10-K 1 form10-k_16272.htm FORM 10K DATED NOVEMBER 30, 2008 WWW.EXFILE.COM, INC. -- 888-775-4789 -- CHATTEM, INC. -- FORM 10-K


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-K
 
ANNUAL REPORT
PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended November 30, 2008
 
Commission file number 0-5905
 
 
CHATTEM, INC.
A TENNESSEE CORPORATION
 
IRS EMPLOYER IDENTIFICATION NO. 62-0156300
 
 
1715 WEST 38TH STREET
CHATTANOOGA, TENNESSEE 37409
TELEPHONE: 423-821-4571
 
Securities registered pursuant to Section 12(b) of the Act:
 
Title of Each Class
 
Name of Each Exchange on
Which Registered
None
 
None
 
Securities registered pursuant to Section 12(g) of the Act:
 
Common Stock, without par value
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
YES  þ       NO  ¨
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
YES  ¨       NO  þ
 
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, and (2) has been subject to such filing requirements for the past 90 days.
YES  þ       NO  ¨
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check one):

Large accelerated filer  þ                                                                                      Accelerated filer
Non-accelerated filer  (Do not check if a smaller reporting company)      Smaller reporting company

 
Indicate by check mark whether the registrant is a shell company (as defined in rule 12b-2 of the Act).    YES       NO þ
 
As of May 31, 2008, the aggregate market value of voting and non-voting shares held by non-affiliates was $1,129,498,322.  For the sole purpose of this computation, all executive officers and directors of the registrant have been deemed to be affiliates of the registrant.
 
As of January 22, 2009, 19,468,434 shares of common stock were outstanding.
 
 
DOCUMENTS INCORPORATED BY REFERENCE:
 
Portions of the registrant’s Proxy Statement for the registrant’s 2009 Annual Meeting of Shareholders (the “2009 Proxy Statement”) are incorporated by reference in Part III of this Form 10-K to the extent described herein.


 
CHATTEM, INC.
 
TABLE OF CONTENTS
 
 
PART I
 
Item
 
Page
1.
Business
3
 
1A.
Risk Factors
16
 
1B.
Unresolved Staff Comments
26
 
2.
Properties
26
 
3.
Legal Proceedings
26
 
4.
Submission of Matters to a Vote of Securities Holders
26
     
     
PART II
     
5.
Market for the Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of   Equity Securities
27
 
6.
Selected Financial Data
 
29
7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
29
 
7A.
Quantitative and Qualitative Disclosures about Market Risk
43
 
8.
Financial Statements and Supplementary Data
45
 
9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
88
 
9A.
Controls and Procedures
88
 
9B.
Other Information
89
     
     
PART III
     
10.
Directors, Executive Officers and Corporate Governance
89
 
11.
Executive Compensation
91
 
12.
Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters
91
 
13.
Certain Relationships and Related Transactions, and Director Independence
91
 
14.
Principal Accounting Fees and Services
91
     
     
PART IV
     
15.
Exhibits and Financial Statement Schedules
92
 
2

PART I
 
Item 1. Business
 
Except as otherwise indicated, all references in this Form 10-K to “we”, “us”, “our” or “Chattem” refer to Chattem, Inc. and our subsidiaries. In addition, in this Form 10-K, our fiscal years ended November 30, 2006, November 30, 2007 and November 30, 2008 are referred to as fiscal 2006, fiscal 2007 and fiscal 2008, respectively.  Our fiscal year ending on November 30, 2009 is referred to as fiscal 2009.  Brand names that are italicized in this Form 10-K refer to trademarks that we own.
 
General
 
Founded in 1879, we are a leading marketer and manufacturer of a broad portfolio of branded over-the-counter (“OTC”) healthcare products, toiletries and dietary supplements in such categories as medicated skin care, topical pain care, oral care, internal OTC, medicated dandruff shampoos, dietary supplements and other OTC and toiletry products. Our portfolio of products includes well-recognized brands such as:
 
 
Gold Bond, Cortizone-10 and Balmex  - medicated skin care;
 
 
Icy Hot, Aspercreme and Capzasin - topical pain care;
 
 
ACT and Herpecin-L - oral care;
 
 
Unisom, Pamprin and Kaopectate - internal OTC;
 
 
Selsun Blue - medicated dandruff shampoos;
 
 
Dexatrim, Garlique and New Phase - dietary supplements; and
 
 
Bullfrog, UltraSwim and Sun-In - other OTC and toiletry products.
 
Our products target niche markets that are often outside the focus of larger companies where we believe we can achieve and sustain significant market share through product innovation and strong advertising and promotion support. Many of our products are among the U.S. market leaders in their respective categories. For example, our portfolio of topical analgesic brands, our Cortizone-10 anti-itch ointment and our Gold Bond medicated body powders have the leading U.S. market share in their respective categories. We support our brands through extensive and cost-effective advertising and promotion. We sell our products nationally through mass merchandiser, drug and food channels, principally utilizing our own sales force.
 
Our experienced management team has grown our business by acquiring brands, developing product line extensions and increasing market penetration of our existing products.  We will continue to seek opportunities to acquire attractive brands in niche markets.
 
 
Competitive Strengths
 
We believe that the following key competitive strengths are critical to our continuing success:
 
Diverse and broad portfolio of well-recognized branded products.  We currently market a diverse and broad portfolio of 26 brands in a variety of different product categories. Our products are marketed under well-recognized brand names, which include lcy Hot, Gold Bond, Selsun Blue, ACT, Cortizone-10 and Unisom.  Our presence in diverse product categories reduces our exposure to changing consumer demand or weakness in any single category.
 
Significant presence in niche markets.  We acquire and develop brands that compete in small to medium sized niche markets where we believe we can achieve significant market presence and build brand equity. Our products often face less competitive pressures because we focus on markets that are frequently outside the core product areas of larger consumer products and pharmaceutical companies. This focus provides us with the opportunity to develop strong brand equity, identify and respond to consumer trends and leverage our strong selling and distribution capabilities in these markets.
 
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High margins and efficient operating structure.  We are able to achieve high gross margins as a result of our ability to build and maintain brand equity, our significant market presence in niche markets and efficiencies in purchasing, manufacturing and distribution. In addition, we seek to tightly control our expenses, which strengthens our operating margins. Our high margins and resulting strong cash flow allow us to withstand temporary fluctuations in our product markets that could have adverse effects on our business.
 
Proven advertising and promotion strategy.  We aggressively build awareness and consumer loyalty of our brands through extensive and cost-effective advertising strategies that emphasize the competitive strengths of our products. We rely principally on television advertising and, to a lesser extent, radio and print advertising and promotional programs. We strive to achieve cost efficiencies in our advertising by being opportunistic in our purchase of media and through control of our production costs. We also maintain the flexibility to allocate purchased media time among our key brands to respond quickly to changing consumer trends and to support our growing brands. We believe our well-developed advertising and promotion platform allows us to quickly and efficiently launch and support newly acquired brands and product line extensions as well as increase market penetration of existing brands. Advertising and promotion expenditures represented approximately 26% of our total revenues in fiscal 2008. Given the importance of our products’ brand equity we expect to maintain a significant level of spending on advertising and promotion.
 
Established national sales and distribution network.  We have an established national sales and distribution network that sells to mass merchandiser, drug and food retailers such as Wal-Mart Stores, Inc., Walgreens Co. and The Kroger Co. In fiscal 2008, sales to our top ten customers constituted approximately 74% of our total domestic gross sales, which allows us to target our selling efforts to our key customers and tailor specific programs to meet their needs.  Our fiscal 2008 sales to Wal-Mart Stores, Inc. accounted for approximately 33% of our total domestic gross sales. Through targeted sales and utilization of our established distribution network, including our approximately 55 person sales force, we believe we can effectively sell and distribute our products, including newly acquired brands and product line extensions, while maintaining tight controls over our selling expenses.
 
Focused new product development.  We strive to increase the value of our brands while obtaining an increased market presence through product line extensions.  In fiscal 2008, our product development expenditures were $5.7 million.  During the past several years, we have expanded our product development staff and increased research and development spending.  We rely on internal market research as well as consultants to identify new product formulations and line extensions that we believe appeal to the needs of consumers. In fiscal 2008, we introduced 11 new product line extensions: Unisom Sleep Melts, Cortizone-10 Intensive Healing, Gold Bond Ultimate Restoring Lotion, Gold Bond Ultimate Foot Cream, Gold Bond Ultimate Soothing Lotion, Icy Hot PM Lotion, Icy Hot PM Patch, Aspercreme Heat Pain Relieving Gel, Aspercreme Nighttime Lotion, Dexatrim Max Daytime Control and Dexatrim Max Complex 7.  We have 13 new product launches scheduled for fiscal 2009.
 
 
Business Strategy
 
Our strategy to achieve future growth is to generate new sales through strong marketing and promotional programs, new product development and the acquisition of new brands.
 
Brand management and growth.  We seek to increase market share for our major brands through focused marketing of our existing products and product line extensions while maintaining market share for our smaller brands. Our marketing strategy is to position our products to meet consumer preferences identified through extensive use of market and consumer research. We intend to channel advertising and promotion resources to those brands that we feel exhibit the most potential for growth. We also seek continued growth through our new product line extension activities as evidenced by our increased research and development spending and the expansion of our product development staff.  In addition, we continually evaluate the profit potential of and markets for our brands and, in instances where our objectives are not realized, will dispose of under-performing brands and redeploy the resulting cash assets.
 
Strategic acquisitions.  We intend to identify and acquire brands in niche markets where we believe we can achieve a significant market presence through our established advertising and promotion platform, sales and distribution network and research and development capabilities. We target brands with sales that are responsive to increased advertising support, provide an opportunity for product line extensions through our research and development efforts and have the potential to meet our high gross margin goals.  On January 2, 2007, we acquired the U.S. rights to the following five consumer and OTC brands from Johnson & Johnson (“J & J Acquisition”): ACT, Unisom, Cortizone-10, Kaopectate and Balmex.  Also in fiscal 2007, we acquired the worldwide trademark and rights to sell and market ACT in Western Europe from Johnson & Johnson (“ACT Acquisition”).  We will continue to seek opportunities to acquire attractive brands in niche markets.
 
4

Developments During Fiscal 2008
 
Products
 
In fiscal 2008, we introduced the following product line extensions: Unisom Sleep Melts, Cortizone-10 Intensive Healing, Gold Bond Ultimate Restoring Lotion, Gold Bond Ultimate Foot Cream, Gold Bond Ultimate Soothing Lotion, Icy Hot PM Lotion, Icy Hot PM Patch, Aspercreme Heat Pain Relieving Gel, Aspercreme Nighttime Lotion, Dexatrim Max Daytime Control and Dexatrim Max Complex 7.
 
Product Recall

On February 8, 2008, we initiated a voluntary nationwide recall of our Icy Hot Heat Therapy product. Icy Hot Heat Therapy is an air-activated, self-heating disposable device for temporary relief of muscular and joint pain.  We recalled these products because we received some consumer reports of first, second and third degree burns and skin irritation resulting from the use or possible misuse of the product.  Based in part on consideration of on-hand factory inventory and retail point of sales data, during the first quarter of fiscal 2008 we recorded an estimate of approximately $6.0 million of recall expenses related to product returns, inventory obsolescence, destruction costs, consumer refunds, legal fees and other estimated expenses. Subsequent to our first fiscal quarter, we increased our estimate of recall expenses by $0.3 million, to a total of $6.3 million, primarily as a result of additional legal fees and settlement payments.  The remaining accrued liability for product recall expenses was $0.8 million as of November 30, 2008.

Loss on Early Extinguishment of Debt

During the first quarter of fiscal 2008, we utilized borrowings under the revolving credit facility portion of our Credit Facility to repay $35.0 million of the term loan under the Credit Facility.  In connection with the term loan repayment, we retired a proportional share of the term loan debt issuance costs and recorded the resulting loss on extinguishment of debt of $0.5 million.

Stock Repurchase

During fiscal 2008, we repurchased 418,281 shares of our common stock under our stock repurchase program for $26.3 million at an average price per share of $62.94.

Litigation Settlement
 
During the third quarter of fiscal 2008, we reached a settlement on all 26 known claims alleging pulmonary arterial hypertension as a result of the ingestion of Dexatrim products in 1998 through 2003.  Included as litigation settlement in the consolidated statements of income is the settlement of the 26 claims totaling $13.3 million and $0.6 million of legal expenses, which were partially offset by $2.6 million of proceeds from the Dexatrim litigation settlement trust.
 
Subsequent Event
 
On December 4, 2008, we issued an aggregate of 487,123 shares of our common stock in exchange for $28.7 million in aggregate principal amount of our outstanding 2.0% Convertible Senior Notes due 2013 (“2.0% Convertible Notes”).  As a result of this transaction, the balance of the remaining 2.0% Convertible Notes was reduced to $96.3 million outstanding.
5

Products
 
We currently market a diverse and broad portfolio of branded OTC healthcare products, toiletries and dietary supplements in such categories as medicated skin care, topical pain care, oral care, internal OTC, medicated dandruff shampoos, dietary supplements and other OTC and toiletry products. Our branded products by category consist of:
 
Category and Brands  Product Description
   
Medicated Skin Care
 
Gold Bond
Medicated powder, cream, lotion, first aid and foot care products
Cortizone-10
Hydrocortisone anti-itch
Balmex
Diaper rash
   
Topical Pain Care
 
Icy Hot
Dual action muscular and arthritis pain reliever
Aspercreme
Odor-free arthritis pain reliever
Flexall
Aloe-vera based pain reliever
Capzasin
Deep penetrating, odor-free arthritis pain reliever
Sportscreme
Odor-free muscular pain reliever
Arthritis Hot
Value-priced arthritis pain reliever
   
Oral Care
 
ACT
Anti-cavity mouthwash/mouth rinse
Herpecin-L
Cold sore lip treatment
Benzodent
Denture pain relief cream
   
Internal OTC
 
Pamprin
Menstrual pain reliever
Prēmsyn PMS
Premenstrual pain reliever
Unisom
OTC sleep-aid
Kaopectate
Anti-diarrheal remedy
   
Medicated Dandruff Shampoos
 
Selsun Blue
Medicated dandruff shampoos
   
Dietary Supplements
 
Dexatrim
Diet pills
Garlique
Cholesterol health supplement
Melatonex
Natural sleep aid
New Phase
Menopausal supplement
Omnigest EZ
Digestive aid
   
Other OTC and Toiletry Products
 
Bullfrog
Sunscreens
Sun-In
Spray-on hair lightener
UltraSwim
Chlorine-removing shampoo and conditioner
Mudd
Facial masque
 
 
Medicated Skin Care
 
The Gold Bond brand competes in numerous product categories with specially formulated products for both adults and babies, including body powder, therapeutic hand and body lotions, foot care and first aid.  Gold Bond has long been the number one selling brand of medicated body powder domestically, and its strong brand equity among consumers has allowed us to successfully launch new line extensions, most recently under the Gold Bond Ultimate line.
 
Initially launched in fiscal 2003, Gold Bond Ultimate Healing Skin Therapy Lotion helps to heal and nurture extremely dry, cracked and irritated skin with seven intensive moisturizers plus vitamins A, C and E. The Gold Bond Ultimate line expanded into the everyday bath powder category with the introduction of Gold Bond Ultimate Comfort Body Powder in fiscal 2005. Gold
 
6

Bond Ultimate Comfort Body Powder is a talc-free powder that provides freshness, odor protection and moisture control and features the signature Ultimate fragrance.  In fiscal 2006, we introduced Gold Bond Ultimate Softening Lotion.  The new Ultimate Softening lotion is specially formulated to soften rough, dry skin.  In fiscal 2008 we launched three additions to the Gold Bond Ultimate line: Restoring Lotion, Soothing Lotion and Foot Cream.
 
As part of the J&J Acquisition in 2007, Cortizone-10 and Balmex joined the Gold Bond brand in the medicated skin care category.  Cortizone-10 is the leading brand in the anti-itch category and helps to relieve itching associated with various skin irritations including rashes, dry skin, eczema, poison ivy and insect bites.  All Cortizone-10 products contain 1% hydrocortisone and are available in multiple forms.  The Cortizone-10 Crème with aloe and Crème Plus with 10 moisturizers are designed to relieve itch fast and moisturize the skin.  Cortizone-10 Intensive Healing Formula, launched in January 2008, contains moisturizers, anti-oxidant vitamins, and chamomile designed to moisturize for 24 hours and to help relieve itchy skin.
 
Balmex is a line of diaper rash products available in two formulas.  The primary formula contains zinc oxide to treat and prevent diaper rash.  The second formula is a petrolatum based product for treatment and prevention of diaper rash and other skin irritations.
 
Topical Pain Care
 
Our topical pain care portfolio features six distinctly positioned brands. Our flagship brand, Icy Hot, is a leader in the external analgesic category and receives heavy media support and strong advertising featuring NBA super-star Shaquille O'Neal.  In fiscal 2008, we extended the Icy Hot brand with two new products – Icy Hot PM Lotion and Icy Hot PM Patch – specifically designed to help relieve arthritis sufferers’ nighttime pain.
 
Aspercreme provides odor-free pain relief for sufferers of arthritis and other joint and muscle pain. In fiscal 2008, this brand was extended with two new product introductions:  Aspercreme Nighttime Lotion offers maximum nighttime pain relief, and Aspercreme Heat Pain Relieving Gel delivers fast-acting pain relief with a heat sensation in a no-mess gel.  Capzasin is an arthritis pain reliever that contains capsaicin.  Sportscreme is targeted at serious athletes as well as “weekend warriors”.  Flexall is marketed toward those who seek a menthol and aloe vera based pain reliever for conditions such as back pain or muscle strain.  Arthritis Hot rounds out the portfolio and competes against private label products at a value price.
 
