplace, both in the branded and non-branded/generic pharmaceutical
areas. We believe that this differentiation provides substantial competitive
advantages for our products, allowing us to establish a strong record of
growth and profitability and a leadership position in certain segments of
our industry.
RESULTS OF OPERATIONS
Net income decreased $1.0 million, or 11.8%, to $7.6 million for the three
months ended June 30, 2004. During the quarter, net revenues increased 11.3%
as we experienced sales growth in all three of our operating segments:
branded products, specialty generics and specialty materials. The resultant
$4.0 million increase in gross profit was more than offset by a $5.5 million
increase in operating expenses. The increase in operating expenses was
primarily due to an increase in costs associated with the addition of 80
specialty sales representatives and sales management personnel since the
year-ago second quarter to support new product initiatives for our branded
products segment and an increase in branded marketing expense to continue
the better-than-expected performance of our technology-improved anemia
product line.
14
Net Revenues by Segment
- -----------------------
THREE MONTHS ENDED JUNE 30,
-----------------------------------------
CHANGE
-----------------
($ IN THOUSANDS): 2004 2003 $ %
------- ------- ------ -----
Branded products $15,919 $14,781 $1,138 7.7%
as % of net revenues 24.1% 24.9%
Specialty generics 45,455 39,455 6,000 15.2%
as % of net revenues 68.8% 66.4%
Specialty materials 4,131 3,902 229 5.9%
as % of net revenues 6.3% 6.6%
Other 582 1,241 (659) (53.1)%
------- ------- ------
Total net revenues $66,087 $59,379 $6,708 11.3%
The increase in branded product sales was due primarily to continued market
share gains in our women's healthcare family of products and our two
hematinic product lines. Branded product sales grew despite the impact on
first quarter sales of wholesalers making larger than normal purchases
during the fourth quarter of fiscal 2004 in anticipation of annual price
increases on branded products. Sales of Gynazole-1(R), our vaginal
antifungal cream product, increased 31.0% to $3.9 million during the quarter
as our share of the prescription vaginal antifungal cream market increased
to 27.9% compared to 18.9% at the end of the first quarter of fiscal 2004.
Also included in the women's healthcare family of products is our PreCare(R)
product line which contributed $6.2 million of sales during the first
quarter. Although sales from the PreCare(R) product line declined 9.3%
during the quarter, the PreCare(R) family of products continued to be the
leading branded line of prescription prenatal nutritional supplements in the
United States as market share for the product line grew to 39.9% at the end
of the first quarter of fiscal 2005 compared to 32.5% at the end of the
first quarter of fiscal 2004. Also during the quarter, sales from our two
hematinic product lines, Chromagen(R) and Niferex(R), increased 35.2% to
$3.6 million as both product lines experienced significant growth in new
prescriptions filled. Since we introduced technology-improved versions of
the hematinic products in the second quarter of fiscal 2004, Chromagen(R)
has become the most prescribed branded oral prescription anemia product in
the United States. These increases were further supplemented by a $0.3
million, or 13.6%, increase in sales from the cardiovascular product line.
The growth in sales for specialty generics resulted from a $6.0 million
increase in sales of products in our cardiovascular product line. The $1.1
million increase in sales experienced by the pain management and prenatal
products lines was offset by sales declines in our cough/cold and other
product lines. The cardiovascular product line, which comprised 50.2% of
specialty generic sales in the first quarter of fiscal 2005, contributed
$7.1 million of increased sales volume from existing products, which was
offset in part by $1.1 million of product price erosion that resulted from
normal and expected pricing pressures on certain cardiovascular products.
The sales growth level for specialty generics in the first quarter could
have been greater had it not been for later-than-expected ANDA approvals on
a number of brand equivalent products that were pending approval at the FDA.
We did receive approval late in the first quarter for two strengths of
Morphine Sulphate extended release tablets (the generic equivalent to MS
Contin(R)) and for Carbidopa Levodopa (the generic equivalent to Sinemet(R)
CR).
The increase in specialty material product sales was primarily due to an
increase in new customer business in areas of expanded focus.
The decrease in other revenue resulted primarily from a smaller contract
manufacturing customer base due to continued de-emphasis of this lower
margin operation in our business strategy.
