10-Q 1 d10q.htm FORM 10-Q Form 10-Q

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

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

For the quarterly period ended December 31, 2009

OR

 

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

For the transition period from              to             

Commission file number 1-9601

 

 

K-V PHARMACEUTICAL COMPANY

(Exact Name of Registrant as Specified in Its Charter)

 

 

 

Delaware   43-0618919

(State or other Jurisdiction of

Incorporation or Organization)

 

(I.R.S. Employer

Identification No.)

One Corporate Woods Drive Bridgeton, MO   63044
(Address of Principal Executive Offices)   (Zip Code)

(314) 645-6600

(Registrant’s Telephone Number, Including Area Code)

(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)

 

 

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

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   x    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 Exchange Act).    Yes  ¨    No  x

As of May 31, 2010, the registrant had outstanding 37,741,444 and 12,112,285 shares of Class A and Class B Common Stock, respectively, exclusive of treasury shares.

 

 

 


EXPLANATORY NOTE

The filing of this Quarterly Report on Form 10-Q for the fiscal quarter ended December 31, 2009 was delayed due to the time required to (1) complete the internal investigation conducted by the Audit Committee (the “Audit Committee”) of our Board of Directors (the “Board”) with respect to a range of specific allegations involving, among other items, U.S. Food and Drug Administration (the “FDA”) regulatory and other compliance matters and management misconduct, (2) resolve certain matters with a potential financial reporting impact resulting from such investigation, (3) evaluate the financial statement implications of the provisions of the consent decree we entered into with the FDA on March 2, 2009 and of the previously disclosed actions to recall all of the drug products we manufactured, suspend manufacturing and shipment of our products, substantially reduce our workforce and realign our cost and organizational structure and (4) prepare and file with the Securities and Exchange Commission (the “SEC”) our Annual Report on Form 10-K for the fiscal year ended March 31, 2009.

Information provided herein for periods after December 31, 2009 is preliminary. As such, this information is not final or complete, and remains subject to change, possibly materially.

Unless otherwise noted, when we refer to a specific fiscal year, we are referring to our fiscal year that ended on March 31 of that year (for example, fiscal year 2009 refers to the fiscal year ended March 31, 2009).

 

2


CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q contains various forward-looking statements within the meaning of the United States Private Securities Litigation Reform Act of 1995 (the “PSLRA”) and which may be based on or include assumptions concerning our operations, future results and prospects. Such statements may be identified by the use of words like “plan,” “expect,” “aim,” “believe,” “project,” “anticipate,” “commit,” “intend,” “estimate,” “will,” “should,” “could,” “potential” and other expressions that indicate future events and trends.

All statements that address expectations or projections about the future, including without limitation, statements about product development, product launches, our strategy for growth, regulatory approvals, governmental and regulatory actions and proceedings, market position, acquisitions, sale of assets, revenues, expenditures, resumption of manufacturing and distribution of products and the impact of the recall and suspension of shipments on revenues, and other financial results, are forward-looking statements.

All forward-looking statements are based on current expectations and are subject to risk and uncertainties. In connection with the PSLRA’s “safe harbor” provisions, we provide the following cautionary statements identifying important economic, competitive, political, regulatory and technological factors, among others, that could cause actual results or events to differ materially from those set forth or implied by the forward-looking statements and related assumptions.

Such factors include (but are not limited to) the following:

 

  (1) the ability to continue as a going concern;

 

  (2) difficulties and uncertainties with respect to obtaining additional capital, as more fully described in Part I, Item 2—“Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources” in this Quarterly Report on Form 10-Q;

 

  (3) the consent decree between us and the FDA and our suspension of the production and shipment of all of the products that we manufacture and the related nationwide recall affecting all of the products that we manufacture, as well as the related material adverse effect on our revenue, assets and liquidity and capital resources, as more fully described in Part I, Item 2—“Management’s Discussion and Analysis of Financial Condition and Results of Operations—Background—Discontinuation of Manufacturing and Distribution; Product Recalls; and the FDA Consent Decree” in this Quarterly Report on Form 10-Q;

 

  (4) the possibility of further reducing our operations, including further reductions of our employee base, and significantly curtailing some or all of our efforts to meet the consent decree’s requirements and return our approved products to market in order to maintain and attempt to increase our limited cash and financial resources, and related costs and accounting charges from taking such actions;

 

  (5) the plea agreement between us and the U.S. Department of Justice and our obligations in connection therewith, as well as the related material adverse effect, if any, on our revenue, assets and liquidity and capital resources, as more fully described in Note 20—“Subsequent Events” of the Notes to the Consolidated Financial Statements in this Quarterly Report on Form 10-Q;

 

  (6) changes in the current and future business environment, including interest rates and capital and consumer spending;

 

  (7) the difficulty of predicting FDA approvals, including timing, and that any period of exclusivity may not be realized;

 

  (8) the possibility of not obtaining FDA approvals or delay in obtaining FDA approvals;

 

  (9) acceptance of and demand for our new pharmaceutical products;

 

  (10) the introduction and impact of competitive products and pricing, including as a result of so-called authorized-generic drugs;

 

  (11) new product development and launch, including the possibility that any product launch may be delayed;

 

  (12) reliance on key strategic alliances;

 

  (13) the availability of raw materials and/or products manufactured for us under contract manufacturing arrangements with third parties;

 

  (14) the regulatory environment, including regulatory agency and judicial actions and changes in applicable law or regulations;

 

3


  (15) fluctuations in revenues;

 

  (16) the difficulty of predicting international regulatory approvals, including timing;

 

  (17) the difficulty of predicting the pattern of inventory movements by our customers;

 

  (18) the impact of competitive response to our sales, marketing and strategic efforts, including the introduction or potential introduction of generic or competing products against products sold by us and our subsidiaries;

 

  (19) risks that we may not ultimately prevail in litigation, including product liability lawsuits and challenges to our intellectual property rights by actual or potential competitors or to our ability to market generic products due to brand company patents and challenges to other companies’ introduction or potential introduction of generic or competing products by third parties against products sold by us or our subsidiaries including without limitation the litigation and claims referred to in Note 18—“Commitments and Contingencies” of the Notes to the Consolidated Financial Statements in this Quarterly Report on Form 10-Q;

 

  (20) the possibility that our current estimates of the financial effect of certain announced product recalls could prove to be incorrect;

 

  (21) whether any product recalls or product introductions result in litigation, agency action or material damages;

 

  (22) failure to supply claims by certain of our customers, including CVS Pharmacy, Inc., that, despite the formal discontinuation action by us of our products, we should compensate such customers for any additional costs they allegedly incurred for procuring products we did not supply;

 

  (23) the satisfaction or waiver of the terms and conditions for the acquisition of the full U.S. and worldwide rights to Gestiva™ set forth in the previously disclosed Gestiva™ acquisition agreement, as amended;

 

  (24) the series of putative class action lawsuits alleging violations of the federal securities laws by us and certain individuals, all as more fully described in Note 18—“Commitments and Contingencies” of the Notes to the Consolidated Financial Statements in this Quarterly Report on Form 10-Q;

 

  (25) the possibility that insurance proceeds are insufficient to cover potential losses that may arise from litigation, including with respect to product liability, failure to supply or securities litigation;

 

  (26) the informal inquiry initiated by the SEC and any related or additional governmental investigative or enforcement proceedings as more fully described in Note 18—“Commitments and Contingencies” of the Notes to the Consolidated Financial Statements in this Quarterly Report on Form 10-Q;

 

  (27) the possibility that the pending investigation by the Office of Inspector General of the Department of Health and Human Services into potential false claims under Title 42 of the U.S. Code as more fully described in Note 18—“Commitments and Contingencies” of the Notes to the Consolidated Financial Statements in this Quarterly Report on Form 10-Q could result in significant civil fines or penalties, including exclusion from participation in federal healthcare programs such as Medicare and Medicaid;

 

  (28) delays in returning, or failure to return, certain or many of our approved products to market, including loss of market share as a result of the suspension of shipments, and related costs;

 

  (29) the ability to sell or license certain assets, and the terms of such transactions;

 

  (30) the possibility that default on one type or class of our indebtedness could result in cross default under, and the acceleration of, our other indebtedness; and

 

  (31) the risks detailed from time to time in our filings with the SEC.

This discussion is not exhaustive, but is designed to highlight important factors that may impact our forward-looking statements.

Because the factors referred to above, as well as the statements included under the caption Part I, Item 2—“Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this Quarterly Report on Form 10-Q, could cause actual results or outcomes to differ materially from those expressed in any forward-looking statements made by us or on our behalf, you should not place undue reliance on any forward-looking statements. All forward-looking statements attributable to us are expressly qualified in their entirety by the cautionary statements in this “Cautionary Note Regarding Forward-Looking Statements” and the risk factors that are included under Part I, Item 1A—“Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended March 31, 2009, Part II, Item 1A—“Risk Factors” in the Quarterly Report on Form 10-Q for the quarter ended June 30, 2009, and Part II, Item 1A—“Risk Factors” in the Quarterly Report on Form 10-Q for the quarter ended September 30, 2009, as supplemented by our subsequent SEC filings. Further, any forward-looking statement speaks only as of the date on which it is made and we are under no obligation to update any of the forward-looking statements after the date of this Quarterly Report on Form 10-Q. New factors emerge from time

 

4


to time, and it is not possible for us to predict which factors will arise, when they will arise and/or their effects. In addition, we cannot assess the impact of each factor on our future business or financial condition or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.

 

5


PART I. FINANCIAL INFORMATION

 

Item 1. FINANCIAL STATEMENTS

K-V PHARMACEUTICAL COMPANY AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited; in thousands, except per share data)

 

     Three Months Ended
December 31,
    Nine Months Ended
December 31,
 
     2009     2008     2009     2008  

Net revenues

   $ 147,480      $ 27,616      $ 157,027      $ 289,817   

Cost of sales

     37,052        92,960        65,850        186,510   
                                

Gross profit (loss)

     110,428        (65,344     91,177        103,307   
                                

Operating expenses:

        

Research and development

     7,273        21,375        24,727        55,251   

Selling and administrative

     30,235        54,305        91,947        176,620   

Amortization of intangible assets

     2,980        3,605        8,875        10,619   

Purchased in-process research and development

     —          —          —          2,000   

Litigation and governmental inquiries, net

     150        23        5,003        49,732   

Restructuring

     —          725        533        725   

Gain on sale

     (14,500     —          (14,500     —     
                                

Total operating expenses

     26,138        80,033        116,585        294,947   
                                

Operating income (loss)

     84,290        (145,377     (25,408     (191,640
                                

Other expense (income):

        

Interest expense

     2,053        2,201        6,211        6,836   

Interest and other expense (income)

     (941     8,341        (2,801     6,866   
                                

Total other expense, net

     1,112        10,542        3,410        13,702   
                                

Income (loss) from continuing operations before income taxes

     83,178        (155,919     (28,818     (205,342

Income tax benefit

     (24,157     (59,892     (23,807     (68,401
                                

Income (loss) from continuing operations

     107,335        (96,027     (5,011     (136,941

Income from discontinued operations (net of taxes of $725, $548, $2,671 and $2,230)

     1,252        944        4,609        3,848   
                                

Net income (loss)

   $ 108,587      $ (95,083   $ (402   $ (133,093
                                

Earnings (loss) per share:

        

Basic - Class A common

   $ 2.27      $ (1.91   $ (0.01   $ (2.68

Basic - Class B common

     1.89        (1.91     (0.01     (2.68

Diluted - Class A common

     1.79        (1.91     (0.01     (2.68

Diluted - Class B common

     1.54        (1.91     (0.01     (2.68

Shares used in per share calculation:

        

Basic - Class A common

     37,797        37,754        37,799        37,539   

Basic - Class B common

     11,982        12,047        12,024        12,072   

Diluted - Class A common

     61,333        49,801        49,823        49,611   

Diluted - Class B common

     11,982        12,047        12,024        12,072   

See Accompanying Notes to Consolidated Financial Statements

 

6


K-V PHARMACEUTICAL COMPANY AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share information)

 

     December 31,
2009
    March 31,
2009
 
     (unaudited)        
ASSETS     

Current Assets:

    

Cash and cash equivalents

   $ 96,612      $ 75,730   

Marketable securities

     —          —     

Receivables, net

     2,701        21,058   

Inventories, net

     24,901        22,186   

Prepaid and other assets

     10,439        16,609   

Income taxes receivable

     24,284        81,031   

Deferred tax asset

     5,090        8,842   

Current assets held for sale

     6,897        6,770   
                

Total Current Assets

     170,924        232,226   

Property and equipment, less accumulated depreciation

     175,073        188,212   

Investment securities

     66,118        65,971   

Intangible assets, net

     139,839        148,399   

Other assets

     24,324        22,730   

Non-current assets held for sale

     8,180        1,616   
                

Total Assets

   $ 584,458      $ 659,154   
                
LIABILITIES     

Current Liabilities:

    

Accounts payable

   $ 35,338      $ 35,975   

Accrued liabilities

     81,184        152,686   

Income taxes payable

     —          —     

Current maturities of long-term debt

     36,259        37,824   

Current liabilities associated with assets held for sale

     823        567   
                

Total Current Liabilities

     153,604        227,052   

Long-term debt

     200,308        200,725   

Other long-term liabilities

     40,338        44,045   

Deferred tax liability

     46,607        47,804   
                

Total Liabilities

     440,857        519,626   
                
SHAREHOLDERS’ EQUITY     

7% cumulative convertible Preferred Stock, $.01 par value; $25.00 stated and liquidation value; 840,000 shares authorized; issued and outstanding — 40,000 shares at both December 31, 2009 and March 31, 2009 (convertible into Class A shares on a 8.4375-to-one basis)

     —          —     

Class A and Class B Common Stock, $.01 par value; 150,000,000 and 75,000,000 shares authorized, respectively;

    

Class A – issued 41,131,684 and 41,065,529 at December 31, 2009 and March 31, 2009, respectively

     411        411   

Class B – issued 12,206,684 at both December 31, 2009 and March 31, 2009 (convertible into Class A shares on a one-for-one basis)

     122        122   

Additional paid-in capital

     169,715        165,427   

Retained earnings

     29,318        29,772   

Accumulated other comprehensive income

     1,395        845   

Less: Treasury stock, 3,404,324 shares of Class A and 94,572 shares of Class B Common Stock at December 31, 2009, and 3,365,218 shares of Class A and 94,572 shares of Class B Common Stock at March 31, 2009, at cost

     (57,360     (57,049
                

Total Shareholders’ Equity

     143,601        139,528   
                

Total Liabilities and Shareholders’ Equity

   $ 584,458      $ 659,154   
                

See Accompanying Notes to Consolidated Financial Statements

 

7


K-V PHARMACEUTICAL COMPANY AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited; in thousands)

 

     Nine Months Ended
December 31,
 
     2009     2008  

Operating Activities:

    

Net loss

   $ (402   $ (133,093

Adjustments to reconcile net loss to net cash provided by operating activities:

    

Purchased in-process research and development

     —          2,000   

Depreciation and amortization

     24,697        26,921   

Loss on property and equipment

     1,157        1,171   

Insurance proceeds

     (5,600     —     

Loss on investment securities

     —          9,208   

Deferred income tax (benefit) provision

     2,387        (21,258

Deferred compensation

     —          (8,551

Stock-based compensation

     3,602        3,663   

Excess tax benefits associated with stock options

     —          (371

Changes in operating assets and liabilities:

    

Receivables, net

     17,958        46,359   

Inventories, net

     (2,443     46,184   

Income taxes

     58,212        (50,918

Accounts payable and accrued liabilities

     (70,420     30,687   

Deferred revenue

     —          68,129   

Other assets and liabilities, net

     (1,477     36,019   
                

Net cash provided by operating activities

     27,671        56,150   
                

Investing Activities:

    

Purchase of property and equipment, net

     (10,833     (19,591

Insurance proceeds

     5,600        —     

Purchase of marketable securities

     —          (559

Sale of marketable securities

     500        52,111   

Product acquisition

     —          (2,000

Cash paid for acquired company

     —          (3,000
                

Net cash provided by (used in) investing activities

     (4,733     26,961   
                

Financing Activities:

    

Principal payments on long-term debt

     (1,982     (1,975

Dividends paid on preferred stock

     (52     (52

Purchase of common stock for treasury

     (311     (185

Excess tax benefits associated with stock options

     —          371   

Cash deposits received for stock options

     2        774   
                

Net cash used in financing activities

     (2,343     (1,067
                

Increase in cash and cash equivalents

     20,595        82,044   

Effect of foreign exchange rate changes on cash

     287        (213

Cash and cash equivalents:

    

Beginning of year

     75,730        88,493   

Cash balances of assets held for sale

     —          —     
                

End of period

   $ 96,612      $ 170,324   
                

Supplemental Information:

    

Interest paid

   $ 6,722      $ 8,226   

Income taxes paid

     422        6,439   

Stock options exercised (at expiration of two-year forfeiture period)

     686        1,394   

See Accompanying Notes to Consolidated Financial Statements

 

8


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

(In thousands, except per share data)

1. DESCRIPTION OF BUSINESS

General Overview

K-V Pharmaceutical Company was incorporated under the laws of Delaware in 1971 as a successor to a business originally founded in 1942. K-V Pharmaceutical Company and its wholly-owned subsidiaries, including Ther-Rx Corporation (“Ther-Rx”), ETHEX Corporation (“ETHEX”) and Particle Dynamics, Inc. (“PDI”), are referred to in the Notes to the Consolidated Financial Statements in this Quarterly Report on Form 10-Q as “KV” or the “Company.” The Company’s original strategy was to engage in the development of proprietary drug delivery systems and formulation technologies which enhance the effectiveness of new therapeutic agents and existing pharmaceutical products. Today the Company utilizes several of those technologies, such as SITE RELEASE® and oral controlled release technologies, in its branded and generic products. In 1990, the Company established a marketing capability in the generic business through its wholly-owned subsidiary, ETHEX. In 1999, KV established a wholly-owned subsidiary, Ther-Rx, to market proprietary branded pharmaceuticals directly to physicians. The Company’s wholly-owned subsidiary, PDI, was acquired in 1972. Through PDI, KV develops and markets specialty value-added raw materials, including drugs, directly compressible and micro-encapsulated products, and other products used in the pharmaceutical industry and other markets.

Significant Developments

On March 2, 2009, the Company entered into a consent decree with the FDA regarding its drug manufacturing and distribution. The consent decree was entered by the U.S. District Court, Eastern District of Missouri, Eastern Division on March 6, 2009. As part of the consent decree, the Company agreed not to directly or indirectly do or cause the manufacture, processing, packing, labeling, holding, introduction or delivery for introduction into interstate commerce at or from any of its facilities of any drug, until the Company has satisfied certain requirements designed to demonstrate compliance with the FDA’s current good manufacturing practice (“cGMP”) regulations. The consent decree provides for a series of measures that, when satisfied, will permit the Company to resume the manufacture and distribution of approved drug products. The Company has also agreed not to distribute its products that are not FDA approved, including its prenatal vitamins and hematinic products, unless it obtains FDA approval for such products through the FDA’s New Drug Application (“NDA”) and Abbreviated New Drug Application (“ANDA”) processes.

Please refer to the Annual Report on Form 10-K for the fiscal year ended March 31, 2009 for a discussion of related events, including the discussion of several product recalls and the discontinuation of manufacturing and distribution. See also Part I, Item 2—“Management’s Discussion and Analysis of Financial Condition and Results of Operations—Background” in this Quarterly Report on Form 10-Q for a discussion of significant developments.

2. BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements of the Company have been prepared in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. However, in the opinion of management, all adjustments considered necessary for a fair presentation have been included. Certain reclassifications, none of which affected net income or retained earnings, have been made to prior year amounts to conform to the current year presentation.

 

9


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

The results of operations and cash flows for the three- and nine-month periods ended December 31, 2009 are not necessarily indicative of the results of operations and cash flows that may be expected for the fiscal year ending March 31, 2010. The interim consolidated financial statements and accompanying notes should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended March 31, 2009. The balance sheet information as of March 31, 2009 has been derived from the Company’s audited consolidated balance sheet as of that date.

PDI

As a result of the decision by the Company to sell PDI, the Company has identified the assets and liabilities of PDI as held for sale in the Company’s consolidated balance sheets at December 31, 2009 and March 31, 2009 and has segregated PDI’s operating results and presented them separately as a discontinued operation for all periods presented. (See Note 20—“Subsequent Events” for more information regarding the sale of PDI.)

Use of Estimates

The preparation of the consolidated financial statements requires the use of estimates, judgments and assumptions, which the Company believes to be reasonable, based on the information available. Variances in such estimates or assumptions could yield materially different accounting results. On an ongoing basis, the Company evaluates the continued appropriateness of accounting policies and resulting estimates to make judgments management considers appropriate under applicable facts and circumstances.

The Company assesses the impairment of its assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. The factors that the Company considers in its assessment include the following: (1) significant underperformance of the assets relative to expected historical or projected future operating results; (2) significant changes in the manner of the Company’s use of the acquired assets or the strategy for its overall business; (3) significant negative industry or economic trends; and (4) significant adverse changes as a result of legal proceedings or governmental or regulatory actions. Certain significant events occurred in the three months ended March 31, 2010 that indicate that the carrying value of certain assets as of March 31, 2010 may not be recoverable. These events include: (a) the expectation of when the Company would be able to resume manufacturing and shipment and begin generating cash flow from the sale of certain of its approved products, which is currently expected to occur in the fourth calendar quarter of 2010, at the earliest; (b) the entry into the plea agreement with the U.S. Department of Justice (see Note 18—“Commitments and Contingencies” and Note 20—“Subsequent Events”); and (c) the substantial reduction of the Company’s workforce that occurred on March 31, 2010 (see Note 20—“Subsequent Events”). Furthermore, in addition to trying to sell certain of its assets, the Company is evaluating various strategic and operating alternatives, including further reduction of its operations, and/or outsourcing to a third party some or all of its manufacturing operations.

Based on the events described above, the Company has determined that a triggering event has occurred in the fourth quarter of fiscal year 2010 giving rise to the need to assess the recoverability of its long lived assets. Depending upon which and when, if any, of the strategic and operating alternatives are implemented, the Company believes it is likely that future undiscounted cash flows will not be sufficient to support the carrying value of certain of its long-lived assets and this will result in material non-cash charges for impairment of inventory, property and equipment, intangible and other long-lived assets in the quarter ended March 31, 2010. Cash flow projections require a significant level of judgment and estimation in order to determine a number of interdependent variables and assumptions such as probability, timing, pricing and various cost factors. Cash flow projections are highly sensitive to changes in these variables and assumptions. Until the Company is able to determine and assess these variables, it cannot assess the level or range of impairment that may be incurred. The Company is currently working to determine which of the strategic and operating alternatives it can pursue to address its liquidity constraints. The result of these determinations will form the basis for management’s assumptions regarding the ultimate use and/or potential disposition of assets. Assumptions necessary to establish the fair value of long lived assets will be derived from the outcome of these decisions, which will be determined within approximately the next two months. Management believes it will have the necessary information at that time to prepare its recoverability analysis. As of December 31, 2009, the carrying values of the Company’s inventory, net, property and equipment, net and intangible assets, net (excluding PDI assets, which are accounted for as assets held for sale) were $24,901, $175,073 and $139,839 respectively.

 

10


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

3. GOING CONCERN AND LIQUIDITY CONSIDERATIONS

The Company’s consolidated financial statements are prepared using accounting principles generally accepted in the United States applicable to a going concern, which contemplates the realization of assets and liquidation of liabilities in the normal course of business. The accompanying historical consolidated financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern.

The assessment of the Company’s ability to continue as a going concern was made by management considering, among other factors: (i) the Company’s need to obtain additional capital; (ii) the suspension of shipment of all products manufactured by the Company and the requirements under the consent decree with the FDA; (iii) the timing and number of approved products that will be reintroduced to the market and the related costs; (iv) the potential outcome with respect to the governmental inquiries, litigation or other matters described in Note 18—“Commitments and Contingencies;” and (v) the Company’s ability to comply with debt covenants. The Company’s assessment was further affected by the Company’s fiscal year 2009 net loss of $313,627, its net loss for the first three quarters of the Company’s fiscal year 2010 of $402 and the outstanding balance of cash, cash equivalents and short-term marketable securities (excluding PDI assets, which are accounted for as assets held for sale) of $96,612 as of December 31, 2009. For periods subsequent to December 31, 2009, the Company expects losses to continue because the Company is unable to generate any significant revenues from its own manufactured products until the Company is able to resume shipping certain or many of its approved products, which currently is not expected to occur until the fourth quarter of calendar year 2010 at the earliest. In addition, the Company must meet ongoing operating costs as well as costs related to the steps the Company is currently taking to prepare for reintroducing its approved products to the market. If the Company is not able to obtain the FDA’s clearance to resume manufacturing and distribution of its approved products in a timely manner and at a reasonable cost, the Company’s financial position, results of operations, cash flows and liquidity will continue to be materially adversely affected. These conditions raise substantial doubt about the Company’s ability to continue as a going concern.

The Company believes that it is not in compliance, as of March 31, 2009, June 30, 2009, September 30, 2009 and December 31, 2009, with one or more of the requirements of the Company’s $43,000 mortgage loan arrangement (see Note 14—“Long-Term Debt”). Failure by the Company to comply with the requirements of the mortgage loan arrangement or to otherwise receive a waiver from the mortgage lender for any noncompliance could result in the Company’s outstanding mortgage debt obligation accelerating and immediately becoming due and payable. If the acceleration occurs and the mortgage debt is not immediately paid in full, an event of default could also be deemed to have occurred under the $200,000 principal amount of 2.5% Contingent Convertible Subordinated Notes (the “Notes”). If an event of default is deemed to have occurred on the Notes, the principal amount plus any accrued and unpaid interest could also become immediately due and payable. The acceleration of these outstanding debt obligations would materially adversely affect the Company’s business, financial condition and cash flows.

Based on current financial projections, the Company believes the continuation of the Company as a going concern is primarily dependent on its ability to address, among other factors: (i) the Company’s need to obtain additional capital; (ii) the suspension of shipment of all products manufactured by the Company and the requirements under the consent decree with the FDA; (iii) the timing and number of approved products that will be reintroduced to the market and the related costs; (iv) the potential outcome with respect to the governmental inquiries, litigation or other matters described in Note 18—“Commitments and Contingencies;” and (v) the Company’s ability to comply with debt covenants. While the Company addresses these matters, it must continue to meet expected near-term obligations, including normal course operating cash requirements and costs associated with reintroducing its approved products to the market (such as costs related to its employees, facilities and FDA compliance), remaining payments associated with the acquisition of the rights to Gestiva™ (see Note 5—“Acquisitions”), the financial obligations pursuant to the plea agreement with the U.S. Department of Justice (see Note 20—“Subsequent Events”), as well as the significant costs, such as legal and consulting fees, associated with the steps taken by the Company in connection with the consent decree and the litigation and governmental inquiries described in Note 18—“Commitments and Contingencies.” If the Company is not able to obtain the FDA’s clearance to resume manufacturing and distribution of its approved products in a timely manner and at a reasonable cost, and/or if the Company experiences adverse outcomes with respect to any of the governmental inquiries or litigation described in Note 18—“Commitments and Contingencies,” the Company’s financial position, results of operations, cash flows and liquidity will continue to be materially adversely affected.

 

11


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

In the near term, the Company is focused on meeting the requirements of the consent decree, which will allow its approved products to be reintroduced to the market, and is pursuing various means to increase cash. Since December 31, 2009, the Company has generated non-recurring cash proceeds to support its on-going operating and compliance requirements from the receipt of tax refunds, the monetization of its auction rate securities (“ARS”), the divestiture of PDI and the sale of certain other assets (see Note 20—“Subsequent Events”). While these cash proceeds were sufficient to meet near term cash requirements, the Company is pursuing ongoing efforts to increase cash, including the continued implementation of cost savings, divestiture of certain assets and the return of certain of the Company’s approved products to market in a timely manner. In addition, in order to continue to meet the expected near-term obligations described above, the Company will still need to obtain additional capital through additional asset sales. The Company is also engaged in external financing efforts. The Company is evaluating its capital needs and availability of financing to assess and identify the best available external financing alternatives. The Company cannot provide assurance that it will be able to realize the cost reductions it anticipates from reducing its operations or its employee base, that some or many of its approved products can be returned to the market in a timely manner, that its higher profit approved products will return to the market in the near term, that the Company can obtain additional cash through asset sales, or that external financing can be obtained, under acceptable terms or in the amounts required. If the Company is unsuccessful in its efforts to sell assets and raise additional capital in the near term, the Company will be required to further reduce its operations, including further reductions of its employee base, or the Company may be required to cease operations in order to offset the lack of available funding.