Oral Care
 
Our oral care brands include Herpecin-L, a lip care product that treats cold sores and protects lips from the harmful rays of the sun, and Benzodent, a dental analgesic cream for pain related to dentures.  With the J&J Acquisition, we added ACT, a line of anti-cavity mouthwash and mouth rinses.  ACT is available in three flavors of anti-cavity fluoride rinse and in the ACT Restoring line with four flavors and multiple package sizes.  The ACT Restoring line of products seeks to restore minerals to soft spots; strengthen enamel to prevent tooth decay; and kill bad breath germs.  In 2009, we will launch the ACT Total Care line of mouthwashes which combines the consumer benefits of strong teeth, healthy gums and fresh breath in two flavors – Icy clean mint and alcohol-free Fresh mint.
 
Internal OTC’s
 
We compete in the menstrual analgesic category with two brands, Pamprin and Prēmsyn PMS.  Pamprin, featuring four distinct formulas, seeks to provide complete relief of a woman’s menstrual symptoms, while Prēmsyn PMS has one formula designed to address specific symptoms of premenstrual syndrome.  Pamprin is available in four formulas: Multi-Symptom, Cramp, All Day, and Max.
 
In connection with the J&J Acquisition, the Unisom and Kaopectate brands joined the internal OTC category in 2007.  Unisom is the leading single ingredient brand in the OTC sleep aid category. Unisom is available in three product forms: SleepTabs, with the active ingredient diphenhydramine; SleepGels, which contains the active ingredient doxylamine; and Sleep Melts, launched in fiscal 2008, which melts in your mouth.  Kaopectate is a well established anti-diarrheal remedy.  Kaopectate is available in Regular and Extra Strength and three flavors: regular, Peppermint and Cherry.  In addition, Kaopectate offers a stool softener under its brand banner.
 
7

Medicated Dandruff Shampoos
 
The Selsun Blue line of products consists of three distinct product offerings, each using different active medication and ingredients to provide unique formulas for the various consumer segments in the marketplace.
 
The Selsun Blue base formula contains the active ingredient selenium sulfide and is comprised of four shampoos: Medicated, with a cooling clean feel; Moisturizing, with aloe and moisturizers; 2-in-1, with a patented conditioning system; and Daily for more sensitive scalp treatment.
 
Selsun Salon, launched in 2005, contains the active ingredient, pyrithione zinc, plus moisturizers and nutrients for enhanced hair care.  All Selsun Salon products are formulated with a blend of salon quality moisturizers, vitamins and nutrients to provide great looking hair.
 
Selsun Natural, launched in fiscal 2007, contains the active ingredient salicylic acid.  The two shampoos (Artic Energy and Island Breeze) have a clear-looking formula with moisturizers, botanicals and vitamins to provide gentler care of the hair and scalp and help restore hair to its natural, healthy state.
 
Dietary Supplements
 
Dexatrim is a leading brand in the diet pill category that includes such products as Dexatrim Max, Dexatrim Max2O, Dexatrim Max Evening Appetite Control, Dexatrim Natural and, launched in fiscal 2008, Dexatrim Max Daytime Control and Dexatrim Max Complex 7.
 
We also compete in the dietary supplements category with our Sunsource line of products.  All Sunsource products are specially formulated to provide consumers with an all-natural, drug-free way to support their specific health care goals.  Known for its support of cardiovascular health, Garlique leads the garlic supplement category and is positioned as an odor-free, one-per-day supplement that helps maintain cholesterol levels already within a healthy range.
 
Other OTC and Toiletry Products
 
The majority of sales of our seasonal brands, Bullfrog, Sun-In and UltraSwim, typically occur during the first three quarters of our fiscal year.  Bullfrog is a line of high quality, high SPF waterproof sunblocks.  Included in the Bullfrog line is Bullfrog Mosquito Coast which combines an SPF 30 sunblock with a DEET Free insect repellent, QuickGel Sportspray, Superblock, Quik Stick, and Marathon Mist, a convenient continuous spray sunblock product in children and adult versions.  In 2008 and 2009, the Bullfrog line is being enhanced with “UV Extender” which provides broader UVB and UVA protection for the Quick Gel, Sportspray and Marathon Mist products.  In addition, in 2009 Bullfrog Superblock will be reformulated to provide SPF 50 protection for those seeking sun protection.
 
Sun-In, a hair lightener, is available in two varieties of spray-on and a highlighting gel.  UltraSwim is our niche line of swimmers’ shampoos and conditioner.  Our other brands include Mudd, a line of specialty masque products, and a variety of other smaller brands.
 
 
International Business
 
Our international business, which represented approximately 7%, 7% and 8% of our total revenues in fiscal 2008, 2007 and 2006, respectively, has been concentrated in Canada, an export market driven from our operations in Ireland, the United Kingdom (“U.K.”), Greece and in Latin American countries in which Selsun, ACT and certain of our other products are sold.
 
Canada
 
Chattem Canada, a wholly-owned subsidiary based in Mississauga, Ontario, Canada, markets and distributes certain of our consumer products throughout Canada. The manufacturing of these products is principally done in our facilities in Chattanooga, Tennessee, while some packaging is done in Mississauga. Chattem Canada utilizes a national broker for its sales efforts. Brands marketed and sold in Canada include Icy Hot, Selsun, Gold Bond, Pamprin, Sun-In, UltraSwim and Aspercreme.
 
8

Europe
 
Our European business is conducted through Chattem Global Consumer Products Limited (“Chattem Global”), our Irish subsidiary, located in Limerick, Ireland; Chattem (U.K.) Limited (“Chattem (U.K.)”), a wholly-owned subsidiary located in Basingstoke, Hampshire, England; and Chattem Greece, a wholly-owned subsidiary located in Alimos Attica, Greece.  Packaging and distribution operations are conducted principally in Ireland with certain products sourced from our U.S. operations. Chattem uses a national broker in the U.K., while distributors are used to market and sell our products on the European continent and elsewhere. Our products sold in Europe include Selsun, ACT, Sun-In, and Mudd. Cornsilk® is sold by Chattem (U.K.) under a licensing arrangement with the owner of its registered trademark, Coty, Inc. Spray Blond Spray-In Hair lightener is marketed only on the European continent.  Certain of our OTC health care products are sold by Chattem Global to customers in parts of Central Europe and the Middle East.
 
Peru
 
In the fourth quarter of fiscal 2008, we established Chattem Peru SRL (“Chattem Peru”), a wholly-owned subsidiary located in Lima, Peru.  Chattem Peru sells certain of our Selsun products throughout Peru using third party distributors.
 
United States Export
 
Our United States export division services various distributors primarily located in the Caribbean and Latin America. We distribute Selsun, ACT, Gold Bond, Dexatrim, Icy Hot, Aspercreme, Capzasin and Sportscreme into these markets.
 
Selsun International
 
We plan to focus our efforts on expanding Selsun’s international presence in existing key markets, such as Canada, Mexico, Brazil, the U.K. and Australia.  In certain international markets, we sell Selsun through distributors and receive a royalty based on a percentage of distributor sales.  We have entered into distributor agreements with third party distributors for Selsun in various international markets other than Canada and the U.K., where we engage national brokers.
 
 
Marketing, Sales and Distribution
 
Advertising and Promotion
 
We aggressively seek to build brand awareness and product usage through extensive and cost effective advertising strategies that emphasize the competitive strengths of our products. We allocate a significant portion of our revenues to the advertising and promotion of our products. Expenditures for these purposes were approximately 26%, 27% and 32% of total revenues in fiscal 2008, 2007 and 2006, respectively.
 
We seek to increase market share for our major brands through focused marketing of our existing products and product line extensions while maintaining market share for our smaller brands. Our marketing strategy is to position our products to meet consumer preferences identified through extensive use of market and consumer research. We intend to channel advertising and promotion resources to those brands that we feel exhibit the most potential for growth. We rely principally on television advertising and to a lesser extent, radio and print advertising and promotional programs. We strive to achieve cost efficiencies in our advertising by being opportunistic in our purchase of media and controlling our production costs. We also maintain the flexibility to allocate purchased media time among our key brands to respond quickly to changing consumer trends and to support our growing brands. We believe our well-developed advertising and promotion platform allows us quickly and efficiently to launch and support newly acquired brands and product line extensions as well as increase market penetration of existing brands.
 
We work directly with retailers to develop promotional calendars and campaigns for each brand, customizing the promotion to the particular requirements of the individual retailer. These programs, which include cooperative advertising, temporary price reductions, in-store displays and special events, are designed to obtain or enhance distribution at the retail level and to reach the ultimate consumers of the product. We also utilize consumer promotions such as coupons, samples and trial sizes to increase the trial and consumption of the products.
 
9

Customers
 
Our customers consist of mass merchandisers such as Wal-Mart Stores, Inc., drug retailers such as Walgreens Co. and food retailers such as The Kroger Co. In fiscal 2008, our ten largest customers represented approximately 74% of total domestic gross sales, and our 20 largest customers represented approximately 84% of total domestic gross sales, which allows us to target our selling efforts to our key customers and customize programs to meet their needs.  Our fiscal 2008 sales to Wal-Mart Stores, Inc. accounted for approximately 33% of total domestic gross sales. No other customer accounts for more than 10% of our total domestic gross sales.  No international retailers accounted for more than 10% of our total international gross sales in fiscal 2008.  Consistent with industry practice, we do not operate under a long-term written supply contract with any of our customers.
 
Sales and Distribution
 
We have an established national sales and distribution organization that sells to mass merchandiser, drug and food retailers. We utilize our national sales network, consisting primarily of our own sales force, to sell and distribute our products, including newly acquired brands and product line extensions, while maintaining tight controls over our selling expenses. Our experienced sales force of approximately 55 people serves all direct buying accounts on an individual basis.  For the more fragmented food channel and for the smaller individual stores, we rely on a national network of regional brokers to provide retail support. In excess of 95% of our domestic orders are received electronically through our electronic data interchange, or EDI, system, and accuracy for our order fulfillment has been consistently high. Our sales department performs significant analysis helping both our sales personnel and customers understand sales patterns and create appropriate promotions and merchandising aids for our products. Although not contractually obligated to do so, in certain circumstances, we allow our customers to return unsold merchandise, and for seasonal products we provide extended payment terms to our customers.
 
Internationally, our products are sold by national brokers in Canada and the U.K. and by distributors in Europe and Latin America. We have entered into distribution agreements with third party distributors for Selsun in various international markets except Canada and the U.K.
 
Most of our products, including those manufactured by third party manufacturers, are shipped from leased warehouses located in Chattanooga, Tennessee. We also use a third party logistics service located in California to warehouse and distribute our products to the west coast area of the United States. We use third party common carriers to transport our products. We do not generally experience wide variances in the amount of inventory we maintain. At present, we have no backlog of customer orders and are promptly meeting customer requirements.
 
Manufacturing and Quality Control
 
During fiscal 2008, we manufactured products representing approximately 57% of our domestic sales volume at our two Chattanooga, Tennessee, facilities. The balance of our products are manufactured by third party contract manufacturers including our Gold Bond medicated powders, Icy Hot patches and sleeves, ACT, Herpecin-L, and our dietary supplements, including Dexatrim products.  We contract with third party manufacturers to manufacture products that are not compatible with our existing manufacturing facilities or which can be more cost-effectively manufactured by others. In certain cases, third party manufacturers are not obligated under contracts that fix the term of their commitment. We believe we have adequate capacity to meet anticipated demand for our products through our own manufacturing facilities and third party manufacturers.
 
To monitor the quality of our products, we maintain an internal quality control system supported by onsite microbiology and analytical laboratories. We have trained quality control technicians who test our products and processes and guide the products through the manufacturing cycle. Consultants also are employed from time to time to test our quality control procedures and the compliance of our manufacturing operations with the United States Food and Drug Administration (“FDA”) regulations. We audit our third party manufacturers to monitor compliance with applicable current good manufacturing practices (“GMPs”) as defined by FDA regulations.
 
We purchase raw materials and packaging materials from a number of third party suppliers primarily on a purchase order basis. Except for a select few active ingredients used in our Pamprin and Prēmsyn PMS products, we are not limited to a single source of supply for the ingredients used in the manufacture of our products.  Sales of our Pamprin and Prēmsyn PMS products represented approximately 3% of our consolidated total revenues in fiscal 2008.  In addition, we have a limited source of supply for selenium sulfide, the active ingredient in Selsun Blue.  As a result of the limited supply and increase in worldwide
 
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demand for selenium metal, a major component in the manufacture of selenium sulfide, our cost of selenium sulfide has been and is expected to be volatile.  We believe that our current and potential alternative sources of supply will be adequate to meet future product demands.  Sales of our Selsun Blue products represented approximately 11% of our consolidated total revenues in fiscal 2008.
 
Research and Development
 
We strive to increase the value of our base brands and obtain an increased market presence through product line extensions. We rely on internal market research as well as consultants to identify new product formulations and line extensions that we believe appeal to the needs of consumers. Our growth strategy includes an emphasis on new product development as evidenced by our increased research and development spending and the expansion of our product development staff.  We currently employ approximately 34 people in our research and development department and also engage consultants from time to time to provide expertise or research in a particular product area. Our product development expenditures were $5.7 million in fiscal 2008 and $5.5 million in fiscal 2007.
 
Competition
 
We compete in the OTC health care, toiletries and dietary supplements markets. These markets are highly competitive and are characterized by the frequent introduction of new products, including the migration of prescription drugs to the OTC market, often accompanied by major advertising and promotional support. Our competitors include large pharmaceutical companies such as Johnson & Johnson, consumer products companies such as Procter & Gamble Co., and dietary supplements companies such as GlaxoSmithKline and Nature’s Bounty, Inc., many of which have considerably greater financial and other resources and are not as highly leveraged as we are. Our competitors may be better positioned to spend more on research and development, employ more aggressive pricing strategies, utilize greater purchasing power, build stronger vendor relationships and develop broader distribution channels than us. In addition, our competitors have often been willing to use aggressive spending on trade promotions and advertising as a strategy for building market share at the expense of their competitors, including us. The private label or generic category has also become increasingly more competitive in certain of our product markets. Our products continue to compete for shelf space among retailers who are increasingly consolidating.
 
Trademarks and Patents
 
Our trademarks are of material importance to our business and among our most important assets. We own all of our trademarks associated with brands that we currently market. In fiscal 2008, substantially all of our total revenues were from products bearing proprietary or licensed brand names. Accordingly, our future success may depend in part upon the goodwill associated with our brand names, particularly Gold Bond, Selsun Blue, Icy Hot, ACT, Unisom and Cortizone-10.
 
Our principal brand names are registered trademarks in the United States and certain foreign countries. We maintain or have applied for patent and copyright protection in the United States relating to certain of our existing and proposed products and processes.  We also license from third parties other intellectual property that is used in certain of our products. The sale of these products relies on our ability to maintain and extend our supply and licensing agreements with these third parties.
 
Government Regulation
 
The U.S. manufacturing, distribution, processing, formulation, packaging, labeling and advertising of our products are subject to regulation by federal agencies, including, but not limited to:
 
 
•   the Food & Drug Administration (the “FDA”);
 
•   the Federal Trade Commission (the “FTC”);
 
•   the Drug Enforcement Administration (the “DEA”);
 
•   the Consumer Product Safety Commission (the “CPSC”);
 
•   the United States Postal Service;
 
•   the Environmental Protection Agency (“EPA”); and
 
•   the Occupational Safety and Health Administration (“OSHA”).
 
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These activities are also regulated by various agencies of the states, localities and foreign countries in which our products are sold. In particular, the FDA regulates the safety, manufacturing, labeling and distribution of OTC drugs, medical devices, dietary supplements, functional toiletries, and skin care products. In addition, the FTC has primary jurisdiction to regulate the advertising of OTC drugs, medical devices, dietary supplements, functional toiletries and skin care products.  In foreign countries these same activities may be regulated by ministries of health, or other local regulatory agencies.  The manner in which products sold in foreign countries are registered, how they are formulated, or what claims may be permitted may differ from similar products and practices in the U.S.
 
Under the Federal Food, Drug, and Cosmetic Act (“FDC Act”) all “new drugs”, including OTC products, are subject to pre-market approval by the FDA under the new drug application (“NDA”) process. The FDC Act defines a “new drug” as a drug that is not generally recognized among scientifically qualified experts as safe and effective for use under the conditions stated in its labeling. A drug might also be considered new if it has not been used, outside of clinical investigations, to a material extent or for a material time under conditions described for a product. A drug that is generally regarded as safe and effective is not a “new drug” and therefore does not require pre-market approval.
 
The FDA has adopted an administrative process, the OTC Drug Review, to determine which active ingredients and indications are safe and effective for use in OTC products. With the aid of independent expert advisory review panels, the FDA develops rules, referred to as “monographs”, which define categories of safe and effective OTC drugs. These monographs group drug ingredients into therapeutic classes such as OTC external analgesics. Products that comply with monograph conditions do not require pre-market approval from the FDA.
 
The FDA has finalized monographs for certain categories of OTC drugs such as drug products for the control of dandruff. If a product is marketed beyond the scope of a particular final monograph and without an approved NDA, such as if the manufacturer makes a label claim not covered by the monograph, the FDA will consider the product to be unapproved and misbranded and can take enforcement action against the drug company and product including, but not limited to, issuing a warning letter or initiating a product seizure. In order to market a product whose active ingredients are not permitted by a final monograph, a company must submit an NDA to the FDA.
 
There are several categories of OTC drugs, such as external analgesics, for which the FDA has not completed its review. In such cases, the FDA has established tentative final monographs. These tentative final monographs are similar to final monographs in that they establish conditions under which OTC drugs can be marketed for certain uses without FDA pre-marketing approval. The FDA generally does not take enforcement action against an OTC drug subject to a tentative final monograph unless there is a safety problem or a substantial effectiveness question.
 