15
Gross Profit by Segment
- -----------------------
THREE MONTHS ENDED JUNE 30,
------------------------------------------
CHANGE
------------------
($ IN THOUSANDS): 2004 2003 $ %
------- ------- ------- -----
Branded products $13,983 $12,875 $ 1,108 8.6%
as % of net revenues 87.8% 87.1%
Specialty generics 27,948 23,962 3,986 16.6%
as % of net revenues 61.5% 60.7%
Specialty materials 1,283 1,154 129 11.2%
as % of net revenues 31.1% 29.6%
Other (861) 398 (1,259) NM
------- ------- -------
Total gross profit $42,353 $38,389 $ 3,964 10.3%
as % of total net revenues 64.1% 64.7%
The increase in gross profit was primarily attributable to sales growth
experienced by all three of our segments: branded products, specialty
generics, and specialty materials. The lower gross profit percentage on a
consolidated basis was unfavorably impacted by a decline in other revenue
that primarily resulted from a smaller contract manufacturing customer base
due to continued de-emphasis of this lower margin operation and higher
production costs. The gross profit percentage increase experienced by the
branded products segment was primarily due to a March 1, 2004 price increase
instituted by Ther-Rx on all of its products. The higher gross profit
percentage in the specialty generics segment reflected a favorable shift in
the mix of product sales during the quarter toward higher margin
cardiovascular products, which comprised a larger percentage of their net
revenues.
Research and Development
- ------------------------
THREE MONTHS ENDED JUNE 30,
-----------------------------------------
CHANGE
-----------------
($ IN THOUSANDS): 2004 2003 $ %
------- ------- ------ -----
Research and development $4,624 $ 5,542 $ (918) (16.6)%
as % of net revenues 7.0% 9.3%
The decrease in research and development expense was primarily due to
rescheduling the timing of certain clinical studies. Although the level of
research and development expense for the quarter was below management's
expectation, we still project that research and development costs for fiscal
2005 will increase by approximately 20-30% over fiscal 2004 levels.
Selling and Administrative
- --------------------------
THREE MONTHS ENDED JUNE 30,
-----------------------------------------
CHANGE
-----------------
($ IN THOUSANDS): 2004 2003 $ %
------- ------- ------ ----
Selling and administrative $24,131 $17,723 $6,408 36.2%
as % of net revenues 36.5% 29.8%
The increase in selling and administrative expense was due primarily to
greater personnel expenses resulting from
16
an increase in management personnel coupled with expansion of the branded
sales force by 80 specialty sales representatives and sales management
personnel since the year-ago second quarter, an increase in rent,
depreciation and utilities associated with recently added facilities, an
increase in branded marketing expense commensurate with the growth of the
segment and to support the on-going promotion of technology-improved
versions of the Chromagen(R) and Niferex(R) products we acquired at the end
of fiscal 2003, and higher insurance costs related to the growth of our
business and escalating insurance rates. We also experienced an increase in
legal expense due to an increase in litigation activity, which included
various patent infringement actions brought by potential competitors with
respect to products we propose to market and for which we have filed
Abbreviated New Drug Applications (ANDA) and provided notice of
certification required under the provisions of the Hatch-Waxman Act.
We anticipate that selling and administrative expense for the remainder of
fiscal 2005 could increase by as much as 30% to 40% over fiscal 2004 levels
due to a full year of our most recent sales force expansion to more than 220
sales representatives, continued expected increases in litigation expenses
associated with ANDA patent challenges, and the expected approval and launch
of a new women's healthcare branded product planned for the second half of
fiscal 2005. To the extent the approval of this product by the FDA is
delayed, anticipated expense spending levels in the latter half of the year
would be diminished.
Interest Expense
- ----------------
THREE MONTHS ENDED JUNE 30,
---------------------------------------
CHANGE
---------------
($ IN THOUSANDS): 2004 2003 $ %
------ ------ ---- ----
Interest expense $1,446 $1,085 $361 33.3%
The increase in interest expense resulted primarily from a full quarter's
interest accrual on the $200.0 million of Convertible Subordinated Notes
issued in May 2003.