The Company’s ability to obtain capital has been and continues to be materially and negatively affected by a number of factors. The current and evolving credit market condition and general adverse economic conditions have caused the cost of prospective debt and equity financings to increase considerably. These circumstances have materially adversely affected liquidity in the financial markets, making terms for certain financings unattractive, and in some cases have resulted in the unavailability of financing. The Company also anticipates that the uncertainty created by the ongoing governmental inquiries and litigation, steps taken by the Company in connection with the nationwide recall and suspension of shipment of all drug products manufactured by the Company, the consent decree and the uncertainty with respect to when it will resume shipment of its products, if at all, will affect the Company’s ability to obtain capital on a timely basis, or at all. In light of the factors described above, the Company may not be able to obtain additional capital. Even if it is able to obtain additional financing or issue debt securities under these circumstances, the cost to the Company likely will be high and the terms and conditions are likely to be onerous. In addition, if the Company were to issue equity securities, such securities likely would be priced at or below the current market price for the Company’s securities. As a result, sales of equity securities at or below current market prices likely would result in substantial dilution for current shareholders who purchased the Company’s equity securities at or above current market prices.

4. RECENTLY ISSUED ACCOUNTING STANDARDS

Adoption of the FASB Accounting Standards Codification

In June 2009, the Financial Accounting Standards Board (“FASB”) issued the FASB Accounting Standards Codification (“ASC”). Effective with the quarter ended September 30, 2009, the ASC became the single source of all authoritative GAAP recognized by the FASB and is required to be applied to financial statements issued for interim and annual periods ending after September 15, 2009. The ASC does not change GAAP and did not impact the Company’s consolidated financial statements.

Accounting Standards Not Yet Adopted

In October 2009, the FASB issued new accounting guidance for recognizing revenue for a multiple-deliverable revenue arrangement. The new guidance amends the existing guidance for separately accounting for individual deliverables in a revenue arrangement with multiple deliverables, and removes the criterion that an entity must use objective and reliable evidence of fair value to separately account for the deliverables. The new guidance also establishes a hierarchy for determining the value of each deliverable and establishes the relative selling price method for allocating consideration when vendor specific objective evidence or third party evidence of value does

 

12


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

not exist. The Company must adopt the new guidance prospectively for new revenue arrangements entered into or materially modified beginning in the first quarter of fiscal year 2012. Earlier adoption is permitted. The Company is currently evaluating the impact that the new guidance will have on its consolidated financial statements and the timing of its adoption.

5. ACQUISITIONS

In September 2008, the Company acquired assets from the pharmaceutical division of LycoRed Natural Products Industries Ltd. (“LycoRed”), an Israeli company. Under the terms of the asset purchase agreement, the Company paid $3,000 for tangible assets and an assembled workforce. The acquirer of these assets is Nesher Solutions, Ltd., an Israeli entity that is 100% owned by Nesher Solutions USA, Inc., a wholly-owned KV company. The purpose of the acquisition was to expand the Company’s expertise in the area of controlled-release products as well as enhance its generic pipeline development capacity. The results of operations are included in the consolidated statement of operations since the date of acquisition.

On January 16, 2008, the Company entered into an Asset Purchase Agreement (the “Original Gestiva Agreement”) with Cytyc Prenatal Products Corp. and Hologic, Inc. (Cytyc Prenatal Products Corp. and Hologic, Inc. are referred to collectively as “Hologic”). On January 8, 2010, the Company and Hologic entered into an Amendment (the “Gestiva Amendment”) to the Original Gestiva Agreement.

The Original Gestiva Agreement provided for, among other things, the following:

 

   

The Company would acquire the U.S. and worldwide rights to Gestiva™ (17-alpha hydroxyprogesterone caproate) and certain related assets (the “Purchased Assets”) upon approval of the pending New Drug Application for Gestiva™ (the “Gestiva NDA”) under review by the FDA.

 

   

The Purchased Assets would be transferred and sold to the Company free and clear of all encumbrances on the transfer date (the “Transfer Date”), which is to occur no later than five business days after the satisfaction of certain conditions, including, among other things, (1) the approval of the Gestiva NDA by the FDA (as more fully described in the Original Gestiva Agreement) and (2) the delivery by the Company of the Additional Purchase Price Amount (as defined below). As previously disclosed by the Company, the FDA has not yet approved the Gestiva NDA and the Transfer Date has not yet occurred.

 

   

The Company agreed to pay Hologic a total of $82,000 for the Purchased Assets, in the following increments:

 

   

A $7,500 cash payment (the “Initial Purchase Price”) on the initial closing date. The Company made such payment in February 2008.

 

   

A $2,000 cash payment (the “NDA Milestone Payment”) upon receipt by Hologic of an acknowledgement from the FDA that Hologic’s response to the FDA’s October 20, 2006 “approvable” letter was sufficient for the FDA to proceed with its review of the Gestiva NDA. The Company made such payment in May 2008.

 

   

A $72,500 cash payment (the “Additional Purchase Price Amount”) to be paid on the Transfer Date.

 

   

The Company and Hologic each had the right to terminate the Original Gestiva Agreement in the event that the Transfer Date did not occur by February 19, 2010, the second anniversary of the initial closing date (the “February 2010 Termination Right”).

The following is a description of the material terms by which the Gestiva Amendment modifies the Original Gestiva Agreement (as amended, the “Amended Gestiva Agreement”):

 

   

Hologic is no longer entitled to receive the Additional Purchase Price Amount. Instead, the Company agrees to pay the following:

 

   

A $70,000 cash payment (the “Amendment Payment”) upon execution of the Gestiva Amendment. The Company made such payment on January 8, 2010 which will be reflected in in-process research and development expense in the consolidated statement of operations for the quarter ending March 31, 2010.

 

13


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

   

Upon successful completion of agreed upon milestones, a series of additional future scheduled cash payments in the aggregate amount of $120,000, the first of which payments is due on the Transfer Date (which will occur after, among other things, the FDA approves the Gestiva NDA) and the last of which payments is due no later than 21 months after the FDA approves the Gestiva NDA, provided that the Transfer Date has already occurred. The Company has the right to prepay any such amounts at any time. In addition, if the Company is unable to obtain sufficient quantities of Gestiva for a period of time (not to exceed 12 months) under certain specified circumstances set forth in the Amended Gestiva Agreement, then the due date of the next following scheduled cash payment will be delayed for such period of time. The date on which the Company makes the final cash payment is referred to as the “Final Payment Date.”

 

   

If, prior to the Final Payment Date, the Company fails to timely pay a scheduled payment, the Company is obligated to transfer back to Hologic ownership of the Purchased Assets, including certain improvements made thereto by the Company, as well as other after-acquired assets and rights used by the Company in connection with the Gestiva business (the “Retransfer”). Certain liabilities associated with the foregoing are to be transferred to Hologic in connection with any Retransfer, subject to Hologic’s rights to reject the assumption of certain liabilities.

 

   

The termination provisions set forth in the Original Gestiva Agreement have been modified to include the following to the existing termination rights set forth in the Original Gestiva Agreement:

 

   

The February 2010 Termination Right has been eliminated.

 

   

Hologic has the right to terminate the Amended Gestiva Agreement if the Company fails to deliver the cash payment due on the Transfer Date (as described above) within 10 days of receipt of notice from the Seller that all conditions related to the Transfer Date have been met.

Hologic informed the Company in January 2009 that the FDA, in a complete response letter, (1) indicated it would not approve Gestiva™ until additional data and information are submitted to and accepted by the FDA and (2) requested Hologic to initiate a confirmatory clinical study and enroll a certain number of patients. The Company currently is working with Hologic to achieve the required patient enrollment and to submit the additional data and information in order to obtain FDA approval of the Gestiva NDA.

In May 2007, the Company acquired the U.S. marketing rights to Evamist™, a transdermal estrogen therapy, from VIVUS, Inc. Under the terms of the asset purchase agreement for Evamist, the Company paid $10,000 in cash at closing and agreed to make an additional cash payment of $141,500 upon final approval of the product by the FDA. The agreement also provides for two future payments upon achievement of certain net sales milestones. If Evamist™ achieves $100,000 of net sales in a fiscal year, a one-time payment of $10,000 will be made, and if net sales levels reach $200,000 in a fiscal year, a one-time payment of up to $20,000 will be made. Because the product had not obtained FDA approval when the initial payment was made at closing, the Company recorded $10,000 of in-process research and development expense during the three months ended June 30, 2007. In July 2007, FDA approval for Evamist™ was received and a payment of $141,500 was made to VIVUS, Inc. The final purchase price allocation completed during the fiscal year ended March 31, 2009, resulted in estimated identifiable intangible assets of $44,078 for product rights; $12,774 for trademark rights; $82,542 for rights under a sublicense agreement; and, $2,106 for a covenant not to compete. Upon FDA approval in July 2007, the Company began amortizing the product rights, trademark rights and rights under the sublicense agreement over 15 years and the covenant not to compete over nine years.

6. EARNINGS (LOSS) PER SHARE

The Company has two classes of common stock: Class A Common Stock and Class B Common Stock that is convertible into Class A Common Stock. With respect to dividend rights, holders of Class A Common Stock are

 

14


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

entitled to receive cash dividends per share equal to 120% of the dividends per share paid on the Class B Common Stock. For purposes of calculating basic earnings (loss) per share, undistributed earnings (loss) are allocated to each class of common stock based on the contractual participation rights of each class of security.

The Company presents diluted earnings (loss) per share for Class B Common Stock for all periods using the two-class method which does not assume the conversion of Class B Common Stock into Class A Common Stock. The Company presents diluted earnings (loss) per share for Class A Common Stock using the if-converted method which assumes the conversion of Class B Common Stock into Class A Common Stock, if dilutive.

Basic earnings (loss) per share is computed using the weighted average number of common shares outstanding during the period except that it does not include unvested common shares subject to repurchase. Diluted earnings (loss) per share is computed using the weighted average number of common shares and, if dilutive, potential common shares outstanding during the period. Potential common shares consist of the incremental common shares issuable upon the exercise of stock options, unvested common shares subject to repurchase, convertible preferred stock and convertible notes. The dilutive effects of outstanding stock options and unvested common shares subject to repurchase are reflected in diluted earnings (loss) per share by application of the treasury stock method. Convertible preferred stock and convertible notes are reflected on an if-converted basis. The computation of diluted earnings (loss) per share for Class A Common Stock assumes the conversion of the Class B Common Stock, while the diluted earnings (loss) per share for Class B Common Stock does not assume the conversion of those shares.

 

15


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

The following tables set forth the computation of basic earnings (loss) per share for the three and nine months ended December 31, 2009 and 2008:

 

     Three Months Ended December 31,  
     2009    2008  
     Class A    Class B    Class A     Class B  

Basic earnings (loss) per share:

          

Numerator:

          

Allocation of undistributed earnings (loss) from continuing operations

   $ 84,891    $ 22,426    $ (72,811   $ (23,234

Allocation of undistributed earnings from discontinued operations

     990      262      716        228   
                              

Allocation of undistributed earnings (loss)

   $ 85,881    $ 22,688    $ (72,095   $ (23,006
                              

Denominator:

          

Weighted average shares outstanding

     37,797      11,982      37,836        12,118   

Less - weighted average unvested common shares subject to repurchase

     —        —        (82     (71
                              

Number of shares used in per share computations

     37,797      11,982      37,754        12,047   
                              

Basic earnings (loss) per share from continuing operations

   $ 2.25    $ 1.87    $ (1.93   $ (1.93

Basic earnings per share from discontinued operations

     0.02      0.02      0.02        0.02   
                              

Basic earnings (loss) per share

   $ 2.27    $ 1.89    $ (1.91   $ (1.91
                              

 

16


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

     Nine Months Ended December 31,  
     2009     2008  
     Class A     Class B     Class A     Class B  

Basic loss per share:

        

Numerator:

        

Allocation of undistributed loss from continuing operations

   $ (3,841   $ (1,222   $ (103,658   $ (33,335

Allocation of undistributed earnings from discontinued operations

     3,497        1,112        2,912        936   
                                

Allocation of undistributed loss

   $ (344   $ (110   $ (100,746   $ (32,399
                                

Denominator:

        

Weighted average shares outstanding

     37,799        12,026        37,788        12,149   

Less - weighted average unvested common shares subject to repurchase

     —          (2     (249     (77
                                

Number of shares used in per share computations

     37,799        12,024        37,539        12,072   
                                

Basic loss per share from continuing operations

   $ (0.10   $ (0.10   $ (2.76   $ (2.76

Basic earnings per share from discontinued operations

     0.09        0.09        0.08        0.08   
                                

Basic loss per share

   $ (0.01   $ (0.01   $ (2.68   $ (2.68
                                

 

17


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

The following tables set forth the computation of diluted earnings (loss) per share for the three and nine months ended December 31, 2009 and 2008:

 

     Three Months Ended December 31,  
     2009     2008  
     Class A    Class B     Class A     Class B  

Diluted earnings (loss) per share:

         

Numerator:

         

Allocation of undistributed earnings (loss) from continuing operations

   $ 84,891    $ 22,426      $ (72,811   $ (23,234

Reallocation of undistributed earnings (loss) from continuing operations as a result of conversion of Class B to Class A shares

     22,426      —          (23,234     —     

Reallocation of undistributed earnings from continuing operations to Class B shares

     —        (4,211     —          —     

Add - preferred stock dividends

     18      —          —          —     

Add - interest expense convertible notes

     909      —          —          —     
                               

Allocation of undistributed earnings (loss) from continuing operations for diluted computation

     108,241      18,215        (96,045     (23,234

Allocation of undistributed earnings from discontinued operations

     990      262        716        228   

Reallocation of undistributed earnings from discontinued operations as a result of conversion of Class B to Class A shares

     262      —          228        —     

Reallocation of undistributed earnings from discontinued operations to Class B shares

     —        (51     —          —     
                               

Allocation of undistributed earnings from discontinued operations for diluted computation

     1,252      211        944        228   
                               

Allocation of undistributed earnings (loss)

   $ 109,493    $ 18,426      $ (95,101   $ (23,006
                               

Denominator:

         

Number of shares used in basic computation

     37,797      11,982        37,754        12,047   

Weighted average effect of dilutive securities:

         

Conversion of Class B to Class A shares

     11,982      —          12,047        —     

Employee stock options

     2,524      —          —          —     

Convertible preferred stock

     338      —          —          —     

Convertible notes

     8,692      —          —          —     
                               

Number of shares used in per share computations

     61,333      11,982        49,801        12,047   
                               

Diluted earnings (loss) per share from continuing operations

   $ 1.77    $ 1.52      $ (1.93   $ (1.93

Diluted earnings per share from discontinued operations

     0.02      0.02        0.02        0.02   
                               

Diluted earnings (loss) per share (1)  (2)

   $ 1.79    $ 1.54      $ (1.91   $ (1.91
                               

 

(1)

For the three months ended December 31, 2009, there were stock options to purchase 1,691 out of the money shares of Class A Common Stock and 28 out of the money shares of Class B Common Stock that were excluded from the computation of diluted loss per share because their effect would have been anti-dilutive.

 

18


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

(2)

For the three months ended December 31, 2008, there were stock options to purchase 38 shares (excluding 1,699 out of the money shares) of Class A Common Stock, stock options to purchase 38 shares (excluding 845 out of the money shares) of Class B Common Stock, preferred shares convertible into 338 shares of Class A Common Stock, and $200,000 principal amount of convertible notes convertible into 8,692 shares of Class A Common Stock that were excluded from the computation of diluted loss per share because their effect would have been anti-dilutive.

 

     Nine Months Ended December 31,  
     2009     2008  
     Class A     Class B     Class A     Class B  

Diluted loss per share:

        

Numerator:

        

Allocation of undistributed loss from continuing operations

   $ (3,841   $ (1,222   $ (103,658   $ (33,335

Reallocation of undistributed loss from continuing operations as a result of conversion of Class B to Class A shares

     (1,222     —          (33,335     —     

Reallocation of undistributed loss from continuing operations to Class B shares

     —          —          —          —     

Add - preferred stock dividends

     —          —          —          —     

Add - interest expense convertible notes

     —          —          —          —     
                                

Allocation of undistributed loss from continuing operations for diluted computation

     (5,063     (1,222     (136,993     (33,335

Allocation of undistributed earnings from discontinued operations

     3,497        1,112        2,912        936   

Reallocation of undistributed earnings from discontinued operations as a result of conversion of Class B to Class A shares

     1,112        —          936        —     

Reallocation of undistributed earnings from discontinued operations to Class B shares

     —          —          —          —     
                                

Allocation of undistributed earnings from discontinued operations for diluted computation

     4,609        1,112        3,848        936   
                                

Allocation of undistributed loss

   $ (454   $ (110 )   $ (133,145   $ (32,399
                                

Denominator:

        

Number of shares used in basic computation

     37,799        12,024        37,539        12,072   

Weighted average effect of dilutive securities:

        

Conversion of Class B to Class A shares

     12,024        —          12,072        —     

Employee stock options

     —          —          —          —     

Convertible preferred stock

     —          —          —          —     

Convertible notes

     —          —          —          —     
                                

Number of shares used in per share computations

     49,823        12,024        49,611        12,072   
                                

Diluted loss per share from continuing operations

   $ (0.10   $ (0.10   $ (2.76   $ (2.76

Diluted earnings per share from discontinued operations

     0.09        0.09        0.08        0.08   
                                

Diluted loss per share (3)  (4)

   $ (0.01   $ (0.01   $ (2.68   $ (2.68
                                

 

19


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

 

(3)

For the nine months ended December 31, 2009, there were stock options to purchase 1,110 shares (excluding 3,086 out of the money shares) of Class A Common Stock, stock options to purchase 2 shares (excluding 55 out of the money shares) of Class B Common Stock, preferred shares convertible into 338 shares of Class A Common Stock and $200,000 principal amount of convertible notes convertible into 8,692 shares of Class A Common Stock that were excluded from the computation of diluted loss per share because their effect would have been anti-dilutive.

(4)

For the nine months ended December 31, 2008, there were stock options to purchase 327 shares (excluding 1,557 out of the money shares) of Class A Common Stock, stock options to purchase 55 shares (excluding 69 out of the money shares) of Class B Common Stock, preferred shares convertible into 338 shares of Class A Common Stock, and $200,000 principal amount of convertible notes convertible into 8,692 shares of Class A Common Stock that were excluded from the computation of diluted loss per share because their effect would have been anti-dilutive.

7. STOCK-BASED COMPENSATION

In August 2002, the Company’s shareholders approved the Company’s 2001 Incentive Stock Option Plan (the “2001 Plan”), which allowed for the issuance of up to 3,000 shares of Class A Common Stock and 1,500 shares of Class B Common Stock. In September 2008, shareholders approved an amendment to the 2001 Plan to increase by 3,000 the number of shares of Class A Common Stock available for issuance under the 2001 Plan. Under the Company’s stock option plan, options to acquire shares of common stock have been made available for grant to all employees. Each option granted has an exercise price of not less than 100% of the market value of the common stock on the date of grant. The contractual life of each option is generally ten years and the options generally vest at the rate of 10% per year from the date of grant.

The Company estimates the fair value of stock options granted using the Black-Scholes option pricing model (the “Option Model”). The Option Model requires the use of subjective and complex assumptions, including the option’s expected term and the estimated future price volatility of the underlying stock, which determine the fair value of the share-based awards. The Company’s estimate of expected term was determined based on the average period of time that options granted are expected to be outstanding considering current vesting schedules and the historical exercise patterns of existing option plans and the two-year forfeiture period (described below). The expected volatility assumption used in the Option Model is based on historical volatility over a period commensurate with the expected term of the related options. The risk-free interest rate used in the Option Model is based on the yield of U.S. Treasuries with a maturity closest to the expected term of the Company’s stock options.

The Company’s stock option agreements for options granted prior to January 2009 include a post-exercise service condition which provides that exercised options are to be held by the Company for a two-year period during which time the shares cannot be sold by the employee. If the employee’s employment is terminated voluntarily or involuntarily (other than by retirement, death or disability) during the two-year period, these stock option agreements provide the Company with the option of repurchasing the shares at the lower of the exercise price or the fair market value of the stock on the date of termination. This repurchase option is considered a forfeiture provision and the two-year period is included in determining the requisite service period over which stock-based compensation expense is recognized. The requisite service period initially is equal to the expected term (as discussed above) and is revised when an option exercise occurs.

If stock options with the two-year post-exercise service condition expire unexercised or an employee terminates employment after options become exercisable, no compensation expense associated with the exercisable, but unexercised, options is reversed. In those instances where an employee terminates employment before options become exercisable or the Company repurchases the shares during the two-year forfeiture period, compensation expense for these options is reversed as a forfeiture.

When an employee exercises stock options with the two-year post exercise service condition, the exercise proceeds received by the Company are recorded as a deposit and classified as a current liability for the two-year forfeiture period. The shares issuable upon exercise of these options are accounted for as issued when the two-year forfeiture period lapses. Until the two-year forfeiture requirement is met, the underlying shares are not considered outstanding and are not included in calculating basic earnings per share.

 

20


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

Commencing in January 2009, the Company granted stock options that vest over three years. Additionally in April 2009, the Company granted stock options that vest over twenty months. These options were granted without a two-year post-exercise service condition. Similar to previous grants, these options have an exercise price of not less than 100% of the market value of the common stock on the date of grant and the contractual life of each option is ten years. The Company’s estimate of the expected term for these options was calculated using the Company’s historical exercise patterns of previously issued options, adjusted to exclude the impact of the two-year forfeiture period.

The Company recognized stock-based compensation of $1,272 and $3,602, respectively, and related tax benefits of $87 and $280, respectively, prior to the consideration of a valuation allowance, for the three and nine months ended December 31, 2009 and stock-based compensation of $998 and $3,633, respectively, and related tax benefits of $88 and $548, respectively, for the three and nine months ended December 31, 2008. There was no stock-based employee compensation cost capitalized as of December 31, 2009 and March 31, 2009. There was no cash received from stock option deposits for the three months ended December 31, 2009. Cash received from stock option deposits for the three months ended December 31, 2008 was $73 and for the nine months ended December 31, 2009 and 2008, respectively, was $2 and $774. The actual tax benefit realized from tax deductions associated with stock option exercises (at expiration of two-year forfeiture period) was $48 and $518 for the three and nine months ended December 31, 2008, respectively. There was no actual tax benefit realized from tax deductions associated with stock option exercises for the three and nine months ended December 31, 2009, as the exercise price of these options was significantly above the market value of the underlying shares of common stock.

The following weighted average assumptions were used for stock options granted during the three and nine months ended December 31, 2009 and the three and nine months ended December 31, 2008:

 

     Three Months  Ended
December 31,
    Nine Months  Ended
December 31,
 
     2009     2008     2009     2008  

Dividend yield

     None        None        None        None   

Expected volatility

     101     39     99     39

Risk-free interest rate

     2.71     3.23     2.48     3.50

Expected term

     6.0 years        9.0 years        5.9 years        9.0 years   

Weighted average fair value per share at grant date

   $ 3.00      $ 10.55      $ 2.32      $ 10.45   

 

21


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

A summary of the changes in the Company’s stock option plans during the nine months ended December 31, 2009 is presented below:

 

     Shares     Weighted
Average
Exercise
Price
   Weighted
Average
Remaining
Contractual
Term
   Aggregate
Intrinsic
Value

Balance, March 31, 2009

   4,292      $ 12.49      

Options granted

   1,231        2.93      

Options exercised

   (171     9.70       $ —  

Options canceled

   (988     13.02      
              

Balance, December 31, 2009

   4,364        9.78    3.6    $ —  
              

Expected to vest at December 31, 2009

   3,234      $ 9.78    3.6    $ —  

Options exercisable at December 31, 2009 (excluding shares in the two-year forfeiture period)

   818      $ 19.47    5.9    $ —  

As of December 31, 2009, the Company had $30,144 of total unrecognized compensation expense related to stock option grants, which will be recognized over the remaining weighted average period of 3.5 years.

8. REVENUE RECOGNITION

Revenue is generally realized or realizable and earned when persuasive evidence of an arrangement exists, the customer’s payment ability has been reasonably assured, title and risk of ownership have been transferred to the customer, and the seller’s price to the buyer is fixed or reasonably determinable. When these conditions have not been met, revenue is deferred and reflected as a liability on the consolidated balance sheet until any uncertainties or contingencies have been resolved. The Company also enters into long-term agreements under which it assigns marketing rights for products it has developed to pharmaceutical markets. Royalties under these arrangements are earned based on the sale of products.

Concurrently with the recognition or deferral of revenue, the Company records estimated provisions for product returns, sales rebates, payment discounts, chargebacks, and other sales allowances. When the occurrence of product recalls becomes probable, the Company also records estimated liabilities for product returns related to recalls. The Company records failure to supply claims when they are probable and reasonably estimable. Provisions are established based upon consideration of a variety of factors, including but not limited to, historical relationship to revenues, historical payment and return experience, estimated and actual customer inventory levels, customer rebate and failure to supply arrangements, current contract sales terms with wholesale and indirect customers, and subsequent payment activity. The following briefly describes each provision and how such provisions are estimated.

 

   

Cash Discounts—Payment discounts are reductions to invoiced amounts offered to customers for payment within a specified period and are estimated utilizing historical customer payment experience.

 

   

Sales Rebates—Sales rebates are offered to certain customers to promote customer loyalty and encourage greater product sales. These rebate programs provide that, upon the attainment of pre-established volumes or the attainment of revenue milestones for a specified period, the customer receives credit against purchases. Other promotional programs are incentive programs periodically offered to customers. Due to the nature of these programs, the Company is able to estimate provisions for rebates and other promotional programs based on the specific terms in each agreement.

 

   

Sales Returns—Consistent with common industry practices, the Company has agreed to terms with its customers to allow them to return product that is within a certain period of the expiration date. Upon recognition of revenue from product sales to customers, the Company provides for an estimate of product to be returned. This estimate is determined by applying a historical relationship of customer returns to amounts invoiced.

 

22


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

   

Chargebacks—The Company markets and sells products directly to wholesalers, distributors, warehousing pharmacy chains, mail order pharmacies and other direct purchasing groups. The Company also markets products indirectly to independent pharmacies, non-warehousing chains, managed care organizations, and group purchasing organizations, collectively referred to as “indirect customers.” The Company enters into agreements with some indirect customers to establish contract pricing for certain products. These indirect customers then independently select a wholesaler from which to purchase the products at these contracted prices. Alternatively, the Company may pre-authorize wholesalers to offer specified contract pricing to other indirect customers. Under either arrangement, the Company provides credit to the wholesaler for any difference between the contracted price with the indirect customer and the wholesaler’s invoice price. This credit is called a chargeback. Provisions for estimated chargebacks are calculated primarily using historical chargeback experience, actual contract pricing, estimated and actual wholesaler inventory levels, and subsequent payment activity.

 

   

Price Protection—Generally, the Company provides credits to wholesale customers for decreases that are made to selling prices for the value of inventory that is owned by these customers at the date of the price reduction. These credits are customary in the industry and are intended to reduce a wholesale customer’s inventory cost to better reflect current market prices. Since a reduction in the wholesaler’s invoice price reduces the chargeback per unit, price reduction credits are typically included as part of the reserve for chargebacks because they act essentially as accelerated chargebacks. Although the Company contractually agreed to provide price adjustment credits to its major wholesale customers at the time they occur, the impact of any such price reductions not included in the reserve for chargebacks is immaterial to the amount of revenue recognized in any given period.

 

   

Medicaid Rebates—Federal law requires that a pharmaceutical manufacturer, as a condition of having its products receive federal reimbursement under Medicaid and Medicare Part B, must pay rebates to state Medicaid programs for units of its pharmaceuticals that are dispensed to Medicaid beneficiaries and paid for by a state Medicaid program. The provision for Medicaid rebates is based upon historical experience of claims submitted by the various states. The Company also monitors Medicaid legislative changes to determine what impact such legislation may have on the provision for Medicaid rebates.

 

   

Product Recall Returns—Liabilities for product returns related to recalls are based on estimated and actual customer inventory levels at the time of the recall and actual contract pricing.