The majority of our OTC drug products are regulated pursuant to the FDA monograph system.  Many of our products are sold according to tentative final monographs. Therefore, we face the risk that the FDA could take action if there is a perceived safety or efficacy issue with respect to one of our product categories or finalize these monographs with conditions as to which of our products do not comply. If any of our products were found not to be in compliance with a final monograph, we may be forced to reformulate or relabel such products, if possible, or submit an NDA or an abbreviated NDA to continue to market our existing formulation. The submission of an NDA would require the preparation and submission of clinical tests, which would be time consuming and expensive. We may not receive FDA approval of any NDA in a timely manner or at all. If we were not able to reformulate or relabel our product or obtain FDA approval of an NDA, we would be required to discontinue selling the affected product. Changes in monographs could also require us to change our product formulation or dosage form, revise our labeling, modify our production process or provide additional scientific data, any of which would involve additional costs and may be prohibitive. For our OTC drug products that are sold according to final monographs, we cannot deviate from the conditions described in the final monograph, such as changes in approved active ingredient levels or labeling claims, unless we obtain pre-marketing approval from the FDA.
 
We have responded to certain questions received from the FDA with respect to efficacy of pyrilamine maleate, one of the active ingredients used in certain of the  Pamprin  Menstrual Pain Relief and Prēmsyn PMS  products. While we addressed all of the FDA questions in detail, the final monograph for menstrual drug products, which has not yet been issued, will determine if the FDA considers pyrilamine maleate safe and effective for menstrual relief products. If pyrilamine maleate is not included in the final monograph, we would be required to reformulate the products to continue to provide the consumer with multi-symptom relief benefits. We believe that any adverse finding by the FDA would likewise affect our principal competitors in the menstrual product category and that finalization of the menstrual products monograph is not imminent. Moreover, we have formulated alternative Pamprin products that fully comply with both the internal analgesic and menstrual product monographs. Sales of our
 
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Pamprin Menstrual Pain Relief and Prēmsyn PMS products represented approximately 3% of our consolidated total revenues in fiscal 2008.
 
We were notified in October, 2000 that the FDA denied a citizen petition submitted by Thompson Medical Company, Inc., the previous owner of Sportscreme and Aspercreme.  The petition sought a determination that 10% trolamine salicylate, the active ingredient in Sportscreme and Aspercreme, was clinically proven to be an effective active ingredient in external analgesic OTC drug products and should be included in the FDA's yet-to-be finalized monograph for external analgesics. We are working to develop alternate formulations for Sportscreme and Aspercreme in the event that the FDA does not consider the available clinical data to conclusively demonstrate the efficacy of trolamine salicylate when the OTC external analgesic monograph is finalized. If 10% trolamine salicylate is not included in the final monograph, we would likely be required to discontinue these products as currently formulated after expiration of an anticipated grace period. If this occurred, we believe we could market related products as homeopathic products and could also reformulate them using other ingredients included in the FDA monograph.  We believe that the monograph is unlikely to become final and take effect before mid-2009. Sales of our Sportscreme and Aspercreme products represented approximately 5% of our consolidated total revenues in fiscal 2008.
 
Certain of our topical analgesic products are currently marketed under an FDA tentative final monograph. In 2003, the FDA proposed that the final monograph exclude external analgesic products in patch, plaster or poultice form, unless the FDA receives additional data supporting the safety and efficacy of these products. On October 14, 2003, we submitted to the FDA information regarding the safety of our Icy Hot patches and arguments to support the inclusion of patch products in the final monograph. We also participated in an industry-wide effort coordinated by Consumer Healthcare Products Association (“CHPA”) requesting that patches be included in the final monograph and seeking to establish with the FDA a protocol of additional research that would allow the patches to be marketed under the final monograph even if the final monograph does not explicitly allow them. The CHPA submission to the FDA was made on October 15, 2003.  The FDA has not responded to our or CHPA’s submission.  The most recent Unified Agenda of Federal Regulatory and Deregulatory Actions published in the Federal Register provided a target final monograph publication date of May 2009. If the final monograph excludes products in patch, plaster or poultice form, we would have to file and obtain approval of an NDA in order to continue to market the Icy Hot, Capzasin and Aspercreme patch products, the Icy Hot Sleeve and/or similar delivery systems under our other topical analgesic brands. In such case, we would have to cease marketing the existing products likely within one year from the effective date of the final monograph, or pending FDA review and approval of an NDA. The preparation of an NDA would likely take us six to 24 months and would be expensive. It typically takes the FDA at least 12 months to rule on an NDA once it is submitted and there is no assurance that an NDA would be approved. Sales of our Icy Hot, Capzasin, and Aspercreme patches and Icy Hot Sleeve products represented approximately 8% of our consolidated total revenues in fiscal 2008.
 
During the finalization of the monograph on sunscreen products, the FDA chose to hold in abeyance specific requirements relating to the characterization of a product's ability to reduce UVA radiation. In September 2007, the FDA published a new proposed rule amending the previously stayed final monograph on sunscreens to include new formulation options, labeling requirements and testing standards for measuring UVA protection and revised testing for UVB protection.  When implemented, the final rule will require all sunscreen manufacturers to conduct new testing and revise the labeling of their products within eighteen months after issuance of the final rule.  We will be required to take such actions for our Bullfrog product line.
 
The Dietary Supplement Health and Education Act of 1994 (“DSHEA”) was enacted on October 25, 1994. DSHEA amends the FDC Act by defining dietary supplements, which include vitamins, minerals, amino acids, nutritional supplements, herbs and botanicals, as a new category of food separate from conventional food. DSHEA provides a regulatory framework to ensure safe, quality dietary supplements and to foster the dissemination of accurate information about such products. Under DSHEA, the FDA is generally prohibited from regulating dietary supplements as food additives or as drugs unless product claims, such as claims that a product may diagnose, mitigate, cure or prevent an illness, disease or malady, permit the FDA to attach drug status to a product. In such case, the FDA could require pre-market approval to sell the product. Manufacturers are not required to obtain prior FDA approval before producing or selling a dietary supplement unless the ingredient is considered “new” or was not on the market as of October 15, 1994.
 
The FDA has promulgated regulations relating to the manufacturing process for drugs, which are known as current GMP's.  In June 2007, the FDA published the final rule on GMP’s for dietary supplements, with an effective date of June 25, 2008.  We source all of our dietary supplement products from outside suppliers, including Dexatrim, New Phase, Garlique, Melatonex, and Omnigest. As part of its regulatory authority, the FDA may periodically conduct audits of the physical facilities, machinery, processes and procedures that we, or our suppliers, use to manufacture products. The FDA may perform these
 
 
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audits at any time without advanced notice. As a result of these audits, the FDA may order us, or our suppliers, to make certain changes in manufacturing facilities and processes. We may be required to make additional expenditures to comply with these orders or the new GMP requirements, or possibly discontinue selling certain products until we, or our suppliers, comply with these orders and requirements. As a result, our business could be adversely affected.
 
In 1997, the FDA published a proposed rule on the use of dietary supplements containing ephedrine alkaloids. In June 2002, the United States Department of Health and Human Services (“HHS”) proposed an expanded scientific evaluation of Ephedra which led to the issuance of a report by the RAND-based Southern California Evidence-Based Practice Center (the “RAND Report”). The RAND Report concluded that ephedrine, ephedrine plus caffeine and Ephedra-containing dietary supplements with or without herbs containing caffeine all promote modest amounts of weight loss over the short term and use of Ephedra, or ephedrine plus caffeine, is associated with an increased risk of gastrointestinal, psychiatric and autonomic symptoms. The adverse event reports contained a smaller number of more serious adverse events. Given the small number of such events, the RAND Report concluded that further study would be necessary to determine whether consumption of Ephedra, or ephedrine, may be causally related to these serious adverse events. In connection with the RAND Report, HHS sought public comment on whether additional measures are required concerning the sale and distribution of dietary supplements containing ephedrine alkaloids.
 
On December 30, 2003, the FDA issued a consumer alert on the safety of dietary supplements containing ephedrine alkaloids and on February 6, 2004 published a final rule with respect to these products. The final rule prohibits the sale of dietary supplements containing ephedrine alkaloids because such supplements present an unreasonable risk of illness or injury. The final rule became effective on April 11, 2004. We discontinued the manufacturing and shipment of Dexatrim containing ephedrine in September 2002.
 
The FDA also regulates some of our products as cosmetics or drug-cosmetics. There are fewer regulatory requirements for cosmetics than for drugs or dietary supplements. Cosmetics marketed in the United States must comply with the FDC Act, the Fair Packaging and Labeling Act and the FDA's implementing regulations. Cosmetics must also comply with quality and labeling requirements proscribed by the FDA. In addition, several of our products are subject to product packaging regulation by the CPSC and the FDA.
 
Combination products can be regulated via a memorandum of understanding between federal agencies. In February 2006, we launched Bullfrog Mosquito Coast, a combination of sunscreen and insect repellent. The sunscreen labeling is regulated by the FDA in its sunscreen monograph, but the insect repellent, IR-3535, and its labeling, require pre-market safety and efficacy testing and approval by the EPA and all 50 states (and U.S. Territories).  Bullfrog Mosquito Coast received approval from all states and the EPA prior to launch. Further, the FDA announced its intention in its November, 2005 Unified Agenda to regulate, under the monograph system, the combination of sunscreens and insect repellents in a notice of proposed rulemaking yet to be published. Any final rule making is years in the future and the FDA might grandfather existing products or otherwise allow time for their compliance.
 
Our business is also regulated by the California Safe Drinking Water and Toxic Enforcement Act of 1986, known as Proposition 65. Proposition 65 prohibits businesses from exposing consumers to chemicals that the state has determined cause cancer or reproduction toxicity without first giving fair and reasonable warning unless the level of exposure to the carcinogen or reproductive toxicant falls below prescribed levels. From time to time, one or more ingredients in our products could become subject to an inquiry under Proposition 65. If an ingredient is on the state's list as a carcinogen, it is possible that a claim could be brought, in which case we would be required to demonstrate that exposure is below a “no significant risk” level for consumers. Any such claims may cause us to incur significant expense, and we may face monetary penalties or injunctive relief, or both, or be required to reformulate our product to acceptable levels. The State of California under Proposition 65 is also considering the inclusion of titanium dioxide on the state's list of suspected carcinogens. Titanium dioxide has a long history of widespread use as an excipient in prescription and OTC pharmaceuticals, cosmetics, dietary supplements and skin care products and is an active ingredient in our Bullfrog Superblock products. We have participated in an industry-wide submission to the State of California, facilitated through CHPA, presenting evidence that titanium dioxide presents “no significant risk” to consumers.
 
Finally, the FDA regulates the quality of all finished drug, medical device, and food products under GMP's. As part of its regulatory authority, the FDA may periodically conduct audits of the physical facilities, machinery, processes and procedures that we, or our suppliers, use to manufacture products. The FDA may perform these audits at any time without advanced notice. In February 2006, we registered as a medical device manufacturer with the FDA in connection with our sale of Icy Hot Pro Therapy products. It might be expected that we could be audited as a new device manufacturer under medical device GMP's. Working
 
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with consultants we have instituted medical device GMP's pursuant to applicable portions of the medical device Quality System Regulation, or QSR. As a result of any audits, the FDA may order us, or our suppliers, to make certain changes in manufacturing facilities and processes. We may be required to make additional expenditures to comply with these orders, or possibly discontinue selling certain products until we, or our suppliers, comply with these orders. As a result, our business could be adversely affected.  In December 2006, the Dietary Supplement and Nonprescription Drug Consumer Protection Act was signed into law with an effective date of December 22, 2007.  This new law requires the mandatory reporting of serious adverse events and specific record keeping requirements for dietary supplements and non-prescription drugs marketed without an approved application.
 
The FDA has broad regulatory and enforcement powers. If the FDA determines that we have failed to comply with applicable regulatory requirements, it can impose a variety of enforcement actions from public warning letters, fines, injunctions, consent decrees and civil penalties to suspension or delayed issuance of approvals, seizure or recall of our products, total or partial shutdown of production, withdrawal of approvals or clearances already granted, and criminal prosecution. The FDA can also require us to repair, replace or refund the cost of devices that we manufactured or distributed. If any of these events were to occur, it could materially adversely affect us.
 
Environmental Matters
 
We continually assess the compliance of our operations with applicable federal, state and local environmental laws and regulations. Our policy is to record liabilities for environmental matters when loss amounts are probable and reasonably determinable. Our manufacturing site utilizes chemicals and other potentially hazardous materials and generates both hazardous and non-hazardous waste, the transportation, treatment, storage and disposal of which are regulated by various governmental agencies. We have engaged environmental consultants on a regular basis to assist with our compliance efforts. We believe we are currently in compliance with all applicable environmental permits and are aware of our responsibilities under applicable environmental laws. Any expenditure necessitated by changes in law and permitting requirements cannot be predicted at this time, although such costs are not expected to be material to our financial position, results of operations or cash flows.
 
In late 2005, we began the manufacture of Bullfrog Mosquito Coast at our Chattanooga, Tennessee plant. Bullfrog Mosquito Coast is a combination of sunscreen and insect repellent. The EPA has primary jurisdiction over insect repellants and combination insect repellant products containing sunscreens, such as Bullfrog Mosquito Coast. Both products and manufacturing establishments must be registered with the EPA.
 
The handling, disposal, and environmental exposure of the insect repellent, IR-3535, is strictly regulated by the EPA under the Clean Waters Act.  Any failure to comply with applicable regulations with respect to the use of IR-3535 might result in EPA action against us, including fines or injunctive action.
 
Employees
 
As of November 30, 2008, we employed approximately 488 people on a full-time basis and 10 people on a part-time basis in the United States. In addition, at the end of fiscal 2008, we employed approximately 24 people at our foreign subsidiaries’ offices. Our employees are not represented by any organized labor union, and we consider our labor relations to be good.
 
Market Data
 
We use market and industry data throughout this Annual Report on Form 10-K and the documents incorporated by reference herein, which we have obtained from market research, publicly available information and industry publications. These sources generally state that the information that they provide has been obtained from sources believed to be reliable, but that the accuracy and completeness of such information are not guaranteed. The market and industry data is often based on industry surveys and the preparers’ experience in the industry. Similarly, although we believe that the surveys and market research that others have performed are reliable, we have not independently verified this information. In particular, market share information has been coordinated and prepared for us by A.C. Nielsen at our request based on market segments that we defined and for which we have paid customary fees. Therefore, such data, including the market category delineations that form the basis for such data, are not necessarily representative of results that would have been obtained from an independent source.  Furthermore, the market share information prepared by A.C. Nielsen does not include data from certain of our customers, most notably Wal-Mart Stores, Inc.
 
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Financial Information on Products and Geographical Areas
 
For financial information on our product categories and geographical areas, see note 11 to our consolidated financial statements.
 
Additional Information
 
Our internet website address is www.chattem.com. We make available free of charge on or through our website our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, reports filed pursuant to Section 16, the proxy statement to our annual shareholders meeting and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission.  We also make available on our website our Code of Business Conduct and Ethics, our Audit Committee Charter and our Compensation Committee Charter.  The information found on our website shall not be deemed incorporated by reference into this annual report on Form 10-K or filed with the Securities and Exchange Commission and does not constitute a part of this annual report on Form 10-K.
 
 
Item 1A.  Risk Factors
 
Our business is subject to a number of risks. Some of the risks associated with our operations are described in the “Competition,” “Government Regulation,” “Environmental,” and “Manufacturing and Quality Control” portions of this Form 10-K. In addition to the other information contained in this Form 10-K, the following risk factors should be carefully considered.
 
We face significant competition in the OTC health care, toiletries and dietary supplements markets.
 
The OTC health care, toiletries and dietary supplements markets are highly competitive and are characterized by the frequent introduction of new products, including the migration of prescription drugs to the OTC market, often accompanied by major advertising and promotional support. These introductions may adversely affect our business especially because we compete in categories in which product sales are highly influenced by advertising and promotions. Our competitors include large pharmaceutical companies such as Johnson & Johnson, consumer products companies such as Procter & Gamble Co., and dietary supplements companies such as GlaxoSmithKline and Nature’s Bounty, Inc., many of which have considerably greater financial and other resources than we do and are not as highly leveraged as we are. These competitors are thus better positioned to spend more on research and development, employ more aggressive pricing strategies, utilize greater purchasing power, build stronger vendor relationships and develop broader distribution channels than us. In addition, our competitors have often been willing to use aggressive spending on trade promotions and advertising as a strategy for building market share at the expense of their competitors including us. The private label or generic category has also become increasingly more competitive in certain of our product markets. If we are unable to continue to introduce new and innovative products that are attractive to consumers or are unable to allocate sufficient resources to effectively advertise and promote our products so that they achieve wide spread market acceptance, we may not be able to compete effectively, and our operating results and financial condition may be adversely affected.
 
Our business could be adversely affected by a prolonged downturn or recession in the United States and/or the other countries in which we conduct significant business.
 
A prolonged economic downturn or recession in the United States or any of the other countries in which we do significant business could materially and adversely affect our business, financial condition and results of operations.  In particular, such a downturn or recession could adversely impact (i) the level of spending by our ultimate consumers, (ii) our ability to collect accounts receivable on a timely basis from certain customers, (iii) the ability of certain suppliers to fill our orders for raw materials, packaging or co-packed finished goods on a timely basis and (iv) the mix of our products sales.
 
We may be adversely affected by factors affecting our customers’ businesses.
 
Factors that adversely impact our customers’ businesses may also have an adverse effect on our business, prospects, results of operations, financial condition or cash flows.  These factors may include:
 
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any credit risks associated with the financial condition of our customers;
 
 
the effect of consolidation or weakness in the retail industry, including the closure of our customer’s retail stores and the uncertainty resulting therefrom; and
 
 
inventory reduction initiatives and other factors affecting customer buying patterns, including any reduction in retail space commitment and practices used to control inventory shrinkage.
 