Interest and Other Income
- -------------------------
THREE MONTHS ENDED JUNE 30,
----------------------------------------
CHANGE
----------------
($ IN THOUSANDS): 2004 2003 $ %
---- ---- ---- ----
Interest and other income $513 $363 $150 41.3%
The increase in interest and other income was primarily due to the impact of
a full quarter's investment of the $144.2 million of net proceeds from the
May 2003 Convertible Subordinated Notes offering in short-term, highly
liquid investments.
17
Provision for Income Taxes
- --------------------------
THREE MONTHS ENDED JUNE 30,
---------------------------------------
CHANGE
---------------
($ IN THOUSANDS): 2004 2003 $ %
------ ------ ----- -----
Provision for income taxes $3,982 $4,718 $(736) (15.6)%
effective tax rate 34.5% 35.5%
The decrease in the provision for income taxes resulted primarily from a
corresponding decrease in income before taxes. The decline in the effective
tax rate was due to the impact of various tax planning initiatives, coupled
with the generation of income tax credits at both the Federal and state
levels.
LIQUIDITY AND CAPITAL RESOURCES
Cash and cash equivalents and working capital were $218.8 million and $303.6
million, respectively, at June 30, 2004, compared to $226.9 million and
$306.6 million, respectively, at March 31, 2004. Internally generated funds
from product sales continued to be the primary source of operating capital
used in the funding of our businesses. The net cash flow from operating
activities was $5.6 million for the first quarter of fiscal 2005. Cash flow
from operations was favorably impacted by net income adjusted for non-cash
items, offset in part by a decline in reserve balances associated with sales
returns and allowances, an increase in inventories due to increased
production in anticipation of continued sales growth and new product
launches and a reduction in current liabilities related primarily to the
timing of payments.
Net cash flow used in investing activities consisted of capital expenditures
of $13.8 million for the three months ended June 30, 2004 compared to $3.6
million for the corresponding prior year period, which excluded the $8.8
million cost of a building we purchased in April 2003 with proceeds from a
term loan. Capital expenditures during the first quarter of fiscal 2005 were
primarily for purchasing machinery and equipment to upgrade and expand our
pharmaceutical manufacturing and distribution capabilities, and for other
building renovation projects. Other investing activities for the
corresponding prior year quarter also included a cash payment of $14.3
million made in April 2003 for the Niferex(R) product line. We continue to
expect our capital expenditures in fiscal 2005 to increase by up to $50.0
million as we ramp up our manufacturing, distribution and laboratory
capabilities and expand other facilities needed for planned growth over the
next five to seven years.
Our debt balance was $218.5 million at June 30, 2004 compared to $218.7
million at March 31, 2004. In May 2003, we issued $200.0 million in
Convertible Subordinated Notes that are convertible, under certain
circumstances, into shares of our Class A Common Stock at an initial
conversion price of $23.01 per share. The Convertible Subordinated Notes
bear interest at a rate of 2.50% and mature on May 16, 2033. We are also
obligated to pay contingent interest at a rate equal to 0.5% per annum
during any six-month period commencing May 16, 2006, if the average trading
price of the Notes per $1,000 principal amount for the five trading day
period ending on the third trading day immediately preceding the first day
of the applicable six-month period equals $1,200 or more. We may redeem some
or all of the Convertible Subordinated Notes at any time on or after May 21,
2006, at a redemption price, payable in cash, of 100% of the principal
amount of the Convertible Subordinated Notes, plus accrued and unpaid
interest (including contingent interest, if any) to the date of redemption.
Holders may require us to repurchase all or a portion of their Convertible
Subordinated Notes on May 16, 2008, 2013, 2018, 2023 and 2028, or upon a
change in control, as defined in the indenture governing the Convertible
Subordinated Notes, at 100% of the principal amount of the Convertible
Subordinated Notes, plus accrued and unpaid interest (including contingent
interest, if any) to the date of repurchase, payable in cash. The
Convertible Subordinated Notes are subordinate to all of our existing and
future senior obligations.
We have a credit agreement with a bank that provides for a revolving line of
credit for borrowing up to $65 million. The credit agreement provides for a
$40 million unsecured revolving line of credit along with an unsecured
supplemental credit line of $25 million for financing acquisitions. The $40
million unsecured revolving line of credit expires in October 2006 and the
unsecured supplemental credit line of $25 million expires in December 2004.