 

   

Failure to Supply—The Company has entered into purchase agreements with certain customers that include a provision whereby the Company is required to reimburse these customers for price differences on product orders that the Company is unable to fulfill. The Company estimates this liability based on the terms of the agreements.

Actual product returns, chargebacks and other sales allowances incurred are dependent upon future events and may be different from the Company’s estimates. The Company continually monitors the factors that influence sales allowance estimates and makes adjustments to these provisions when management believes that actual product returns, chargebacks and other sales allowances may differ from established allowances.

The provisions discussed above are presented in the consolidated financial statements as reductions to gross revenues and a decrease to accounts receivable or an increase to accrued liabilities. Provisions totaled $5,018 and $97,353 for the three months ended December 31, 2009 and 2008, respectively, and $7,114 and $279,146 for the nine months ended December 31, 2009 and 2008, respectively.

 

23


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

The reserve balances related to the provisions are included in “Receivables, less allowance for doubtful accounts” or “Accrued liabilities” in the accompanying consolidated balance sheets. A summary of activity for each reserve or liability for the nine months ended December 31, 2009 follows:

 

(in thousands)    Beginning
Balance
   Current Provision
Related to Sales
Made in the
Current Period
   Current Provision
Related to Sales
Made in the
Prior Periods
   Actual Returns
or Credits
in the
Current Period
    Ending
Balance

Nine Months Ended December 31, 2009

             

Accounts Receivable Reserves:

             

Chargebacks

   $ 1,021    $ 998    $ —      $ (1,863   $ 156

Cash Discounts and Other Allowances

     1,035      3,145      —        (3,421     759

Liabilities:

             

Sales Rebates

     8,264      812      —        (7,098     1,978

Sales Returns

     12,009      531      —        (5,557     6,983

Medicaid Rebates

     6,312      1,079      —        (4,345     3,046

Medicare and Medicaid Restitution

     2,275      —        —        —          2,275

Product Recall Returns

     40,695      —        —        (33,789     6,906

Failure to Supply Claims

     17,101      —        —        (4,801     12,300

Chargeback Audit Adjustments

     1,823      —        321      (2,144     —  

Other

     2,955      228      —        (2,630     553
                                   

Total

   $ 93,490    $ 6,793    $ 321    $ (65,648   $ 34,956
                                   

The liabilities for sales rebates, sales returns, Medicaid rebates, Medicare and Medicaid restitution, product recall returns, failure to supply claims and chargeback audit adjustments are classified as accrued liabilities in the consolidated balance sheets as of December 31, 2009 and March 31, 2009. The expense associated with these accruals is classified in the consolidated statement of operations for the three and nine months ended December 31, 2009 as a reduction of gross revenue.

In connection with litigation described in greater detail in Note 18—“Commitments and Contingencies,” on June 9, 2009, the Company entered into a Distribution and Supply Agreement (the “Distribution Agreement”) with Purdue Pharma L.P., The P.F. Laboratories, Inc. and Purdue Pharmaceuticals L.P (collectively “Purdue”).

On September 1, 2009, the Company elected for the Distribution Agreement to become effective as of September 1, 2009. Pursuant to the terms of the Distribution Agreement, Purdue provided the Company with a limited quantity of certain generic versions of OxyContin, as specified in the Distribution Agreement, to be distributed by the Company during a limited period, and the Company paid Purdue a royalty fee and the cost of manufacturing the product supplied by Purdue.

During the three months ended December 31, 2009, the Company received and sold to its customers all of the generic OxyContin allotted under the Distribution Agreement and recognized net revenue in the amount of approximately $143,400 in the consolidated statement of operations. The Company recognized the revenue when it had determined that persuasive evidence of an arrangement existed, the customers’ payment ability had been reasonably assured, title and risk of ownership had been transferred to the customers, and the Company’s price to its customers was determined. Additionally, the Company recorded approximately $20,300 as cost of sales in the three months ended December 31, 2009, which included royalty fees and the cost of the generic OxyContin supplied by Purdue. Accordingly, the Company recognized gross profit of $123,100 in the three months ended December 31, 2009 as a result of the Distribution Agreement entered into with Purdue.

 

24


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

9. INVESTMENT SECURITIES

The carrying amount of available-for-sale investment securities and their approximate fair values at December 31, 2009 and March 31, 2009 were as follows:

 

     December 31, 2009
     Cost    Gross
Unrealized
Gains
   Gross
Unrealized
Losses
   Fair
Value

Non-current auction rate securities

   $ 63,468    $ 2,650    $ —      $ 66,118
                           
     March 31, 2009
     Cost    Gross
Unrealized
Gains
   Gross
Unrealized
Losses
   Fair
Value

Non-current auction rate securities

   $ 63,752    $ 2,219    $ —      $ 65,971
                           

At December 31, 2009 and March 31, 2009, the Company had $72,300 and $72,800, respectively of principal invested in ARS. These securities all have a maturity in excess of 10 years. The Company’s investments in ARS primarily represent interests in collateralized debt obligations supported by pools of student loans, the principal of which is guaranteed by the U.S. Government. ARS backed by student loans are viewed as having low default risk and therefore very low risk of credit downgrade. The ARS held by the Company are AAA-rated securities with long-term nominal maturities for which the interest rates are reset through a Dutch auction process that occurs at pre-determined intervals of up to 35 days. The auctions historically have provided a liquid market for these securities.

With the liquidity issues experienced in global credit and capital markets, the ARS held by the Company at December 31, 2009 and March 31, 2009 experienced multiple failed auctions beginning in February 2008 as the amount of securities submitted for sale exceeded the amount of purchase orders. Given the failed auctions, the Company’s ARS are illiquid until a successful auction for them occurs. Accordingly, the $66,118 and $65,971 of ARS at December 31, 2009 and March 31, 2009, respectively, were classified as non-current assets and are included in the line item “Investment securities” in the accompanying Consolidated Balance Sheets.

On February 25, 2009, the Company initiated legal action against Citigroup Global Markets Inc. (“CGMI”), through which it acquired the ARS the Company held at that time, in the District Court for the Eastern District of Missouri. On January 21, 2010, the Company and CGMI entered into a Purchase and Release Agreement pursuant to which CGMI agreed to purchase the Company’s remaining ARS for an aggregate purchase price of approximately $61,707. The Company also received a two-year option (which expires on January 21, 2012) to reacquire the ARS (in whole or on a class-by-class basis) for the prices at which they were sold, as well as the right to receive further payments in the event any ARS are redeemed prior to the expiration of the option. (See Note 20—“Subsequent Events.”)

The Company faces significant liquidity concerns as discussed in Note 3—“Going Concern and Liquidity Considerations.” As a result, the Company determined it could no longer support its previous assertion that it had the ability to hold impaired securities until their forecasted recovery. Accordingly, the Company concluded that the ARS became other-than-temporarily impaired during December 2008 and recorded a loss into earnings during the three months ended December 31, 2008. This adjustment reduced the carrying value of the ARS to $63,678 at December 31, 2008. At March 31, 2009, the estimated fair value of the Company’s ARS holdings was $65,971. The Company recorded discount accretion of $74 on the carrying value of ARS and recorded the $2,219 difference between the fair value and carrying value of the ARS at March 31, 2009 in accumulated other comprehensive income as an unrealized gain of $1,415, net of tax. The estimated fair value of the Company’s

 

25


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

ARS holdings at December 31, 2009 was $66,118. During the nine months ended December 31, 2009, the Company sold $500 in principal amount of the ARS and recorded discount accretion of $216 on the ARS. The $2,650 difference in fair value compared to the corresponding carrying value of $63,468 at December 31, 2009 was recorded in accumulated other comprehensive income as an unrealized gain of $1,678, net of tax.

The ARS are valued based on a discounted cash flow model that considers, among other factors, the time to work out the market disruption in the traditional trading mechanism, the stream of cash flows (coupons) earned until maturity, the prevailing risk-free yield curve, credit spreads applicable to a portfolio of student loans with various tenures and ratings and an illiquidity premium. These factors were used in a Monte Carlo simulation based methodology to derive the estimated fair value of the ARS.

10. FAIR VALUE MEASURES

In September 2006, the FASB issued authoritative guidance for fair value measurements. The Company implemented the authoritative guidance, effective April 1, 2008, which relates to disclosures for financial assets, financial liabilities, and any other assets and liabilities that are recognized or disclosed at fair value in the consolidated financial statements on a recurring basis. The guidance defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In order to increase consistency and comparability in fair value measurements, the authoritative guidance established a fair value hierarchy that ranks the quality and reliability of the information used to measure fair value. Financial assets and liabilities carried at fair value are classified and disclosed in one of the following three categories:

 

   

Level 1 – Primarily consists of financial assets and liabilities whose values are based on unadjusted quoted prices for identical assets or liabilities in an active market that the Company has the ability to access.

 

   

Level 2 – Includes financial instruments measured using significant other observable inputs that are valued by reference to similar assets or liabilities, such as: quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability; and inputs that are derived principally from or corroborated by observable market data by correlation or other means.

 

   

Level 3 – Comprised of financial assets and liabilities whose values are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. These inputs reflect management’s own assumptions about the assumptions a market participant would use in pricing the asset or liability.

The following table presents the Company’s fair value hierarchy as of December 31, 2009 for those financial assets measured at fair value on a recurring basis:

 

     Fair Value Measurements at December 31, 2009
     Total    Level 1    Level 2    Level 3

Non-current auction rate securities

   $ 66,118    $ —      $ —      $ 66,118
                           

The Company’s investments in ARS primarily represent interests in collateralized debt obligations supported by pools of student loans, the principal of which is guaranteed by the U.S. Government. The ARS held by the Company are AAA-rated securities with long-term nominal maturities for which the interest rates are reset through a Dutch auction process that occurs at pre-determined intervals of up to 35 days. Due to the lack of observable market quotes and an illiquid market for the Company’s ARS portfolio as of December 31, 2009, the Company utilized a valuation model that relied exclusively on Level 3 inputs, including those that are based on expected cash flow streams and collateral values.

 

26


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

The contingent interest feature of the $200,000 principal amount of Contingent Convertible Subordinated Notes (see Note 14—“Long-Term Debt”) meets the criteria of and qualifies as an embedded derivative. Although this feature represents an embedded derivative financial instrument, based on its de minimis value at the time of issuance and at December 31, 2009, no value has been assigned to this embedded derivative.

The following table presents the changes in fair value for financial assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3):

 

     Non-Current Auction
Rate Securities
(Level 3)
 

Balance at April 1, 2009

   $ 65,971   

Unrealized gains included in other comprehensive loss

     431   

Accretion of investment impairment

     216   

Sales of ARS Securities

     (500
        

Balance at December 31, 2009

   $ 66,118   
        

11. INVENTORIES

Inventories consisted of the following:

 

     December 31, 2009    March 31, 2009

Raw materials

   $ 23,463    $ 20,208

Finished goods

     1,061      1,978

Work-in-process

     377      —  
             
   $ 24,901    $ 22,186
             

Inventory is carried at the lower of cost or market. Management establishes reserves for potentially obsolete or slow-moving inventory based on an evaluation of inventory levels, forecasted demand, and market conditions.

Inventories included $2,729 and $2,304 of raw materials as of December 31, 2009 and March 31, 2009, respectively, that will be used in future research and development activities.

The Company ceased all manufacturing activities during the fourth quarter of fiscal year 2009, and its net revenues are limited to sales of products manufactured by third parties. Additionally, all costs associated with the Company’s manufacturing operations are recognized directly into cost of sales rather than capitalized into inventory.

 

27


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

12. INTANGIBLE ASSETS

Intangible assets consisted of the following:

 

     December 31, 2009    March 31, 2009
     Gross
Carrying
Amount
   Accumulated
Amortization
    Net
Carrying
Amount
   Gross
Carrying
Amount
   Accumulated
Amortization
    Net
Carrying
Amount

Product rights acquired:

               

Micro-K®

   $ 36,140    $ (19,500   $ 16,640    $ 36,140    $ (18,145   $ 17,995

Evamist™

     44,078      (7,141     36,937      44,078      (4,937     39,141

Trademarks acquired:

               

Evamist™

     12,774      (2,070     10,704      12,774      (1,431     11,343

License agreements:

               

Evamist™

     82,542      (13,372     69,170      82,542      (9,245     73,297

Other

     375      (34     341      375      —          375

Covenants not to compete:

               

Evamist™

     2,106      (569     1,537      2,106      (393     1,713

Trademarks and patents

     5,373      (1,362     4,011      5,129      (1,135     3,994

Assembled workforce

     679      (180     499      612      (71     541
                                           

Total intangible assets

   $ 184,067    $ (44,228   $ 139,839    $ 183,756    $ (35,357   $ 148,399
                                           

The final purchase price allocation related to Evamist™ was completed during the three months ended June 30, 2008, resulting in adjustments to the gross carrying amounts for intangible assets related to Evamist™ during the quarter ended June 30, 2008.

As of December 31, 2009, the Company’s intangible assets had a weighted average useful life of approximately 16 years. Amortization expense for intangible assets was $2,980 and $3,605 for the three months ended December 31, 2009 and 2008, respectively, and $8,875 and $10,619 for the nine months ended December 31, 2009 and 2008, respectively.

Assuming no additions, disposals or adjustments are made to the carrying values and/or useful lives of the intangible assets, annual amortization expense on product rights, trademarks acquired and other intangible assets is estimated to be approximately $2,900 for the remainder of fiscal year 2010 and approximately $12,000 in each of the four succeeding fiscal years.

Management tests the carrying value of intangible assets for impairment at least annually and also assesses and evaluates on a quarterly basis if any events have occurred which indicate the possibility of impairment. During the assessment as of December 31, 2009, management did not identify any events that were indicative of impairment. However, any significant changes in actual future results from the assessment used to perform the quarterly evaluation, such as lower sales, increases in production costs, technological changes or decisions not to produce or sell products, could result in impairment at a future date (see Note 2—“Basis of Presentation”).

13. ACCRUED SEVERANCE

Accrued severance consists primarily of severance benefits owed to employees whose employment was terminated in connection with the ongoing realignment of the Company’s cost structure. Severance expense recognized in the nine months ended December 31, 2009 was recorded in part to restructuring charges and in part to cost of sales in the consolidated statement of operations. The activity in accrued severance for the nine months ended December 31, 2009 is summarized as follows:

 

Balance at March 31, 2009

   $ 10,002   

Provision for severance benefits

     1,950   

Amounts charged to accrual

     (11,156
        

Balance at December 31, 2009

   $ 796   
        

 

28


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

14. LONG-TERM DEBT

Long-term debt consisted of the following:

 

     December 31, 2009     March 31, 2009  

Convertible notes

   $ 200,000      $ 200,000   

Building mortgages

     35,843        37,432   

Software financing arrangement

     724        1,117   
                
     236,567        238,549   

Less current portion

     (36,259     (37,824
                
   $ 200,308      $ 200,725   
                

In May 2003, the Company issued $200,000 principal amount of 2.5% Contingent Convertible Subordinated Notes (the “Notes”) that are convertible, under certain circumstances, into shares of Class A Common Stock at an initial conversion price of $23.01 per share. The Notes, which mature on May 16, 2033, bear interest that is payable on May 16 and November 16 of each year at a rate of 2.50% per annum. The Company also is obligated to pay contingent interest at a rate equal to 0.5% per annum during any six-month period from May 16 to November 15 and from November 16 to May 15, with the initial six-month period commencing May 16, 2006, if the average trading price of the Notes per $1,000 principal amount for the five trading day period ending on the third trading day immediately preceding the first day of the applicable six-month period equals $1,200 or more. In November 2007, the average trading price of the Notes reached the threshold for the five-day trading period that resulted in the payment of contingent interest and for the period from November 16, 2007 to May 15, 2008 the Notes paid interest at a rate of 3.00% per annum. In May 2008, the average trading price of the Notes fell below the contingent interest threshold for the five-day trading period and beginning May 16, 2008 the Notes began to pay interest at a rate of 2.50% per annum, which is the current rate as of December 31, 2009.

The Company may redeem some or all of the Notes at any time on or after May 21, 2006, at a redemption price, payable in cash, of 100% of the principal amount of the Notes, plus accrued and unpaid interest, including contingent interest, if any. Holders may require the Company to repurchase all or a portion of their Notes on May 16, 2013, 2018, 2023 and 2028 or upon a change in control, as defined in the indenture governing the Notes, at a purchase price, payable in cash, of 100% of the principal amount of the Notes, plus accrued and unpaid interest, including contingent interest, if any. Holders had the right to require the Company to repurchase all or a portion of their Notes on May 16, 2008 and, accordingly, the Company classified the Notes as a current liability as of March 31, 2008. Since no holders required the Company to repurchase all or a portion of their Notes on this date and because the next occasion holders may require the Company to repurchase all or a portion of their Notes is May 16, 2013, the Notes were classified as a long-term liability as of December 31, 2009. The Notes are subordinate to all of the Company’s existing and future senior obligations.

The Notes are convertible, at the holders’ option, into shares of the Company’s Class A Common Stock prior to the maturity date under the following circumstances:

 

   

during any quarter commencing after June 30, 2003, if the closing sale price of the Company’s Class A Common Stock over a specified number of trading days during the previous quarter is more than 120% of the conversion price of the Notes on the last trading day of the previous quarter. The Notes are initially convertible at a conversion price of $23.01 per share, which is equal to a conversion rate of approximately 43.4594 shares per $1,000 principal amount of Notes;

 

29


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

   

if the Company has called the Notes for redemption;

 

   

during the five trading day period immediately following any nine consecutive trading day period in which the trading price of the Notes per $1,000 principal amount for each day of such period was less than 95% of the product of the closing sale price of our Class A Common Stock on that day multiplied by the number of shares of our Class A Common Stock issuable upon conversion of $1,000 principal amount of the Notes; or

 

   

upon the occurrence of specified corporate transactions.

The Company has reserved 8,691,880 shares of Class A Common Stock for issuance in the event the Notes are converted.

The Notes, which are unsecured, do not contain any restrictions on the payment of dividends, the incurrence of additional indebtedness or the repurchase of the Company’s securities, and do not contain any financial covenants. The Company is current in all its financial payment obligations under the indenture governing the Notes. However, a failure by the Company or any of its subsidiaries to pay any indebtedness or any final non-appealable judgments in excess of $750 constitutes an event of default under the indenture. An event of default would permit the trustee under the indenture or the holders of at least 25% of the Notes to declare all amounts owing to be immediately due and payable and exercise other remedies.

In March 2006, the Company entered into a $43,000 mortgage loan arrangement with one of its primary lenders, in part, to refinance $9,859 of existing mortgages. The $32,764 of net proceeds the Company received from the mortgage loan was used for working capital and general corporate purposes. This mortgage loan, which is secured by three of the Company’s buildings, bears interest at a rate of 5.91% and matures on April 1, 2021. The Company is current in all its financial payment obligations under the mortgage loan arrangement. However, the Company believes that at December 31, 2009 it was not in compliance with one or more of the requirements of the mortgage loan documentation. Accordingly, the $35,843 that remained outstanding under the mortgage arrangement as of December 31, 2009 was classified as a current liability as of December 31, 2009.

In June 2007, the Company entered into an installment payment agreement with a financial institution for the purchase of software products and the right to receive consulting or other services from the seller. Upon delivery of the products and services, the financial institution pays the seller amounts owed for the software products and services. As a result, the Company recorded debt in the amount of $1,733 which will be paid ratably over 16 consecutive quarters to the financial institution. In August 2007, the Company entered into another agreement with the same financial institution for the payment of additional consulting services that will be provided on a time and material basis. In exchange for the institution paying the seller for fees owed, the Company recorded additional debt of $306 which will be paid to the financial institution ratably over 16 consecutive quarters. The two installment payment agreements were discounted using an imputed annual interest rate that approximated the Company’s borrowing rate for similar debt instruments at the time of the borrowings.

 

30


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

The aggregate maturities of long-term debt as of December 31, 2009 were as follows:

 

Due in one year

   $ 36,259

Due in two years

     308

Due in three years

     —  

Due in four years

     200,000
      
   $ 236,567
      

15. TAXABLE INDUSTRIAL REVENUE BONDS

In December 2005, the Company entered into a financing arrangement with St. Louis County, Missouri related to expansion of its operations in St. Louis County. Up to $135,500 of industrial revenue bonds may be issued to the Company by St. Louis County relative to capital improvements made through December 31, 2009. This agreement provides that 50% of the real and personal property taxes on up to $135,500 of capital improvements will be abated for a period of 10 years subsequent to the property being placed in service. Industrial revenue bonds totaling $129,907 were outstanding at December 31, 2009. The industrial revenue bonds are issued by St. Louis County to the Company upon its payment of qualifying costs of capital improvements, which are then leased by the Company for a period ending December 1, 2019, unless earlier terminated. The Company has the option at any time to discontinue the arrangement and regain full title to the abated property. The industrial revenue bonds bear interest at 4.25% per annum and are payable as to principal and interest concurrently with payments due under the terms of the lease. The Company has classified the leased assets as property and equipment and has established a capital lease obligation equal to the outstanding principal balance of the industrial revenue bonds. Lease payments may be made by tendering an equivalent portion of the industrial revenue bonds. As the capital lease payments to St. Louis County may be satisfied by tendering industrial revenue bonds (which is the Company’s intention), the capital lease obligation, industrial revenue bonds and related interest expense and interest income, respectively, have been offset for presentation purposes in the Consolidated Financial Statements.

16. COMPREHENSIVE INCOME (LOSS)

Comprehensive income (loss) includes all changes in equity during a period except those that resulted from investments by or distributions to the Company’s shareholders. Other comprehensive income (loss) refers to revenues, expenses, gains and losses that, under GAAP, are included in comprehensive income (loss), but excluded from net income (loss) as these amounts are recorded directly as an adjustment to shareholders’ equity. For the Company, comprehensive income (loss) is comprised of net income (loss), the net changes in unrealized gains and losses on available for sale marketable securities, net of applicable income taxes, and changes in the cumulative foreign currency translation adjustment. Total comprehensive income (loss) was $108,998 and $(91,407) for the three months ended December 31, 2009 and 2008, respectively, and $148 and $(131,763) for the nine months ended December 31, 2009 and 2008, respectively.

17. SEGMENT REPORTING

The reportable operating segments of the Company are branded products (through the Company’s Ther-Rx subsidiary) and specialty generic/non-branded products (through the Company’s ETHEX subsidiary). The branded products segment includes patent-protected products and certain trademarked off-patent products that the Company sells and markets as brand pharmaceutical products. The specialty generic/non-branded segment includes off-patent pharmaceutical products that are therapeutically equivalent to proprietary products. The Company sells its branded and specialty generic/non-branded products primarily to pharmaceutical wholesalers, drug distributors and chain drug stores.

In the fourth quarter of fiscal year 2009, the Company decided to market the Company’s specialty materials segment, PDI, for sale because of liquidity concerns and the Company’s expected near-term cash requirements.

 

31


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

As a result, the Company has segregated PDI’s operating results and presented them separately as a discontinued operation for all periods presented. (See Note 20—“Subsequent Events” for more information regarding the sale of PDI.)

In connection with the plea agreement with the U.S. Department of Justice and the exclusion of ETHEX from participation in federal healthcare programs, the Company plans to cease operations of ETHEX. However, the Company has retained the ability to manufacture (once the requirements under the consent decree have been met), market and distribute all generic products and is in possession of all intellectual property related to generic products, including all NDAs and ANDAs. (See Note 20—“Subsequent Events.”)

Accounting policies of the segments are the same as the Company’s consolidated accounting policies. Segment profits are measured based on income before taxes and are determined based on each segment’s direct revenues and expenses. The majority of research and development expense, corporate general and administrative expenses, amortization, interest expense, impairment charges, litigation expense and interest and other income are not allocated to segments, but included in the “all other” classification. Identifiable assets for the two reportable operating segments primarily include receivables, inventory, and property and equipment. For the “all other” classification, identifiable assets consist of cash and cash equivalents, certain property and equipment not included with the two reportable segments, intangible and other assets and all income tax related assets.

The following tables represent information for the Company’s reportable operating segments for the three and nine months ended December 31, 2009 and 2008.

 

     Three  Months
Ended
December 31,
   Branded
Products
    Specialty
Generics
    All
Other
    Eliminations     Consolidated  

Net Revenues

             
   2009    $ 3,065      $ 144,415      $ —        $ —        $ 147,480   
   2008      13,577        13,862        177        —          27,616   

Segment profit (loss)

             
   2009      (4,794     136,259        (48,287     —          83,178   
   2008      (20,022     (17,724     (118,173     —          (155,919

Identifiable assets

             
   2009      2,335        10,913        557,891        (1,758     569,381   
   2008      32,529        89,198        768,604        (1,758     888,573   

Property and equipment additions

             
   2009      —          —          256        —          256   
   2008      —          —          7,050        —          7,050   

Depreciation and amortization

             
   2009      132        17        7,670        —          7,819   
   2008      155        71        8,829        —          9,055   

 

32


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

     Nine Months
Ended
December 31,
   Branded
Products
    Specialty
Generics
   All
Other
    Eliminations    Consolidated  

Net Revenues

               
   2009    $ 11,287      $ 145,733    $ 7      $ —      $ 157,027   
   2008      102,292        187,151      374        —        289,817   

Segment profit (loss)

               
   2009      (11,387     133,741      (151,172     —        (28,818
   2008      (1,784     48,918      (252,476     —        (205,342

Property and equipment additions

               
   2009      —          —        3,583        —        3,583   
   2008      —          —        19,398        —        19,398   

Depreciation and amortization

               
   2009      396        52      23,247        —        23,695   
   2008      458        221      26,092        —        26,771   

Consolidated revenues are principally derived from customers in North America and substantially all property and equipment is located in the St. Louis, Missouri metropolitan area.

The tables below reflect the operating results of PDI for the three and nine months ended December 31, 2009 and 2008 and its net assets as of December 31, 2009 and 2008.

 

     Three Months Ended
December 31,
   Nine Months Ended
December 31,
     2009     2008    2009     2008

Net revenues

   $ 4,402      $ 5,159    $ 11,649      $ 15,974

Cost of sales

     3,551        3,464      9,074        9,111
                             

Gross profit

     851        1,695      2,575        6,863
                             

Operating expenses:

         

Research and development

     2        68      7        93

Selling and administrative

     (1,128     135      (4,712     692
                             

Total operating expenses

     (1,126     203      (4,705     785
                             

Operating income

     1,977        1,492      7,280        6,078

Provision for income taxes

     725        548      2,671        2,230
                             

Net income

   $ 1,252      $ 944    $ 4,609      $ 3,848
                             

 

33


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

     December 31,
2009
   December  31,
2008

Cash and cash equivalents

   $ —      $ 212

Receivables, net

     3,400      3,334

Inventories, net

     3,497      4,540
             

Total current assets held for sale

     6,897      8,086

Property and equipment, less accumulated depreciation

     7,623      1,034

Intangible assets and goodwill, net

     557      —  
             

Total assets held for sale

   $ 15,077    $ 9,120
             

Accounts payable

     823      114
             

Total liabilities associated with assets held for sale

   $ 823    $ 114
             

Additionally, PDI had $1,578 and $7,250 of net property and equipment additions for the three and nine months ended December 31, 2009, respectively, and $63 and $193 of net property and equipment additions for the three and nine months ended December 31, 2008, respectively. Depreciation and amortization for PDI totaled $913 and $1,002 for the three and nine months ended December 31, 2009, respectively and $52 and $150 for the three and nine months ended December 31, 2008, respectively.

On June 1, 2009, a leased facility used by PDI was damaged by an accidental fire. The incident did not affect any of the Company’s finished product manufacturing, packaging or distribution facilities. The Company received insurance proceeds of $5,600 during the nine months ended December 31, 2009, which were used to repair and restore the damaged facilities. The insurance proceeds have been reflected as a gain in the periods in which payment was received, while expenditures have been reflected as operating expenses or capitalized property and equipment in the period incurred.

18. COMMITMENTS AND CONTINGENCIES

Contingencies

The Company is currently subject to legal proceedings and claims that have arisen in the ordinary course of business. While the Company is not presently able to determine the potential liability, if any, related to such matters, the Company believes the matters it currently faces, individually or in the aggregate, could have a material adverse effect on its financial condition or operations and liquidity.