We rely on a few large customers, particularly Wal-Mart Stores, Inc., for a significant portion of our sales.
 
In fiscal 2008, Wal-Mart Stores, Inc. represented approximately 33% of our total domestic gross sales, our ten largest customers represented approximately 74% of our total domestic gross sales and our 20 largest customers represented approximately 84% of our total domestic gross sales. Consistent with industry practice, we do not operate under a long-term written supply contract with Wal-Mart Stores, Inc. or any of our other customers. Our business would materially suffer if we lost Wal-Mart Stores, Inc. as a continuing major customer or if our business with Wal-Mart Stores, Inc. significantly decreases. The loss of sales to any other large customer could also materially and adversely affect our financial results.
 
Our acquisition strategy is subject to risk and may not be successful.
 
A component of our growth strategy depends on our ability to successfully execute acquisitions, which involves numerous risks including:
 
 
not accurately identifying suitable products or brands for acquisition;
 
 
difficulties in integrating the operations, technologies and manufacturing processes of the acquired products;
 
 
the diversion of management’s attention from other business concerns; and
 
 
incurring substantial additional indebtedness.
 
Any future acquisitions, or potential acquisitions, may result in substantial costs, disrupt our operations or materially adversely affect our operating results.
 
Our initiation of a voluntary recall of our Icy Hot Heat Therapy products could expose us to additional product liability claims.

On February 8, 2008, we initiated a voluntary nationwide recall of our Icy Hot Heat Therapy products.  The recall was conducted to the consumer level.  We recalled these products because we received some consumer reports of first, second and third degree burns, as well as skin irritation resulting from consumer use or possible misuse of the products.  As of January 22, 2009, there were approximately 170 consumers with pending claims against us and four product liability lawsuits pending against us alleging burns and skin irritation from the use of Icy Hot Heat Therapy products. We may receive additional lawsuits and/or claims in the future alleging skin irritation and/or burns from use of our Heat Therapy products.  The outcome of any such potential litigation cannot be predicted.

We may receive additional claims that allege personal injury from ingestion of Dexatrim.

During the third quarter of fiscal 2008, we reached a settlement on all 26 known claims alleging pulmonary arterial hypertension as a result of the ingestion of Dexatrim products in 1998 through 2003.  However, we may receive additional claims and some or all of these potential claimants may file lawsuits against us.  If the lawsuits are filed, we plan to vigorously defend these claims.  If notwithstanding our defenses these or other product liability claims are resolved in favor of the claimants, it could have a material adverse effect on our results of operation and financial condition.

 
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Litigation may adversely affect our business, financial condition and results of operations.
 
Our business is subject to the risk of litigation by consumers, employees, suppliers or others through private actions, class actions, administrative proceedings, regulatory actions or other litigation.  The outcome of litigation, particularly class action lawsuits and regulatory actions, is difficult to assess or quantify.  Plaintiffs in these types of lawsuits may seek recovery of very large or indeterminate amounts, and the magnitude of the potential loss relating to such lawsuits may remain unknown for substantial periods of time.  The cost to defend current and future litigation may be significant.  There may also be adverse publicity associated with litigation that could decrease customer acceptance of our products, regardless of whether the allegations are valid or whether we are ultimately found liable.  As a result, litigation may adversely affect our business, financial condition and results of operations.
 
We have a significant amount of debt that could adversely affect our business and growth prospects.
 
As of November 30, 2008, our total long-term debt was $459.5 million.  In the future, we may incur significant additional debt. Our debt could have significant adverse effects on our business including:
 
 
requiring us to dedicate a substantial portion of our available cash for interest payments and the repayment of principal;
 
 
limiting our ability to capitalize on significant business opportunities;
 
 
making us more vulnerable to economic downturns;
 
 
limiting our ability to withstand competitive pressures; and
 
 
making it more difficult for us to obtain additional financing on favorable terms.
 
If we are unable to generate sufficient cash flow from operations in the future, we may not be able to service our debt and may have to refinance all or a portion of our debt, obtain additional financing or sell assets to repay such debt. We cannot assure you that we will be able to obtain such refinancing, additional financing or asset sale on favorable terms or at all.

We may discontinue products or product lines, which could result in returns and asset write-offs, and/or engage in product recalls, any of which would reduce our cash flow and earnings.
 
In the past, we have discontinued certain products and product lines which resulted in returns from customers and asset write-offs.  We may suffer similar adverse consequences in the future to the extent we discontinue products that do not meet expectations or no longer satisfy consumer demand.  Product returns or write-offs would reduce cash flow and earnings.  Product efficacy or safety concerns could result in product recalls or declining sales, which also would reduce our cash flow and earnings.
 
Our product liability insurance coverage may be insufficient to cover existing or future product liability claims.
 
An inherent risk of our business is exposure to product liability claims by users of our products. We have product liability insurance through our captive insurance subsidiary and a third party reinsurance policy that provides coverage for product liability claims. Our product liability insurance coverage for all of our products consists of $30.0 million of coverage through our captive insurance subsidiary, of which approximately $2.8 million is funded as of January 22, 2009, and an additional $25.0 million of excess coverage through a third party reinsurance policy.
 
All of our insurance policies are subject to certain limitations that are generally customary for policies of this type such as deductibles and exclusions for exemplary and punitive damages. Since plaintiffs in product liability claims may seek exemplary and punitive damages, if these damages were awarded, some of our insurance coverage would not cover these amounts, and we may not have sufficient resources to pay these damages.  Any amounts paid by our insurance to satisfy product liabilities would decrease product liability insurance coverage available for any other claims. If our liability for product liability claims is significant, our existing insurance is likely to be insufficient to cover these claims, and we may not have sufficient resources to pay the liabilities in excess of our insurance coverage. Furthermore, our product liability insurance
 
 
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provided by third parties will expire at the end of each annual policy period, currently in August of each year. We may incur significant additional costs to obtain insurance coverage upon the expiration of our current policies and may not be able to obtain coverage in the future in amounts equal to that which we currently have or in amounts sufficient to satisfy future claims.
 
Our business is regulated by numerous federal, state and foreign governmental authorities, which subjects us to elevated compliance costs and risks of non-compliance.
 
The manufacturing, distributing, processing, formulating, packaging and advertising of our products are subject to numerous and complicated federal, state and foreign governmental regulations. Compliance with these regulations is difficult and expensive. In particular, the FDA regulates the safety, manufacturing, labeling and distributing of our OTC products, medical devices, and dietary supplements. In addition, the FTC may regulate the promotion and advertising of our drug products, particularly OTC versions and dietary supplements.  The EPA regulates our Bullfrog Mosquito Coast insect repellent products.  We are also regulated by various state statutes, including the California Safe Drinking Water and Toxic Enforcement Act of 1986.  If we fail to adhere to the standards required by these federal and state regulations, or are alleged to have failed to adhere to such regulations, our operating results and financial condition may be adversely affected.
 
Our success depends on our ability to anticipate and respond in a timely manner to changing consumer preferences.
 
Our success depends on our products’ appeal to a broad range of consumers whose preferences cannot be predicted with certainty and are subject to change. If our current products do not conform to consumer preferences, our sales may decline. In addition, our growth depends upon our ability to develop new products through product line extensions and product modifications, which involve numerous risks. We may not be able to accurately identify consumer preferences and translate our knowledge into customer-accepted products or successfully integrate these products with our existing product platform or operations. We may also experience increased expenses incurred in connection with product development, marketing and advertising that are not subsequently supported by a sufficient level of sales, which would negatively affect our margins. Furthermore, product development may divert management’s attention from other business concerns, which could cause sales of our existing products to suffer. We cannot assure you that newly developed products will contribute favorably to our operating results.
 
Our projections of earnings are highly subjective and our future earnings could vary in a material amount from our projections.
 
From time to time, we provide projections to our shareholders and the investment community of our future earnings.  Since we do not require long-term purchase commitments from our major customers and the customer order and ship process is very short, it is difficult for us to accurately predict the amount of our future sales and related earnings.  Our projections are based on management’s best estimate of sales using historical sales data and other information deemed relevant.  These projections are highly subjective since sales to our customers can fluctuate substantially based on the demands of their retail customers and due to other risks described in this report.  Additionally, changes in retailer inventory management strategies could make inventory management more difficult.  Because our ability to forecast sales is highly subjective, there is a risk that our future earnings could vary materially from our projections.
 
We may be adversely affected by fluctuations in buying decisions of mass merchandiser, drug and food trade buyers and the trend toward retail trade consolidation.
 
We sell our products to mass merchandiser and food and drug retailers in the United States. Consequently, our total revenues are affected by fluctuations in the buying patterns of these customers. These fluctuations may result from wholesale buying decisions, economic conditions and other factors. In addition, with the growing trend towards retail consolidation, we are increasingly dependent upon a few leading retailers, such as Wal-Mart Stores, Inc., whose bargaining strength continues to grow due to their size. Such retailers have demanded, and may continue to demand, increased service and order accommodations as well as price and incremental promotional investment concessions. As a result, we may face downward pressure on our prices and increased promotional expenses to meet these demands, which would reduce our margins. We also may be negatively affected by changes in the policies of our retail trade customers such as inventory destocking, limitations on access to shelf space and other conditions.
 
 
 
19

We rely on third party manufacturers for a portion of our product portfolio, including products under our Gold Bond, Icy Hot, Selsun, Dexatrim, ACT and Unisom brands.
 
We use third party manufacturers to make products representing approximately 43% of our fiscal 2008 sales volume, including our Gold Bond medicated powders and foot spray, the Icy Hot patches and sleeves, Herpecin-L, ACT mouthwash and mouthrinse, Unisom products and our line of dietary supplements including Dexatrim Max and, internationally, our line of Selsun medicated dandruff shampoos. In certain cases, third party manufacturers are not bound by fixed term commitments in our contracts with them, and they may discontinue production with little or no advance notice. Manufacturers also may experience problems with product quality or timeliness of product delivery. We rely on these manufacturers to comply with applicable current GMPs. The loss of a contract manufacturer may force us to shift production to in-house facilities and possibly cause manufacturing delays, disrupt our ability to fill orders or require us to suspend production until we find another third party manufacturer. We are not able to control the manufacturing efforts of these third party manufacturers as closely as we control our business. Should any of these manufacturers fail to meet our standards, we may face regulatory sanctions, additional product liability claims or customer complaints, any of which could harm our reputation and our business.
 
Our dietary supplement business could suffer as a result of injuries caused by dietary supplements in general, unfavorable scientific studies or negative press.
 
Our dietary supplements consist of Dexatrim and our Sunsource product line.  We are highly dependent upon consumers’ perceptions of the benefit and integrity of the dietary supplements business as well as the safety and quality of products in that industry. Injuries caused by dietary supplements or unfavorable scientific studies or news relating to products in this category, such as the December 30, 2003 consumer alert on the safety of dietary supplements containing ephedrine alkaloids issued by the FDA and the subsequent FDA rule banning the sale of supplements containing ephedrine alkaloids that became effective on April 11, 2004, may negatively affect consumers’ overall perceptions of products in this category, including our products, which could harm the goodwill of these brands and cause our sales to decline.
 
Our business could be adversely affected if we are unable to successfully protect our intellectual property or defend claims of infringement by others.
 
Our trademarks are of material importance to our business and are among our most important assets. In fiscal 2008, substantially all of our total revenues were from products bearing proprietary brand names. Accordingly, our future success may depend in part upon the goodwill associated with our brand names, particularly Gold Bond, Selsun Blue, Icy Hot, ACT, Cortizone-10 and Unisom.  Although our principal brand names are registered trademarks in the United States and certain foreign countries, we cannot assure you that the steps we take to protect our proprietary rights in our brand names will be adequate to prevent the misappropriation of these registered brand names in the United States or abroad. In addition, the laws of some foreign countries do not protect proprietary rights in brand names to the same extent as do the laws of the United States.  We cannot assure you that we will be able to successfully protect our trademarks from infringement or otherwise. The loss or infringement of our trademarks could impair the goodwill associated with our brands, harm our reputation and materially adversely affect our financial results.
 
We license additional intellectual property from third parties that is used in certain of our products, and we cannot assure you that these third parties can successfully maintain their intellectual property rights. In addition, the sale of these products relies on our ability to maintain and extend our licensing agreements with third parties, and we cannot assure you that we will be successful in maintaining these licensing agreements. Any significant impairment of the intellectual property covered by these licenses, or in our rights to use this intellectual property, may cause our sales to decline.
 
In addition, our product line extensions are often based on new or unique delivery methods for those products like our Icy Hot patches and sleeves. These delivery methods may not be protected by intellectual property rights that we own or license on an exclusive basis or by exclusive manufacturing agreements. As a result, we may be unable to prevent any competitor or customer from duplicating our delivery methods to compete directly with these product line extensions, which could cause sales to suffer.
 
We are defending and may have to defend in the future litigation and/or claims alleging that we have infringed the intellectual property rights of others. Intellectual property litigation can be extremely expensive.  If we were unable to successfully defend against any claims that our products infringe the intellectual property rights of others, we may be
 
 
20

forced to pay significant damages and on-going royalties or reformulate, redesign or remove our affected product from the market.  As a result, intellectual property litigation could materially adversely affect our business.
 
Because most of our operations are located in Chattanooga, Tennessee, we are subject to regional and local risks.
 
Approximately 57% of our domestic sales volume in fiscal 2008 was from products manufactured in our two plants located in Chattanooga, Tennessee. We store the raw materials used in our manufacturing activities in two warehouses that are also located in Chattanooga. We package and ship most of our products from Chattanooga. Additionally, our corporate headquarters are also located in Chattanooga, and most of our employees live in the area. Because of this, we are subject to regional and local risks, such as:
 
 
changes in state and local government regulations;
 
 
severe weather conditions, such as floods, ice storms and tornadoes;
 
 
natural disasters, such as fires and earthquakes;
 
 
power outages;
 
 
nuclear facility incidents;
 
 
spread of infectious diseases;
 
 
hazardous material incidents; or
 
 
any other catastrophic events in our area.
 
If our region, city or facilities were to suffer a significant disaster, our operations are likely to be disrupted and our business would suffer.
 
We depend on sole source suppliers for three active ingredients used in our Pamprin and Prēmsyn PMS products and a limited source of supply for selenium sulfide, the active ingredient in Selsun Blue, and if we are unable to buy these ingredients, we will not be able to manufacture these products.
 
Pamabrom, pyrilamine maleate and compap, active ingredients used in our Pamprin and Prēmsyn PMS products, are purchased from single sources of supply. Pamabrom is sold only by Chattem Chemicals, Inc. (an unrelated company), pyrilamine maleate is produced only in India and sold only by Lonza, Inc. and compap is sold only by Mallinckrodt, Inc.  In addition, we have a limited source of supply for selenium sulfide, the active ingredient in Selsun Blue.  Financial, regulatory or other difficulties faced by these source suppliers or significant changes in demand for these active ingredients could limit the availability and increase the price of these active ingredients. We may not be able to obtain necessary supplies in a timely manner, and we may be required to pay higher than expected prices for these active ingredients, which could adversely affect our gross margin from these products. Any interruption or significant delay in the supply of these active ingredients would impede our ability to manufacture these products, which would cause our sales to decline. We would not be able to find an alternative supplier and would either need to reformulate these products or discontinue their production. We cannot assure you that we will be able to continue to purchase adequate quantities of these active ingredients at acceptable prices in the future.
 
We are subject to the risk of doing business internationally.
 
In fiscal 2008, approximately 7% of our total consolidated revenues were attributable to our international business.  We operate in regions and countries where we have little or no experience, and we may not be able to market our products in, or develop new products successfully for, these markets. We may also encounter other risks of doing business internationally including:
 
 
unexpected changes in, or impositions of, legislative or regulatory requirements;
 
21

 
fluctuations in foreign exchange rates, which could cause fluctuations in the price of our products in foreign markets or cause fluctuations in the cost of certain raw materials purchased by us;
 
 
delays resulting from difficulty in obtaining export licenses, tariffs and other barriers and restrictions, potentially longer payment cycles, greater difficulty in accounts receivable collection and potentially adverse tax treatment;
 
 
potential trade restrictions and exchange controls;
 
 
differences in protection of our intellectual property rights; and
 
 
the burden of complying with a variety of foreign laws.
 
In addition, we will be increasingly subject to general geopolitical risks in foreign countries where we operate such as political and economic instability and changes in diplomatic and trade relationships, which could affect, among other things, customers’ inventory levels and consumer purchasing, which could cause our results to fluctuate and our sales to decline. It has not been our practice to engage in foreign exchange hedging transactions to manage the risk of fluctuations in foreign exchange rates because of the limited nature of our past international operations. Due to the significant expansion of our international operations, our exposure to fluctuations in foreign exchange rates has increased.
 
The terms of our outstanding debt obligations limit certain of our activities.
 
The terms of the indenture under which our 7.0% Subordinated Notes are issued and our Credit Facility impose operating and financial restrictions on us including restrictions on:
 
 
incurrence of additional indebtedness;
 
 
dividends and restricted payments;
 
 
investments;
 
 
loans and guarantees;
 
 
creation of liens;
 
 
transactions with affiliates;
 
 
use of proceeds from sales of assets and subsidiary stock; and
 
 
certain mergers, consolidations and transfers of assets.
 
The terms of our Credit Facility also require us to comply with financial maintenance covenants. In the future, we may have other indebtedness with similar or even more restrictive covenants. These restrictions may impair our ability to respond to changing business and economic conditions or to grow our business. In the event that we fail to comply with these covenants, there could be an event of default under the applicable debt instrument, which in turn could cause a cross default to other debt instruments. As a result, all amounts outstanding under our various debt instruments may become immediately due and payable.
 
To service our indebtedness, we will require a significant amount of cash.
 