At June 30, 2004, we had no cash borrowings outstanding under either credit
facility.
We believe our cash and cash equivalents balance, cash flows from
operations, funds available under our credit
18
facilities, and proceeds received from the Convertible Subordinated Notes
issuance will be adequate to fund operating activities for the presently
foreseeable future, including the payment of short-term and long-term debt
obligations, capital improvements, research and development expenditures,
product development activities and expansion of marketing capabilities for
the branded pharmaceutical business. In addition, we continue to examine
opportunities to expand our business through the acquisition of or
investment in companies, technologies, product rights, research and
development and other investments that are compatible with our existing
businesses. We intend to use our available cash to help in funding any
acquisitions or investments. As such, cash has been invested in short-term,
highly liquid instruments. We also may use funds available under our credit
facility, or financing sources that subsequently become available, including
the future issuances of additional debt or equity securities, to fund these
acquisitions or investments. If we were to fund one or more such
acquisitions or investments, our capital resources, financial condition and
results of operations could be materially impacted in future periods.
INFLATION
Inflation may apply upward pressure on the cost of goods and services used
by us in the future. However, we believe that the net effect of inflation on
our operations during the past three years has been minimal. In addition,
changes in the mix of products sold and the effect of competition has made a
comparison of changes in selling prices less meaningful relative to changes
in the overall rate of inflation over the past three years.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our consolidated financial statements are presented on the basis of
accounting principles that are generally accepted in the United States.
Certain of our accounting policies are particularly important to the
portrayal of our financial position and results of operations and require
the application of significant judgment by our management. As a result,
these policies are subject to an inherent degree of uncertainty. In applying
these policies, we make estimates and judgments that affect the reported
amounts of assets, liabilities, revenues and expenses and related
disclosures. We base our estimates and judgments on historical experience,
the terms of existing contracts, observance of trends in the industry,
information that is obtained from customers and outside sources, and on
various other assumptions that are believed to be reasonable and appropriate
under the circumstances, the results of which form the basis for making
judgments about the carrying values of assets and liabilities that are not
readily apparent from other sources. Although we believe that our estimates
and assumptions are reasonable, actual results may differ significantly from
our estimates. Changes in estimates and assumptions based upon actual
results may have a material impact on our results of operations and/or
financial condition. Our critical accounting policies are described below.
Revenue and Provision for Sales Returns and Allowances. When we sell our
- ------------------------------------------------------
products, we reduce the amount of revenue we recognize from such sale by an
estimate of future product returns and sales allowances. Sales allowances
include cash discounts, rebates, chargebacks, and other similar expected
future payments relating to product sold in the current period. Factors that
are considered in our estimates of future product returns and sales
allowances include historical payment experience in relationship to
revenues, estimated customer inventory levels, and current contract prices
and terms with both direct and indirect customers. If actual future payments
for product returns and sales allowances exceed the estimates we made at the
time of sale, our financial position, results of operations and cash flows
would be negatively impacted.
The provision for chargebacks is the most significant and complex estimate
used in the recognition of revenue. We establish contract prices for
indirect customers who are supplied by our wholesale customers. A chargeback
represents the difference between our invoice price to the wholesaler and
the indirect customer's contract price, which is lower. We credit the
wholesaler for purchases by indirect customers at the lower price.
Accordingly, we record these chargebacks at the time we recognize revenue in
connection with our sales to wholesalers. Provisions for estimating
chargebacks are calculated primarily using historical chargeback experience,
actual contract pricing and estimated wholesaler inventory levels. We
continually monitor our assumptions giving consideration to estimated
wholesaler inventory levels and current pricing trends and make adjustments
to these estimates when we believe that the actual chargeback amounts
payable in the future will differ from our original estimates.
Allowance for Inventories. Inventories consist of finished goods held for
- -------------------------
distribution, raw materials and work in process. Our inventories are stated
at the lower of cost or market, with cost determined on the first-in,
first-out
19
basis. In evaluating whether inventory is to be stated at the lower of cost
or market, we consider such factors as the amount of inventory on hand and
in the distribution channel, estimated time required to sell existing
inventory, remaining shelf life and current and expected market conditions,
including levels of competition. We establish reserves, when necessary, for
slow-moving and obsolete inventories based upon our historical experience
and management's assessment of current product demand.