On December 5, 2008, the Board terminated the employment agreement of Marc S. Hermelin, the Chief Executive Officer of the Company at that time, “for cause” (as that term is defined in such employment agreement). In addition, the Board removed Mr. M. Hermelin as Chairman of the Board and as the Chief Executive Officer, effective December 5, 2008. In accordance with the termination provisions of his employment agreement, the Company determined that Mr. M. Hermelin would not be entitled to any severance benefits. In addition, as a result of Mr. M. Hermelin’s termination “for cause,” the Company determined it was no longer obligated for the retirement benefits specified in the employment agreement. However, Mr. M. Hermelin informed the Company that he believed he effectively retired from his employment with the Company prior to the termination of his employment agreement on December 5, 2008 by the Board. If it is determined that Mr. M. Hermelin did effectively retire prior to December 5, 2008, the actuarially determined present value of the retirement benefits due to him would total $36,900. Mr. M. Hermelin remains a member of the Board.

Litigation and Governmental Inquiries

Resolution of one or more of the matters discussed below could have a material adverse effect on the Company’s results of operations, financial condition or liquidity. The Company intends to vigorously defend its interests in the matters described below while cooperating in governmental inquiries.

Accrued litigation consists of settlement obligations as well as loss contingencies recognized by the Company because settlement was determined to be probable and the related payouts were reasonably estimable.

 

34


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

The Company and its subsidiaries Drugtech Corporation and Ther-Rx Corporation were named as defendants in a declaratory judgment case filed in the U.S. District Court for the District of Delaware by Lannett Company, Inc. on June 6, 2008 and styled Lannett Company Inc. v. KV Pharmaceuticals et al. The action sought a declaratory judgment of patent invalidity, patent non-infringement, and patent unenforceability for inequitable conduct with respect to five patents owned by, and two patents licensed to, the Company or its subsidiaries and pertaining to the PrimaCare ONE® product marketed by Ther-Rx Corporation; unfair competition; deceptive trade practices; and antitrust violations. On June 17, 2008, the Company filed suit against Lannett in the form of a counterclaim, asserting infringement of three of the Company’s patents, infringement of its trademarks (PrimaCare® and PrimaCare ONE®), and various other claims. On March 23, 2009 a Consent Judgment was entered by the U.S. District Court of Delaware, in which the patents were not found invalid or unenforceable, and the manufacture, sale, use, importation, and offer for sale of the Lannett Products Multivitamin with Minerals and OB-Natal ONE was found to infringe the patents. Judgment was also entered in favor of the Company on its claim for trademark infringement based on Lannett’s marketing of Multivitamin with Minerals in bottles. Unless permitted by license, Lannett, its officers, directors, agents, and others in active concert and participation with them are permanently enjoined and restrained from infringing on these patents during the terms of such patents, by making, using, selling, offering for sale, or importing the products or mere colorable variations thereof; and unless permitted by license, Lannett is permanently enjoined and restrained from infringing the trademark PrimaCare ONE. All other claims and counterclaims have been dismissed with prejudice. On March 17, 2009, the Company and Lannett entered into a settlement and license agreement pursuant to which Lannett may continue to market its prenatal products under the Company’s U.S. Patent Nos. 6,258,846 (the “846 Patent”), 6,576,666 (the “666 Patent”) and 7,112,609 (the “609 Patent”) until the later of (1) October 17, 2009, or (2) 45 days after the Company notifies Lannett in writing that the Company has received regulatory approval to return PrimaCare ONE or a successor product to the market or that the Company has entered into an agreement with a third party that intends to introduce a product under the PrimaCare marks evidenced by U.S. Trademark Registrations 2,582,817 and 3,414,475. In consideration for the foregoing, Lannett has agreed to pay the Company a royalty fee equal to (1) 20% of Lannett’s net sales of its prenatal products using the license set forth in the settlement and license agreement on or before October 17, 2009 and (2) 15% of such net sales after October 17, 2009. On May 27, 2010, Lannett filed suit against the Company and its subsidiaries alleging breach of the binding agreement and settlement reached on March 17, 2009. The Company is in the process of evaluating the lawsuit.

The Company is named as a defendant in a patent infringement case filed in the U.S. District Court for the District of Delaware by UCB, Inc. and Celltech Manufacturing CA, Inc. (collectively, “UCB”) on April 21, 2008 and styled UCB, Inc. et al. v. KV Pharmaceutical Company. After the Company filed an ANDA with the FDA seeking permission to market a generic version of the 40-mg, 50-mg and 60-mg strengths of Metadate CD® methylphenidate hydrochloride extended-release capsules, UCB filed this lawsuit under a patent owned by Celltech. In a Paragraph IV certification accompanying the ANDA, KV contended that its proposed 40-mg generic formulation would not infringe Celltech’s patent. Because the patent was not listed in the Orange Book for the 50-mg and 60-mg dosages, a Paragraph I certification was filed with respect to them. The Company has filed an answer, asserted certain affirmative defenses (including that Plaintiffs are estopped to assert infringement of the 50-mg and 60-mg dosages due to their not listing the Celltech patent in the Orange Book for these dosages), and has asserted a counterclaim in which it seeks a declaratory judgment of invalidity and non-infringement of the claims in the Celltech patent, and an award of attorney’s fees and costs. A motion for summary judgment was filed on January 19, 2010. On April 2, 2010, the parties entered into a Settlement Agreement. The Agreement is currently under review by the U.S. Department of Justice and the Federal Trade Commission.

The Company was named as a defendant in two related patent infringement cases filed on December 14, 2007 in the U.S. District Courts in New Jersey and Delaware by Janssen, L.P., Janssen Pharmaceutica N.V. and Ortho-McNeil Neurologics, Inc. (collectively, “Janssen”) and styled Janssen, L.P. et al. v. KV Pharmaceutical Company. After the Company filed an ANDA with the FDA seeking permission to market a generic version of the 8-mg and 16-mg strengths of Razadyne® ER (formerly Reminyl®) Galantamine Hydrobromide Extended Release Capsules, Janssen filed these lawsuits for patent infringement under the provisions of the Hatch-Waxman Act with respect to its U.S. Patent No. 7,160,599 (the “‘599 patent”) under a patent owned by Janssen. In the

 

35


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

Company’s Paragraph IV certification, the Company contended that its proposed generic versions do not infringe Janssen’s patent and/or that the patent is invalid. A Stipulated Dismissal of Action was ordered by the Court on March 31, 2009. In the dismissal, Janssen agreed to dismiss all claims regarding infringement of the ‘599 patent and the Company agreed to dismiss with prejudice its counterclaim for non-infringement and invalidity of the ‘599 patent. Janssen also agreed that it will not use the existence or terms of this stipulated dismissal as evidence of infringement, validity or enforceability of the ‘599 patent in any future action between the parties.

The Company is named as a defendant in a patent infringement case filed in the U.S. District Court for the District of New Jersey by Celgene Corporation (“Celgene”) and Novartis Pharmaceuticals Corporation and Novartis Pharma AG (collectively, “Novartis”) on October 4, 2007 and styled Celgene Corporation et al. v. KV Pharmaceutical Company. After the Company filed an ANDA with the FDA seeking permission to market a generic version of the 10-mg, 20-mg, 30-mg, and 40-mg strengths of Ritalin LA® methylphenidate hydrochloride extended-release capsules, Celgene and Novartis filed this lawsuit for patent infringement under the provisions of the Hatch-Waxman Act with respect to two patents owned by Celgene and licensed to Novartis. In the Company’s Paragraph IV certification, the Company contended that its proposed generic versions do not infringe Celgene’s patents.

The Company is named as a defendant in another patent infringement case filed in the U.S. District Court for the District of New Jersey by Celgene and Novartis on December 5, 2008 and styled Celgene Corporation et al. v. KV Pharmaceutical Company. After the Company filed an ANDA with the FDA seeking approval to market a generic version of FOCALIN XR® drug products, Celgene and Novartis filed this lawsuit for patent infringement under the patent laws of the United States. In the Company’s Paragraph IV Certification, the Company contended the Patents-In-Suit would not be infringed by the activities described in the Company’s ANDA. On March 1, 2010, the Company entered into a Confidential Settlement Agreement to settle the patent infringement actions with respect to Ritalin LA® and FOCALIN XR®. No objections to the agreement were raised by the FDA and Federal Trade Commission. A Stipulation and Order of Dismissal was entered on April 21, 2010.

The Company was named as a defendant in three patent infringement cases brought by Purdue Pharma L.P., The P.F. Laboratories, Inc. and Purdue Pharmaceuticals L.P. (collectively “Purdue”). On January 16, 2007, after the Company filed an ANDA with the FDA seeking permission to market generic versions of the 10-mg, 20-mg, 40-mg and 80-mg dosage strengths of OxyContin, a controlled-release oxycodone product marketed and sold under NDA No. 20-553 (“OxyContin”), in extended-release tablet form, Purdue filed a lawsuit in the U.S. District Court for the District of Delaware against the Company and an unrelated third party for patent infringement under the provisions of Hatch-Waxman Act with respect to three Purdue patents. In the Company’s Paragraph IV certification set forth in the Company’s ANDA, the Company contended that Purdue’s patents were invalid, unenforceable, or would not be infringed by the Company’s proposed generic versions of OxyContin. On February 12, 2007, Purdue filed a second patent infringement lawsuit against the Company in the same court, asserting patent infringement under the same three patents with respect to the Company’s filing of an amendment to its ANDA to sell a generic equivalent of Purdue’s OxyContin, 30-mg and 60-mg dosage strengths, product. On June 6, 2007, Purdue filed a third patent infringement lawsuit against the Company in the U.S. District Court for the Southern District of New York (the “NY District Court”), asserting infringement under the same three Purdue patents with respect to the Company’s filing of an amendment to its ANDA to sell a generic equivalent of Purdue’s OxyContin, 15-mg dosage strength, product. The two lawsuits filed in federal court in Delaware were transferred to the NY District Court for multi-district litigation purposes.

Pursuant to the Hatch-Waxman Act, the filing of the patent infringement lawsuits against the Company by Purdue instituted an automatic stay of any FDA approval of the Company’s ANDA, on a dosage strength-by-dosage strength basis, until the earlier of a judgment, or 30 months from the date that Purdue received notice from the Company that its ANDA had been submitted to the FDA.

In connection with the above referenced litigation, on June 9, 2009, the Company entered into a Settlement Agreement with Purdue (the “Settlement Agreement”). In connection with the Settlement Agreement, the Company and Purdue also entered into a Patent License Agreement (the “Patent License Agreement”) and a Distribution and Supply Agreement (the “Distribution Agreement”).

 

36


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

Pursuant to the Settlement Agreement, the Company and Purdue agreed to a complete settlement of Civil Actions No. 07 Civ. 3972, 07 Civ. 3973 and 07 Civ. 4810 (SHS) in the NY District Court regarding, among other things, the validity and enforceability of United States Patents Nos. 5,508,042 (the “‘042 Patent”), 5,226,331, 5,549,912 and 5,656,295 relating to OxyContin (collectively, the “Purdue Patents”) as well as the alleged patent infringement by the Company. The Company has also agreed to no longer dispute, among other things, the validity, enforceability or infringement of the Purdue Patents and to make, use or sell generic versions of controlled-release oxycodone product, including OxyContin that are described in the Company’s ANDA (the “Company Product”) only in accordance with the Patent License Agreement.

Pursuant to the terms of the Patent License Agreement, dated as of June 9, 2009, Purdue granted to the Company a limited, non-exclusive, royalty-bearing, non-transferable (except as permitted by the Patent License Agreement) license of limited duration under the ‘042 Patent (the “License”) to sell, in the United States, a certain amount of various dosage strengths of the Company Product under the Purdue NDA. The Company will pay Purdue a royalty fee as set forth in the Patent License Agreement. The License terminates upon certain circumstances, including upon the effectiveness of the Distribution Agreement.

Pursuant to the Distribution Agreement, dated as of June 9, 2009, the Company was appointed, based on certain contingencies, as an authorized, non-exclusive distributor in the United States of certain generic versions of OxyContin specified in the Distribution Agreement (the “Product”). The Company or Purdue may elect for the Distribution Agreement to become effective within a period of time specified in the Distribution Agreement, so long as the Company’s ANDA has not yet been approved by the FDA. The Company plans to take all actions reasonably necessary to obtain FDA approval of the Company’s ANDA as soon as reasonably practicable. On September 1, 2009, the Company elected for the Distribution Agreement to become effective as of September 1, 2009. Pursuant to the terms of the Distribution Agreement, Purdue provided the Company with a specified amount of the Product to be distributed by the Company on the terms set forth in the Distribution Agreement, and the Company paid Purdue a royalty fee and reimbursed Purdue the cost of manufacturing of the supplied Product.

The Company and ETHEX were named as defendants in a case brought by CIMA LABS, Inc. and Schwarz Pharma, Inc. and styled CIMA LABS, Inc. et al. v. KV Pharmaceutical Company et al., filed in U.S. District Court for the District of Minnesota. CIMA alleged that the Company and ETHEX infringed on a CIMA patent in connection with the manufacture and sale of Hyoscyamine Sulfate Orally Dissolvable Tablets, 0.125 mg. The Court entered a stay pending the outcome of the U.S. Patent and Trademark Office’s (“USPTO”) reexamination of a patent at issue in the suit. On August 17, 2009, the Court entered an order “administratively” terminating this action in Minnesota, but any party has the right to seek leave to reinstitute the case. On September 30, 2009, on appeal of the Examiner’s rejection of the claims, the Board of Patent Appeals and Interferences affirmed the Examiner’s rejections. After the Board’s denial of CIMA’s appeal, CIMA requested a rehearing with the Board, which remains pending.

The Company and its subsidiaries Ther-Rx Corporation and Drugtech Corporation, together with Albion International Inc., filed a patent infringement case against Breckenridge Pharmaceutical, Inc. in the U.S. District Court for the Eastern District of Missouri on July 17, 2008, styled KV Pharmaceutical Company et al. v. Breckenridge Pharmaceutical, Inc. The Company and the other plaintiffs alleged that Breckenridge infringed a patent owned by Albion which has been exclusively licensed to KV and its subsidiaries in the field of oral prescription products for prenatal products and hematinic products (including the Company’s Chromagen® and Chromagen® Forte hematinic products), among others, with respect to Breckenridge’s Multigen® and Multigen® Plus caplet products. The Company and other plaintiffs sought injunctive relief and damages from Breckenridge.

The Company and its subsidiary Ther-Rx Corporation together with Albion International, Inc., were named as defendants in a patent infringement case filed in the U.S. District Court for the Southern District of Florida on August 29, 2008 and styled Breckenridge Pharmaceutical, Inc. v. KV Pharmaceutical Company, Ther-Rx Corporation and Albion International, Inc. Breckenridge sought a declaratory judgment of non-infringement and invalidity of the same patent in issue in the Eastern District of Missouri (described in the preceding paragraph). This case was transferred to the U.S. District Court for the Eastern District of Missouri on June 2, 2009. The parties in the KV Pharmaceutical et al v. Breckenridge Pharmaceutical, Inc. and Breckenridge Pharmaceutical, Inc. v. KV Pharmaceutical Company, Ther-Rx Corporation and Albion International, Inc. matters entered into a Settlement Agreement, dated June 22, 2009. Under the terms of the Settlement Agreement, Breckenridge agreed to pay the Company a total of $1,000, payable in nine monthly payments beginning July 1, 2009, with the final payment due on March 1, 2010.

 

37


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

Stiefel Laboratories, Inc. (“Stiefel”) filed a patent infringement case against the Company on May 28, 2009 in the U.S. District Court for the District of Delaware styled Stiefel Laboratories, Inc. v. KV Pharmaceutical Company. The suit arose from the Company’s submission of a first to file Paragraph IV ANDA seeking permission to market a generic version of Duac® (clindamycin, 1% benzoyl peroxide, 5%) gel indicated for the topical treatment of mild to moderate acne vulgaris. Stiefel filed suit for patent infringement under the provisions of the Hatch-Waxman Act with respect to its U.S. Patent No. 5,466,446 (the “446 Patent”). On September 21, 2009, the Company entered into a sale agreement with Perrigo Company to sell the rights to the ANDA. Pursuant to the sale agreement, Perrigo Company assumed the Company’s obligations under this litigation. On October 15, 2009, a stipulated dismissal with prejudice was submitted by the parties and entered by the Court.

The Company and ETHEX were named as defendants in a case brought by Axcan ScandiPharm, Inc. and styled Axcan ScandiPharm, Inc. v. ETHEX Corporation, et al., filed in U.S. District Court in Minnesota on June 1, 2007. In general, Axcan alleged that ETHEX’s comparative promotion of its Pangestyme™ UL12 and Pangestyme™ UL18 products to Axcan’s Ultrase® MT12 and Ultrase® MT18 products constituted false advertising and misleading statements under various federal and state laws, and constituted unfair and deceptive trade practices. The Company disagreed, and denied the material allegations of the complaint. Nonetheless, a confidential settlement agreement with Axcan was entered into on May 4, 2009 in which the Company agreed to grant undertakings to cease and refrain from future marketing of its Pangestyme UL product line and to the payment of a global confidential settlement, payable in three installments. The first installment payment of $3,500 was paid in May 2009. On February 5, 2010, the Company satisfied all remaining payments owed to Axcan by paying Axcan $1,950.

On July 24, 2008, a federal action was filed against certain unapproved drug products manufactured by the Company, in the U.S. District Court for the Eastern District of Missouri, styled United States v. Various Quantities of Articles of Drug et al. By this complaint, which the Company received on July 29, 2008, the FDA sought to take possession of the Company’s inventory of those products, in order to prevent their distribution. The lawsuit had been preceded in March 2008 by the Missouri Department of Health and Senior Services, acting at the FDA’s behest, embargoing most of the products that were later the subject of the federal seizure action and notifying the Company of a hold on its inventory of these products, restricting its ability to remove or dispose of those inventories without permission. Ultimately, the products that were the subject of the lawsuit were destroyed.

The Company and/or ETHEX have been named as defendants in certain multi-defendant cases alleging that the defendants reported improper or fraudulent pharmaceutical pricing information, i.e., Average Wholesale Price, or AWP, and/or Wholesale Acquisition Cost, or WAC, information, which allegedly caused the governmental plaintiffs to incur excessive costs for pharmaceutical products under the Medicaid program. Cases of this type have been filed against the Company and/or ETHEX and other pharmaceutical manufacturer defendants by the States of Massachusetts, Alabama, Mississippi, Utah and Iowa, by New York City, and by approximately 45 counties in New York State. The State of Mississippi effectively voluntarily dismissed the Company and ETHEX without prejudice on October 5, 2006 by virtue of the State’s filing an Amended Complaint on such date that does not name either the Company or ETHEX as a defendant. On August 13, 2007 ETHEX settled the Massachusetts lawsuit and received a general release of liability with no admission of liability. On October 7, 2008, ETHEX settled the Alabama lawsuit for $2,000 and received a general release of liability with no admission of liability. On November 25, 2009, ETHEX settled the New York City and New York county cases (other than the Erie, Oswego and Schenectady County cases) and received a general release of liability. On February 23, 2010, ETHEX settled the Iowa lawsuit and received a general release of liability.

The Company received a subpoena from the Office of Inspector General of the Department of Health and Human Services, seeking documents with respect to two of ETHEX’s nitroglycerin products. Both are unapproved products, that is, they have not received FDA approval. (In certain circumstances, FDA approval may not be required for drugs to be sold in the marketplace.) The subpoena states that it is in connection with an investigation into potential false claims under Title 42 of the U.S. Code, and appears to pertain to whether these products were eligible for reimbursement under federal health care programs. On or about July 2, 2008, the Company received a supplementary subpoena in this matter, seeking additional documents and information. In a

 

38


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

letter dated August 4, 2008, that subpoena was withdrawn and a separate supplementary subpoena was substituted. In October 2009, the Office of Inspector General of the Department of Health and Human Services identified five additional products as being subject to its investigation: Hydro-tussin (carbinoxamine); Guaifenex (extended release); Hyoscyamine sulfate (extended release); Hycoclear (hydrocodone); and Histinex (hydrocodone). The Company has provided additional documents requested in the subpoena, as supplemented. Discussions with the U.S. Department of Justice and the United States Attorney’s Office for the District of Massachusetts indicate that this matter is a False Claims Act qui tam action that is currently still under seal and that the government is reviewing similar claims relating to other drugs manufactured by ETHEX, as well as drugs manufactured by other companies. The Company has not been provided a copy of the qui tam complaint. On or about March 26, 2009, the Company consented to an extension of the time during which the government may elect to intervene in the qui tam lawsuit.

On December 12, 2008, by letter, the Company was notified by the staff of the SEC that it had commenced an informal inquiry to determine whether there have been violations of certain provisions of the federal securities laws. The Company is cooperating with the government and, among other things, has provided copies of requested documents and information.

As previously disclosed, the Company, at the direction of the Special Committee appointed by the Board of Directors (the “Special Committee”), responded to requests for information from the Office of the United States Attorney for the Eastern District of Missouri and FDA representatives working with that office. In connection therewith, on February 25, 2010, the Board, at the recommendation of the Special Committee, approved entering into a plea agreement subject to court approval with the Office of the United States Attorney for the Eastern District of Missouri and the Office of Consumer Litigation of the United States Department of Justice (referred to herein collectively as the “Department of Justice”).

The plea agreement was executed by the parties and was entered by the U.S. District Court, Eastern District of Missouri, Eastern Division on March 2, 2010. Pursuant to the terms of the plea agreement, ETHEX pleaded guilty to two felony counts, each stemming from the failure to make and submit a field alert report to the FDA in September 2008 regarding the discovery of certain undistributed tablets that failed to meet product specifications. Sentencing pursuant to the plea agreement also took place on March 2, 2010.

Pursuant to the plea agreement, ETHEX agreed to pay a criminal fine in the amount of $23,437 in four installments. The first installment, in the amount of $2,344, was due within 10 days of sentencing. The second and third installments, each in the amount of $5,859, are due on December 15, 2010 and July 11, 2011, respectively. The fourth and final installment, in the amount of $9,375, is due on July 11, 2012. ETHEX also agreed to pay, within 10 days of sentencing, restitution to the Medicare and the Medicaid programs in the amounts of $1,762 and $573, respectively. In addition to the fine and restitution, ETHEX agreed not to contest an administrative forfeiture in the amount of $1,796, which was payable 45 days after sentencing and satisfies any and all forfeiture obligations ETHEX may have as a result of the guilty plea. In total, ETHEX agreed to pay fines, restitution and forfeiture in the aggregate amount of $27,569.

In exchange for the voluntary guilty plea, the Department of Justice agreed that no further federal prosecution will be brought in the Eastern District of Missouri against ETHEX, the Company or the Company’s wholly-owned subsidiary, Ther-Rx Corporation, regarding allegations of the misbranding and adulteration of any oversized tablets of drugs manufactured by the Company, and the failure to file required reports regarding these drugs and patients’ use of these drugs with the FDA, during the period commencing on January 1, 2008 through December 31, 2008.

In connection with the guilty plea by ETHEX, ETHEX is expected to be excluded from participation in federal healthcare programs, including Medicare and Medicaid. In addition, as a result of the guilty plea by ETHEX, the U.S. Department of Health and Human Services (“HHS”) may use its discretionary authority to also exclude the Company from participation in federal healthcare programs. However, the Company is in receipt of correspondence from the Office of the Inspector General of HHS stating that, absent any transfer of assets or operations that would trigger successor liability, HHS has no present intent to exercise its discretionary authority to exclude the Company as a result of the guilty plea by ETHEX.

 

39


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

In connection with the exclusion of ETHEX from participation in federal healthcare programs, the Company plans to cease operations of ETHEX. However, the Company has retained the ability to manufacture (once the requirements under the consent decree have been met), market and distribute all generic products and is in possession of all intellectual property related to generic products, including all New Drug Applications and Abbreviated New Drug Applications.

The Company currently does not anticipate that the voluntary guilty plea by ETHEX will have a material adverse effect on the Company’s efforts to comply with the requirements pursuant to the consent decree and to resume production and shipments of its approved products.

The Company has received a subpoena from the State of California, Department of Justice, seeking documents with respect to ETHEX’s NitroQuick product. In an email dated August 12, 2009, the California Department of Justice advised that after reading CMS Release 151, it might resolve the subpoena that was issued. The Company provided limited information requested by the California Department of Justice on October 7, 2009, and on November 10, 2009 the California Department of Justice informed the Company that the California Department of Justice is contemplating what additional information, if any, it will request.

On February 27, 2009, by letter, the Company was notified by the U.S. Department of Labor that it was conducting an investigation of the Company’s Fifth Restated Profit Sharing Plan and Trust, to determine whether such plan is conforming with the provisions of Title I of the Employee Retirement Income Security Act (“ERISA”) or any regulations or orders thereunder. The Company cooperated with the Department of Labor in its investigation and on August 27, 2009, the Department of Labor notified the Company it had completed a limited review and no further review was contemplated at that time.

On February 3, 2009, plaintiff Harold Crocker filed a putative class-action complaint against the Company in the United States District Court for the Eastern District of Missouri, Crocker v. KV Pharmaceutical Co., et al., No. 4-09-cv-198-CEJ. The Crocker case was followed shortly thereafter by two similar cases, also in the Eastern District of Missouri (Bodnar v. KV Pharmaceutical Co., et al., No. 4:09-cv-00222-HEA, on February 9, 2009, and Knoll v. KV Pharmaceutical Co., et al., No. 4:09-cv-00297-JCH, on February 24, 2009). The two later cases were consolidated into Crocker so that only a single action now exists, and the plaintiffs filed a Consolidated Amended Complaint on June 26, 2009 (“Complaint”).

The Complaint purports to state claims against the Company and certain current and former employees for alleged breach of fiduciary duties to participants in the Company’s 401(k) plan. Defendants, including the Company and certain of its directors and officers, moved to dismiss the amended complaint on August 25, 2009, and briefing of those motions was completed on October 19, 2009. The court granted the motion to dismiss of the Company and all individual defendants on March 24, 2010. A motion to alter or amend the judgment and second amended consolidated complaint was filed on April 21, 2010. The Company, on May 17, 2010, filed a Memorandum in Opposition to plaintiff’s motion to alter or amend the judgment and for leave to amend the consolidated complaint.

The Company was named as a defendant in an ERISA and Worker Adjustment and Retraining Notification (“WARN”) Act putative class action filed on March 12, 2009 in the U.S. District Court, Eastern District of Missouri styled John Foster on behalf of himself and all others similarly situated v. KV Pharmaceutical Company. The putative class action is being brought on behalf of terminated or laid off employees who allegedly were not provided sixty (60) days advance written notice as required by the WARN Act. Service was received on April 8, 2009. A motion to dismiss or in the alternative a motion for summary judgment was filed on April 28, 2009 and on March 12, 2010, the court dismissed the case with prejudice pursuant to the Company’s motion to dismiss or, in the alternative, for summary judgment. The time for filing an appeal has passed and the matter is concluded.

On December 2, 2008, plaintiff Joseph Mas filed a complaint against the Company, in the United States District Court for the Eastern District of Missouri, Mas v. KV Pharma. Co., et al., Case No. 08-CV-1859. On January 9, 2009, plaintiff Herman Unvericht filed a complaint against the Company also in the Eastern District of Missouri, Unvericht v. KV Pharma. Co., et al., Case No. 09-CV-0061. And on January 21, 2009, plaintiff Norfolk County Retirement System filed a complaint against the Company, again in the Eastern District of Missouri, Norfolk County Retirement System v. KV Pharma. Co., et al., Case No. 09-CV-00138.

 

40


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

The operative complaints in these three cases purport to state claims arising under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 on behalf of a putative class of stock purchasers. On April 15, 2009, the Honorable Carol E. Jackson consolidated the Unvericht and Norfolk County cases into the Mas case already before her. The amended complaint for the consolidated action, styled Public Pension Fund Group v. KV Pharma. Co., et al., Case No. 4:08-CV-1859 (CEJ), was filed on May 22, 2009. Defendants, including the Company and certain of its directors and officers, moved to dismiss the amended complaint on July 27, 2009, and briefing was completed on the motions to dismiss on September 3, 2009. The court granted the motion to dismiss of the Company and all individual defendants in February 2010. On March 18, 2010, the plaintiffs filed a motion for relief from the order of dismissal and to amend their complaint, and also filed a notice of appeal. The Company filed its opposition to plaintiffs’ motion for relief from judgment and to amend the complaint on April 8, 2010. Briefing was completed on April 29, 2010.