Our ability to make payments on our indebtedness will depend on our ability to generate cash in the future.  This, to a certain extent, is subject to general economic, financial, competitive, regulatory and other factors that are beyond our control.  We cannot assure you that our business will generate sufficient cash flow from operations or that future borrowings will be available to us under our secured Credit Facility in an amount sufficient to enable us to pay our indebtedness or to fund our other liquidity needs.  We may need to refinance all or a portion of our indebtedness on or before maturity, sell assets, reduce or delay
 
 
22

capital expenditures or seek additional financing.  We may not be able to refinance any of our indebtedness on commercially reasonable terms or at all.
 
Our operations are subject to significant environmental laws and regulations.
 
Our manufacturing sites use chemicals and other potentially hazardous materials and generate both hazardous and non-hazardous waste, the transportation, treatment, storage and disposal of which are regulated by various governmental agencies and federal, state and local laws and regulations. Under these laws and regulations, we are exposed to liability primarily as an owner or operator of real property, and as such, we may be responsible for the clean-up or other remediation of contaminated property. Environmental laws and regulations can change rapidly, and we may become subject to more stringent environmental laws and regulations in the future, which may be retroactively applied to earlier events.  Product line extensions, such as Bullfrog Mosquito Coast, or acquisitions of new products, such as those acquired in the J&J Acquisition, may also subject our business to new or additional environmental laws and regulations.  In addition, compliance with new or more stringent environmental laws and regulations could involve significant costs.
 
We are dependent on certain key executives, the loss of whom could have a material adverse effect on our business.
 
Our future performance depends significantly upon the efforts and abilities of certain members of senior management, in particular those of Zan Guerry, our chairman and chief executive officer, and Robert E. Bosworth, our president and chief operating officer. If we were to lose any key senior executive, our business could be materially adversely affected.
 
Our shareholder rights plan and charter contain provisions that may delay or prevent a merger, tender offer or other change of control of us.
 
Provisions of our shareholder rights plan and our restated charter, as well as certain provisions of Tennessee corporation law, may deter unfriendly offers or other efforts to obtain control over us and could deprive shareholders (including holders of the Convertible Notes which may convert into common stock) of their ability to receive a premium on their common stock.
 
Generally, if any person attempts to acquire 15% or more of our common stock then outstanding without the approval of our independent directors, pursuant to our shareholder rights plan, our shareholders may purchase a significant amount of additional shares of our common stock at 50% of the then applicable market price. This threat of substantial dilution will discourage takeover attempts not approved by our board despite significant potential benefits to our shareholders.
 
Our charter contains the following additional provisions, which may have the effect of discouraging takeover attempts:
 
 
our directors are divided into three classes, with only one class of directors elected at each annual meeting for a term of three years, making it difficult for new shareholders to quickly gain control of our board of directors;
 
 
directors may be removed only for cause prior to the expiration of their terms; and
 
 
we are prohibited from engaging in certain business combination transactions with any interested shareholder unless such transaction is approved by the affirmative vote of at least 80% of the outstanding shares of our common stock held by disinterested shareholders, unless disinterested members of our board of directors approve the transaction or certain fairness conditions are satisfied, in which case such transaction may be approved by either the affirmative vote of the holders of not less than 75% of our outstanding shares of common stock and the affirmative vote of the holders of not less than 66% of the outstanding shares of our common stock which are not owned by the interested shareholder, or by a majority of disinterested members of our board of directors, provided that certain quorum requirements are met.
 
The Tennessee Business Combination Act prevents an interested shareholder, which is defined generally as a person owning 10% or more of our voting stock, from engaging in a business combination with us for five years following the date such person became an interested shareholder unless before such person became an interested shareholder, our board of directors approved the transaction in which the interested shareholder became an interested shareholder or approved the business combination, and the proposed business
 
 
23

combination satisfied any additional applicable requirements imposed by law and by our restated charter or bylaws. If the requisite approval for the business combination or share acquisition has not been obtained, any business combination is prohibited until the expiration of five years following the date such person became an interested shareholder.
 
The trading price of our common stock may be volatile.
 
The trading price of our common stock could be subject to significant fluctuations in response to several factors, some of which are beyond our control.  Among the factors that could affect our stock price are:
 
 
our operating and financial performance and prospects;
 
 
quarterly variations in key financial performance measures, such as earnings per share, net income and revenue;
 
 
changes in revenue or earnings estimates or publication of research reports by financial analysts;
 
 
announcements of new products by us or our competitors;
 
 
speculation in the press or investment community;
 
 
strategic actions by us or our competitors, such as acquisitions or restructurings;
 
 
product liability claims;
 
 
further issuance of convertible securities or common stock by us or sales of our common stock or other actions by investors with significant shareholdings;
 
 
general market conditions for companies in our industry; and
 
 
domestic and international economic, legal, political and regulatory factors unrelated to our performance.
 
The stock markets in general have experienced substantial volatility that has often been unrelated to the operating performance of particular companies.  These broad market fluctuations may adversely affect the trading price of our common stock.
 
We have no current intention of paying dividends to holders of our common stock.
 
We presently intend to retain our earnings, if any, for use in our operations, to repay our outstanding indebtedness and to repurchase our common stock and have no current intention of paying dividends to holders of our common stock.
 
We can be affected adversely and unexpectedly by the implementation of new, or changes in the interpretation of existing, accounting principles generally accepted in the United States of America (“GAAP”).
 
Our financial reporting complies with GAAP, and GAAP is subject to change over time.  If new rules or interpretations of existing rules require us to change our financial reporting, our financial condition and results from operations could be adversely affected.
 
Identification of a material weakness in our internal controls over financial reporting may adversely affect our financial results.
 
We are subject to ongoing obligations under the internal control provisions of the Sarbanes-Oxley Act of 2002.  Those provisions require us to identify and report material weaknesses in our system of internal controls over financial reporting.  If such a material weakness is identified, it could indicate a lack of controls adequate to generate accurate financial statements.  We routinely assess our internal controls over financial reporting, but we cannot assure you that we will be able to timely
 
 
24

remediate any material weaknesses that may be identified in future periods, or maintain all of the controls necessary for continued compliance.  Likewise, we cannot assure you that we will be able to retain sufficient skilled finance and accounting personnel, especially in light of the increased demand for such personnel among publicly-traded companies.
 
The convertible note hedge and warrant transactions may affect the value of our common stock and our convertible notes.
 
In connection with the sale of our convertible notes in November 2006 and April 2007, we entered into separate convertible note hedge transactions.  These transactions are expected, but are not guaranteed, to eliminate the potential dilution upon conversion of the convertible notes.  We also entered into warrant transactions.  In connection with hedging these transactions, the counterparty:
 
•      
  
will enter into various over-the-counter derivative transactions with respect to our common stock, and may have purchased our common stock concurrently with and shortly after the pricing of the notes: and
 
•      
may have entered into, or may unwind, various over-the-counter derivatives and/or purchased or sold our common stock in secondary market transactions following the pricing of the notes (including during any conversion reference period related to a conversion of our convertible notes).
 
Such activities could have the effect of increasing, or preventing a decline in, the price of our common stock.  Such effect is expected to be greater in the event we elect to settle converted convertible notes entirely in cash.  The counterparty to these transactions is likely to modify its hedge positions from time to time prior to conversion or maturity of the convertible notes or termination of the transactions by purchasing and selling shares of our common stock, other of our securities, or other instruments it may wish to use in connection with such hedging.  In particular, such hedging modification may occur during any conversion reference period for a conversion of convertible notes, which may have a negative effect on the value of the consideration received in relation to the conversion of those convertible notes.  In addition, we intend to exercise options we hold under the convertible note hedge transaction whenever convertible notes are converted.  In order to unwind its hedge position with respect to those exercised options, the counterparty to these transactions expects to sell shares of our common stock in secondary market transactions or unwind various over-the-counter derivative transactions with respect to our common stock during the conversion reference period for the converted convertible notes.
 
Conversion of our convertible notes may dilute the ownership interest of existing shareholders, including holders who had previously converted their convertible notes.
 
The conversion of some or all of the convertible notes may dilute the ownership interests of existing shareholders.  All or a portion of the amounts payable upon conversion of the convertible notes may, at our election, be paid in cash rather than in the form of shares of common stock.  Any sales in the public market of the common stock issued upon such conversion could adversely affect prevailing market prices of our common stock.  In addition, the existence of the convertible notes may encourage short selling by market participants because the conversion of the convertible notes could depress the price of our common stock.
 
Virtually all of our assets consist of intangibles.
 
As our financial statements indicate, a substantial portion of our assets consist of intangibles, principally the trademarks, trade names and patents that we have acquired.  In the event that the value of those assets became impaired or our business is materially adversely affected in any way, we would not have sufficient tangible assets that could be sold to repay our liabilities.  As a result, our creditors and investors may not be able to recoup the amount of the indebtedness that they have extended to us or the amount they have invested in us.
 

 
25

Item 1B. Unresolved Staff Comments
 
None
 
Item 2.   Properties
 
Our headquarters and administrative offices are located at 1715 West 38th Street, Chattanooga, Tennessee. Our primary production facilities are in close proximity to our headquarters on land owned by us. We lease our primary warehouse and distribution centers in Chattanooga, Tennessee for our domestic consumer products. The following table describes in detail the principal properties owned and leased by us:
 
 
Total Area
(Acres)
 
Total Buildings
(Square Feet)
 
Use
 
Square
Feet
Owned Properties:
                   
Chattanooga, Tennessee
12.0
   
117,600
   
Manufacturing
Office & Administration
 
77,000
40,600
 
Chattanooga, Tennessee
8.3
   
78,500
   
Manufacturing
Office
Product Development Center
 
58,300
10,200
10,000
 
Leased Properties:
                   
Chattanooga, Tennessee
5.1
   
139,000
   
Warehousing
 
139,000
 
Chattanooga, Tennessee
10.0
   
150,350
   
Warehousing
 
150,350
 
Chattanooga, Tennessee
   
43,000
   
Manufacturing
 
43,000
 
Mississauga, Ontario, Canada
0.3
   
15,100
   
Warehousing
Office & Administration
Packaging
 
10,600
3,000
1,500
 
Basingstoke, Hampshire, England
     
2,143
   
Office & Administration
 
2,143
 
Limerick, Ireland
   
2,100
   
Office & Administration
 
2,100
 
Alimos Attica, Greece
   
194
   
Office & Administration
 
194
 
 
We are currently operating our manufacturing facilities at approximately 70% of total capacity. These manufacturing facilities are FDA registered and are capable of further utilization through the use of a full-time second shift and the addition of a third shift.
 
Item 3.   Legal Proceedings
 
See note 12 of notes to consolidated financial statements included in Item 8 “Financial Statements and Supplementary Data”.
 
Item 4.   Submission of Matters to a Vote of Security Holders
 
None
 
26

PART II
 
Item 5.   Market for the Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities
 
Market Information
 
Our common stock is traded on the Nasdaq Global Select Market under the symbol “CHTT”. The table below sets forth the high and low closing sales prices of our common stock as reported on the Nasdaq Global Select Market for the periods indicated.
 
Fiscal 2008
 
High
   
Low
 
First Quarter
  $ 81.45     $ 65.15  
Second Quarter
    79.58       62.21  
Third Quarter
    70.12       57.52  
Fourth Quarter
    79.84       63.05  
                 
Fiscal 2007
 
High
   
Low
 
First Quarter
  $ 58.45     $ 48.18  
Second Quarter
    64.80       50.23  
Third Quarter
    66.85       56.16  
Fourth Quarter
    74.48       62.17  
 
Holders
 
As of January 22, 2009, there were approximately 214 holders of record of our common stock. The number of record holders does not include beneficial owners whose shares are held in the names of banks, brokers, nominees or other fiduciaries.
 
Dividends
 
We have not paid dividends on our common stock during the past two fiscal years. We are restricted from paying dividends by the terms of the indenture under which our 7.0% Subordinated Notes were issued and by the terms of our Credit Facility.
 
Purchases of Equity Securities by the Issuer and Affiliated Purchasers
 
                 Period              
 
Total Number of Shares  Purchased
   
Average Price Paid
Per Share (1)
   
Total Number of Shares Purchased as Part of Publicly Announced Plans or   Programs (2)
   
Maximum Dollar Value of Shares that may yet be Purchased under the Plans or  Programs (2)
 
9/1/08-9/30/08
        $           $ 73,913,336  
10/1/08-10/31/08
                      73,913,336  
11/1/08-11/30/08
                      73,913,336  
Total Fourth Quarter
        $             73,913,336  

(1)           Average price paid per share includes broker commissions
(2)           On April 30, 2008, our Board of Directors increased the authorization to a total of $100.0 million of our common stock under the terms of our existing stock repurchase program.
 
 
27

Stock Performance Graph
 
The following is a graph comparing the cumulative total return to shareholders of the Company, assuming reinvestment of dividends, for the five-year period ending November 30, 2008 with the return from (i) the S&P 500 Index and (ii) a peer group of public companies engaged in either the functional toiletries, cosmetics or non-prescription drug business, for the same period.  The peer group consists of the following selected comparable companies: Alberto-Culver Co., Church & Dwight, Inc., Prestige Brands Holdings, Inc., Helen of Troy Ltd. and Elizabeth Arden, Inc.
 

 
 
 
2003
 
2004
 
2005
 
2006
 
2007
 
2008
Chattem, Inc.
$   100.00
 
$   226.08
 
$   198.30
 
$   303.65
 
$   442.62
 
$   472.33
S&P 500
$   100.00
 
$   110.93
 
$   118.08
 
$   132.62
 
$   139.97
 
$     84.69
Peer Group
$   100.00
 
$   116.12
 
$   108.70
 
$     89.04
 
$   106.73
 
$   106.39
 
 
 

 
 
 
28

Item 6.   Selected Financial Data
 
This selected financial data should be read in conjunction with Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and notes thereto included elsewhere in this Annual Report on Form 10-K.
 
   
Year Ended November 30,
 
   
2008
   
2007
   
2006
   
2005
   
2004
 
   
(dollars in thousand, except per share amount)
 
INCOME STATEMENT DATA:
                             
Total revenues
  $ 454,879     $ 423,378     $ 300,548     $ 279,318     $ 258,155  
Operating costs and expenses
    329,843       301,196       217,804       212,830       228,292  
Income from operations
    125,036       122,182       82,744       66,488       29,863  
Other expense, net
    (25,121 )     (31,103     (13,454 )     (13,478 )     (27,709 )
Income before income taxes
    99,915       91,079       69,290       53,010       2,154  
Provision for income taxes
    33,629       31,389       24,178       16,963       703  
Net income
  66,286     $ 59,690     $ 45,112     $ 36,047     $ 1,451  
PER SHARE DATA:
                                       
Income per diluted share
  $ 3.42     $ 3.08     $ 2.34     $ 1.77     $ .07  
BALANCE SHEET DATA:
(At end of year)
                                       
Total assets
  $ 792,972     $ 780,560     $ 415,313     $ 367,214     $ 372,642  
Long-term debt, less current maturities
  $ 456,500     $ 505,000     $ 232,500     $ 145,500     $ 200,000  
 
 
 
Item 7.   Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The following discussion and analysis of our financial condition and results of operations should be read together with Item 6, “Selected Financial Data”, and our consolidated financial statements and notes therein included elsewhere in this annual report on Form 10-K.
 
This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. The actual results may differ materially from those anticipated in these forward-looking statements as a result of a number of factors, including, but not limited to, those described in our filings with the Securities and Exchange Commission.
 
Overview
 
Founded in 1879, we are a leading marketer and manufacturer of a broad portfolio of branded over-the-counter (“OTC”) healthcare products, toiletries and dietary supplements including such categories as medicated skin care, topical pain care, oral care, internal OTC, medicated dandruff shampoos, dietary supplements and other OTC and toiletry products. Our portfolio of products includes well-recognized brands such as:
 
 
Gold Bond, Cortizone-10 and Balmex - medicated skin care;
 
 
Icy Hot, Aspercreme and Capzasin - topical pain care;
 
 
ACT and Herpecin-L - oral care;
 
 
Unisom, Pamprin and Kaopectate - internal OTC;
 
 
Selsun Blue - medicated dandruff shampoos;
 
 
Dexatrim, Garlique and New Phase - dietary supplements; and
 
 
Bullfrog, UltraSwim and Sun-In - other OTC and toiletry products.
 
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Our products target niche markets that are often outside the focus of larger companies where we believe we can achieve and sustain significant market share through innovation and strong advertising and promotion support. Many of our products are among the U.S. market leaders in their respective categories. For example, our portfolio of topical analgesic brands, our Cortizone-10 anti-itch ointment and our Gold Bond medicated body powders have the leading U.S. market share in their respective categories. We support our brands through extensive and cost-effective advertising and promotion, the expenditures for which represented approximately 26% of our total revenues in fiscal 2008. We sell our products nationally through mass merchandiser, drug and food channels, principally utilizing our own sales force.
 
Developments During Fiscal 2008
 
Products

In fiscal 2008, we introduced the following 11 product line extensions: Unisom Sleep Melts, Cortizone-10 Intensive Healing, Gold Bond Ultimate Restoring Lotion, Gold Bond Ultimate Foot Cream, Gold Bond Ultimate Soothing Lotion, Icy Hot PM Lotion, Icy Hot PM Patch, Aspercreme Heat Pain Relieving Gel, Aspercreme Nighttime Lotion, Dexatrim Max Daytime Control and Dexatrim Max Complex 7.