Intangible Assets and Goodwill. Our intangible assets consist of product
- ------------------------------
rights, license agreements and trademarks resulting from product
acquisitions and legal fees and similar costs relating to the development of
patents and trademarks. Intangible assets that are acquired are stated at
cost, less accumulated amortization, and are amortized on a straight-line
basis over their estimated useful lives. Upon approval, costs associated
with the development of patents and trademarks are amortized on a
straight-line basis over estimated useful lives ranging from five to 17
years. We determine amortization periods for intangible assets that are
acquired based on our assessment of various factors impacting estimated
useful lives and cash flows of the acquired products. Such factors include
the product's position in its life cycle, the existence or absence of like
products in the market, various other competitive and regulatory issues, and
contractual terms. Significant changes to any of these factors may result in
a reduction in the intangible asset's useful life and an acceleration of
related amortization expense.
We assess the impairment of intangible assets whenever events or changes in
circumstances indicate that the carrying value may not be recoverable. Some
factors we consider important which could trigger an impairment review
include the following: (1) significant underperformance relative to expected
historical or projected future operating results; (2) significant changes in
the manner of our use of the acquired assets or the strategy for our overall
business; and (3) significant negative industry or economic trends.
When we determine that the carrying value of intangible assets may not be
recoverable based upon the existence of one or more of the above indicators
of impairment, we first perform an assessment of the asset's recoverability.
Recoverability is determined by comparing the carrying amount of an
intangible asset against an estimate of the undiscounted future cash flows
expected to result from its use and eventual disposition. If the sum of the
expected future undiscounted cash flows is less than the carrying amount of
the intangible asset, an impairment loss is recognized based on the excess
of the carrying amount over the estimated fair value of the intangible asset.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our exposure to market risk is limited to fluctuating interest rates
associated with variable rate indebtedness that is subject to interest rate
changes.
Advances to us under our credit facilities bear interest at a rate that
varies consistent with increases or decreases in the publicly announced
prime rate and/or the LIBOR rate with respect to LIBOR-related loans, if
any. A material increase in such rates could significantly increase
borrowing expenses. We did not have any cash borrowings under our credit
facilities at June 30, 2004.
In May 2003, we issued $200.0 million of Convertible Subordinated Notes. The
interest rate on the Convertible Subordinated Notes is fixed at 2.50% and
therefore not subject to interest rate changes.
In April 2003, we entered into an $8.8 million term loan secured by a
building under a floating rate loan with a bank. We also entered into an
interest rate swap agreement with the same bank, which fixed the interest
rate of the building mortgage at 5.31% for the term of the loan.
ITEM 4. CONTROLS AND PROCEDURES
The Company maintains disclosure controls and procedures that are designed
to ensure that information required to be disclosed in our 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 our
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
20
was required to apply its judgment in evaluating the cost-benefit
relationship of possible controls and procedures.
As of the end of the period covered by this report, we carried out an
evaluation, under the supervision and with the participation of our
management, including our principal executive officer and principal
financial officer, of the effectiveness of the design and operation of our
disclosure controls and procedures. Based on the foregoing, our principal
executive officer and principal financial officer concluded that our
disclosure controls and procedures were effective as of the end of the
period covered by this report.
There have been no significant changes in our internal control over
financial reporting or in other factors that have materially affected, or
are reasonably likely to materially affect, our internal controls over
financial reporting in the first quarter of fiscal year 2005.
PART II. - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
ETHEX is a defendant in a lawsuit styled Healthpoint, Ltd. v. ETHEX
Corporation, filed in federal court in San Antonio, Texas. In general, the
plaintiffs allege that ETHEX's comparative promotion of its Ethezyme(TM) to
Healthpoint's Accuzyme(R) product resulted in false advertising and
misleading statements under various federal and state laws, and constituted
unfair competition and misappropriation of trade secrets. In September 2001,
the jury returned verdicts against ETHEX on certain false advertising,
unfair competition and misappropriation claims. The jury awarded
compensatory and punitive damages totaling $16.5 million. On October 1,
2002, the U.S. District Court for the Western District of Texas denied
ETHEX's motion to set aside the jury's verdict. On December 17, 2002, the
court entered a judgment awarding attorneys' fees to Healthpoint in an
amount to be subsequently determined.