On February 25, 2009, the Company initiated a legal action against Citigroup Global Markets Inc. (“CGMI”) in connection with $72,200 in outstanding principal amount of certain ARS, which the Company acquired through CGMI, in the U.S. District Court for the Eastern District of Missouri styled K-V Pharmaceutical Company v. Citigroup Global Markets Inc. On January 21, 2010, the Company and CGMI entered into a Purchase and Release Agreement, pursuant to which CGMI agreed to purchase the Company’s remaining ARS for an aggregate purchase price of approximately $61,707. The Company also received a two-year option (which expires on January 21, 2012) to reacquire the ARS (in whole or on a class-by-class basis) for the prices at which they were sold, as well as the right to receive further payments in the event any ARS are redeemed prior to the expiration of the option. The Company agreed to release CGMI from any liability or claim arising from the Company’s investment in ARS sold by CGMI, and the Company and CGMI agreed to take all necessary steps to dismiss with prejudice all claims asserted by the Company against CGMI regarding the ARS, including the legal action referred to above. (See Note 20—“Subsequent Events” for more information regarding the settlement agreement and the proceeds received in connection therewith.)

On October 2, 2009, the U.S. Equal Employment Opportunity Commission sent the Company a Notice of Charge of Discrimination regarding a charge, dated September 23, 2009, of employment discrimination based on religion (in connection with the termination of his employment with the Company) filed against the Company by David S. Hermelin, a current director and former Vice President, Corporate Strategy and Operations Analysis of the Company. On January 29, 2010, the Company filed its response to the Notice of Charge of Discrimination, which stated the Company’s position that Mr. D. Hermelin’s termination had nothing to do with religious discrimination and that his claim should be dismissed.

The Company and/or ETHEX are named defendants in at least 34 pending product liability lawsuits that relate to the voluntary product recalls initiated by the Company in late 2008 and early 2009. The plaintiffs in these lawsuits allege damages as a result of the ingestion of purportedly oversized tablets allegedly distributed in 2007 and 2008. The lawsuits are pending in federal and state courts in various jurisdictions. Of the 34 pending lawsuits, including four that have settled but have not yet been dismissed, 2 plaintiffs allege economic harm, 24 plaintiffs allege that a death occurred, 32 plaintiffs allege personal injury and the plaintiffs in the remaining lawsuits allege non-fatal physical injuries. Plaintiffs’ allegations of liability are based on various theories of recovery, including, but not limited to strict liability, negligence, various breaches of warranty, misbranding, fraud and other common law and/or statutory claims. Plaintiffs seek substantial compensatory and punitive damages. Two of the lawsuits are putative class actions, one of the lawsuits is on behalf of 24 claimants, and the remaining lawsuits are individual lawsuits. The Company believes that these lawsuits are without merit and is vigorously defending against them, except where, in its judgment, settlement is appropriate. In addition to the 34 pending lawsuits, there are at least 208 pending pre-litigation claims (at least 30 of which involve a death) that may or may not eventually become lawsuits. The Company has also resolved a significant number of related product liability lawsuits and pre-litigation claims. In addition to self insurance, the Company possesses third party product liability insurance, which the Company believes is applicable to the pending lawsuits and claims.

The Company and ETHEX are named as defendants in a complaint filed by CVS Pharmacy, Inc. (“CVS”) in the United States District Court for the District of Rhode Island on or about February 26, 2010 and styled CVS Pharmacy, Inc. v. K-V Pharmaceutical Company and Ethex Corporation (No. CA-10-095) (“CVS Complaint”).

 

41


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

The CVS Complaint alleges three claims: breach of contract, breach of implied covenant of good faith and fair dealing, and, in the alternative, promissory estoppel. CVS’ claims are premised on the allegation that the Company and/or ETHEX failed to perform their alleged promises to either supply CVS with its requirements for certain generic drugs or reimburse CVS for any higher price it must pay to obtain the generic drugs. CVS seeks damages of no less than $100,000, plus interest and costs. The Company was served with the CVS Complaint on March 8, 2010. An Answer was filed on April 14, 2010. On June 2, 2010, the Company filed a Motion to Dismiss this action based on failure to join an indispensible party and lack of standing.

On April 16, 2010, a derivative action was filed in the Circuit Court of St. Louis County, Missouri, styled Thomas Henry, Derivatively on Behalf of K-V Pharmaceutical Company v. David A. Van Vliet, Marc S. Hermelin, Norman D. Schellenger, Terry B. Hatfield, Kevin S. Carlie, Jean M. Bellin, David S. Hermelin, Jonathon E. Killmer, Rita E. Bleser, and Ronald J. Kanterman and K-V Pharmaceutical Company. The suit alleged breach of fiduciary duties, waste of corporate assets and unjust enrichment that have caused substantial monetary losses to the Company and other damages, such as its reputation and goodwill. On May 21, 2010, the Company filed a Petition for Breach of Contract against the plaintiff, Thomas Henry, a former employee of the Company, for breach of his Agreement and Release with the Company. The Company and Mr. Henry reached an agreement to dismiss both actions with prejudice, except that the derivative action is to be dismissed without prejudice as to the rights of the Company and any other shareholder. On June 7, 2010, orders of dismissal were entered in both cases, contingent upon the Company providing notice of the dismissal of the derivative action in its next Quarterly Report on Form 10-Q.

From time to time, the Company is involved in various other legal proceedings in the ordinary course of its business. While it is not feasible to predict the ultimate outcome of such other proceedings, the Company believes the ultimate outcome of such other proceedings will not have a material adverse effect on its results of operations, financial condition or liquidity.

There are uncertainties and risks associated with all litigation and there can be no assurance the Company will prevail in any particular litigation.

19. INCOME TAXES

On November 6, 2009, President Obama signed into law H.R. 3548, the Worker, Homeownership, and Business Assistance Act of 2009. This new law provides an optional longer net operating loss carry back period and allows most taxpayers the ability to elect a carry back period of three, four or five years (the net operating loss carry back period was previously limited to two years). This election can only be made for one year for net operating losses incurred for a tax year ending after December 31, 2007 and beginning before January 1, 2010. The Company elected to apply this extended carry back period to its tax year ended March 31, 2009. The Company elected a carry back period of five years. The Company filed an Application for Tentative Refund with the Internal Revenue Service for this additional carry back period and subsequently received a refund in the amount of $23,672 in February, 2010 (see Note 20—“Subsequent Events”).

After the carry back of the net operating losses to these additional periods, the Company has federal loss carry forwards of approximately $10,000 and state loss carry forwards of approximately $139,000 related to the net operating loss incurred during the fiscal year ended March 31, 2009. The Company also has tax credit carry forwards for alternative minimum tax, research credit, and foreign tax credit of approximately $11,450 as a result of the additional carry back period. The loss carry forwards begin to expire in the year 2029, while the alternative minimum tax credits have no expiration date. The research credit and foreign tax credit begin to expire in the year 2029 and 2019, respectively.

In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers all significant available positive and negative evidence, including the existence of losses in recent years, the timing of deferred tax liability reversals, projected future taxable income, taxable income in carry back years, and tax planning strategies to assess the need for a valuation allowance. Based upon the level of current taxable loss, projections for future taxable income over the periods in which the temporary differences are deductible, the taxable income in available carry back years and tax planning strategies, management concluded that it was more likely than not that the Company will not realize the benefits of these deductible differences. The operating loss for the fiscal year ended March 31, 2009 exceeded the cumulative

 

42


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

income from the two preceding fiscal years. The available carry back of this operating loss was not fully absorbed, which resulted in an operating loss carry forward. The Company established valuation allowances of $82,449 that were charged to income tax expense in the fiscal year ended March 31, 2009. A portion of such valuation allowances was released during the three months ended December 31, 2009 due to the additional carry back period.

The operating income reported for the three months ended December 31, 2009 and the utilization of the additional carry back period has allowed the Company to reduce its valuation allowance by $57,352 during the quarter. The Company still has a valuation allowance of $66,036 related to its deferred tax assets as of December 31, 2009.

The consolidated balance sheets reflect liabilities for unrecognized tax benefits of $7,137 and $5,194 as of December 31, 2009 and March 31, 2009, respectively. Accrued interest and penalties included in the consolidated balance sheets were $772 and $1,250 as of December 31, 2009 and March 31, 2009, respectively. The increase in unrecognized tax benefits during the quarter resulted from management’s evaluation of the tax positions taken on filed tax returns and the impact of the expanded operating loss carryback period on the relevant statute of limitations.

The Company recognizes interest and penalties associated with uncertain tax positions as a component of income tax expense in the consolidated statements of income.

It is anticipated the Company will recognize approximately $568 of unrecognized tax benefits within the next 12 months as a result of the expected expiration of the relevant statute of limitations.

Management regularly evaluates the Company’s tax positions taken on filed tax returns using information about recent court decisions and legislative activities. Many factors are considered in making these evaluations, including past history, recent interpretations of tax law, and the specific facts and circumstances of each matter. Because tax law and regulations are subject to interpretation and tax litigation is inherently uncertain, these evaluations can involve a series of complex judgments about future events and can rely heavily on estimates and assumptions. The recorded tax liabilities are based on estimates and assumptions that have been deemed reasonable by management. However, if the Company’s estimates are not representative of actual outcomes, recorded tax liabilities could be materially impacted.

20. SUBSEQUENT EVENTS

On January 8, 2010, the Company and Hologic entered into an amendment to the original Gestiva™ asset purchase agreement. See Note 5—“Acquisitions” for more information about the Amended Gestiva Agreement.

On February 25, 2009, the Company initiated legal action against Citigroup Global Markets Inc. (“CGMI”), through which it acquired the ARS the Company held at that time, in the District Court for the Eastern District of Missouri. On January 21, 2010, the Company and CGMI entered into a Purchase and Release Agreement pursuant to which CGMI agreed to purchase the Company’s remaining ARS for an aggregate purchase price of approximately $61,707. The Company also received a two-year option (which expires on January 21, 2012) to reacquire the ARS (in whole or on a class-by-class basis) for the prices at which they were sold, as well as the right to receive further payments in the event any ARS are redeemed prior to the expiration of the option.

The Company received approximately $23,672 subsequent to December 31, 2009 of tax refunds from the federal and state tax authorities as a result of amended returns and operating loss carry backs.

On February 25, 2010, the Board, at the recommendation of the Special Committee, approved entering into the plea agreement with the U.S. Department of Justice. The plea agreement was executed by the parties and was entered by the U.S. District Court, Eastern District of Missouri, Eastern Division on March 2, 2010. Pursuant to the terms of the plea agreement, ETHEX pleaded guilty to two felony counts, each stemming from the failure to make and submit a field alert report to the FDA in September 2008 regarding the discovery of certain undistributed tablets that failed to meet product specifications. Sentencing pursuant to the plea agreement also took place on March 2, 2010. The Company expects to pay fines, restitution and forfeiture in the aggregate amount of $27,569. See Note 18—“Commitments and Contingencies” for more information regarding the plea agreement.

 

43


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

(In thousands, except per share data)

 

On March 1, 2010, the Company entered into a Settlement Agreement with Celgene Corporation and Novartis Pharmaceuticals Corporation and Novartis Pharma AG to resolve the patent infringement litigation on Ritalin LA® and Focalin XR®. The Settlement Agreement is currently under review by the U.S. Department of Justice and the Federal Trade Commission.

On March 30, 2010, the Company committed to a plan to reduce its workforce from 681 to 392. On March 31, 2010, the Company implemented such plan. The reduction in the Company’s workforce is a part of its efforts to manage its cash and financial resources while it continues working with the FDA to return its approved products to market. In connection with the reduction of its work force, the Company expects to incur termination and other associated costs of approximately $5,000 to $6,000, which are expected to be paid between April 1, 2010 and July 31, 2010. Such costs include severance and paid-leave payments, FICA taxes and medical benefits.

On May 7, 2010, the Company received $11,000 in cash proceeds, and a right to receive an additional payment of $2,000 based on the occurrence of certain events, from the sale of certain intellectual property and other assets related to the Company’s ANDA, submitted with the FDA for the approval to engage in the commercial manufacture and sale of 1gm/10mL sucralfate suspension.

On June 2, 2010 (the “Closing Date”), pursuant to the Asset Purchase Agreement (the “PDI Agreement”) by and among the Company, PDI, DrugTech Corporation (“DrugTech”) and Particle Dynamics International, LLC (the “Purchaser”), the Company, PDI and DrugTech sold to the Purchaser certain assets associated with the business of PDI (as described below, the “Divested PDI Assets”).

PDI and DrugTech are wholly-owned subsidiaries of the Company. The Purchaser is a newly-formed affiliate of Edgewater Capital Partners.

The Divested PDI Assets, as more fully described in the PDI Agreement, consist of all of the right, title and interest in, to and under (1) the assets, rights, interests and other properties, real, personal and mixed, tangible and intangible, and goodwill owned by PDI and used by PDI on the Closing Date in its business, which consists of the manufacture of directly compressible calcium carbonate and other special ingredient products (including but not limited to the products specifically identified in the PDI Agreement) for the pharmaceutical, nutritional, food and personal-care industries using proprietary technologies, (2) the intellectual property owned by DrugTech related to certain PDI product lines, including U.S. and foreign patents and trademarks, and (3) certain leases with respect to facilities used by PDI that were leased by the Company. The Purchaser also agreed to hire approximately 24 employees of the Company that were employed in the operation of the PDI business.

In consideration for the Divested PDI Assets, the Purchaser (1) paid to the Company on the Closing Date $24,600 in cash, subject to certain operating working capital adjustments, and (2) assumed certain liabilities, including certain contracts. The Purchaser deposited $2,000 of the purchase price in an escrow arrangement for post-closing indemnification purposes. The operating working capital adjustments, assumed liabilities and escrow arrangement are more fully described in the PDI Agreement. In addition, the Purchaser also agreed to pay to the Company four contingent earn-out payments in total aggregate amount up to, but not to exceed, $5,500.

The four earn-out payments are determined as follows:

 

   

For every dollar of EBITDA (as such term is defined in the PDI Agreement) earned by the Purchaser or its affiliates during the first year following the Closing Date with respect to sales of PDI products in excess of $7,400, the Company will receive $3.00, up to a maximum aggregate amount of $1,833 (the “First Earn-Out”).

 

   

For every dollar of EBITDA earned by the Purchaser or its affiliates during the second year following the Closing Date with respect to sales of PDI products in excess of $8,400, the Company will receive $3.00, up to a maximum aggregate amount of $1,833 (the “Second Earn-Out”). In addition, to the extent that the First Earn-Out is not fully earned during the first year following the Closing Date, for every dollar of EBITDA earned by the Purchaser or its affiliates during the second year following the Closing Date with respect to sales of PDI products in excess of $7,400, the Company will receive $1.50, up to a maximum aggregate amount of $1,333. However, the sum of the total aggregate earn-out payments payable after the first and the second year following the Closing Date may not exceed $3,667.

 

   

For every dollar of EBITDA earned by the Purchaser or its affiliates during the third year following the Closing Date with respect to sales of PDI products in excess of $8,900, the Company will receive $3.00, up to a maximum aggregate amount of $1,833 (the “Third Earn-Out”). In addition, to the extent that the Second Earn-Out is not fully earned during the second year following the Closing Date, for every dollar of EBITDA earned by the Purchaser or its affiliates during the third year following the Closing Date with respect to sales of PDI products in excess of $8,400, the Company will receive $1.50, up to a maximum aggregate amount of $1,333.

 

   

To the extent that the Third Earn-Out is not fully earned during the third year following the Closing Date, for every dollar of EBITDA earned by the Purchaser or its affiliates during the fourth year following the Closing Date with respect to sales of PDI products in excess of $8,900, the Company will receive $1.50, up to a maximum aggregate amount of $1,333.

The above-described earn-out payments are fully subordinated to outstanding indebtedness of the Purchaser pursuant to certain subordination arrangements entered into on the Closing Date by the Company. In connection with the sale of the Divested PDI Assets, the Company and the Purchaser also entered into a transition services agreement on the Closing Date, pursuant to which the Company agrees to provide certain transition assistance to the Purchaser for up to a one-year period.

The Company expects to record a gain on sale in connection with the PDI transaction in the quarter ended June 30, 2010.

 

44


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

Except for the historical information contained herein, the following discussion contains forward-looking statements that are subject to known and unknown risks, uncertainties, and other factors that may cause our actual results to differ materially from those expressed or implied by those forward-looking statements. These risks, uncertainties and other factors are discussed under Part I, Item 1A—“Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended March 31, 2009, Part II, Item 1A—“Risk Factors” in the Quarterly Report on Form 10-Q for the quarter ended June 30, 2009, Part II, Item 1A—“Risk Factors” in the Quarterly Report on Form 10-Q for the quarter ended September 30, 2009 and above under the caption “Cautionary Note Regarding Forward-Looking Statements.” In addition, the following discussion and analysis of financial condition and results of operations, should be read in conjunction with the consolidated financial statements, the related notes to consolidated financial statements and Item 7—“Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in our Annual Report on Form 10-K for the fiscal year ended March 31, 2009, and the unaudited interim consolidated financial statements and related notes to unaudited interim consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q. Information provided herein for periods after December 31, 2009 is preliminary. As such, this information is not final or complete, and remains subject to change, possibly materially.

Background

Unless the context otherwise indicates, when we use the words “we,” “our,” “us,” “our company” or “KV” we are referring to K-V Pharmaceutical Company and its wholly-owned subsidiaries, including Ther-Rx Corporation (“Ther-Rx”), ETHEX Corporation (“ETHEX”) and Particle Dynamics, Inc. (“PDI”). Unless otherwise noted, when we refer to a specific fiscal year, we are referring to our fiscal year that ended on March 31 of that year. (For example, fiscal year 2009 refers to the fiscal year ended March 31, 2009.)

We are a fully integrated specialty pharmaceutical company that develops, manufactures, acquires and markets technologically-distinguished branded and generic/non-branded prescription pharmaceutical products. We have a broad range of dosage form manufacturing capabilities, including tablets, capsules, creams, liquids and ointments. We conduct our branded pharmaceutical operations through Ther-Rx and our generic/non-branded pharmaceutical operations through ETHEX, which focuses principally on technologically-distinguished generic products. Through PDI, we develop, manufacture and market technologically advanced, value-added raw material products for the pharmaceutical, nutritional, personal care, food and other markets.

Our original strategy was to engage in the development of proprietary drug delivery systems and formulation technologies which enhance the effectiveness of new therapeutic agents and existing pharmaceutical products. Today we utilize several of those technologies, such as SITE RELEASE® and oral controlled release technologies, in our branded and generic products.

As a result of the decision by the Company to sell PDI, the Company has identified the assets and liabilities of PDI as held for sale in the Company’s consolidated balance sheet at March 31, 2009 and December 31, 2009 and has segregated PDI’s operating results and presented them separately as a discontinued operation for all periods presented. (See Note 20—“Subsequent Events” of the Notes to the Consolidated Financial Statements in this Quarterly Report on Form 10-Q for more information regarding the sale of PDI.)

As set forth below and as more fully described in our Annual Report on Form 10-K for the fiscal year ended March 31, 2009, certain events which occurred during fiscal year 2009 had a material adverse effect on our financial results for fiscal year 2009 and for the three- and nine-month periods ended December 31, 2009, as shown in the comparison of our fiscal year 2010 results to our fiscal year 2009 results for the interim periods discussed in this Quarterly Report on Form 10-Q.

Discontinuation of Manufacturing and Distribution; Product Recalls; and the FDA Consent Decree

In May 2008, we received two reports of an oversized morphine sulfate extended-release tablet in commercial distribution. We conducted an investigation into the possible causes of any such oversized tablets and the likelihood that additional lots of morphine sulfate extended-release tablets or other products might contain

 

45


oversized tablets. We instituted changes in our manufacturing processes to address the identified causes and intended to prevent any oversized tablets from entering commercial distribution. In addition, in June 2008, ETHEX initiated voluntary recalls of morphine sulfate 30-mg and 60-mg extended-release tablets. In July 2008, a voluntary recall was initiated in Canada by the seller of specific lots of morphine sulfate 60-mg, 30-mg and 15-mg extended-release tablets that we manufactured. On October 15, 2008, ETHEX commenced a voluntary recall of three specific lots of dextroamphetamine sulfate 5-mg tablets as a precaution due to the possible presence of oversized tablets. On November 7, 2008, ETHEX announced a voluntary recall to the consumer level of multiple lots of five generic products of varying strengths as a precaution due to the potential presence of oversized tablets. These products included: propafenone HCl tablets, isosorbide mononitrate extended-release tablets, morphine sulfate extended-release tablets, morphine sulfate immediate release tablets, and dextroamphetamine sulfate tablets. On November 10, 2008, ETHEX initiated a voluntary recall to the retail level as a precaution due to the possible presence of oversized tablets. This recall affected multiple lots of 18 generic/non-branded products.

On December 15, 2008, the FDA began an inspection of our facilities.

On December 19, 2008, we voluntarily suspended all shipments of our FDA approved drug products in tablet form and commenced a voluntary nationwide single production lot recall of one of our pain management drugs. The 14 products of varying strengths affected by the suspension included metoprolol succinate extended-release tablets (metoprolol), oxycodone HCl tablets and potassium chloride 20 mEq extended-release tablets.

Effective January 22, 2009, we voluntarily suspended the manufacturing and shipment of the remainder of our products, except for three products we distribute but do not manufacture and which do not generate a significant amount of revenue.

On January 28, 2009, we initiated a nationwide voluntary recall affecting most of our products. The recall was subsequently expanded on February 3, 2009. This recall affected multiple lots of over 150 branded and generic/non-branded products.

On January 30, 2009, in response to the FDA’s inspectional activities, we initiated the disposal of our existing inventory of products, which was subsequently mandated by the consent decree.

On February 2, 2009, the FDA issued a Form 483 Report that set forth inspectional observations.

On March 2, 2009, we entered into a consent decree with the FDA regarding our drug manufacturing and distribution. The consent decree was entered by the U.S. District Court, Eastern District of Missouri, Eastern Division on March 6, 2009. As part of the consent decree, we have agreed not to directly or indirectly do or cause the manufacture, processing, packing, labeling, holding, introduction or delivery for introduction into interstate commerce at or from any of our facilities of any drug, until we have satisfied certain requirements designed to demonstrate compliance with the FDA’s current good manufacturing practice (“cGMP”) regulations. The consent decree provides for a series of measures that, when satisfied, will permit us to resume the manufacture and distribution of approved drug products. We have also agreed not to distribute our products that are not FDA approved, including our prenatal vitamins and hematinic products, unless we obtain FDA approval for such products through the FDA’s ANDA or NDA processes.

As part of such measures set forth in the consent decree, we are required to provide, and have provided, to the FDA a work plan (the “Work Plan”) for approval, which sets forth the steps we have taken and will subsequently take to address previously identified deficiencies in our compliance with cGMP regulations.

On July 27, 2009, a representative of the Compliance Branch of the FDA’s Kansas City District, acting in conjunction with the Office of Compliance of the FDA’s Center for Drug Evaluation and Research (CDER), notified us by electronic mail that the FDA had completed its review of the Work Plan. Subject to the addition of certain changes, to which we have agreed and incorporated into the Work Plan, the FDA has accepted the Work Plan. While acceptance of the Work Plan was pending, we, with the knowledge of the FDA, had already begun implementing certain measures set forth in the Work Plan.

The consent decree further provides that, before resuming manufacturing, we will retain and have an independent cGMP expert undertake a review of our facilities and operations and certify compliance with cGMP regulations. Following that certification, the FDA will make a determination as to whether we are in compliance. The consent decree further provides a process pursuant to which we may request approval from the FDA to resume

 

46


manufacturing and distribution of up to two groups of approved products prior to receiving approval from the FDA to resume full operations. On January 13, 2010, our independent cGMP expert, Lachman Consultants (“Lachman”), notified the FDA that Lachman had performed a comprehensive inspection and that our facilities and controls are in compliance with cGMP and the consent decree, but advised us to enact further enhancements to certain aspects of our cGMP systems. In accordance with the advice from Lachman, we continued to enhance our cGMP systems, and Lachman subsequently reinspected our cGMP systems and on April 26, 2010 certified our compliance with cGMP systems requirements.

The next step in the process for resumption of product shipment is for Lachman to certify an individual product manufactured under the newly certified cGMP systems. We are working diligently on preparing for the manufacture of validation batches of the first product, which began in May 2010.

Assuming Lachman certifies the manufacture of the product, the FDA will then conduct its own inspection of our facilities, systems and processes and the Lachman certified product. If the FDA inspection is satisfactory, we expect to be permitted to resume shipment of that product.

A successful FDA inspection is a prerequisite to resuming manufacturing and shipment of the initial product, and we anticipate additional FDA reviews before we return other products to market or are permitted to resume full operations. We cannot predict with certainty the timing or the outcome of the Lachman product certifications or subsequent FDA reviews.

Even after a successful FDA inspection, we anticipate that additional data will need to be generated and submitted to the FDA with respect to certain of our products before we can return them to the market. For example, we will need to perform additional work with regard to product development and formulation and to submit additional data to the FDA before certain products can be returned to the market. Similarly, the FDA has also informed us that, with respect to certain of our products that are subject to ANDAs or supplemental ANDAs we had submitted before entering into the consent decree, we will need to develop and/or submit additional data before those applications can be considered for approval.

The steps taken by us in connection with the nationwide recall and suspension of shipment of all products manufactured by us and the requirements under the consent decree have had, and are expected to continue to have, a material adverse effect on our results of operations. We do not expect to generate any significant revenues from products that we manufacture until we can resume shipping certain or many of our approved products, which currently is not expected to occur until the fourth quarter of calendar year 2010 at the earliest. In the meantime, we must meet ongoing operating costs related to our employees, facilities and FDA compliance, as well as costs related to the steps we are currently taking to prepare for reintroducing our products to the market. If we are not able to obtain the FDA’s clearance to resume manufacturing and distribution of our approved products in a timely manner and at a reasonable cost, our financial position, results of operations, cash flows and liquidity will continue to be materially adversely affected.

Workforce Reduction

On February 5, 2009, we commenced a substantial reduction of our workforce as part of an ongoing realignment of our cost structure that was necessitated by our product recalls and the requirements under the consent decree. We have also realigned and restructured the Ther-Rx sales force and, in connection with this realignment and restructuring, have significantly reduced the number of sales employees. In July 2009, we also realigned and restructured the production workforce and reduced the number of production employees by approximately 300. Most of these employees had been laid off in February 2009 and later were terminated once we were satisfied that our staffing levels were adequate to meet our needs. In March 2010, we further reduced our workforce by approximately 290 employees. As a result of this realignment and restructuring, we have reduced our employee headcount from approximately 1,700 at December 31, 2008 to approximately 390 as of March 31, 2010. Despite the realignment and restructuring, we believe we have retained an adequate level of personnel to support our initial re-entry into the market. The total number of employees we had during the nine months ended December 31, 2009 averaged 649, as compared to 1,647 during the nine months ended December 31, 2008.

 

47


Audit Committee Internal Investigation

As more fully described in our Annual Report on Form 10-K for the fiscal year ended March 31, 2009, in August 2008, the Audit Committee of our Board, with the assistance of outside legal counsel, including regulatory counsel with respect to FDA matters, and other advisers, conducted an internal investigation with respect to a range of specific allegations involving, among other items, FDA regulatory and other compliance matters and management misconduct. The investigation was substantially completed in December 2008 and the investigation of all remaining matters was completed in June 2009.

Results of Operations

Net revenues for the three and nine months ended December 31, 2009, respectively, increased $119.9 million, or 434.0%, and decreased $132.8 million, or 45.8%, compared to the three and nine months ended December 31, 2008, respectively. The increase in net revenues for the three months ended December 31, 2009 was due to revenue generated from the sale of certain products not manufactured by us under the Distribution Agreement with Purdue (see Note 8—“Revenue Recognition” and Note 18—“Commitments and Contingencies” of the Notes to the Consolidated Financial Statements in this Quarterly Report on Form 10-Q), partially offset by decreases in product sales due to the impact of the nationwide recalls we initiated in the fourth quarter of fiscal year 2009 and the shipment suspensions we initiated of all approved tablet-form products in December 2008 and all other drug products in January 2009. The decrease in net revenues for the nine months ended December 31, 2009 resulted primarily from the impact of the nationwide recalls and the shipment suspensions we initiated in fiscal year 2009, as discussed above, partially offset by the net revenue generated pursuant to the Distribution Agreement with Purdue. The overall increase in gross profit of $175.8 million for the three months ended December 31, 2009 resulted primarily from the change in net revenues, coupled with the decrease in cost of sales of $55.9 million due to a reduction in personnel costs and production activity. The decrease in gross profit of $12.1 million for the nine months ended December 31, 2009 resulted primarily from the changes in net revenues, partially offset by the decrease in cost of sales of $120.7 million due to a reduction in personnel costs and production activity.