Product Recall

On February 8, 2008, we initiated a voluntary nationwide recall of our Icy Hot Heat Therapy product. Icy Hot Heat Therapy is an air-activated, self-heating disposable device for temporary relief of muscular and joint pain.  We recalled these products because we received some consumer reports of first, second and third degree burns and skin irritation resulting from the use or possible misuse of the product.  Based in part on consideration of on-hand factory inventory and retail point of sales data, during the first quarter of fiscal 2008 we recorded an estimate of approximately $6.0 million of recall expenses related to product returns, inventory obsolescence, destruction costs, consumer refunds, legal fees and other estimated expenses.  Subsequent to our first fiscal quarter, we increased our estimate of recall expenses by $0.3 million, to a total of $6.3 million, primarily as a result of additional legal fees and settlement payments.  The remaining accrued liability for product recall expenses was $0.8 million as of November 30, 2008.

Loss on Early Extinguishment of Debt

During the first quarter of fiscal 2008, we utilized borrowings under the revolving credit facility portion of our Credit Facility to repay $35.0 million of the term loan under the Credit Facility.  In connection with the term loan repayment, we retired a proportional share of the term loan debt issuance costs and recorded the resulting loss on extinguishment of debt of $0.5 million.

Stock Repurchase

During fiscal 2008, we repurchased 418,281 shares of our common stock under our stock repurchase program for $26.3 million at an average price per share of $62.94.

Litigation Settlement

During the third quarter of fiscal 2008, we reached a settlement on all 26 known claims alleging pulmonary arterial hypertension as a result of the ingestion of Dexatrim products in 1998 through 2003.  Included as litigation settlement in the consolidated statements of income is the settlement of the 26 claims totaling $13.3 million and $0.6 million of legal expenses, which were partially offset by $2.6 million of proceeds from the Dexatrim litigation settlement trust.

Subsequent Event

On December 4, 2008 we issued an aggregate of 487,123 shares of our common stock in exchange for $28.7 million in aggregate principal amount of our outstanding 2.0% Convertible Senior Notes due 2013 (“2.0% Convertible Notes”).  Upon completion of the transaction, the balance of the remaining 2.0% Convertible Notes was reduced to $96.3 million outstanding.
 
 
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Results of Operations
 
The following table sets forth for the periods indicated, certain items from our consolidated statements of income expressed as a percentage of total revenues:
 
   
Year Ended November 30,
 
   
2008
   
2007
   
2006
 
TOTAL REVENUES
    100.0 %     100.0 %     100.0 %
COSTS AND EXPENSES:
                       
Cost of sales
    28.9       30.5       31.3  
Advertising and promotion
    26.0       26.5       32.0  
Selling, general and administrative
    13.7       13.6       15.6  
Product recall expenses
    1.4              
Acquisition expenses
          0.5        
Litigation settlement
    2.5             (6.4 )  
Total costs and expenses
    72.5       71.1       72.5  
INCOME FROM OPERATIONS
    27.5       28.9       27.5  
OTHER INCOME (EXPENSE):
                       
Interest expense
    (5.6 )       (7.1 )       (3.9 )  
Investment and other income, net
    0.2       0.3       0.4  
Loss on early extinguishment of debt
    (0.1 )       (0.6 )       (0.9 )  
Total other income (expense)
    (5.5 )       (7.4 )       (4.4 )  
INCOME BEFORE INCOME TAXES
    22.0       21.5       23.1  
PROVISION FOR INCOME TAXES
    7.4       7.4       8.1  
NET INCOME
    14.6 %     14.1 %     15.0 %
 
Critical Accounting Estimates
 
The preparation of financial statements in accordance with U.S. generally accepted accounting principles requires management to use estimates.  Several different estimates or methods can be used by management that might yield different results.  The following are the significant estimates used by management in the preparation of the November 30, 2008 consolidated financial statements:
 
Allowance for Doubtful Accounts
 
As of November 30, 2008, an estimate was made of the collectibility of the outstanding accounts receivable balances.   This estimate requires the utilization of outside credit services, knowledge about the customer and the customer’s industry, new developments in the customer’s industry and operating results of the customer as well as general economic conditions and historical trends.  When all these facts are compiled, a judgment as to the collectibility of the individual account is made.   Many factors can impact this estimate, including those noted in this paragraph.  The adequacy of the estimated allowance may be impacted by the deterioration in the financial condition of a large customer, weakness in the economic environment resulting in a higher level of customer bankruptcy filings or delinquencies and the competitive environment in which the customer operates.  During the year ended November 30, 2008, we performed an assessment of the collectibility of trade accounts receivable and did not make any significant adjustments to our estimate of allowance for doubtful accounts.  The balance of allowance for doubtful accounts was $0.4 million at November 30, 2008 and 2007.
 
Revenue Recognition
 
Revenue is recognized when our products are shipped and title transfers to our customers.  It is generally our policy across all classes of customers that all sales are final.  As is common in the consumer products industry, customers return
 
 
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products for a variety of reasons including products damaged in transit, discontinuance of a particular size or form of product and shipping errors.  As sales are recorded, we accrue an estimated amount for product returns, as a reduction of these sales, based upon our historical experience and consideration of discontinued products, product divestitures, estimated inventory levels held by our customers and retail point of sale data on existing and newly introduced products.  The level of returns may fluctuate from our estimates due to several factors including weather conditions, customer inventory levels and competitive conditions.  We charge the allowance account for product returns when the customer provides appropriate supporting documentation that the product is properly destroyed or upon receipt of the product.
 
We separate returns into the two categories of seasonal and non-seasonal products.  We use the historical return detail of seasonal and non-seasonal products for at least the most recent three fiscal years on generally all products, which is normalized for any specific occurrence that is not reasonably likely to recur, to determine the amount of product returned as a percentage of sales, and estimate an allowance for potential returns based on product sold in the current period.  To consider product sold in current and prior periods, an estimate of inventory held by our retail customers is calculated based on customer inventory detail.  This estimate of inventory held by our customers, along with historical returns as a percentage of sales, is used to determine an estimate of potential product returns.  This estimate of the allowance for seasonal and non-seasonal returns is further analyzed by considering retail customer point of sale data.  We also consider specific events, such as discontinued product or product divestitures, when determining the adequacy of the allowance.
 
Our estimate of product returns for seasonal and non-seasonal products was $1.4 million and $1.3 million as of November 30, 2008, and $1.2 million and $1.3 million as of November 30, 2007 and November 30, 2006.  Due to higher sales volume during fiscal 2008, we increased our estimate of seasonal returns by approximately $0.2 million, which resulted in a decrease to net sales in our consolidated financial statements.  Higher sales volume in fiscal 2007 offset by customers returning seasonal products earlier in the season resulted in our estimate of returns for seasonal products remaining consistent as compared to fiscal 2006.  During fiscal 2008 and 2007, our estimate of non-seasonal returns remained consistent as compared to fiscal 2007 and 2006, respectively.  Each percentage point change in the seasonal return rate would impact net sales by approximately $0.2 million.  Each percentage point change in the non-seasonal return rate would impact net sales by approximately $0.6 million.
 
At November 30, 2006, based on consideration of the sales of Icy Hot Pro Therapy performing below expectations, review of retail point of sales data throughout fiscal 2006 and an estimate of inventory on hand at customers, we estimated returns of Icy Hot Pro Therapy as of November 30, 2006 of $3.3 million, which was included as a reduction of net sales.  During fiscal 2007, we continued to monitor Icy Hot Pro Therapy retail sales and inventory levels on-hand at customers and increased the specific reserve for Icy Hot Pro Therapy by $4.5 million as of November 30, 2007, which is included as a reduction of net sales in our consolidated financial statements.  As of November 30, 2007, the allowance remaining for Icy Hot Pro Therapy returns was $4.5 million.  During fiscal 2008, based on a revised estimate of inventory held by customers, we reduced the estimated remaining liability for returns by $1.5 million, which resulted in an increase to net sales in our consolidated financial statements.  As of November 30, 2008, the allowance remaining for Icy Hot Pro Therapy returns is $0.7 million.
 
We routinely enter into agreements with customers to participate in promotional programs.  The cost of these programs is recorded as either advertising and promotion expense or as a reduction of sales as prescribed by Emerging Issues Task Force 01-9, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products)”.  A significant portion of the programs are recorded as a reduction of sales and generally take the form of coupons and vendor allowances, which are normally taken via temporary price reductions, scan downs, display activity and participations in in-store programs provided uniquely by the customer.  We also enter into cooperative advertising programs with certain customers, the cost of which is recorded as advertising and promotion expense.  In order for retailers to receive reimbursement under such programs, the retailer must meet specified advertising guidelines and provide appropriate documentation of the advertisement being run.
 
We analyze promotional programs in two primary categories -- coupons and vendor allowances.  Customers normally utilize vendor allowances in the form of temporary price reductions, scan downs, display activity and participations in in-store programs provided uniquely by the customer.  We estimate the accrual for outstanding coupons by utilizing a third-party clearinghouse to track coupons issued, coupon value, distribution and expiration dates, quantity distributed and estimated redemption rates that are provided by us.  We estimate the redemption rates based on internal analysis of historical coupon redemption rates and expected future retail sales by considering recent point of sale data.  The estimate for vendor allowances is based on estimated unit sales of a product under a program and amounts committed for such programs in each fiscal year.  Estimated unit sales are determined by considering customer forecasted sales, point of sale data and the nature of the program
 
 
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being offered.  The three most recent years of expected program payments versus actual payments made and current year retail point of sale trends are analyzed to determine future expected payments.  Customer delays in requesting promotional program payments due to their audit of program participation and resulting request for reimbursement is also considered to evaluate the accrual for vendor allowances.  The costs of these programs are often variable based on the number of units actually sold.  As of November 30, 2008, the coupon accrual and reserve for vendor allowances were $1.8 million and $4.9 million, respectively, and $1.9 million and $5.5 million, respectively, as of November 30, 2007.  Each percentage point change in promotional program participation would impact net sales by $0.2 million and advertising and promotion expense by an insignificant amount.
 
Income Taxes

We account for income taxes using the asset and liability approach as prescribed by SFAS 109, FIN 48, FSP FIN 48-1 and other applicable FSP’s and FASB Interpretations.  This approach requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in our consolidated financial statements or tax returns.  Using the enacted tax rates in effect for the year in which the differences are expected to reverse, deferred tax assets and liabilities are determined based on the differences between the financial reporting and the tax basis of an asset or liability.  We adopted FIN 48, as amended by FSP FIN 48-1, on December 1, 2007.  FIN 48 clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with SFAS 109.  In connection with the adoption of FIN 48, we recognized an increase in the unrecognized tax benefits of $1.6 million, which is included in the consolidated financial statements as a reduction to retained earnings of $0.7 million and an increase to deferred tax assets of $0.9 million.  We had a total unrecognized tax benefit of $2.2 million as of December 1, 2007.  Our effective tax rate was 33.7% for fiscal 2008, as compared to 34.5% in fiscal 2007 and 34.9% in fiscal 2006.

Accounting for Acquisitions and Intangible Assets

We account for our acquisitions under the purchase method of accounting for business combinations as prescribed by SFAS No. 141, “Business Combinations” (“SFAS 141”).  Under SFAS 141, the cost, including transaction costs, are allocated to the underlying net assets, based on their respective estimated fair values.  Business combinations consummated beginning in the first quarter of our fiscal 2010 will be accounted for under SFAS No. 141R, “Business Combinations” (“SFAS 141R”).

We account for our intangible assets in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”).  Under SFAS 142, intangible assets with indefinite useful lives are not amortized but are reviewed for impairment at least annually. Intangible assets with finite lives are amortized over their estimated useful lives using the straight-line method.

The judgments made in determining the estimated fair value and expected useful lives assigned to each class of assets and liabilities acquired can significantly affect net income.  For example, the useful life of property, plant, and equipment acquired will differ substantially from the useful life of brand licenses and trademarks.  Consequently, to the extent a longer-lived asset is ascribed greater value under the purchase method than a shorter-lived asset or a value is assigned to an indefinite-lived asset, net income in a given period may be higher.

Determining the fair value of certain assets and liabilities acquired is judgmental in nature and often involves the use of significant estimates and assumptions.  An area that requires significant judgment is the fair value and useful lives of intangible assets.  In this process, we often obtain the assistance of a third party valuation firm for certain intangible assets.

Our intangible assets consist of exclusive brand licenses, trademarks and other intellectual property, customer relationships and non-compete agreements.  We have determined that our trademarks have indefinite useful lives, as cash flows from the use of the trademarks are expected to be generated indefinitely. The useful lives of our intangible assets are reviewed as circumstances dictate in accordance with the provisions of SFAS 142.

The value of our intangible assets is exposed to future adverse changes if we experience declines in operating results or experience significant negative industry or economic trends.  We review our indefinite-lived intangible assets for impairment at least annually by comparing the carrying value of the intangible assets to their estimated fair value.  The estimate of fair value is determined by discounting the estimate of future cash flows of the intangible assets.  Consistent with our policy, we perform the annual impairment testing of our indefinite-lived intangible assets during the quarter ended November 30, with the most recent test performed in the quarter ended November 30, 2008.  No impairment or adjustment to the carrying value of our indefinite-lived intangible assets was required as a result of this testing.

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In January 2007, we completed the acquisition of the U.S. rights to five consumer and OTC brands from Johnson & Johnson (“J&J Acquisition”).  The acquired brands were: ACT, Unisom, Cortizone-10, Kaopectate, and Balmex.  In May 2007, we acquired the worldwide trademark and rights to sell and market ACT in Western Europe from Johnson & Johnson (“ACT Acquisition”).

Fair Value Measurements
 
On December 1, 2007, we adopted SFAS 157 as it pertains to financial assets and liabilities, which provides guidance for using fair value to measure assets and liabilities.  SFAS 157 applies both to items recognized and reported at fair value in the financial statements and to items disclosed at fair value in the notes to the financial statements.  SFAS 157 does not change existing accounting rules governing what can or must be recognized and reported at fair value and clarifies that fair value is defined as the price received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date.  Additionally, SFAS 157 does not eliminate practicability exceptions that exist in accounting pronouncements amended by SFAS 157 when measuring fair value.  As a result, we are not required to recognize any new assets or liabilities at fair value.  SFAS 157-2 defers the date of SFAS 157 for nonfinancial assets and liabilities and is effective in our fiscal 2009.
 
SFAS 157 also establishes a framework for measuring fair value.  Fair value is generally determined based on quoted market prices in active markets for identical assets or liabilities.  If quoted market prices are not available, SFAS 157 provides guidance on alternative valuation techniques that place greater reliance on observable inputs and less reliance on unobservable inputs.
 
Stock-Based Compensation

We account for stock-based compensation under the provisions of SFAS 123R, which requires the recognition of the cost of employee services received in exchange for an award of equity instruments in the financial statements and is measured based on the grant date fair value of the award.  The fair value of each stock option grant is estimated using a Flex Lattice Model.  The input assumptions used in determining fair value are the expected life of the stock options, the expected volatility of our common stock, the risk-free interest rate over the expected life of the option and the expected forfeiture rate of the options granted.  We recognize stock option compensation expense over the period during which an employee provides service in exchange for the award (the vesting period).

For additional information regarding our significant accounting policies, see note 2 of notes to consolidated financial statements.
 

 
 
 
 
 
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Fiscal 2008 Compared to Fiscal 2007
 
To facilitate discussion of our operating results for the years ended November 30, 2008 and 2007, we have included the following selected data from our consolidated statements of income:
 
   
For the Year Ended November 30,
 
               
Increase ( Decrease)
 
   
2008
   
2007
   
Amount
   
Percentage
 
   
(dollars in thousands)
 
       
Domestic net sales
  $ 423,088     $ 393,493     $ 29,595       7.5 %
International revenues (including royalties)
    31,791       29,885       1,906       6.4  
Total revenues
    454,879       423,378       31,501       7.4  
Cost of sales
    131,620       129,055       2,565       2.0  
Advertising and promotion expense
    118,093       112,206       5,887       5.2  
Selling, general and administrative expense
    62,590       57,878       4,712       8.1  
Product recall expenses
    6,269             6,269       100.0  
Acquisition expenses
          2,057       (2,057 )     (100.0 )
Litigation settlement
    11,271             11,271       100.0  
Interest expense
    25,310       29,930       (4,620 )     (15.4
Loss on early extinguishment of debt
    526       2,633       (2,107 )     (80.0
Net income
    66,286       59,690       6,596       11.1  
 
Domestic Net Sales
 
Domestic net sales for fiscal 2008 increased $29.6 million, or 7.5%, to $423.1 million from $393.5 million in fiscal 2007. A comparison of domestic net sales for the categories of products included in our portfolio of OTC healthcare products is as follows:
 
   
For the Year Ended November 30,
 
               
Increase ( Decrease)
 
   
2008
   
2007
   
Amount
   
Percentage
 
   
(dollars in thousands)
 
       
Medicated skin care
  $ 141,942     $ 123,456     $ 18,486       15.0 %
Topical pain care
    96,779       95,858       921       1.0  
Oral care
    62,872       48,863       14,009       28.7  
Internal OTC
    48,006       45,043       2,963       6.6  
Medicated dandruff shampoos
    35,737       36,934       (1,197 )     (3.2 )
Dietary supplements
    19,491       26,121       (6,630 )     (25.4 )
Other OTC and toiletry products
    18,261       17,218       1,043       6.1  
Total
  $ 423,088     $ 393,493     $ 29,595       7.5  

 
Net sales growth in the medicated skin care category increased $18.5 million, or 15.0%, in fiscal 2008 compared to fiscal 2007 as a result of the launch of Gold Bond Ultimate Restoring Lotion and Cortizone-10 Intensive Healing in the first quarter of fiscal 2008, the continued success of Gold Bond Ultimate Softening Lotion and our ownership of the Cortizone-10 and Balmex brands for the entire twelve month period of fiscal 2008 compared to only eleven months of ownership in fiscal 2007.