We believe that the jury award and judgment is excessive and is not
sufficiently supported by the facts or the law. We are vigorously
prosecuting an appeal. We and our counsel believe that there are meritorious
arguments to be raised during the appeal process; however, we cannot give
any assurance that we will prevail on appeal. As a result of the court's
earlier decisions, our results of operations for the quarter ended September
30, 2002 included a provision for potential damages of $16.5 million, which
was reflected in accrued liabilities on our consolidated balance sheet as of
June 30, 2004. As discussed above, Healthpoint also requested reimbursement
for approximately $1.8 million in attorneys' fees in addition to the
judgment. In September 2003, the court entered an order specifying the
amount of attorneys' fees to be awarded. As a result of this decision, we
recorded, during the quarter ended September 30, 2003, an additional
provision of $1.8 million, which was reflected in accrued liabilities on our
consolidated balance sheet as of June 30, 2004.
The Company and ETHEX are named as defendants in a second lawsuit brought by
Healthpoint and others styled Healthpoint Ltd. v. ETHEX Corporation, filed
in federal court in San Antonio, Texas. In general, the plantiffs allege
that ETHEX's comparative promotion of its Ethezyme(TM) 830 to Healthpoint's
Accuzyme(R) product resulted in false advertising and misleading statements
under various federal and state laws, and constituted unfair competition and
misappropriation of trade secrets. The case has been inactive for several
years. Discovery has resumed and the case is expected to proceed to trial in
August, 2004. The Company believes it has meritorious defenses and will
vigorously defend the case; however, it cannot give any assurance that it
will prevail.
The Company and ETHEX are named as defendants in a case brought by CIMA
LABS, Inc. and Schwarz Pharma, Inc. and styled CIMA LABS, Inc. et. al. v. KV
Pharmaceutical Company et. al. filed in federal court in Minnesota. It is
alleged that the Company and ETHEX infringe on a CIMA patent in connection
with the manufacture and sale of Hyoscyamine Sulfate Orally Dissolvable
Tablets, 0.125 mg. The court has denied the paintiff's motion for a
preliminary injunction, which allows ETHEX to continue marketing the product
during the pendancy of the subject lawsuit and calls into question CIMA's
and Schwarz's ability to prevail in the lawsuit. Discovery is active. The
Company believes it has meritorious defenses and will vigorously defend the
case; however, it cannot give any assurance that it will prevail.
The Company and ETHEX are named as defendants in a case brought by Solvay
Pharmaceuticals, Inc and styled Solvay Pharmaceuticals, Inc. v. ETHEX
Corporation, filed in federal court in Minnesota. In general, Solvay
21
alleges that ETHEX's comparative promotion of its Pangestyme(TM) CN 10 and
Pangestyme(TM) CN 20 products to Solvay's Creon(R) 10 and Creon(R) 20
products resulted in false advertising and misleading statements under
various federal and state laws, and constituted unfair and deceptive trade
practices. Discovery has recently become active. The Company believes it has
meritorious defenses and will vigorously defend the case; however, it cannot
give any assurance that it will prevail.
We previously distributed several low-volume pharmaceutical products that
contained phenylpropanolamine, or PPA, and that were discontinued in 2000
and 2001. We are presently named as a defendant in a product liability
lawsuit in federal court in Mississippi involving PPA. The suit originated
out of a case, Virginia Madison, et al. v. Bayer Corporation, et al. The
original suit was filed on December 23, 2002, but was not served on us until
February 2003. The case was originally filed in the Circuit Court of Hinds
County, Mississippi, and was removed to the United States District Court for
the Southern District of Mississippi by then co-defendant Bayer Corporation.