Operating expenses decreased $53.9 million or 67.3%, and $178.4 million, or 60.5%, for the three and nine months ended December 31, 2009, respectively. The decrease in operating expenses for the three months ended December 31, 2009 was primarily due to the decrease in research and development and selling and administrative expenses, coupled with the gain on sale of our first-to-file Paragraph IV ANDA with the FDA for a generic equivalent version of GlaxoSmithKline’s Duac® gel to Perrigo Company of $14.0 million, while the decrease in operating expenses for the nine months ended December 31, 2009 was due primarily to decreases in litigation and governmental inquiry costs related to actual and probable legal settlements and government fines, personnel costs, branded marketing and promotion expense, research and development expense, purchased in-process research and development and amortization of intangibles, coupled with the gain on sale of $14.0 million as described above. The decrease in operating expenses, coupled with the increase in gross profit of $175.8 million for the three months ended December 31, 2009, resulted in a $229.7 million decrease in operating loss, as compared to the three months ended December 31, 2008, which resulted in operating income for the three months ended December 31, 2009. The decrease in operating expenses, partially offset by the decrease in gross profit of $12.1 million for the nine months ended December 31, 2009, resulted in a $166.2 million decrease in operating loss, as compared to the nine months ended December 31, 2009. Our results of operations for the three months ended December 31, 2009 also included the impact of a $57.4 million valuation allowance release that was credited to income tax expense for the income reported during the quarter and the additional carry back period. Because of these factors, we incurred net income of $108.6 million in the three months ended December 31, 2009, which, when compared to the three months ended December 31, 2008, represents a $203.7 million decrease in net loss, resulting in net income. We incurred a net loss of $0.4 million in the nine months ended December 31, 2009 which, when compared to the nine months ended December 31, 2008, represents a $132.7 million decrease in net loss.

 

48


Net Revenues by Segment

 

     Three Months  Ended
December 31,
    Change
%
    Nine Months  Ended
December 31,
    Change
%
 
($ in thousands):    2009     2008       2009     2008    

Branded products

   $ 3,065      $ 13,577      (77.4 )%    $ 11,287      $ 102,292      (89.0 )% 

as % of net revenues

     2.1     49.2       7.2     35.3  

Specialty generics/non-branded

     144,415 (1)      13,862      941.8     145,733        187,151      (22.1 )% 

as % of net revenues

     97.9     50.2       92.8     64.6  

Other

     —          177      (100.0 )%      7        374      (98.1 )% 
                                            

Total net revenues

   $ 147,480      $ 27,616      434.0   $ 157,027      $ 289,817      (45.8 )% 

 

(1)

Includes $143.4 million of net revenue resulting from the sale of all of the generic OxyContin allotted pursuant to the Distribution Agreement entered into with Purdue.

The decreases in branded product sales of $10.5 million and $91.0 million for the three and nine month periods ended December 31, 2009, respectively, from the three and nine month periods ended December 31, 2008, respectively, were due to ceasing all of our manufacturing operations, as described above, during the fourth quarter of fiscal year 2009. As a result, branded product net revenues were derived primarily from Evamist™, which is manufactured by a third party. Net revenues from Evamist™ during the three and nine months ended December 31, 2009, respectively, were approximately $3.0 million and $7.4 million, while Evamist™ net revenues were nominal during the three and nine months ended December 31, 2008. During the three months ended December 31, 2008, net revenues of our anti-infective, hematinic and advanced prescription nutritional products were $11.0 million, $6.0 million and $11.9 million, respectively. During the nine months ended December 31, 2008, net revenues of these products were $35.1 million, $26.4 million and $51.9 million, respectively.

The decrease in branded product net revenues for the nine months ended December 31, 2009 was partially offset by $3.5 million received in the three months ended June 30, 2009 as license revenue related to the transfer of certain existing product registrations, manufacturing technology and intellectual property rights.

The increase in specialty generic/non-branded net revenues of $130.6 million for the three months ended December 31, 2009 was primarily due to net revenues generated from the sale of all of the limited amount of generic OxyContin during the limited period of time as allotted under the Distribution Agreement with Purdue (see Note 8—“Revenue Recognition” and Note 18—“Commitments and Contingencies” of the Notes to the Consolidated Financial Statements in this Quarterly Report on Form 10-Q). We recognized approximately $143.4 million of net revenues pursuant to the Distribution Agreement. Excluding sales of products purchased from Purdue, net revenues decreased $12.8 million for the three months ended December 31, 2009, as compared to the three months ended December 31, 2008.

Net revenues for the specialty generic/non-branded segment decreased $41.4 million for the nine months ended December 31, 2009, as compared to the nine months ended December 31, 2008. Excluding sales of products purchased from Purdue, net revenues decreased $184.8 million.

The decreases in specialty generic/non-branded net revenues of $12.8 million and $184.8 million, respectively, for the three and nine month periods ended December 31, 2009, were due to ceasing all of our manufacturing operations, as described above, during the fourth quarter of fiscal year 2009. As a result, sales of generic products were derived primarily from Keterolac and Naproxen, which are manufactured by a third party, and from royalty revenue generated from product sales of morphine sulfate 15-mg, 30-mg and 60-mg extended-release tablets, which are marketed and manufactured by a third party. Net revenues from Keterolac and Naproxen during the three months ended December 31, 2009 were approximately $0.5 million, compared to $0.6 million during the three months ended December 31, 2008. During the nine months ended December 31, 2009, net revenues from

 

49


Keterolac and Naproxen were approximately $1.4 million, compared to $2.4 million during the nine months ended December 31, 2008. Royalty revenue generated from product sales of morphine sulfate extended-release tablets during the three and nine months ended December 31, 2009 was approximately $0.4 million and $1.0 million, respectively.

Gross Profit (Loss) by Segment

 

     Three Months  Ended
December 31,
    Change
%
    Nine Months  Ended
December 31,
    Change
%
 
($ in thousands):    2009     2008       2009     2008    

Branded products

   $ 2,593      $ 9,607      (73.0 )%    $ 9,757      $ 88,553      (89.0 )% 

as % of net revenues

     84.6     70.8       86.4     86.6  

Specialty generics/non-branded

     123,001 (1)      (17,763   (792.5 )%      123,133        81,269      51.5

as % of net revenues

     85.2     (128.1 )%        84.5     43.4  

Other

     (15,166     (57,188   (73.5 )%      (41,713     (66,515   (37.3 )% 
                                            

Total gross profit (loss)

   $ 110,428      $ (65,344   (269.0 )%    $ 91,177      $ 103,307      (11.7 )% 

as % of total net revenues

     74.9     (236.6 )%        58.1     35.6  

 

(1) Includes $123.1 million of gross profit resulting from the net revenue generated from the sale of all of the generic OxyContin allotted, partially offset by the royalty fee and the cost of the supplied product paid to Purdue, as pursuant to the Distribution Agreement entered into with Purdue.

The decreases in gross profit in our branded segment for the three and nine months ended December 31, 2009 as compared to the same periods in the prior fiscal year, were primarily due to ceasing all of our manufacturing operations, as described above, during the fourth quarter of fiscal year 2009, which limited our net revenues to sales of products manufactured by third parties and revenue generated from license agreements. Additionally, because we ceased all manufacturing activities, all costs associated with our manufacturing operations were immediately expensed as incurred.

The increases in gross profit in our specialty generics/non-branded segment for the three and nine months ended December 31, 2009, as compared to the same periods in the prior fiscal year, were primarily due to the net revenues of $143.4 generated from the sale of all of the limited quantity of generic OxyContin pursuant to the Distribution Agreement with Purdue, partially offset by $20.3 million recognized as cost of sales for royalty fees owed to Purdue and the cost of product paid to Purdue pursuant to the Distribution Agreement (see Note 8—“Revenue Recognition” and Note 18—“Commitments and Contingencies” of the Notes to the Consolidated Financial Statements in this Quarterly Report on Form 10-Q). The gross profit resulting from the Distribution Agreement was $123.1 million.

The increases in gross profit for the three and nine months ended December 31, 2009 were partially offset by the impact of ceasing all of our manufacturing operations, as described above, during the fourth quarter of fiscal year 2009. Additionally, because we ceased all manufacturing activities, all costs associated with our manufacturing operations were immediately expensed as incurred.

The “Other” category for gross profit (loss) reflected above includes the impact of contract manufacturing revenues, pricing and production variances, and changes to inventory reserves associated with production. Any inventory reserve changes associated with finished goods are reflected in the applicable segment. The fluctuation in the “Other” category was primarily the result of the lack of production activity in the three and nine months ended December 31, 2009. In the three and nine months ended December 31, 2008, we were capitalizing the majority of labor and overhead expense into inventory. Since we were not producing products during the three and nine months ended December 31, 2009, labor and overhead expenses were recognized directly into cost of sales rather than capitalized into inventory.

 

50


Research and Development

 

     Three Months  Ended
December 31,
    Change
%
    Nine Months  Ended
December 31,
    Change
%
 
($ in thousands):    2009     2008       2009     2008    

Research and development

   $ 7,273      $ 21,375      (66.0 )%    $ 24,727      $ 55,251      (55.2 )% 

as % of net revenues

     4.9     77.4       15.7     19.1  

Research and development expenses consist mainly of personnel-related costs and costs related to bioequivalency studies for proposed generic products, laboratory and preclinical tests for proposed branded products, clinical studies to determine the safety and efficacy of proposed branded products, and material used in research and development activities. The decreases in research and development expense of $14.1 million and $30.5 million for the three and nine months ended December 31, 2009, respectively, as compared to the corresponding periods in the prior fiscal year, were primarily due to lower personnel costs associated with the reduction in force discussed above that occurred in the fourth quarter of fiscal year 2009 and lower costs associated with the testing of drugs under development due to a reduction in bioequivalency studies and clinical trials during the three and nine months ended December 31, 2009, as compared to the same periods during the prior fiscal year.

Selling and Administrative

 

     Three Months  Ended
December 31,
    Change
%
    Nine Months  Ended
December 31,
    Change
%
 
($ in thousands):    2009     2008       2009     2008    

Selling and administrative

   $ 30,235      $ 54,305      (44.3 )%    $ 91,947      $ 176,620      (47.9 )% 

as % of net revenues

     20.5     196.6       58.6     60.9  

The decreases in selling and administrative expenses of $24.1 million and $84.7 million for the three and nine months ended December 31, 2009 respectively, as compared to the corresponding periods in the prior fiscal year were primarily due to:

 

   

$10.3 million and $39.8 million decreases in marketing and promotion expenses for the three and nine months ended December 31, 2009, respectively, related to suspending shipment of all approved tablet-form products in December 2008 and all other drug products in January 2009;

 

   

$5.1 million and $33.3 million decreases in personnel costs for the three and nine months ended December 31, 2009, respectively, due to decreases in management, sales and other personnel related to the significant reduction in our workforce which occurred in the fourth quarter of fiscal year 2009;

 

   

$5.7 million decrease in professional fees for the three months ended December 31, 2009, primarily as a result of the decrease in fees related to the internal investigation conducted by the Audit Committee, which was completed in June 2009;

 

   

$3.2 million decrease in expenses for administrative costs for the nine months ended December 31, 2009, in connection with the voluntary recall of multiple lots of 23 generic/non-branded products that was announced in November 2008;

 

   

$0.7 million and $3.0 million decreases in product development costs for the three and nine months ended December 31, 2009, respectively, as a result of our discontinuation of manufacturing and distribution and the ongoing realignment of our cost structure;

 

   

$1.7 million and $4.9 million decreases in facility expenses for the three and nine months ended December 31, 2009, respectively, due to the ongoing realignment of our cost structure that was necessitated by our product recalls and the requirements under the consent decree; and

 

   

$1.3 million increase in expenses for consulting, legal and other professional services for the nine months ended December 31, 2009, associated with engaging external resources to assist with current good manufacturing practice (cGMP) compliance efforts and legal inquiries and investigations.

 

51


We entered into a settlement agreement with Breckenridge Pharmaceutical, Inc. on June 22, 2009 regarding an existing litigation (see Note 18—“Commitments and Contingencies” of the Notes to the Consolidated Financial Statements in this Quarterly Report on Form 10-Q). Under the terms of the settlement agreement, Breckenridge agreed to pay us a total of $1.0 million, payable in nine monthly payments beginning July 1, 2009, with the final payment due on March 1, 2010. We recorded the settlement as a reduction to selling and administrative expense for the three months ended June 30, 2009. For the nine months ended December 31, 2009, selling and administrative expenses were offset by the $1.0 million gain.

Amortization of Intangible Assets

 

     Three Months  Ended
December 31,
    Change
%
    Nine Months  Ended
December 31,
    Change
%
 
($ in thousands):    2009     2008       2009     2008    

Amortization of intangible assets

   $ 2,980      $ 3,605      (17.3 )%    $ 8,875      $ 10,619      (16.4 )% 

as % of net revenues

     2.0     13.1       5.7     3.7  

Because of the events that occurred beginning in the third quarter of fiscal year 2009, which included four voluntary recalls involving 25 generic products and the suspension of all shipments of our FDA-approved tablet-form products, we completed an evaluation of each of our intangible assets. Based upon management’s analysis, it was determined the following intangible assets were impaired:

 

   

Pursuant to the terms of the consent decree, we agreed not to distribute our unapproved products, including our prenatal vitamins and hematinic products, unless we obtain approval through the FDA’s ANDA or NDA processes. Since we were unable to generate any revenues from these products and they were not approved by the FDA, we recorded $34.1 million during fiscal year 2009 as an impairment charge to write-off the net book value of the intangible assets related to our branded prenatal vitamins and hematinic products.

 

   

During fiscal year 2009, we recognized an impairment charge of $2.5 million for the intangible assets related to a product we had under development to treat endometriosis. It was determined at the end of our Phase II study that this product was not effective because its efficacy was not better than that of a placebo. As a result, we decided to abandon development of the product in fiscal year 2009 and wrote-off the related intangible assets.

Due to the write-off of the intangible assets described above, amortization expense decreased by $0.6 million and $1.7 million, respectively, for the three and nine months ended December 31, 2009 as compared to the corresponding periods in the prior fiscal year.

We test the carrying value of long-lived assets for impairment at least annually and also assess and evaluate on a quarterly basis if any events have occurred which indicate the possibility of impairment. Any significant changes in actual future results from the assessment used to perform the quarterly evaluation, such as lower sales, increases in production costs, technological changes or decisions not to produce or sell products, could result in impairment at a future date (see Note 2—“Basis of Presentation” of the Notes to the Consolidated Financial Statements in this Quarterly Report on Form 10-Q).

 

52


Purchased In-Process Research and Development

 

     Three Months  Ended
December 31,
    Change
%
    Nine Months  Ended
December 31,
    Change
%
 
($ in thousands):    2009     2008       2009     2008    

Purchased in-process research and development

   $ —        $ —        NA   $ —        $ 2,000      (100.0 )% 

as % of net revenues

     0.0     0.0       0.0     0.7  

In January 2008, we entered into a definitive asset purchase agreement to acquire the U.S. and worldwide rights to Gestiva™ (17-alpha hydroxyprogesterone caproate) (see Note 5—“Acquisitions” of the Notes to the Consolidated Financial Statements in this Quarterly Report on Form 10-Q). Under the terms of the asset purchase agreement, we made a $2.0 million cash payment in May 2008 upon achievement of a milestone. Because the product was not FDA approved at the time when this payment was made, we recorded this payment as an in-process research and development charge.

Pursuant to the Amended Gestiva Agreement (see Note 5—“Acquisitions” of the Notes to the Consolidated Financial Statements in this Quarterly Report on Form 10-Q), a $70,000 cash payment was due upon execution of the Gestiva Amendment. We made such payment in the fourth quarter of fiscal year 2010, which will be reflected as in-process research and development expense in the consolidated statement of operations for the quarter ending March 31, 2010.

Litigation and Governmental Inquiries

 

     Three Months  Ended
December 31,
    Change
%
    Nine Months  Ended
December 31,
    Change
%
 
($ in thousands):    2009     2008       2009     2008    

Litigation and governmental inquiries

   $ 150      $ 23      552.2   $ 5,003      $ 49,732      (89.9 )% 

as % of net revenues

     0.1     0.1       3.2     17.2  

The decrease in litigation and governmental inquiries expense of $44.7 million for the nine months ended December 31, 2009, respectively, as compared to the corresponding period in the prior fiscal year, was primarily due to significant costs recognized in the nine months ended December 31, 2008 associated with:

 

   

the plea agreement with the U.S. Department of Justice recorded during the three months ended September 30, 2008 (see Note 18—“Commitments and Contingencies” and Note 20—“Subsequent Events” of the Notes to the Consolidated Financial Statements in this Quarterly Report on Form 10-Q);

 

   

various product liability actions (based on our product liability insurance coverage and the number of product liability actions that were pending, that had been settled and that we expect to occur) related to the voluntary product recalls initiated by us in calendar year 2008 and early 2009 and alleged damages as a result of the ingestion of purportedly oversized tablets allegedly distributed in 2007 and 2008 (see Note 18—“Commitments and Contingencies” of the Notes to the Consolidated Financial Statements in this Quarterly Report on Form 10-Q); and

 

   

the settlement agreement with Axcan (see Note 18—“Commitments and Contingencies” of the Notes to the Consolidated Financial Statements in this Quarterly Report on Form 10-Q) that was recorded during the three months ended September 30, 2008.

During the nine months ended December 31, 2009, we recorded $6.9 million as litigation and governmental inquiries expense for various matters, which was partially offset by an adjustment of $1.9 million to reduce our expected direct liability (as discussed above) for product liability actions related to the voluntary product recalls initiated by us in calendar year 2008 and early 2009 and alleged damages as a result of the ingestion of purportedly oversized tablets allegedly manufactured and distributed by us.

 

53


Restructuring

 

     Three Months  Ended
December 31,
    Change
%
    Nine Months  Ended
December 31,
    Change
%
 
($ in thousands):    2009     2008       2009     2008    

Restructuring

   $ —        $ 725      (100.0 )%    $ 533      $ 725      (26.5 )% 

as % of net revenues

     0.0     2.6       0.3     0.3  

During the first quarter of fiscal year 2010, we further reduced our workforce as part of an ongoing realignment of our cost structure. We recorded expense of $0.5 million in the nine months ended December 31, 2009 for severance benefits related to these terminations.

Gain on Sale

 

     Three Months  Ended
December 31,
    Change
%
    Nine Months  Ended
December 31,
    Change
%
 
($ in thousands):    2009     2008       2009     2008    

Gain on Sale

   $ 14,500      $ —        NA   $ 14,500      $ —        NA

as % of net revenues

     9.8     0.0       9.2     0.0  

During the three months ended December 31, 2009, we completed the sale of our Paragraph IV ANDA with the FDA for a generic equivalent version of GlaxoSmithKline’s Duac® gel to Perrigo Company. We were the first to file the Paragraph IV ANDA for this product with the FDA. Under the terms of the transaction, we received $14.0 million from Perrigo Company at closing and will receive an additional $2.0 million as a milestone payment upon the completion of a successful technical transfer.

During the three months ended December 31, 2009, we recognized a $0.5 million gain from the sale of certain intellectual property and other assets associated with our ANDA for the generic version of Lotensin® 5-mg, 10-mg, 20-mg, and 40-mg Tablets to Huahai US, Inc.

Interest Expense

 

     Three Months  Ended
December 31,
   Change
%
    Nine Months  Ended
December 31,
   Change
%
 
($ in thousands):    2009    2008      2009    2008   

Interest expense

   $ 2,053    $ 2,201    (6.7 )%    $ 6,211    $ 6,836    (9.1 )% 

The decreases in interest expense for the three and nine months ended December 31, 2009, as compared to the corresponding periods in the prior fiscal year, resulted primarily from the decline in interest expense of $0.3 million and $0.8 million, respectively, incurred on the $30.0 million line of credit that was outstanding during the nine months ended December 31, 2008. The line of credit was fully repaid in February 2009. The decrease in interest expense for the nine months ended December 31, 2009 was also attributable to the deferred financing costs related to the issuance of the convertible notes becoming fully amortized during the first quarter of fiscal year 2009. Deferred financing costs of $0.2 million were recorded in the consolidated statement of operations during the nine months ended December 31, 2008.

The decrease in interest expense for the nine months ended December 31, 2009, as compared to the corresponding period in the prior fiscal year, is partially offset by interest accretion expense of $0.4 million recorded during the nine months ended December 31, 2009, as compared to accretion expense of $0.1 million recorded during the nine months ended December 31, 2008, related to the fines and penalties pursuant to the plea agreement with the U.S. Department of Justice (see Note 18—“Commitments and Contingencies” and Note 20—“Subsequent

 

54


Events” of the Notes to the Consolidated Financial Statements in this Quarterly Report on Form 10-Q), which was recorded at present value as of September 30, 2008. The interest accretion represents the difference between the present value of the fines and penalties of $25.9 million and the undiscounted amount of $27.6 million, which will be recognized ratably over the period during which installment payments will be made pursuant to the plea agreement (March 2010 until July 2012).

Interest and Other Income (Expense)

 

     Three Months Ended
December 31,
    Change
%
    Nine Months Ended
December 31,
    Change
%
 
($ in thousands):    2009    2008       2009    2008    

Interest and other income (expense)

   $ 941    $ (8,341   (111.3 )%    $ 2,801    $ (6,866   (140.8 )% 

The changes in interest and other income (expense) for the three and nine months ended December 31, 2009, as compared to the corresponding periods in the prior fiscal year consisted of the following:

 

   

Decreases in expense of $10.5 million related to other-than-temporary impairment recognized into earnings during the three months ended December 31, 2008 on our ARS, offset in part by a $1.3 million gain recognized during the same three-month period for a settlement agreement with one of our brokers for a $10.0 million ARS;

 

   

Increases in income of $0.8 million and $3.0 million, respectively, for the three and nine months ended December 31, 2009, due to the recognition of foreign currency transaction gains on an investment denominated in the Indian Rupee as compared to transactions losses on the investment recognized in the three and nine months ended December 31, 2008; and

 

   

Declines in interest income of $0.6 million and $2.5 million, respectively, for the three and nine months ended December 31, 2009, due to the impact of lower short-term market interest rates, which reduced our weighted average interest rate on interest-earning assets for the three and nine months ended December 31, 2009, as compared to the same periods during the prior fiscal year.

Income Tax Benefit

 

     Three Months Ended
December 31,
    Change
%
    Nine Months Ended
December 31,
    Change
%
 
($ in thousands):    2009     2008       2009     2008    

Income tax benefit

   $ (24,157   $ (59,892   (59.7 )%    $ (23,807   $ (68,401   (65.2 )% 

Effective tax rate

     (29.0 )%      38.4       82.6     33.3  

The income tax benefits recorded during the three and nine months ended December 31, 2008 were the result of pretax losses for both periods.

The benefit for income taxes for the three and nine months ended December 31, 2009 was primarily due to the additional carry back period allowed as a result of a change in law, offset by the timing of certain deferred tax liabilities which are not scheduled to reverse within the applicable carry forward periods for the deferred tax assets.

 

55


Income from Discontinued Operations

 

     Three Months Ended
December 31,
   Change
%
    Nine Months Ended
December 31,
   Change
%
 
($ in thousands):    2009    2008      2009    2008   

Income from discontinued operations

   $ 1,252    $ 944    32.6   $ 4,609    $ 3,848    19.8

During the fourth quarter of fiscal year 2009, our Board authorized management to sell PDI, our specialty materials segment. (See Note 20—“Subsequent Events” of the Notes to the Consolidated Financial Statements in this Quarterly Report on Form 10-Q for more information regarding the sale of PDI.) Therefore, we have segregated PDI’s operating results and presented them separately as a discontinued operation for all periods presented. (See Note 17—“Segment Reporting” of the Notes to the Consolidated Financial Statements included in this Quarterly Report on Form 10-Q.) The increases in income from discontinued operations for the three and nine months ended December 31, 2009, respectively, as compared to the three and nine months ended December 31, 2008, respectively, were primarily due to the decreases in PDI’s total operating expenses, partially offset by the decreases in gross profit.

Liquidity, Capital Resources and Going Concern

Cash and cash equivalents and working capital were $96.6 million and $17.3 million, respectively, at December 31, 2009, as compared to $75.7 million and $5.2 million, respectively, at March 31, 2009. Working capital is defined as total current assets as reduced by total current liabilities. Working capital increased primarily due to a decrease in accrued liabilities of $71.5 million and an increase in cash of $20.9 million, partially offset by decreases in income taxes receivable of $56.7 million and accounts receivable (net) of $18.4 million. The decrease in income taxes receivable is primarily due to the receipt of tax refunds associated with carrying back net operating losses to previous years while the decrease in accounts receivable resulted primarily from applying credits owed to our customers for returns and failure to supply costs associated with the product recalls in fiscal year 2009 against outstanding amounts our customers owed to us. The decrease in accrued liabilities is primarily due to payments and credits associated with return and failure to supply costs described above that we provided to customers that did not have outstanding amounts owed to us. The decrease in accrued liabilities is also attributable to payments associated with product recall processing fees, litigation settlements and legal and consulting fees associated with the FDA consent decree and governmental inquiries.

For the nine months ended December 31, 2009, our net cash provided by operating activities of $27.7 million resulted primarily from the receipt of tax refunds and the decrease in receivables, net, partially offset by the decrease in accounts payable and accrued liabilities, which was primarily driven by recall-related costs (including product costs, product returns, failure to supply claims and third party processing fees) processed in the current period and the decline in sales-related reserves that are classified as accrued liabilities. The declines in sales related reserves are a result of the cessation of all of our manufacturing operations which occurred in the fourth quarter of fiscal year 2009. For the nine months ended December 31, 2008, our net cash flow from operations of $56.2 million primarily consisted of increases in deferred revenue, accrued liabilities and other long-term liabilities and decreases in receivables and inventories, partially offset by a decrease in income taxes payable and a net loss of $133.1 million, adjusted for non-cash items.

Net cash flow used in investing activities included capital expenditures of $10.8 million (the majority of which related to PDI capital expenditures during the three months ended September 30, 2009, in connection with an accidental fire that damaged a leased facility used by PDI; see Note 17—“Segment Reporting” of the Notes to the Consolidated Financial Statements in this Quarterly Report on Form 10-Q) for the nine months ended December 31, 2009, as compared to $19.6 million for the corresponding prior year period. The decrease in capital expenditures during the nine month period was primarily due to ceasing operations and cancelling capital projects in the fourth quarter of fiscal year 2009. Other investing activities during the nine months ended December 31, 2009 included $5.6 million of insurance proceeds received as a result of an accidental fire that damaged a leased facility used by PDI (see Note 17—“Segment Reporting” of the Notes to the Consolidated Financial Statements

 

56


in this Quarterly Report on Form 10-Q) and $0.5 million sales of marketable securities. Other investing activities during the nine months ended December 31, 2008 included $0.6 million and $52.1 million of purchases and sales, respectively, of short-term marketable securities classified as available for sale and the $2.0 million milestone payment we made in connection with the Gestiva™ acquisition (see Note 5—“Acquisitions” of the Notes to the Consolidated Financial Statements in this Quarterly Report on Form 10-Q). Also, we paid $3.0 million during the second quarter of fiscal year 2009 to acquire assets associated with the pharmaceutical division of LycoRed, a product development company located in Israel (see Note 5—“Acquisitions” of the Notes to the Consolidated Financial Statements in this Quarterly Report on Form 10-Q).

At December 31, 2009, our investment securities included $72.3 million in principal amount of auction rate securities (“ARS”). Consistent with our investment policy guidelines, the ARS held by us are AAA-rated securities with long-term nominal maturities secured by student loans which are guaranteed by the U.S. Government. Liquidity for the ARS is typically provided by an auction process which allows holders to sell their notes and resets the applicable interest rate at pre-determined intervals, typically between seven to 35 days. However, with the liquidity issues experienced in global credit and capital markets, the ARS experienced failed auctions beginning in February 2008 and throughout fiscal year 2009. An auction failure means that the parties wishing to sell their securities could not be matched with an adequate volume of buyers. The securities for which auctions have failed continue to accrue interest at the contractual rate and continue to be auctioned every seven, 14, 28 or 35 days, as the case may be, until the auction succeeds, the issuer calls the securities, or they mature.