Net sales in the topical pain care category increased $0.9 million, or 1.0%, in fiscal 2008 compared to fiscal 2007, principally due to increases in Icy Hot and Aspercreme, led by the new products introduced in the first quarter of fiscal 2008, Icy Hot PM Lotion, Icy Hot PM Patch, Aspercreme Heat Pain Gel and Aspercreme Nighttime Lotion, offset by declines in Capzasin and the discontinuance of shipments of Icy Hot Heat Therapy following our February 8, 2008 voluntary recall of the product. Excluding sales of Icy Hot Heat Therapy and Icy Hot Pro Therapy, sales in the category increased 6.9% compared to the prior year period.

35

Net sales in the oral care category increased $14.0 million, or 28.7%, in fiscal 2008 compared to fiscal 2007.  The increase primarily results from our ownership of the ACT brand for the entire twelve month period of fiscal 2008 compared to only eleven months of ownership in fiscal 2007 and an expanded distribution base.

Net sales in the internal OTC category increased $3.0 million, or 6.6%, in fiscal 2008 compared to fiscal 2007 as a result of our ownership of the Unisom and Kaopectate brands for the entire twelve month period of fiscal 2008 compared to only eleven months of ownership in fiscal 2007 and the introduction of Unisom SleepMelts in the second quarter of fiscal 2008.

Net sales in the medicated dandruff shampoos category decreased $1.2 million, or 3.2%, in fiscal 2008 compared to fiscal 2007 primarily due to declining sales of Selsun Salon, which were partially offset by a full year of sales of Selsun Blue Naturals, which began shipping in the second quarter of fiscal 2007.

Net sales in the dietary supplements category decreased $6.6 million, or 25.4%, in fiscal 2008 compared to fiscal 2007.  Net sales of Dexatrim decreased 36.9% primarily resulting from increased competitive pressures in the diet-aid category, a decline in sales of Dexatrim Max2O and increased returns of Dexatrim mainly from several retailers discontinuing Dexatrim Max2O, partially offset by the launch of Dexatrim Max Daytime Control in the first quarter of fiscal 2008 and Dexatrim Max Complex 7, which began shipping in the third quarter of fiscal 2008.

Net sales in the other OTC and toiletry products category increased $1.0 million, or 6.1%, in fiscal 2008 compared to fiscal 2007 driven primarily by an increase in fourth quarter shipments of Bullfrog as a result of expanded distribution in key retailers and the early season shipments of upgraded product formulas for the 2009 suncare season.

Domestic sales variances were principally the result of changes in unit sales volume with the exception of certain products for which we implemented a unit sales price increase effective April 2008.
 
International Revenues
 
For fiscal 2008, international revenues increased $1.9 million, or 6.4%, to $31.8 million from $29.9 million in fiscal 2007.  The increase was primarily due to favorable exchange rates that increased net sales approximately $1.5 million in fiscal 2008 and a full twelve months of ownership of ACT internationally in fiscal 2008 compared to seven months of ownership in fiscal 2007.
 
Cost of Sales
 
Cost of sales in fiscal 2008 increased $2.6 million, or 2.0%, to $131.6 million from $129.1 million in fiscal 2007.  Cost of sales as a percentage of total revenues was 28.9% for fiscal 2008 as compared to 30.5% for fiscal 2007.  The decrease in cost of sales as a percentage of total revenues was primarily due to the integration of manufacturing of certain of the acquired brands from the J&J Acquisition in the fourth quarter of fiscal 2007, partially offset by an increase in fuel costs in 2008 resulting in higher inbound freight expense.
 
Advertising and Promotion Expense
 
Advertising and promotion expenses in fiscal 2008 increased $5.9 million, or 5.2%, to $118.1 million from $112.2 million in fiscal 2007 and were 26.0% of total revenues for fiscal 2008 compared to 26.5% for fiscal 2007.  The increase in advertising and promotion expenses results from higher expenditures for advertising and promotion in fiscal 2008 in connection with the ownership of the brands acquired in the J&J Acquisition for the entire twelve month period of fiscal 2008 as compared to eleven months of ownership in fiscal 2007.
 
Selling, General and Administrative Expense
 
Selling, general and administrative expenses increased $4.7 million, or 8.1%, to $62.6 million from $57.9 million in fiscal 2007.  Selling, general and administrative expenses were 13.7% and 13.6% of total revenues for fiscal 2008 and fiscal
 
36

2007, respectively.  The increase in selling, general and administrative expenses as a percentage of total revenues was largely attributable to the absorption of transition service costs similar to those paid to Johnson & Johnson related to freight and administrative costs that were recorded as acquisition expenses in fiscal 2007 and an increase in fuel costs in 2008 resulting in higher outbound freight expense.
 
Product Recall Expenses
 
On February 8, 2008, we initiated a voluntary nationwide recall of our Icy Hot Heat Therapy product. Icy Hot Heat Therapy is an air-activated, self-heating disposable device for temporary relief of muscular and joint pain.  We recalled these products because we received some consumer reports of first, second and third degree burns and skin irritation resulting from the use or possible misuse of the product.  Based in part on consideration of on-hand factory inventory and retail point of sales data, during the first quarter of fiscal 2008 we recorded an estimate of approximately $6.0 million of recall expenses related to product returns, inventory obsolescence, destruction costs, consumer refunds, legal fees and other estimated expenses.  Subsequent to our first fiscal quarter, we increased our estimate of recall expenses by $0.3 million, to a total of $6.3 million, primarily as a result of additional legal fees and settlement payments.  The remaining accrued liability for product recall expenses was $0.8 million as of November 30, 2008.

Acquisition Expenses
 
Acquisition expenses for fiscal 2007 reflect the costs incurred for transition services, including consumer affairs, distribution and collection services, related to the J&J Acquisition.  The distribution and collection services were terminated in April 2007 and the consumer affairs services were terminated in June 2007.
 
Litigation Settlement
 
During the third quarter of fiscal 2008, we reached a settlement on all 26 known claims alleging pulmonary arterial hypertension as a result of the ingestion of Dexatrim products in 1998 through 2003.  Included as litigation settlement in the consolidated statements of income is the settlement of the 26 claims totaling $13.3 million and $0.6 million of legal expenses, which were partially offset by $2.6 million of proceeds from the Dexatrim litigation settlement trust.

Interest Expense
 
Interest expense decreased $4.6 million, or 15.4%, in fiscal 2008 compared to fiscal 2007 reflecting a reduction in the principal portion of debt since August 31, 2007.  Until our indebtedness is reduced substantially, interest expense will continue to represent a significant percentage of our income from operations.

Loss on Early Extinguishment of Debt
 
During the first quarter of fiscal 2008, we utilized borrowings under the revolving credit facility portion of our Credit Facility to repay $35.0 million of the term loan under the Credit Facility.  In connection with the term loan repayment, we retired a proportional share of the term loan debt issuance costs and recorded the resulting loss on extinguishment of debt of $0.5 million.  In April 2007, we utilized the net proceeds from the 1.625% Convertible Notes and borrowings under the revolving credit facility portion of our Credit Facility to repay $128.0 million of the term loan under the Credit Facility.  In July 2007, we utilized borrowings under the revolving credit facility portion of our Credit Facility to repay an additional $25.0 million of the term loan under the Credit Facility.  In connection with the term loan repayments, we retired a proportional share of the term loan debt issuance costs and recorded the resulting loss on early extinguishment of debt of $2.6 million during fiscal 2007.

Income Taxes
 
The effective tax rate decreased from 34.5% in fiscal 2007 to 33.7% in fiscal 2008 primarily as a result of higher inventory contributions and an increase in the statutory percentage used to determine the tax deduction related to domestic production activities.


37

Fiscal 2007 Compared to Fiscal 2006
 
To facilitate discussion of our operating results for the years ended November 30, 2007 and 2006, we have included the following selected data from our consolidated statements of income:
 
   
For the Year Ended November 30,
 
               
 Increase (Decrease)
 
   
2007
   
2006
   
 Amount
   
Percentage
 
   
(dollars in thousands)
 
       
Domestic net sales
  $ 393,493     $ 276,397     $ 117,096       42.4 %
International revenues (including royalties)
    29,885       24,151       5,734       23.7  
Total revenues
    423,378       300,548       122,830       40.9  
Cost of sales
    129,055       94,036       35,019       37.2  
Advertising and promotion expense
    112,206       96,071       16,135       16.8  
Selling, general and administrative expense
    57,878       46,989       10,889       23.2  
Acquisition expenses
    2,057             2,057       100.0  
Litigation settlement
          (19,292 )     (19,292     (100.0 )   
Interest expense
    29,930       11,725       18,205       155.3  
Loss on early extinguishment of debt
    2,633       2,805       (172     (6.1 )   
Net income
    59,690       45,112       14,578       32.3  
 
 
Domestic Net Sales
 
Domestic net sales for fiscal 2007 increased $117.1 million, or 42.4%, as compared to fiscal 2006.   A comparison of domestic net sales for the categories of products included in our portfolio of OTC healthcare products is as follows:
 
   
 For the Year Ended November 30,
 
               
Increase (Decrease)
 
   
2007
   
2006
   
Amount
   
Percentage
 
   
(dollars in thousands)
 
       
Medicated skin care
  $ 123,456     $ 67,238     $ 56,218       83.6 %
Topical pain care
    95,858       101,396       (5,538 )     (5.5 )  
Oral care
    48,863       6,773       42,090       621.5  
Internal OTC
    45,043       11,958       33,085       276.7  
Medicated dandruff shampoos
    36,934       37,742       (808 )     (2.1 )  
Dietary supplements
    26,121       35,081       (8,960 )     (25.5 )  
Other OTC and toiletry products
    17,218       16,209       1,009       6.2  
Total
  $ 393,493     $ 276,397     $ 117,096       42.4  

 
Net sales growth in the medicated skin care products category was a result of the acquisition of Cortizone-10 and Balmex in the first fiscal quarter of fiscal 2007 (brands acquired in the J&J Acquisition) and a 20% sales increase of the total Gold Bond franchise in fiscal 2007 as compared to fiscal 2006, led by increases of 35%, 19% and 8% in the lotion, foot care and powder lines, respectively.  The increase in the Gold Bond lotion line was led by a full year of sales for Ultimate Softening Lotion, which was launched in the fourth quarter of fiscal 2006.
 
The decline in net sales in the topical pain care category was primarily attributable to reduced sales of Icy Hot Pro Therapy, which was originally launched in fiscal 2006.  Contributing to the decrease in net sales was a $4.5 million charge for expected returns of Icy Hot Pro Therapy recorded in the fourth quarter of fiscal 2007, which resulted in lower net sales and reduced gross margins.  Sportscreme and Aspercreme experienced sales declines of 31% and 9%, respectively, in fiscal 2007.  This decrease was offset in part by the launch of Icy Hot Heat Therapy in fiscal 2007 and a 7% increase in the base Icy Hot business, led by the launch in fiscal 2007 of the Icy Hot XL Back Patch and Icy Hot Vanishing Scent Cream.
 
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The net sales growth in the oral care category was attributable to ACT, which was acquired as part of the J&J Acquisition.
 
The net sales growth in the internal OTC category was attributable to Unisom and Balmex, which were acquired as part of the J&J Acquisition.
 
The decline in net sales in the medicated dandruff shampoos category was a result of lower sales of Selsun Salon in fiscal 2007 when compared to fiscal 2006, the product’s first full year of sales.  The overall decline was offset in part by a 3% increase in Selsun Blue sales, partially as a result of the launch of Selsun Blue Naturals in fiscal 2007.
 
The decline in net sales in the dietary supplements category in fiscal 2007 was a result of a 29% sales decrease of Dexatrim, resulting from increased competitive pressures in the category and the decline in sales of Dexatrim Max2O after its initial launch in fiscal 2006.  Also contributing to the decline were 23% lower Garlique sales and a 33% decline in New Phase sales.
 
The higher net sales in the other OTC and toiletry products category was due principally to the introduction of Bullfrog Marathon Mist in fiscal 2007.
 
Domestic sales variances were principally the result of changes in unit sales volumes.
 
International Revenues
 
For fiscal 2007, international revenues increased $5.7 million, or 23.7%, as compared to fiscal 2006, primarily due to the brands acquired in the J&J Acquisition and the ACT Acquisition in fiscal 2007.  Sales variances for international operations were principally the result of changes in unit sales volumes.
 
Cost of Sales
 
Cost of sales in fiscal 2007 increased $35.0 million, or 37.2%, to $129.1 million from $94.0 million in fiscal 2006.  Cost of sales as a percentage of total revenues was 30.5% for fiscal 2007 as compared to 31.3% for fiscal 2006.  The decrease in cost of sales as a percentage of total revenues was attributable to an increase in sales of products with lower cost of sales in fiscal 2007 as compared to fiscal 2006, offset by an estimate recorded for potentially obsolete inventory related to our Icy Hot Pro Therapy line of products.  Based on our evaluation of the carrying value of Icy Hot Pro Therapy inventory in fiscal 2007 and fiscal 2006, including a review of retail point of sale data, on hand inventory and purchase commitments, a reserve was recorded for potentially obsolete inventory of $2.5 million and $2.0 million during the fourth quarter of fiscal 2007 and 2006, respectively, which increased cost of sales in our consolidated financial statements.
 
Advertising and Promotion Expense
 
Advertising and promotion expenses for fiscal 2007 increased $16.1 million, or 16.8%, as compared to the same period in fiscal 2006 and were 26.5% and 32.0% of total revenues in fiscal 2007 and 2006, respectively.  The decrease in advertising and promotion expense as a percentage of revenue for the current period reflected higher advertising and promotion spending, as a percentage of revenue, for Icy Hot Pro Therapy and Selsun Salon during the fiscal 2006 launch period.
 
Selling, General and Administrative Expense
 
Selling, general and administrative expenses for fiscal 2007 increased $10.9 million, or 23.2%, as compared to fiscal 2006 and were 13.6% and 15.6% of total revenues fiscal 2007 and 2006, respectively.  The decrease as a percentage of revenue was attributable to increased revenue from the brands acquired in fiscal 2007 without commensurate increases in selling, general and administrative expenses.
 
 
 
 
39

Acquisition Expenses
 
Acquisition expenses for fiscal 2007 reflect the costs incurred for transition services, including consumer affairs, distribution and collection services, related to the J&J Acquisition.  The distribution and collection services were terminated in April 2007 and the consumer affairs services were terminated in June 2007.
 
Litigation Settlement
 
Litigation settlement for fiscal 2006 reflected the $8.8 million recovery from the DELACO settlement trust in the first quarter of 2006, the $10.7 million recovery from the settlement trust in the third quarter of 2006 in the Dexatrim litigation settlement and net legal expenses related to the Dexatrim litigation of $0.2 million.  No corresponding benefit was recorded in fiscal 2007.
 
Interest Expense
 
Interest expense increased $18.2 million, or 155.3%, in fiscal 2007 as compared to fiscal 2006 as a result of additional indebtedness incurred to finance the J&J Acquisition.  Until our indebtedness is reduced substantially, interest expense will continue to represent a significant percentage of our total revenues.
 
Loss on Early Extinguishment of Debt
 
In April 2007, we utilized the net proceeds from the 1.625% Convertible Notes and borrowings under the revolving credit facility portion of our Credit Facility to repay $128.0 million of the term loan under the Credit Facility.   In July 2007, we utilized borrowings under the revolving credit facility portion of our Credit Facility to repay an additional $25.0 million of the term loan under the Credit Facility.  In connection with the term loan repayments, we retired a proportional share of the term loan debt issuance costs and recorded the resulting loss on early extinguishment of debt of $2.6 million.  Our $75.0 million of Floating Rate Senior Notes were fully redeemed in the first quarter of fiscal 2006, resulting in a loss on early extinguishment of debt of $2.8 million.
 
Liquidity and Capital Resources
 
We have historically funded our operations with a combination of internally generated funds and borrowings.  Our principal uses of cash are for operating expenses, servicing long-term debt, acquisitions, working capital, repurchases of our common stock, payment of income taxes and capital expenditures.
 
Net cash provided by operations in fiscal 2008 increased $5.5 million to $92.2 million as compared to $86.7 million in fiscal 2007.  The increase was primarily the result of higher net income, an increase in deferred taxes, a decrease in inventory as the integration of manufacturing of certain of the acquired brands from the J&J Acquisition has been completed and a decrease in the change in accounts receivable as compared to the fiscal 2007 change in accounts receivable as a result of the fiscal 2007 revenue increase from the J&J Acquisition.  The increase was partially offset by a reduction in the change in accounts payable and accrued liabilities as compared to the fiscal 2007 change in accounts payable and accrued liabilities as a result of the J&J Acquisition.

Investing activities used cash of $6.2 million and $420.2 million in fiscal 2008 and 2007, respectively.  The decrease in cash used in investing activities was a result of lower purchases of equipment for manufacturing operations in fiscal 2008 and the absence of an acquisition in fiscal 2008 like the J&J Acquisition in fiscal 2007.
 
Financing activities used cash of $69.1 million and provided cash of $257.9 million in fiscal 2008 and 2007, respectively.  In fiscal 2008, the financing activities cash was used to reduce borrowings outstanding under our Credit Facility and repurchase shares of our common stock.  In fiscal 2007, the financing activities cash was provided to fund the J&J Acquisition and was partially offset by cash used to reduce borrowings outstanding under our Credit Facility and repurchase shares of our common stock.
 
As of November 30, 2008, our total debt was $459.5 million, consisting of the 7.0% Subordinated Notes of $107.5 million, the 2.0% Convertible Notes of $125.0 million, the 1.625% Convertible Notes of $100.0 million, $107.5 million outstanding
 
 
40

from a term loan under our Credit Facility and $19.5 million outstanding under our Amended Revolving Credit Facility.  In November 2006, we entered into an interest rate swap with decreasing notional principal amounts beginning in October 2007 and a swap rate of 4.98% over the life of the agreement.  As of November 30, 2008, we were in compliance with all covenants in our Credit Facility.
 