The case has been transferred to a Judicial Panel on Multi-District
Litigation for PPA claims sitting in the Western District of Washington. The
claims against us have now been segregated into a lawsuit brought by Johnny
Fulcher individually and on behalf of the wrongful death beneficiaries of
Linda Fulcher, deceased, against KV. It alleges bodily injury, wrongful
death, economic injury, punitive damages, loss of consortium and/or loss of
services from the use of our distributed pharmaceuticals containing PPA that
have since been discontinued and/or reformulated to exclude PPA. In May
2004, the case was dismissed with prejudice by the U.S. District Court for
the Western District of Washington for a failure to timely file an
individual complaint as required by certain court orders. The plaintiff
filed a request for reconsideration which was opposed and subsequently
denied by the court in June 2004. In July 2004, the plaintiffs filed a
notice of appeal of the dismissal. We intend to oppose this appeal.
Management believes that the Company may have substantial defenses to the
underlying claims, though the ultimate outcome of this case and the
potential effect cannot be determined.
Our product liability coverage for PPA claims expired for claims made after
June 15, 2002. Although we renewed our product liability coverage for
coverage after June 15, 2002, that policy excludes future PPA claims in
accordance with the standard industry exclusion. Consequently, as of June
15, 2002, we have provided for legal defense costs and indemnity payments
involving PPA claims on a going forward basis, including the Mississippi
lawsuit that was served after June 15, 2002. Moreover, we may not be able to
obtain product liability insurance in the future for PPA claims with
adequate coverage limits at commercially reasonable prices for subsequent
periods. From time to time in the future, we may be subject to further
litigation resulting from products containing PPA that we formerly
distributed. We intend to vigorously defend any claims that may be raised in
the current and future litigation.
On September 25, 2003, the Commonwealth of Massachusetts filed an action
styled Commonwealth of Massachusetts v. Mylan Laboratories, Inc. et al in
federal court in Massachusetts, against ETHEX and 12 other manufacturers of
generic pharmaceutical products. The Complaint alleges, among other things,
that the defendants reported inflated pricing information for their drugs to
data reporting services, and that Massachusetts relied on this pricing data
in setting reimbursement rates under the Medicaid program. The Complaint
also alleges that Massachusetts received rebates from the defendants under
the Medicaid Drug Rebate Program that were materially less than that to
which Massachusetts was entitled. Massachusetts seeks to recover from the
defendants the amount that it believes it overpaid and the amount it is owed
in rebates, based on claims under Massachusetts and federal law. The case is
in its early stages, and fact discovery has not yet begun. ETHEX is
vigorously defending the litigation.
On or about August 5, 2004, the City of New York filed a lawsuit in U.S.
District Court for the Southern District of New York against 44
manufacturers of pharmaceuticals, including ETHEX. The complaint alleges
that the defendants inflated the average wholesale prices used to calculate
Medicaid reimbursements and that by reporting inflated pricing information
they underpaid Medicaid rebates. The case is in its early stages and fact
discovery has not yet begun. ETHEX intends to vigorously defend its
interests.
22
It is possible that a number of jurisdictions may have commenced
investigations into the generic pharmaceutical industry, at large, regarding
pricing and price reporting practices that may or may not have an effect on
ETHEX. We are involved in various other legal proceedings in the ordinary
course of business. These legal proceedings include various patent
infringement actions brought by potential competitors with respect to
products we propose to market and for which we have filed Abbreviated New
Drug Applications and provided notice of certification required under the
provisions of the Hatch-Waxman Act.
While it is not feasible to predict the ultimate outcome of such other
proceedings, we believe that the ultimate outcome of such other proceedings
will not have a material adverse effect on our results of operations or
financial position.
There are uncertainties and risks associated with all litigation and there
can be no assurances that we will prevail in any particular litigation.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
a) Exhibits. See Exhibit Index.
b) Reports on Form 8-K.
None
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SIGNATURES
----------
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Company has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.
K-V PHARMACEUTICAL COMPANY
Date: August 9, 2004 By /s/ Marc S. Hermelin
------------------------------
Marc S. Hermelin
Vice Chairman of the Board and
Chief Executive Officer
(Principal Executive Officer)
Date: August 9, 2004 By /s/ Gerald R. Mitchell
------------------------------
Gerald R. Mitchell
Vice President, Treasurer and
Chief Financial Officer
(Principal Financial and
Accounting Officer)
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EXHIBIT INDEX
Exhibit No. Description
- ----------- -----------
31.1 Certification of Chief Financial Officer.
31.2 Certification of Chief Executive Officer.
32.1 Certification pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
25