The estimated fair value of our ARS holdings at December 31, 2009 was $66.1 million, as compared to a carrying value of $63.5 million. The estimated fair value of the ARS was based on a discounted cash flow model that considered, among other factors, the time to work out the market disruption in the traditional trading mechanism, the stream of cash flows (coupons) earned until maturity, the prevailing risk-free yield curve, credit spreads applicable to a portfolio of student loans with various tenures and ratings and an illiquidity premium. These factors were used in a Monte Carlo simulation based methodology to derive the estimated fair value of the ARS.

ARS have historically been classified as short-term marketable securities in our consolidated balance sheet. Given the failed auctions, we reclassified the ARS held at March 31, 2009 from current assets to non-current assets and, as of December 31, 2009, we continued to reflect the ARS as non-current assets (see Note 9—“Investment Securities” of the Notes to the Consolidated Financial Statements in this Quarterly Report on Form 10-Q for more information on the ARS).

Our debt balance, including current maturities, was $236.6 million at December 31, 2009, as compared to $238.5 million at March 31, 2009.

In June 2007, we entered into an installment payment agreement with a financial institution related to the purchase of software products and the right to receive consulting or other services from the seller. Upon delivery of the products and services, the financial institution will pay the seller amounts owed for the software products and services. As a result of the installment payment agreement, we recorded debt in the amount of $1.7 million which will be paid ratably over 16 consecutive quarters to the financial institution. Also, in August 2007, we entered into another agreement with the same financial institution for the payment of additional consulting services that will be provided on a time and material basis. In exchange for the institution paying the seller for fees owed, we have recorded additional debt in the amount of $0.3 million which will be paid to the financial institution ratably over 16 consecutive quarters. The two installment payment agreements were discounted using an imputed annual interest rate that approximated our borrowing rate for similar debt instruments at the time of the borrowings.

In March 2006, we entered into a $43.0 million mortgage loan arrangement with one of our primary lenders, in part to refinance $9.9 million of existing mortgages. The $32.8 million of net proceeds we received from the mortgage loan was used for working capital and general corporate purposes. The mortgage loan, which is secured by three of our buildings, bears interest at a rate of 5.91% and matures on April 1, 2021.

In May 2003, we issued $200.0 million principal amount of Notes that are convertible, under certain circumstances, into shares of our Class A Common Stock at an initial conversion price of $23.01 per share. The Notes bear interest at a rate of 2.50% and mature on May 16, 2033. We are also obligated to pay contingent

 

57


interest at a rate equal to 0.5% per annum during any six-month period commencing May 16, 2006, if the average trading price of the Notes per $1,000 principal amount for the five-trading day period ending on the third trading day immediately preceding the first day of the applicable six-month period equals $1,200 or more. In November 2007, the average trading price of the Notes reached the threshold for the applicable five-day trading period which resulted in the payment of contingent interest and beginning November 16, 2007 the Notes began to bear interest at a rate of 3.00% per annum. In May 2008, the average trading price of the Notes fell below the contingent interest threshold for the five-day trading period and beginning May 16, 2008 the Notes began to pay interest at a rate of 2.50% per annum. We may redeem some or all of the Notes at any time on or after May 21, 2006, at a redemption price, payable in cash, of 100% of the principal amount of the Notes, plus accrued and unpaid interest (including contingent interest, if any) to the date of redemption. Holders may require us to repurchase all or a portion of their Notes on May 16, 2013, 2018, 2023 and 2028, or upon a change in control, as defined in the indenture governing the Notes, at 100% of the principal amount of the Notes, plus accrued and unpaid interest (including contingent interest, if any) to the date of repurchase, payable in cash. Since the next date holders may require us to repurchase all or a portion of their Notes is May 16, 2013, the Notes were classified as a long-term liability as of December 31, 2009 and March 31, 2009. The Notes are subordinate to all of our existing and future senior obligations.

In December 2005, we entered into a financing arrangement with St. Louis County, Missouri related to expansion of our operations in St. Louis County (see Note 15—“Taxable Industrial Revenue Bonds” of the Notes to the Consolidated Financial Statements in this Quarterly Report on Form 10-Q). Up to $135.5 million of industrial revenue bonds may be issued to us by St. Louis County relative to capital improvements made through December 31, 2009. This agreement provides that 50% of the real and personal property taxes on up to $135.5 million of capital improvements will be abated for a period of 10 years subsequent to the property being placed in service. Industrial revenue bonds totaling $129.9 million were outstanding at December 31, 2009. The industrial revenue bonds are issued by St. Louis County to us upon our payment of qualifying costs of capital improvements, which are then leased by us for a period ending December 1, 2019, unless earlier terminated. We have the option at any time to discontinue the arrangement and regain full title to the abated property. The industrial revenue bonds bear interest at 4.25% per annum and are payable as to principal and interest concurrently with payments due under the terms of the lease. We have classified the leased assets as property and equipment and have established a capital lease obligation equal to the outstanding principal balance of the industrial revenue bonds. Lease payments may be made by tendering an equivalent portion of the industrial revenue bonds. As the capital lease payments to St. Louis County may be satisfied by tendering industrial revenue bonds (which is our intention), the capital lease obligation, industrial revenue bonds and related interest expense and interest income, respectively, have been offset for presentation purposes in the Consolidated Financial Statements.

Ability to Continue as a Going Concern

There is substantial doubt about our ability to continue as a going concern. Our consolidated financial statements included in this Quarterly Report on Form 10-Q are prepared using accounting principles generally accepted in the United States applicable to a going concern, which contemplates the realization of assets and liquidation of liabilities in the normal course of business. The historical consolidated financial statements included in this Quarterly Report on Form 10-Q do not include any adjustments that might be necessary if we are unable to continue as a going concern.

The assessment of our ability to continue as a going concern was made by management considering, among other factors: (i) our need to obtain additional capital; (ii) the suspension of shipment of all products manufactured by us and the requirements under the consent decree with the FDA; (iii) the timing and number of approved products that will be reintroduced to the market and the related costs; (iv) the potential outcome with respect to the governmental inquiries, litigation or other matters described in Note 18—“Commitments and Contingencies” of the Notes to the Consolidated Financial Statements included in this Quarterly Report on Form 10-Q; and (v) our ability to comply with debt covenants. Our assessment was further affected by our fiscal year 2009 net loss of $313.6 million, our net loss for the first three quarters of fiscal year 2010 of $0.4 million and the outstanding balance of cash, cash equivalents and short-term marketable securities (excluding PDI assets, which are accounted for as assets held for sale) of $96.6 million as of December 31, 2009. For periods subsequent to December 31, 2009, we expect losses to continue because we are unable to generate any significant revenues from our own manufactured products until we are able to resume shipping certain or many of our approved

 

58


products, which currently is not expected to occur until the fourth quarter of calendar year 2010 at the earliest. In addition, we must meet ongoing operating costs as well as costs related to the steps we are currently taking to prepare for reintroducing our approved products to the market. If we are not able to obtain the FDA’s clearance to resume manufacturing and distribution of our approved products in a timely manner and at a reasonable cost, our financial position, results of operations, cash flows and liquidity will continue to be materially adversely affected. These conditions raise substantial doubt about our ability to continue as a going concern.

We believe that we are not in compliance with one or more of the requirements of our mortgage loan arrangement as of March 31, 2009, June 30, 2009, September 30, 2009 and December 31, 2009 (see Note 14—“Long-Term Debt” of the Notes to the Consolidated Financial Statements included in this Quarterly Report on Form 10-Q). Failure by us to comply with the requirements of the mortgage loan arrangement or to otherwise receive a waiver from the mortgage lender for any noncompliance could result in our outstanding mortgage debt obligation accelerating and immediately becoming due and payable. If the acceleration occurs and the mortgage debt is not immediately paid in full, an event of default could also be deemed to have occurred under the $200 million principal amount of 2.5% Contingent Convertible Subordinated Notes. If an event of default is deemed to have occurred on the Notes, the principal amount plus any accrued and unpaid interest could also become immediately due and payable. The acceleration of these outstanding debt obligations would materially adversely affect our business, financial condition and cash flows.

Based on current financial projections, we believe the continuation of our company as a going concern is primarily dependent on our ability to address, among other factors: (i) our need to obtain additional capital; (ii) the suspension of shipment of all products manufactured by us and the requirements under the consent decree with the FDA; (iii) the timing and number of approved products that will be reintroduced to the market and the related costs; (iv) the potential outcome with respect to the governmental inquiries, litigation or other matters described in Note 18—“Commitments and Contingencies” of the Notes to the Consolidated Financial Statements included in this Quarterly Report on Form 10-Q; and (v) our ability to comply with debt covenants. While we address these matters, we must continue to meet expected near-term obligations, including normal course operating cash requirements and costs associated with reintroducing our approved products to the market (such as costs related to our employees, facilities and FDA compliance), remaining payments associated with the acquisition of the rights to Gestiva™ (see Note 5—“Acquisitions” of the Notes to the Consolidated Financial Statements included in this Quarterly Report on Form 10-Q), the financial obligations pursuant to the plea agreement (see Note 20—“Subsequent Events” of the Notes to the Consolidated Financial Statements included in this Quarterly Report on Form 10-Q), as well as the significant costs, such as legal and consulting fees, associated with the steps taken by us in connection with the consent decree and the litigation and governmental inquiries. If we are not able to obtain the FDA’s clearance to resume manufacturing and distribution of our approved products in a timely manner and at a reasonable cost, and/or if we experience adverse outcomes with respect to any of the governmental inquiries or litigation described in Note 18—“Commitments and Contingencies” of the Notes to the Consolidated Financial Statements included in this Quarterly Report on Form 10-Q, our financial position, results of operations, cash flows and liquidity will continue to be materially adversely affected. See Item 1A—“Risk Factors” included in our Annual Report on Form 10-K for the fiscal year ended March 31, 2009 regarding additional risks we face with respect to these matters.

In the near term, we are focused on meeting the requirements of the consent decree, which will allow our approved products to be reintroduced to the market, and are pursuing various means to increase cash. Since December 31, 2009, we have generated non-recurring cash proceeds to support our on-going operating and compliance requirements from the receipt of tax refunds, the monetization of our ARS, the divestiture of PDI and the sale of certain other assets (see Note 20—“Subsequent Events” of the Notes to the Consolidated Financial Statements included in this Quarterly Report on Form 10-Q). While these cash proceeds were sufficient to meet near-term cash requirements, we are pursuing ongoing efforts to increase cash, including the continued implementation of cost savings, divestiture of certain assets and the return of certain of our approved products to market in a timely manner. In addition, in order to continue to meet the expected near-term obligations described above, we will still need to obtain additional capital through additional asset sales. We are also engaged in external financing efforts. We are evaluating our capital needs and availability of financing to assess and identify the best available external financing alternatives. We cannot provide assurance that we will be able to realize the cost reductions we anticipate from reducing our operations or our employee base, that some or many of our approved products can be returned to the market in a timely manner, that our higher profit approved products will

 

59


return to the market in the near term, that we can obtain additional cash through asset sales, or that external financing can be obtained, under acceptable terms or in the amounts required. If we are unsuccessful in our efforts to sell assets and raise additional capital in the near term, we will be required to further reduce our operations, including further reductions of our employee base, or we may be required to cease operations in order to offset the lack of available funding.

Our ability to obtain capital has been and continues to be materially and negatively affected by a number of factors. The current and evolving credit market condition and general adverse economic conditions have caused the cost of prospective debt and equity financings to increase considerably. These circumstances have materially adversely affected liquidity in the financial markets, making terms for certain financings unattractive, and in some cases have resulted in the unavailability of financing. We also anticipate that the uncertainty created by the ongoing governmental inquiries and litigation described in Note 18—“Commitments and Contingencies” of the Notes to the Consolidated Financial Statements included in this Quarterly Report on Form 10-Q, steps taken by us in connection with the nationwide recall and suspension of shipment of all drug products manufactured by us, the consent decree and the uncertainty with respect to when we will resume shipment of our products, if at all, will affect our ability to obtain capital on a timely basis, or at all. In light of the factors described above, we may not be able to obtain additional capital. Even if we are able to obtain additional financing or issue debt securities under these circumstances, the cost to us likely will be high and the terms and conditions are likely to be onerous. In addition, if we were to issue equity securities, such securities likely would be priced at or below the current market price for our securities. As a result, sales of equity securities at or below current market prices likely would result in substantial dilution for current shareholders who purchased our equity securities at or above current market prices.

We continue to evaluate the sale of certain of our assets. However, due to general economic conditions, we will likely be exposed to risks related to the overall macro-economic environment, including a lower rate of return than we have historically experienced on our invested assets and being limited in our ability to sell assets. In addition, we cannot provide any assurance that we will be successful in finding suitable purchasers for the sale of such assets. Even if we are able to find purchasers, we may not be able to obtain attractive terms and conditions for such sales, including attractive pricing. In addition, divestitures of businesses may also involve a number of risks, including the diversion of management and employee attention, significant costs and expenses, the loss of customer relationships, a decrease in revenues and earnings associated with the divested business, and the disruption of operations in the affected business. In addition, divestitures potentially involve significant post-closing separation activities, which could involve the expenditure of significant financial and employee resources. Inability to consummate identified asset sales or manage the post-separation transition arrangements could adversely affect our business, financial condition, results of operations and cash flows.

Current and Anticipated Liquidity Position

At March 31, 2010 and May 31, 2010, we had approximately $60.0 million and $35.0 million, respectively, in cash, cash equivalents and short-term investment securities. We received approximately $125.3 million of cash during the third quarter of fiscal year 2010 as a result of entering into a Distribution and Supply Agreement with Purdue that allowed us to sell limited quantities of oxycodone hydrochloride tablets manufactured by them (see Note 18—“Commitments and Contingencies” of the Notes to the Consolidated Financial Statements included in this Quarterly Report on Form 10-Q for more information regarding the litigation with Purdue and descriptions of the Settlement Agreement, the Patent License Agreement and the Distribution and Supply Agreement). In addition to the $81.9 million tax refunds received in the first nine months of fiscal year 2010, we received additional tax refunds totaling approximately $23.7 million during the remainder of fiscal year 2010. We received an additional $61.7 million related to the settlement agreement on our ARS during the fourth quarter of fiscal year 2010 (see also Note 20—“Subsequent Events” of the Notes to the Consolidated Financial Statements included in this Quarterly Report on Form 10-Q).

At March 31, 2010, we had $236.0 million of outstanding debt, consisting of $200.0 million principal amount of Notes, the remaining principal balance of a $43.0 million mortgage loan and the remaining portion of a $2.0 million software financing arrangement. See the discussion above in this section for more information on our indebtedness.

 

60


During the quarter ended March 31, 2010, our cash operating expenditures were approximately $125.0 million. Of this amount, $70.0 million relates to a payment to Hologic, which payment was made in January 2010 in connection with the amendment to the asset purchase agreement entered into in January 2010 to secure the rights to Gestiva™, approximately $45.0 million relates to on-going operating expenses, approximately $5.0 million relates to financial obligations pursuant to the plea agreement and approximately $1.7 million relates to debt service payments, inventory build and capital expenditures. The remainder of the projected cash expenditures totaling approximately $2.0 million to $7.0 million relates to costs related to our FDA compliance consultants and other costs.

We currently project that during the quarter ending June 30, 2010, our cash operating expenditures will be approximately $40.0 million to $50.0 million, compared to approximately $60.0 million in cash, cash equivalents and short-term investment securities at March 31, 2010. Of the expected cash operating expenditures, approximately $28.0 million to $32.0 million relate to on-going operating expenses, approximately $3.0 million to $4.0 million relate to debt service payments, approximately $6.0 million to $7.0 million relate to termination and other associated costs and approximately $2.0 million to $4.0 million relate to legal and customer settlement payments. The remainder of the projected cash expenditures totaling approximately $1.0 million to $3.0 million is for costs related to our FDA compliance consultants and other costs.

Including (1) the $11.0 million of proceeds received in May 2010 from the sale of certain intellectual property and other assets related to our ANDA submitted with the FDA for the approval to engage in the commercial manufacture and sale of 1gm/10mL sucralfate suspension (see Note 20—“Subsequent Events” of the Notes to the Consolidated Financial Statements included in this Quarterly Report on Form 10-Q), (2) the $22.0 million of proceeds received in June 2010 from the sale of PDI (see Note 20—“Subsequent Events” of the Notes to the Consolidated Financial Statements included in this Quarterly Report on Form 10-Q) and (3) the cash operating expenditures described above, we currently project our cash balance at June 30, 2010 to be approximately $40.0 million to $50.0 million.

Barring any further actions we may take to reduce our cash expenditures, we currently project that during the quarter ended September 30, 2010, our operating expenditures will be approximately $30.0 million to $40.0 million. In addition, pursuant to the Amended Gestiva Agreement, a series of scheduled cash payments becomes due upon successful completion of agreed upon milestones. The successful completion of an agreed upon milestone may occur during the quarter ending September 30, 2010, as a result of which we would be required to make our next scheduled milestone payment of $25.0 million to Hologic in that quarter (see Note 5—“Acquisitions” of the Notes to the Consolidated Financial Statements in this Quarterly Report on Form 10-Q). Although we believe our anticipated cash operating expenditures will be significantly reduced in the quarter ending September 30, 2010 compared to the quarter ending June 30, 2010, our existing cash and financial resources will not be sufficient to fund our operations beyond the quarter ending September 30, 2010, unless we are able to raise sufficient additional capital by selling assets or through external financing.

As discussed above, we are engaged in external financing efforts. We have retained Robert W. Baird & Co. Incorporated to advise us with respect to raising additional capital and have engaged in preliminary discussions with several potential lenders regarding external financing. However, we cannot provide any assurances on the timing or the amount of any potential financing or that our efforts to raise additional capital will ultimately be successful.

In addition, if a director of our company, or a shareholder with an ownership interest in our company of 5% or more (a “significant shareholder”), is excluded from participating in federal or state health care programs, then HHS may use its discretionary authority to also exclude our company from participation in federal healthcare programs. Although we are not aware of any of our directors or significant shareholders having been excluded by HHS at this time, legal counsel to Mr. M. Hermelin, a director and significant shareholder of our company, has confirmed, in response to an inquiry from legal counsel for our company, that Mr. M. Hermelin has received correspondence from HHS regarding potential exclusion. As a result, the possibility that HHS may take action to exclude our company from participating in federal healthcare programs, as well as the mere perception by potential lenders or other sources of external financing that such action by HHS may occur, could have a material adverse effect on our ability to complete any potential financing or other effort to raise additional capital.

For our company not to be subject to the discretionary authority of HHS to exclude it from participation, the affected director would have to resign and the affected significant shareholder would have to divest ownership of such shareholder’s interest (a transfer of the ownership interest to an immediate family member or a member of the significant shareholder’s household in anticipation of or following exclusion would not be sufficient). In such case, we would have limited or no ability to remove the affected director or to compel the affected significant shareholder to divest ownership of such shareholder’s interest.

Therefore, if HHS were to elect to use its discretionary authority to exclude our company from participation in federal healthcare programs in the event that a director of our company or a significant shareholder is excluded from participating in federal or state health care programs, and we are not able to avoid being excluded by HHS, our business, financial condition, results of operations and future prospects would be materially and adversely affected. Moreover, the mere perception by potential lenders or other sources of external financing that such action by HHS may occur could have a material adverse effect on our ability to raise additional capital.

We are continuously reviewing our projected cash expenditures and are evaluating measures to reduce expenditures on an ongoing basis. In addition, our top priority is to maintain and attempt to increase our limited cash and financial resources. As a result, if we determine that our current goal of meeting the consent decree’s requirements and returning our approved products to market is likely to be significantly delayed, we may decide, in addition to selling certain of our assets, to further reduce our operations, to significantly curtail some or all of our efforts to meet the consent decree’s requirements and return our approved products to market and/or to outsource to a third party some or all of our manufacturing operations when and if we return our approved

 

61


products to market. Such decision would be made based on our ability to manage our near-term cash obligations, to obtain additional capital through asset sales and/or external financing and to expeditiously meet the consent decree’s requirements and return our approved products to market. If such decision were to be made, we currently anticipate that we would focus our management efforts on developing product candidates in our development portfolio that we believe have the highest potential return on investment, which we currently believe to be primarily Gestiva™ (17-alpha hydroxyprogesterone caproate). We also expect to evaluate other alternatives available to us in order to increase our cash balance.

As more fully described in Note 2—“Basis of Presentation” of the Notes to the Consolidated Financial Statements in this Quarterly Report on Form 10-Q, the sale of certain of our assets and certain strategic and operating alternatives that we currently are considering (including further reduction of our operations and/or outsourcing to a third party of some or all of our manufacturing operations) may result in significant non-cash charges for impairment of inventory, property and equipment and intangible and other long-lived assets in the period ended March 31, 2010, as we may not be able to realize our recorded value of the associated assets in connection with these actions. As of December 31, 2009, we had, excluding PDI assets (which are accounted for as assets held for sale), inventories, net, of $24.9 million, property and equipment, less accumulated depreciation, of $175.1 million and intangible assets and goodwill, net, of $139.9 million. We currently cannot estimate the amount of the potential impairment charges, if any, that we may incur in a future period related to decisions regarding these strategic and operating alternatives. However, if we were to incur significant impairment charges in a future period related to these decisions, our results of operations could be adversely affected and the value of our common stock could decrease. See also Part II, Item 1A—“Risk Factors—The decisions we make in order to maintain and increase our limited cash and financial resources may result in significant charges for impairment of inventory, property and equipment and intangible and other long-lived assets” in the Quarterly Report on Form 10-Q for the quarter ended June 30, 2009.

Inflation

Inflation may apply upward pressure on the cost of goods and services used by us in the future. However, we believe that the net effect of inflation on our operations during the past three years has been minimal. In addition, changes in the mix of products sold and the effect of competition have made a comparison of changes in selling prices less meaningful relative to changes in the overall rate of inflation over the past three fiscal years.

Critical Accounting Estimates

Our consolidated financial statements are presented on the basis of U.S. generally accepted accounting principles. Certain of our accounting policies are particularly important to the presentation of our financial condition and results of operations and require the application of significant judgment by our management. As a result, amounts determined under these policies are subject to an inherent degree of uncertainty. In applying these policies, we make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures. We base our estimates and judgments on historical experience, the terms of existing contracts, observance of trends in the industry, information that is obtained from customers and outside sources, and on various other assumptions that we believe to be reasonable and appropriate under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Although we believe that our estimates and assumptions are reasonable, actual results may differ significantly from our estimates. Changes in estimates and assumptions based upon actual results may have a material impact on our results of operations and/or financial condition. Our critical accounting estimates are described below.

Revenue Recognition and Provisions for Estimated Reductions to Gross Revenues

Revenue is generally realized or realizable and earned when persuasive evidence of an arrangement exists, the customer’s payment ability has been reasonably assured, title and risk of ownership have been transferred to the customer, and the seller’s price to the buyer is fixed or reasonably determinable. When these conditions have not been met, revenue is deferred and reflected as a liability on the consolidated balance sheet until any uncertainties or contingencies have been resolved. We also enter into long-term agreements under which we assign marketing rights for products we have developed to pharmaceutical markets. Royalties under these arrangements are earned based on the sale of products.

 

62


Concurrently with the recognition or deferral of revenue, we record estimated provisions for product returns, sales rebates, payment discounts, chargebacks, and other sales allowances. These provisions are established based upon consideration of a variety of factors, including but not limited to, historical relationship to revenues, historical payment and return experience, estimated and actual customer inventory levels, customer rebate arrangements, and current contract sales terms with wholesale and indirect customers. We record a liability for product returns related to recalls and for failure to supply claims when their occurrence becomes estimable and probable.

From time to time, we provide incentives to our wholesale customers, such as trade show allowances or stocking allowances that they in turn use to accelerate distribution to their end customers. We believe that such incentives are normal and customary in the industry. Sales allowances are accrued and revenue is recognized as sales are made pursuant to the terms of the allowances offered to the customer. Due to the nature of these allowances, we believe we are able to accurately calculate the required provisions for the allowances based on the specific terms in each agreement. Additionally, customers will normally purchase additional product ahead of regular demand to take advantage of the temporarily lower cost resulting from the sales allowances. This practice has been customary in the industry and we believe would be part of a customer’s ordinary course of business inventory level. We reserve the right, with our major wholesale customers, to limit the amount of these forward buys. Sales made as a result of allowances offered on our specialty generics product line in conjunction with trade shows sponsored by our major wholesale customers and for other promotional programs accounted for 15.2% of total gross revenues for the nine months ended December 31, 2008. There were no allowances offered for the nine months ended December 31, 2009.

In addition, we understand that certain of our wholesale customers may try to anticipate the timing of price increases and have made, and may continue to make, business decisions to buy additional product in anticipation of future price increases. This practice has been customary in the industry and we believe would be part of a customer’s ordinary course of business inventory level.

We evaluate inventory levels at our wholesale customers through an internal analysis that considers, among other things, wholesaler purchases, wholesaler contract sales, available end consumer prescription information and inventory data received from our three largest wholesale customers. We believe that our evaluation of wholesaler inventory levels allows us to make reasonable estimates of our reserve balances. Further, our products are typically sold with adequate shelf life to permit sufficient time for our wholesaler customers to sell our products in their inventory through to the end consumer.

 

63


The following table reflects the activity during the nine months ended December 31, 2009 for each accounts receivable reserve or related liability:

 

(in thousands)    Beginning
Balance
   Current Provision
Related to Sales
Made in the
Current Period
   Current Provision
Related to Sales
Made in the
Prior Periods
   Actual Returns
or Credits
in the
Current Period
    Ending
Balance

Nine Months Ended December 31, 2009

             

Accounts Receivable Reserves:

             

Chargebacks

   $ 1,021    $ 998    $ —      $ (1,863   $ 156

Cash Discounts and Other Allowances

     1,035      3,145      —        (3,421     759

Liabilities:

             

Sales Rebates

     8,264      812      —        (7,098     1,978

Sales Returns

     12,009      531      —        (5,557     6,983

Medicaid Rebates

     6,312      1,079      —        (4,345     3,046

Medicare and Medicaid Restitution

     2,275      —        —        —          2,275

Product Recall Returns

     40,695      —        —        (33,789     6,906

Failure to Supply Claims

     17,101      —        —        (4,801     12,300

Chargeback Audit Adjustments

     1,823      —        321      (2,144     —  

Other

     2,955      228      —        (2,630     553
                                   

Total

   $ 93,490    $ 6,793    $ 321    $ (65,648   $ 34,956
                                   

The estimation process used to determine our reserve provisions has been applied on a consistent basis and no material adjustments have been necessary to increase or decrease our reserves as a result of a significant change in underlying estimates. We use a variety of methods to assess the adequacy of our reserves to ensure our financial statements are fairly stated. These include reviews of customer inventory data, customer contract programs and product pricing trends to analyze and validate the reserves.

The decrease in the accounts receivable or accrued liability reserves of $58.5 million was primarily the result of applying credits owed to our customers for returns and failure to supply costs associated with the product recalls in fiscal year 2009 against outstanding amounts such customers owed to us and of making payments associated with return and failure to supply costs to customers that did not have outstanding amounts owed to us.

The current provision related to sales made in prior periods reflects the impact of a billing audit performed by one of our customers. As a result, we increased our chargeback reserve for the amount of the adjustment shown in the nine months ended December 31, 2009, which was subsequently paid in the current period.

These reserves and their respective provisions are discussed in further detail below.

Chargebacks – We market and sell products directly to wholesalers, distributors, warehousing pharmacy chains, mail order pharmacies and other direct purchasing groups. We also market products indirectly to independent pharmacies, non-warehousing chains, managed care organizations, and group purchasing organizations, collectively referred to as “indirect customers.” We enter into agreements with some indirect customers to establish contract pricing for certain products. These indirect customers then independently select a wholesaler from which to purchase the products at these contracted prices. Alternatively, we may pre-authorize wholesalers to offer specified contract pricing to other indirect customers. Under either arrangement, we provide credit to the wholesaler for any difference between the contracted price with the indirect customer and the wholesaler’s invoice price. This credit is called a chargeback.

Chargeback transactions are almost exclusively related to our specialty generics business segment. During the nine months ended December 31, 2009 and 2008, the chargeback provision reduced the gross sales of our specialty generics segment by $1.3 million and $141.5 million, respectively. These amounts accounted for 96.3% and 99.3% of the total chargeback provisions recorded during the nine months ended December 31, 2009 and 2008, respectively.

 

64


At December 31, 2009, we evaluated the adequacy of the reserve for chargebacks by comparing it against subsequent credits issued.