During fiscal 2008, we repurchased 0.4 million shares of our common stock for $26.3 million.  Effective April 30, 2008, our Board of Directors increased the authorization to repurchase up to an additional $100.0 million of our common stock under the terms of a stock repurchase program, and there remains $73.9 million available under such authorization to repurchase shares.
 
We believe that cash provided by operating activities, our cash and cash equivalents balance and funds available under the revolving credit facility portion of our Credit Facility will be sufficient to fund our capital expenditures, debt service and working capital requirements for the foreseeable future as our business is currently conducted.  It is likely that any acquisitions we make in the future will require us to obtain additional financing.  If additional financing is required, there are no assurances that it will be available, or, if available, that it can be obtained on terms favorable to us or not dilutive to our future earnings.
 
Contractual Obligations
 
The following data summarizes our contractual obligations as of November 30, 2008.  We had no commercial obligations as of November 30, 2008.
 
   
Payments due by
 
Contractual Obligations:
 
Total
   
Within 1 year
   
2-3 years
   
4-5 years
   
After 5 years
 
   
(dollars in thousands)
 
Long-term debt
  $ 459,500     $ 3,000     $ 25,500     $ 223,500     $ 207,500  
Interest payments
    90,133       19,325       36,820       29,413       4,575  
Operating leases
    887       547       267       49       24  
Purchase commitments
    47,816       18,302       27,855       1,106       553  
Endorsements
    5,000       1,850       3,150              
Total
  $ 603,336     $ 43,024     $ 93,592     $ 254,068     $ 212,652  
 
 
Purchase orders or contracts for the purchase of inventory and other goods and services are not included in the table above.  We are not able to determine the aggregate amount of such purchase orders that represent contractual obligations, as purchase orders may represent authorizations to purchase rather than binding agreements.  Our purchase orders are based on our current distribution needs and are fulfilled by our vendors within short time horizons.  Other than as presented in the table above, we do not have significant agreements for the purchase of inventory or other goods specifying minimum quantities or fixed prices that exceed our expected requirements for three months.  We have also excluded from the table above the liability for unrecognized tax benefits due to the uncertainty of payment and amount of payment per period.  As of November 30, 2008, we have a gross liability for unrecognized tax benefits, including interest, of $1.3 million (see Note 7 to the consolidated financial statements).
 
Interest payments consist of interest at the November 30, 2008 effective rate of 6.07% per annum on the $19.5 million revolving credit facility portion of our Credit Facility due 2010, the November 30, 2008 effective rate of 6.57% per annum on the $107.5 million term loan portion of our Credit Facility due 2013, the 7.0% Subordinated Notes due 2014, the 2.0% Convertible Notes due 2013 and the 1.625% Convertible Notes due 2014.
 
We have no existing off-balance sheet financing arrangements.
 
 
Foreign Operations
 
Historically, our primary foreign operations have been conducted through our Canadian and United Kingdom (“U.K.”) subsidiaries.  Since November 1, 2004, our European business has been conducted through Chattem Global Consumer Products Limited, a wholly-owned subsidiary located in Limerick, Ireland.  In connection with the ACT Acquisition, we have been conducting business in Greece through Chattem Greece, a wholly-owned subsidiary located in Alimos Attica, Greece.  In the fourth quarter of fiscal 2008, we established Chattem Peru SRL (“Chattem Peru”) a wholly-owned subsidiary located in Lima,
 
41

Peru.  Chattem Peru utilizes third party distributors to sell certain of our Selsun Blue products throughout Peru.  The functional currencies of these subsidiaries are Canadian dollars, British pounds and Euros, respectively.  Fluctuations in exchange rates can impact operating results, including total revenues and expenses, when translations of the subsidiary financial statements are made in accordance with SFAS No. 52, “Foreign Currency Translation”.  For fiscal 2008 and 2007, these subsidiaries accounted for 7% of total consolidated revenues, respectively, and 2% of total consolidated assets, respectively.  It has not been our practice to hedge our assets and liabilities in Canada, the U.K., Ireland, Greece, and Peru or our intercompany transactions due to the inherent risks associated with foreign currency hedging transactions and the timing of payments between us and our foreign subsidiaries.  Historically, gains or losses from foreign currency transactions have not had a material impact on our operating results.  Losses of $1.0 million and gains of $0.3 million from foreign currency transactions for the years ended November 30, 2008 and 2007, respectively, are included in selling, general and administrative expenses in the consolidated statements of income.
 
Recent Accounting Pronouncements
 
See note 2 of notes to consolidated financial statements included in Item 8 “Financial Statements and Supplementary Data.”
 
Forward Looking Statements
 
We may from time to time make written and oral forward-looking statements. Written forward-looking statements may appear in documents filed with the Securities and Exchange Commission, in press releases and in reports to shareholders or be made orally in publicly accessible conferences or conference calls. The Private Securities Litigation Reform Act of 1995 contains a safe harbor for forward-looking statements. We rely on this safe harbor in making such disclosures. These forward-looking statements generally can be identified by use of phrases such as “believe,” “plan,” “expect,” “anticipate,” “intend,” “forecast” or other similar words or phrases.  These forward-looking statements relate to, among other things, our strategic and business initiatives and plans for growth or operating changes; our financial condition and results of operation; future events, developments or performance; and management’s expectations, beliefs, plans, estimates and projections.  The forward-looking statements are based on management’s current beliefs and assumptions about expectations, estimates, strategies and projections. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in such forward-looking statements. We undertake no obligation to update publicly any forward-looking statements whether as a result of new information, future events or otherwise. Factors that could cause our actual results to differ materially from those anticipated in the forward-looking statements in this Form 10-K and the documents incorporated herein by reference include the following:
 

 
we face significant competition in the OTC healthcare, toiletries and dietary supplements markets;
 
our business could be adversely affected by a prolonged downturn or recession in the United States and/or the other countries in which we conduct significant business;
 
we may be adversely effected by factors affecting our customer’s businesses;
 
we rely on a few large customers, particularly Wal-Mart Stores, Inc., for a significant portion of our sales;
 
our acquisition strategy is subject to risk and may not be successful;
 
our initiation of a voluntary recall of our Icy Hot Heat Therapy products could expose us to additional product liability claims;
 
we may receive additional claims that allege personal injury from ingestion of Dexatrim;
 
litigation may adversely affect our business, financial condition and results of operations;
 
we have a significant amount of debt that could adversely affect our business and growth prospects;
 
we may discontinue products or product lines, which could result in returns and asset write-offs, and/or engage in product recalls, any of which would reduce our cash flow and earnings;
 
our product liability insurance coverage may be insufficient to cover existing or future liability claims;
 
our business is regulated by numerous federal, state and foreign governmental authorities, which subjects us to elevated compliance costs and risks of non-compliance;
 
our success depends on our ability to anticipate and respond in a timely manner to changing consumer preferences;
 
our projections of earnings are highly subjective and our future earnings could vary in a material amount from our projections;
 
 
42

 
we may be adversely affected by fluctuations in buying decisions of mass merchandise, drug and food trade buyers and the trend toward retail trade consolidation;
 
we rely on third party manufacturers for a portion of our product portfolio, including products under our Gold Bond, Icy Hot, Selsun, Dexatrim, ACT, Unisom and Cortizone-10 brands;
 
our dietary supplement business could suffer as a result of injuries caused by dietary supplements in general, unfavorable scientific studies or negative press;
 
our business could be adversely affected if we are unable to successfully protect our intellectual property or defend claims of infringement by others;
 
because most of our operations are located in Chattanooga, Tennessee, we are subject to regional and local risks;
 
we depend on sole or limited source suppliers for ingredients in certain of our products, and our inability to buy these ingredients would prevent us from manufacturing these products;
 
we are subject to the risk of doing business internationally;
 
the terms of our outstanding debt obligations limit certain of our activities;
 
to service our indebtedness, we will require a significant amount of cash;
 
our operations are subject to significant environmental laws and regulations;
 
we are dependent on certain key executives, the loss of whom could have a material adverse effect on our business;
 
our shareholder rights plan and charter contain provisions that may delay or prevent a merger, tender offer or other change of control of us;
 
the trading price of our common stock may be volatile;
 
we have no current intentions of paying dividends to holders of our common stock;
 
we can be affected adversely and unexpectedly by the implementation of new, or changes in the interpretation of existing, accounting principles generally accepted in the United States of America (“GAAP”);
 
identification of a material weakness in our internal controls over financial reporting may adversely affect our financial results;
 
the convertible note hedge and warrant transactions may affect the value of our common stock and our convertible notes;
 
conversion of our convertible notes may dilute the ownership interest of existing shareholders, including holders who had previously converted their convertible notes;
 
virtually all of our assets consists of intangibles; and
 
other risks described in our Securities and Exchange Commission filings.
 
 
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
 
We are exposed to market risk from changes in interest rates and foreign currency exchange rates, which may adversely affect our results of operations and financial condition.  We seek to minimize the risks from these interest rates and foreign currency exchange rate fluctuations through our regular operating and financing activities.
 
Our exposure to interest rate risk currently relates to amounts outstanding under our Credit Facility.  Loans under the revolving credit facility portion of our Credit Facility bear interest at LIBOR plus applicable percentages of 0.875% to 1.50% or the higher of the federal funds rate plus 0.50% or the prime rate (the “Base Rate”).  The applicable percentages are calculated based on our leverage ratio.  The term loan under our Credit Facility bears interest at either LIBOR plus 1.75% or the Base Rate plus 0.75%.  As of November 30, 2008, $19.5 million was outstanding under the revolving credit facility and $107.5 million was outstanding under the term loan portion of our Credit Facility.  The variable rate for the revolving credit facility was LIBOR plus 1.25%, or 6.07% as of November 30, 2008, and the variable rate for the term loan portion was LIBOR plus 1.75%, or 6.57%, as of November 30, 2008.  The 7.0% Subordinated Notes, the 1.625% Convertible Notes and the 2.0% Convertible Notes are fixed interest rate obligations.
 
In November 2006, we entered into an interest rate swap (“swap”) agreement effective January 2007.  The swap has decreasing notional principal amounts beginning in October 2007 and a swap rate of 4.98% over the life of the agreement.  As of November 30, 2008, the decrease in fair value of $0.1 million, net of tax, was recorded to other comprehensive income.  The swap was deemed to be an effective cash flow hedge.  The swap agreement terminates in January 2010.
 
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The impact on our results of operations of a one-point rate change on the January 22, 2009 outstanding term loan balance of our Credit Facility of $106.8 million for the next twelve months would be approximately $0.7 million, net of tax. As of January 22, 2009, we had no borrowings outstanding under the revolving credit facility portion of our Credit Facility.
 
We are subject to risk from changes in the foreign exchange rates relating to our Canadian, U.K., Irish, Grecian and Peruvian subsidiaries. Assets and liabilities of these subsidiaries are translated to U.S. dollars at year-end exchange rates. Income and expense items are translated at average rates of exchange prevailing during the year.  Translation adjustments are accumulated as a separate component of shareholders' equity. Gains and losses, which result from foreign currency transactions, are included in selling, general and administrative expenses on our consolidated statements of income.  The potential loss resulting from a hypothetical 10.0% adverse change in the quoted foreign currency exchange rate amounts to approximately $1.2 million as of November 30, 2008.
 
This market risk discussion contains forward-looking statements.  Actual results may differ materially from this discussion based upon general market conditions and changes in financial markets.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
44

Item 8.    Financial Statements and Supplementary Data
 
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
To the Board of Directors and Shareholders of
Chattem, Inc.:

We have audited the accompanying consolidated balance sheets of Chattem, Inc. (a Tennessee corporation) and subsidiaries (the Company) as of November 30, 2008 and 2007, and the related consolidated statements of income, shareholders’ equity and cash flows for each of the three years in the period ended November 30, 2008. Our audits of the basic financial statements included the financial statement schedule listed in the index appearing under Item 15 (a)(2).  These consolidated financial statements and financial statement schedule are the responsibility of the Company's management.  Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.  An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Chattem, Inc. and subsidiaries as of November 30, 2008 and 2007, and the results of their operations and their cash flows for each of the three years in the period ended November 30, 2008, in conformity with accounting principles generally accepted in the United States of America.  Also in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

As discussed in Note 7 of the consolidated financial statements, the Company has adopted Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109,” as amended by FSP FIN 48-1, Definition of Settlement in FASB Interpretation No. 48, issued by the Financial Accounting Standards Board, in fiscal 2008.

The Company has adopted Statement of Financial Accounting Standards No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans,” in fiscal 2007.

The Company has adopted Statement of Financial Accounting Standards No. 123(R), “Share-Based Payments,” in fiscal 2006.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Chattem, Inc. and subsidiaries’ internal control over financial reporting as of November 30, 2008, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated January 29, 2009, expressed an unqualified opinion on the effectiveness of internal control over financial reporting.

 
/s/ GRANT THORNTON LLP
 
Charlotte, North Carolina
January 29, 2009
 
45

Consolidated Balance Sheets
November 30, 2008 and 2007
(In thousands)
 
 
ASSETS
 
2008
   
2007
 
             
CURRENT ASSETS:
Cash and cash equivalents
  $  32,310     $  15,407  
Accounts receivable, less allowances of $9,718 in 2008 and $13,810  in 2007
    49,417       43,753  
Inventories, net
    40,933       43,265  
Deferred income taxes
    3,968       6,750  
Prepaid expenses and other current assets
    2,451       2,065  
Total current assets
    129,079       111,240  
                 
PROPERTY, PLANT AND EQUIPMENT, NET
      32,243         32,349  
                 
OTHER NONCURRENT ASSETS:
               
Patents, trademarks and other purchased product rights, net
    616,670       616,810  
Debt issuance costs, net
    12,253       15,430  
Other
        2,727           4,731  
Total other noncurrent assets
       631,650          636,971  
                 
TOTAL ASSETS
  $ 792,972     $ 780,560  
 
 
The accompanying notes are an integral part of these consolidated financial statements.
 
 
 
 
 
 
46

Consolidated Balance Sheets
November 30, 2008 and 2007
(In thousands)
 
 
LIABILITIES AND SHAREHOLDERS' EQUITY
 
2008
   
2007
 
             
CURRENT LIABILITIES:
           
Current maturities of long-term debt
  $ 3,000     $ 3,000  
Accounts payable
    18,116       18,239  
Bank overdrafts
    1,184       7,584  
Accrued liabilities
     21,293        21,537  
Total current liabilities
     43,593        50,360  
                 
LONG-TERM DEBT, less current maturities
     456,500        505,000  
                 
DEFERRED INCOME TAXES
    35,412       21,056  
                 
OTHER NONCURRENT LIABILITIES
      1,609         2,436  
                 
COMMITMENTS AND CONTINGENCIES  (Note 12)
               
                 
SHAREHOLDERS' EQUITY:
               
Preferred shares, without par value, authorized 1,000, none issued
           
Common shares, without par value, authorized 100,000, issued and outstanding 18,978 in 2008 and 19,092 in 2007
     28,926        36,800  
Retained earnings
      231,230         165,655  
      260,156       202,455  
Accumulated other comprehensive income (loss), net of taxes
               
Interest rate hedge adjustment
    (1,787 )     (1,747 )
Foreign currency translation adjustment
    (968 )     1,008  
Unrealized actuarial gains and losses
    (1,543 )     (8 )
Total shareholders' equity
    255,858       201,708  
                 
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY
  $ 792,972     $ 780,560  
                 
                 
 
The accompanying notes are an integral part of these consolidated financial statements.
 
 
 
 
 
47

Consolidated Statements of Income
For the Years Ended November 30, 2008, 2007 and 2006
(In thousands, except per share amounts)
 
 
   
2008
   
2007
   
2006
 
                   
TOTAL REVENUES
  $ 454,879     $ 423,378     $ 300,548  
                         
COSTS AND EXPENSES:
                       
Cost of sales
    131,620       129,055       94,036  
Advertising and promotion
    118,093       112,206       96,071  
Selling, general and administrative
    62,590       57,878       46,989  
Product recall expenses
    6,269              
Acquisition expenses
          2,057        
Litigation settlement
    11,271             (19,292 )
Total costs and expenses
     329,843        301,196        217,804  
                         
INCOME FROM OPERATIONS
     125,036         122,182        82,744  
                         
OTHER INCOME (EXPENSE):
                       
Interest expense
    (25,310 )     (29,930 )     (11,725 )
Investment and other income, net
    715       1,460       1,076  
Loss on early extinguishment of debt
    (526 )       (2,633 )     (2,805 )
Total other income (expense)
    (25,121 )     (31,103 )     (13,454 )
                         
INCOME BEFORE INCOME TAXES 
    99,915       91,079       69,290  
                         
PROVISION FOR INCOME TAXES
    33,629       31,389       24,178  
                         
NET INCOME
  $ 66,286     $ 59,690     $ 45,112  
                         
 NUMBER OF COMMON SHARES:
                       
Weighted average outstanding, basic
    18,980       18,927       19,036  
Weighted average and potential dilutive outstanding
    19,364       19,350       19,262  
                         
NET INCOME PER COMMON SHARE:
                       
                         
Basic
  $ 3.49     $ 3.15     $ 2.37  
  
                       
Diluted
  $ 3.42     $ 3.08     $ 2.34  
 
 
The accompanying notes are an integral part of these consolidated financial statements.
 
 
 
 
48

Consolidated Statements of Shareholders' Equity
For the Years Ended November 30, 2008, 2007 and 2006
(In thousands)
   
 
 
Common
 Shares
   
 
 
Retained
Earnings
   
Unamortized
Value of
Restricted
Common
Shares Issued
   
Accumulated
Other
Comprehensive
Income (Loss)
   
 
 
 
 Total
 
Balance, November 30, 2005
  $ 63,876     $ 60,853     $ (1,818 )   $ (284 )   $ 122,627  
Comprehensive income (loss):
                                       
Net income
          45,112                   45,112  
Interest rate hedge adjustment, net of taxes of $323
                      (514 )     (514 )