Shelf-Stock Adjustments – These adjustments, which are included in the chargeback reserves, represent credits issued to our wholesale customers that result from a decrease in our wholesale acquisition cost (“WAC”). Decreases in our invoice prices are discretionary decisions we make to reflect market conditions. These credits are customary in the industry and are intended to reduce a wholesale customer’s inventory cost to better reflect current market prices. Generally, we provide credits to customers at the time the price reduction occurs based on the inventory that is owned by them on the effective date of the price reduction. Since a reduction in WAC reduces the chargeback per unit, or the difference between WAC and the contract price, shelf-stock adjustments are typically included as part of the reserve for chargebacks because the price reduction credits act essentially as accelerated chargebacks. Although we have contractually agreed to provide price adjustment credits to our major wholesale customers at the time they occur, the impact of any such price reductions not included in the reserve for chargebacks is immaterial to the amount of revenue recognized in any given period. As a result of WAC decreases to certain specialty generic/non-branded products, we paid shelf-stock adjustments of $0.4 million to our wholesale customers during the nine months ended December 31, 2009.

Sales Returns – Consistent with industry practice, we maintain a returns policy that allows our direct and indirect customers to return product six months prior to expiration and within one year after expiration. This policy is applicable to both our branded and specialty generics business segments. Upon recognition of revenue from product sales to customers, we provide for an estimate of product to be returned. This estimate is determined by applying a historical relationship of customer returns to gross sales. We evaluate the reserve for sales returns by calculating historical return rates using data from the last 12 months on a product specific basis and by class of trade (wholesale versus retail chain). The calculated percentages are applied against estimates of inventory in the distribution channel on a product specific basis. To determine the inventory levels in the wholesale distribution channel, we utilize actual inventory information from our major wholesale customers and estimate the inventory positions of the remaining wholesalers based on historical buying patterns. For inventory held by our non-wholesale customers, we use the last two months of sales to the direct buying chains and the indirect buying retailers as an estimate.

Medicaid Rebates – Federal law requires that a pharmaceutical manufacturer, as a condition of having its products receive federal reimbursement under Medicaid and Medicare Part B, must pay rebates to state Medicaid programs for units of its pharmaceuticals that are dispensed to Medicaid beneficiaries and paid for by a state Medicaid program. Medicaid rebates apply to both our branded and specialty generic/non-branded segments. Individual states invoice us for Medicaid rebates on a quarterly basis using statutorily determined rates: for non-innovator products, in general generic drugs marketed under ANDAs, the rebate amount, effective the first quarter of calendar year 2010, is 13% of the Average Manufacturer Price (“AMP”) for the quarter. Prior to the first quarter of calendar year 2010, the percentage was 11%. For innovator products, in general brand-name products marketed under new drug applications (NDAs), the rebate amount, effective the first quarter of calendar year 2010, is the greater of 23.1% of the AMP for the quarter (15.1% prior to the first quarter of calendar year 2010) or the difference between such AMP and the best price for that same quarter. This 23.1% is reduced to 17.1% in the case of certain clotting factors and drugs approved exclusively for pediatric indications. An additional rebate for innovator products is payable in the amount by which, if any, the product’s AMP has increased at a rate faster than inflation. For certain new formulations of existing products, the new formulation’s additional rebate may be based on the additional rebate of the original formulation of the drug. The total rebate amount for each particular product is its Unit Rebate Amount, or “URA.” The amount owed is based on the number of units paid for by each state Medicaid program in a quarter extended by the URA. Historically, these units were limited to those paid for by each state Medicaid program under fee-for-service arrangements, but effective March 23, 2010 the utilization will be expanded to include that paid for under Medicaid managed care capitated arrangements. The reserve for Medicaid rebates is based on expected payments, which are affected by patient usage and estimated inventory in the distribution channel. We estimate patient usage by calculating a payment rate as a percentage of related gross sales, which is then applied to current period sales.

Reserve for Failure to Supply Claims – We have historically entered into product purchase arrangements with certain customers that include a provision that requires us to reimburse these customers for price differences on product orders that we are unable to fulfill. We are able to estimate provisions for supply failures based on the

 

65


specific terms in each arrangement. We incurred failure to supply claims in fiscal year 2009 due primarily to us not manufacturing or shipping any of our drug products during the third and fourth quarters of fiscal year 2009. There were no increases to the reserve for failure to supply claims recorded in the nine months ended December 31, 2009.

Liabilities for Product Returns Related to Recalls – Beginning in May 2008 through November 2008, we announced six separate voluntary recalls of certain tablet form generic products as a precaution due to the potential existence of oversized tablets. Liabilities for product returns related to recalls are based on estimated and actual customer inventory levels at the time of the recall and actual contract pricing.

Inventory Valuation

Inventories consist of finished goods held for distribution, raw materials and work in process. Our inventories are stated at the lower of cost or market, with cost determined on the first-in, first-out basis. In evaluating whether inventory should be stated at the lower of cost or market, we consider such factors as the amount of inventory on hand and in the distribution channel, estimated time required to sell existing inventory, remaining shelf life and current and expected market conditions, including levels of competition. We establish reserves, when necessary, for slow-moving and obsolete inventories based upon our historical experience and management’s assessment of current product demand.

Inventories also include costs related to certain products that are pending regulatory approval. From time to time, we capitalize inventory costs associated with products prior to regulatory approval based on management’s judgment of probable future regulatory approval, commercial success and realizable value. Such judgment incorporates our knowledge and best estimate of where the product is in the regulatory review process, our required investment in the product, market conditions, competing products and our economic expectations for the product post-approval relative to the risk of manufacturing the product prior to approval. If final regulatory approval for such products is denied or delayed, we revise our estimates and judgments about the recoverability of the capitalized costs and, where required, provide reserves for such inventory in the period those estimates and judgments change.

Intangible and Other Long-Lived Assets

Our intangible assets principally consist of product rights, license agreements and trademarks resulting from product acquisitions and legal fees and similar costs relating to the development of patents and trademarks. Intangible assets that are acquired are stated at cost, less accumulated amortization, and are amortized on a straight-line basis over their estimated useful lives, which range from nine to 20 years. We determine amortization periods for intangible assets that are acquired based on our assessment of various factors impacting estimated useful lives and cash flows of the acquired products. Such factors include the product’s position in its life cycle, the existence or absence of like products in the market, various other competitive and regulatory issues, and contractual terms. Significant changes to any of these factors may result in a reduction in the intangible asset’s useful life and an acceleration of related amortization expense.

We assess the impairment of intangible and other long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following: (1) significant underperformance relative to expected historical or projected future operating results; (2) significant changes in the manner of our use of the acquired assets or the strategy for our overall business; and (3) significant negative industry or economic trends.

When we determine that the carrying value of an intangible or other long-lived asset may not be recoverable based upon the existence of one or more of the above indicators of impairment, we first perform an assessment of the asset’s recoverability. Recoverability is determined by comparing the carrying amount of an asset against an estimate of the undiscounted future cash flows expected to result from its use and eventual disposition. If the sum of the expected future undiscounted cash flows is less than the carrying amount of the asset, an impairment loss is recognized based on the excess of the carrying amount over the estimated fair value of the asset.

 

66


During the assessment as of December 31, 2009, management did not identify any events that were indicative of impairment. However, any significant changes in actual future results from the assessment used to perform the quarterly evaluation, such as lower sales, increases in production costs, technological changes or decisions not to produce or sell products, could result in impairment of these intangible assets at a future date.

Stock-Based Compensation

We account for stock-based compensation expense in accordance with the applicable accounting standard, which requires the measurement and recognition of compensation expense, based on estimated fair values, for all share-based compensation awards made to employees and directors over the vesting period of the awards. Determining the fair value of share-based awards at the grant date requires judgment to identify the appropriate valuation model and estimate the assumptions, including the expected term of the stock options and expected stock-price volatility, to be used in the calculation. Judgment is also required in estimating the percentage of share-based awards that are expected to be forfeited. We estimate the fair value of stock options granted using the Black-Scholes option-pricing model with assumptions based primarily on historical data. If actual results differ significantly from these estimates, stock-based compensation expense and our results of operations could be materially impacted.

Income Taxes

Our deferred tax assets and liabilities are determined based on temporary differences between the financial reporting and tax basis of assets and liabilities. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets are expected to be realized or settled. We record a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. Management believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with the tax effects of the deferred tax liabilities, will be sufficient to fully recover the remaining deferred tax assets. If all or part of the net deferred tax assets are determined not to be realizable in the future, an adjustment to the valuation allowance would be charged to earnings in the period such determination is made. Similarly, if we subsequently realize deferred tax assets that were previously determined to be unrealizable, the respective valuation allowance would be reversed, resulting in a positive adjustment to earnings in the period such determination is made.

We compute our annual tax rate based on the statutory tax rates and tax planning opportunities available to us in the various jurisdictions in which we earn income. Significant judgment is required in determining our annual tax rate and in evaluating tax positions. We establish reserves for uncertain tax positions if the positions are more likely than not to be sustained upon audit. We adjust these reserves in light of changing facts and circumstances, such as the settlement of a tax audit. Our annual tax rate includes the impact of reserve provisions and changes to reserves.

Management regularly evaluates our tax positions taken on tax returns that we file using information about recent court decisions and legislative activities. Many factors are considered in making these evaluations, including past history, recent interpretations of tax law, and the specific facts and circumstances of each matter. Because tax regulations are subject to interpretation and tax litigation is inherently uncertain, these evaluations can involve a series of complex judgments about future events and can rely heavily on estimates and assumptions. The recorded tax liabilities are based on estimates and assumptions that have been deemed reasonable by management. However, if our estimates are not representative of actual outcomes, recorded tax liabilities could be materially impacted.

Contingencies

We are involved in various legal proceedings, some of which involve claims for substantial amounts. An estimate is made to accrue for a loss contingency relating to any of these legal proceedings if we determine it is probable that a liability was incurred as of the date of the financial statements and the amount of loss can be reasonably estimated. Because of the subjective nature inherent in assessing the future outcome of litigation and because of the potential that an adverse outcome in legal proceedings could have a material impact on our financial condition or results of operations, such estimates are considered to be critical accounting estimates. After completing a review of such matters, we determined that at December 31, 2009, there were certain legal proceedings in which we are involved that met the conditions described above. Accordingly, we have accrued a loss contingency relating to such legal proceedings.

 

67


Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our exposure to market risk is limited to fluctuating interest rates associated with variable rate indebtedness and marketable securities that are subject to interest rate changes.

As of December 31, 2009, we had invested $72.3 million principal amount in ARS consisting of high quality (AAA rated) bonds secured by student loans which are guaranteed by the U.S. Government. The rates on these securities reset at pre-determined intervals of up to 35 days. The maturity of these securities is greater than 10 years, but the rates on these securities were to reset at predetermined intervals up to 35 days. During the fourth quarter of fiscal year 2008, certain developments in the capital and credit markets adversely affected the market for auction rate securities, which has resulted in a loss of liquidity for these investments. We have evaluated these securities to determine if other-than-temporary impairment of the carrying value of the securities has occurred due to the loss of liquidity. Because of recent significant business developments related to our company, including product recalls and the consent decree with the FDA that occurred beginning in December 2008, we face significant liquidity concerns and determined we could no longer support our previous assertion that we had the ability to hold impaired securities until their forecasted recovery. As a result, we concluded that the ARS became other-than-temporarily impaired during December 2008 and we recorded a loss of $9.1 million in current period earnings. This adjustment reduced the carrying value of the ARS to $63.7 million at December 31, 2008. During the quarter ended March 31, 2009, we recorded discount accretion of $0.1 million on the ARS, yielding a carrying value of $63.8 at March 31, 2009. During the nine months ended December 31, 2009, we sold $0.5 million in principal amount of the ARS and recorded additional discount accretion of $0.2 million on the ARS. The estimated fair value of our ARS holdings at December 31, 2009 was $66.1 million. The $2.6 million difference in fair value of the ARS at December 31, 2009 compared to the corresponding carrying value was recorded in accumulated other comprehensive income as an unrealized gain of $1.7 million, net of tax (see Note 9—“Investment Securities” of the Notes to the Consolidated Financial Statements included in this Quarterly Report on Form 10-Q). See Note 20—“Subsequent Events” of the Notes to the Consolidated Financial Statements included in this Quarterly Report on Form 10-Q for information regarding a settlement agreement we entered into regarding the ARS and the proceeds received in connection therewith.

The annual favorable impact on our net income as a result of a 100 basis point (where 100 basis points equals 1%) increase in short-term interest rates would be approximately $1.3 million based on our average cash, cash equivalents and short-term marketable investment balances during the nine months ended December 31, 2009, compared to an increase of $0.5 million during the fiscal year ended March 31, 2009.

In May 2003, we issued $200.0 million principal amount of Convertible Subordinated Notes. The interest rate on the Notes is fixed at 2.50% and therefore not subject to interest rate changes. Beginning May 16, 2006, we became obligated to pay contingent interest at a rate equal to 0.5% per annum during any six-month period, if the average trading price of the Notes per $1,000 principal amount for the five-trading day period ending on the third trading day immediately preceding the first day of the applicable six-month period equals $1,200 or more. In November 2007, the average trading price of the Notes reached the threshold for the applicable five-day trading period which resulted in the payment of contingent interest and beginning November 16, 2007 the Notes began to bear interest at a rate of 3.00% per annum. In May 2008, the average trading price of the Notes fell below the contingent interest threshold for the five-day trading period and beginning May 16, 2008 the Notes began to pay interest at a rate of 2.50% per annum. Holders may require us to repurchase all or a portion of their Notes on May 16, 2013, 2018, 2023 and 2028, or upon a change in control, as defined in the indenture governing the Notes, at 100% of the principal amount of the Notes, plus accrued and unpaid interest (including contingent interest, if any) to the date of repurchase, payable in cash. Because the next occasion holders may require us to repurchase all or a portion of their Notes is May 16, 2013, the Notes were classified as a long-term liability as of December 31, 2009.

In March 2006, we entered into a $43.0 million mortgage loan secured by three of our buildings that matures in April 2021. The interest rate on this loan is fixed at 5.91% per annum and not subject to market interest rate changes.

During fiscal year 2008, we entered into two installment payment agreements related to the purchase of software products and the right to receive consulting or other services from the seller. For the two agreements, we

 

68


recorded debt in the amount of $2.0 million which will be paid ratably over 16 consecutive quarters. The two installment payment agreements were discounted using an imputed annual interest rate that approximated our borrowing rate for similar debt instruments at the time of the borrowings.

 

69


Item 4. CONTROLS AND PROCEDURES

(a) Evaluation of Disclosure Controls and Procedures

An evaluation was conducted under the supervision and with the participation of our management, including the Interim Chief Executive Officer (the “CEO”) and Chief Financial Officer (the “CFO”), of the effectiveness of the design and operation of our disclosure controls and procedures as of December 31, 2009. As a result of the material weaknesses in our internal control over financial reporting described below, our Interim CEO and CFO have concluded that our disclosure controls and procedures were not effective as of December 31, 2009.

As described in Item 9A—“Controls and Procedures” of our Annual Report on Form 10-K for the fiscal year ended March 31, 2009, management determined that the following material weaknesses existed in our internal control over financial reporting. As of December 31, 2009, these material weaknesses have not been remediated.

Material weaknesses in entity-level controls. We did not maintain an effective control environment or entity-level controls with respect to the risk assessment, information and communications and monitoring components of internal control. Specifically, the following individual material weaknesses were identified:

 

   

We did not sufficiently promote an appropriate level of control awareness;

 

   

We did not maintain a sufficient complement of adequately trained personnel with an appropriate level of knowledge, experience and training in the application of GAAP and commensurate with our financial reporting requirements;

 

   

We did not design adequate controls to identify and address risks critical to financial reporting, including noncompliance with applicable FDA rules and regulations;

 

   

We did not design adequate monitoring controls to determine the adequacy of, and to identify deficiencies with respect to, other controls;

 

   

We did not design controls to ensure that identified deficiencies were remediated on a timely basis; and

 

   

The operating effectiveness of our information and communication controls was inadequate to ensure that information was communicated to the appropriate personnel across and within business activities.

These deficiencies resulted in a reasonable possibility that a material misstatement of our annual or interim consolidated financial statements will not be prevented or detected on a timely basis and contributed to the other material weaknesses described below.

Material weaknesses surrounding the financial statement preparation and review procedures. Our policies and procedures did not adequately address the financial reporting risks associated with the preparation and review of our financial statements. Specifically, the following individual material weaknesses were identified:

 

   

Manual journal entries. The operating effectiveness of our controls was inadequate to ensure that we identified, accumulated and documented appropriate information necessary to support manual journal entries;

 

   

Account reconciliations. The operating effectiveness of our controls was inadequate to ensure that account reconciliations were reviewed and approved for accuracy and completeness and that we identified, accumulated and documented appropriate information necessary to support account balances;

 

   

Spreadsheets. We did not design adequate controls over access, changes to and review of our spreadsheets used in the preparation of financial statements;

 

   

Customer and supplier agreements. The design of our controls was inadequate to ensure that necessary information for new and modified agreements was identified and communicated to those responsible for evaluating the accounting implications;

 

   

Stock-based compensation. The operating effectiveness of our controls was inadequate to ensure the proper grant dates and expected terms were used to measure the fair values of the options and to ensure that necessary information resulting from the modification of options was identified and communicated to those responsible for evaluating the accounting implications;

 

70


   

Medicaid rebates. The operating effectiveness of our controls was inadequate to ensure that accurate information, including information related to pricing of products and the exempt status of customers, was captured and communicated to those responsible for evaluating the accounting implications; and

 

   

Income Taxes. The operating effectiveness of our controls was inadequate to ensure that review and monitoring of the tax provision calculation occurred and that the necessary information was captured and communicated to those responsible for the tax provision calculation.

These deficiencies also resulted in a reasonable possibility that a material misstatement of our interim and annual consolidated financial statements will not be prevented or detected on a timely basis.

Material weaknesses related to the application of accounting principles. Our policies and procedures did not adequately address the financial reporting risks associated with the application of certain accounting principles and standards. Specifically, the following individual material weaknesses were identified:

 

   

Inventories. The operating effectiveness of our controls was inadequate to ensure that manufacturing variances were capitalized as inventory and that purchases of raw materials to be used in research and development activities were expensed as incurred;

 

   

Property and equipment. The operating effectiveness of our controls was inadequate to ensure that maintenance and repairs of equipment were expensed as incurred, asset costs were appropriately capitalized, depreciation expense was appropriately calculated and that the selection of useful lives of property and equipment was appropriately and consistently applied;

 

   

Employee compensation. The operating effectiveness of our controls was inadequate to ensure that costs for vacation pay, severance, and other payroll related accruals were appropriately recorded;

 

   

Reserves for sales allowances. The operating effectiveness of our controls was inadequate to ensure that the process for estimating reserves for sales allowances was reviewed and monitored; and

 

   

Financing transactions. The operating effectiveness of our controls was inadequate to ensure that vendor financing arrangements, including financing costs, were properly reflected on the balance sheet.

These deficiencies also resulted in a reasonable possibility that a material misstatement of our interim and annual consolidated financial statements will not be prevented or detected on a timely basis.

Remediation Activities

During the fourth quarter of fiscal year 2009 and continuing during the fiscal year ended March 31, 2010, we began taking action in order to remediate the material weaknesses described above, including designing and implementing controls by (1) conducting additional analyses and adding substantive procedures, among other things with respect to managing financial information and the preparation of our financial statements, and (2) engaging third-party experts and consultants with relevant accounting experience, skills and knowledge who work under our supervision and direction to assist with, among other things, the account closing and financial statement preparation process.

We remain committed to remediating our material weaknesses in a timely fashion. We will continue our remediation efforts described below, including testing of operating effectiveness of new controls, during the fiscal year ending March 31, 2011. While our remediation efforts are continuing, we anticipate that the implementation of a number of our remedial measures (including testing of operating effectiveness) will occur later in fiscal year 2011, due in part to the changes to and reductions of our workforce, as we also need to devote resources toward efforts to increase our limited cash and financial resources while meeting the consent decree’s requirements in order to return our products to market. We plan to provide an update on the status of our remediation activities on a quarterly basis. While unremediated, these material weaknesses have the potential to result in our failure to prevent or detect material misstatements in our annual or interim consolidated financial statements.

As previously disclosed, in August 2008, the Audit Committee, with the assistance of legal counsel, including FDA regulatory counsel with respect to FDA matters, and other advisers, conducted an internal investigation with

 

71


respect to a range of specific allegations involving, among other items, FDA regulatory and other compliance matters and management misconduct. The investigation was substantially completed in December 2008 and the investigation of all remaining matters was completed in June 2009.

The investigation focused on, among other areas, FDA and other healthcare regulatory and compliance matters, financial analysis and reporting, employment and labor issues, and corporate governance and oversight. See Item 1—“Business—(b) Significant Recent Developments” of our Annual Report on Form 10-K for the fiscal year ended March 31, 2009 for more information on the Audit Committee investigation. As a result of its findings from the investigation, the Audit Committee, with the assistance of its legal counsel, including FDA regulatory counsel with respect to FDA matters, and other advisors, prepared and approved a remedial framework. The Board, either directly or through the Special Committee, has reviewed and approved the remedial framework. Some of the measures included in the remedial framework are intended to remediate certain material weaknesses and are listed below.

The following actions have been taken or are expected to be taken to remediate one or more of the material weaknesses listed above:

 

  (1) Expand the membership of our disclosure committee to include executives with responsibilities over our operating divisions and regulatory affairs; and reviewing, revising and updating existing corporate governance policies and procedures.

 

  (2) Reorganize and relocate our legal department adjacent to the Interim CEO’s office to facilitate greater access to the legal department and more extensive involvement of the legal department in corporate governance and compliance matters.

 

  (3) Adopt measures to strengthen and enhance compliance with FDA regulations and related regulatory compliance, including:

 

   

retaining new outside consultants and counsel for FDA regulatory matters and, with their assistance, reviewing and revising our policies, procedures and practices to enhance compliance with the FDA’s current good manufacturing practice requirements;

 

   

enhancing compliance with FDA drug application, approval and post-approval requirements;

 

   

evaluating compliance with applicable foreign laws and regulations; and

 

   

implementing internal reporting policies pursuant to which our chief compliance officer will report periodically to the non-management members of the Board.

 

  (4) Review the staffing levels, capabilities and experience of the members of the Finance department and add employees with appropriate financial statement closing and GAAP expertise to the Finance department as necessary.

 

  (5) Establish a monthly business review process to ensure an in-depth senior management review of business segment results on a regular basis.

 

  (6) Develop and document comprehensive accounting policies and procedures, including documentation of the methods for applying accounting policies through detailed process maps and procedural narratives.

 

  (7) Define and document roles and responsibilities within the financial statement closing process including required reviews and approval of account reconciliations, journal entries and methodologies used to analyze account balances.

 

  (8) Identify and implement specific steps to improve information flow between the Finance department and business unit finance personnel, as well as other functional areas within our company, to ensure that information that could affect the financial statements, including the effects of all material agreements, is identified, communicated and addressed on a timely basis.

 

72


  (9) Identify and implement specific steps to improve communication, coordination and oversight with respect to the application of critical accounting policies and the determination of estimates.

 

  (10) Implement month-end, quarter-end and year-end closing schedules and closing checklists to ensure timely and documented completion of the financial statements.

 

  (11) Develop and implement a policy and procedure to control the access, modification and review processes for spreadsheets that are used in the preparation of our financial statements and other disclosures.

 

  (12) Conduct training and education of the Finance department personnel on critical accounting policies and procedures, including account reconciliations and financial statement closing procedures, to develop and maintain an appropriate level of skills for proper identification and application of accounting principles.

 

  (13) Define specific roles and responsibilities within the Finance department to improve accounting research and implementation of accounting policies.

 

  (14) Conduct training and education for personnel outside the Finance department on critical accounting policies and procedures to improve the level of control awareness at our company and to ensure an appropriate level of understanding of the proper application of accounting principles that are critical to our financial reporting.

 

  (15) Implement processes and procedures to (1) identify and assess whether certain entities are appropriately exempt from the Medicaid best price calculation and (2) evaluate Public Health Service (“PHS”) pricing requests.

 

  (16) Establish periodic meetings between the contracting functions and the Finance department to improve communication regarding the evaluation and reporting of PHS pricing requests and related matters.

Management believes these remediation measures will strengthen our internal control over financial reporting and remediate the material weaknesses we have identified. However, we have not yet implemented all of these measures and have not completed testing the operating effectiveness of those measures that have been implemented to date. We are committed to improving our internal control processes and will continue to diligently review our financial controls and procedures. However, any control system, regardless of how well designed, operated and evaluated, can provide only reasonable, not absolute, assurance that the control objective will be met. As we continue to evaluate and work to improve our internal control over financial reporting, we may take additional measures to address control deficiencies and/or determine not to complete certain of the remediation measures described above.

(b) Changes in Internal Control Over Financial Reporting

There were no changes in our internal control over financial reporting (as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) during the quarter ended December 31, 2009 that have materially affected, or are reasonably likely to materially affect our internal control over financial reporting, other than progress with respect to the implementation of certain remediation efforts, as described above.

 

73


PART II. OTHER INFORMATION

 

Item 1. LEGAL PROCEEDINGS

The information set forth under Note 18—“Commitments and Contingencies” of the Notes to the Consolidated Financial Statements included in Part I, Item 1 in this Quarterly Report on Form 10-Q is incorporated in this Part II, Item 1 by reference.

 

Item 1A. RISK FACTORS

There were no material changes to the risk factors disclosed in Part I, Item 1A—“Risk Factors” of our Annual Report on Form 10-K for the fiscal year ended March 31, 2009, except to the extent updated in our Quarterly Report on Form 10-Q for the quarter ended June 30, 2009, our Quarterly Report on Form 10-Q for the quarter ended September 30, 2009 or previously updated or to the extent additional factual information disclosed elsewhere in this Quarterly Report on Form 10-Q relates to such risk factors. In addition to the other information set forth in this report, you should carefully consider the risk factors discussed in our Annual Report on Form 10-K for the fiscal year ended March 31, 2009, as updated, which could materially affect our business, financial condition or future results. Such risks are not the only risks facing our company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.

 

Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Purchase of Equity Securities by the Company

The following table provides information about purchases we made of our common stock during the quarter ended December 31, 2009:

 

Period

   Total number
of shares
purchased
   Average price
paid per  share
   Total number of
shares purchased
as part of publicly
announced plans  or
programs
   Maximum number
(or approximate
dollar value) of
shares that may yet
be purchased  under
the plans or
programs

October 1–31, 2009

   18    $ 6.48    —      —  

November 1–30, 2009

   —        —      —      —  

December 1–31, 2009

   75      18.66    —      —  
                     

Total

   93    $ 16.30    —      —  
                     

Shares were purchased from employees upon their termination pursuant to the terms of our stock option plan.

 

74


Item 6. EXHIBITS

 

  3.1    Certificate of Incorporation, as amended through September 5, 2008, incorporated herein by reference to Exhibit 3.1 filed with our Annual Report on Form 10-K for fiscal year 2009, filed March 25, 2010.
  3.2    By-Laws, as amended through December 29, 2009, incorporated herein by reference to Exhibit 3.2 filed with our Current Report on Form 8-K, filed January 4, 2010.
31.1    Certification of Chief Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*
31.2    Certification of Chief Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*
32.1    Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*
32.2    Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*

 

* Filed herewith

 

75


SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

    K-V PHARMACEUTICAL COMPANY
Date: June 9, 2010     By:   /s/    David A. Van Vliet        
      David A. Van Vliet
      Interim President and Interim Chief Executive Officer
      (Principal Executive Officer)
Date: June 9, 2010     By:   /s/    Stephen A. Stamp        
      Stephen A. Stamp
      Chief Financial Officer and Treasurer
      (Principal Financial Officer)

 

76


EXHIBIT INDEX

 

Exhibit

No.

  

Description

  3.1    Certificate of Incorporation, as amended through September 5, 2008, incorporated herein by reference to Exhibit 3.1 filed with our Annual Report on Form 10-K for fiscal year 2009, filed March 25, 2010.
  3.2    By-Laws, as amended through December 29, 2009, incorporated herein by reference to Exhibit 3.2 filed with our Current Report on Form 8-K, filed January 4, 2010.
31.1    Certification of Chief Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*
31.2    Certification of Chief Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*
32.1    Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*
32.2    Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*

 

* Filed herewith

 

77