10-Q 1 form10-q_13368.txt FORM 10-Q (FEBRUARY 28, 2005) ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED FEBRUARY 28, 2005 COMMISSION FILE NUMBER 0-5905 CHATTEM, INC. ------------------------------------------------------- A TENNESSEE CORPORATION I.R.S. EMPLOYER IDENTIFICATION NO. 62-0156300 1715 WEST 38TH STREET CHATTANOOGA, TENNESSEE 37409 TELEPHONE: 423-821-4571 REGISTRANT HAS FILED ALL REPORTS REQUIRED TO BE FILED BY SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 DURING THE PRECEDING 12 MONTHS, AND HAS BEEN SUBJECT TO SUCH FILING REQUIREMENTS FOR THE PAST 90 DAYS. THE REGISTRANT IS AN ACCELERATED FILER (AS DEFINED IN RULE 12b-2 OF THE EXCHANGE ACT). AS OF MARCH 29, 2005, 19,762,791 SHARES OF THE COMPANY'S COMMON STOCK, WITHOUT PAR VALUE, WERE OUTSTANDING. ================================================================================ CHATTEM, INC. ------------- INDEX ----- PAGE NO. -------- PART I. FINANCIAL INFORMATION Item 1. Financial Statements Condensed Consolidated Balance Sheets as of February 28, 2005 and November 30, 2004 .................. 3 Condensed Consolidated Statements of Operations for the Three Months Ended February 28, 2005 and February 29, 2004 ........................................ 5 Condensed Consolidated Statements of Cash Flows for the Three Months Ended February 28, 2005 and February 29, 2004 ........................................ 6 Notes to Condensed Consolidated Financial Statements ..... 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations ...................... 25 Item 3. Quantitative and Qualitative Disclosures About Market Risks ............................................. 33 Item 4. Controls and Procedures .................................. 33 PART II. OTHER INFORMATION Item 1. Legal Proceedings ........................................ 34 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds .......................................... 34 Item 3. Defaults Upon Senior Securities .......................... 34 Item 4. Submission of Matters to a Vote of Security Holders ...... 34 Item 5. Other Information ........................................ 34 Item 6. Exhibits and Reports on Form 8-K ......................... 35 SIGNATURES ................................................................. 36 2 PART 1. FINANCIAL INFORMATION ----------------------------- ITEM 1. FINANCIAL STATEMENTS ----------------------------- CHATTEM, INC. AND SUBSIDIARIES ------------------------------ CONDENSED CONSOLIDATED BALANCE SHEETS ------------------------------------- (In thousands)
FEBRUARY 28, NOVEMBER 30, ASSETS 2005 2004 ------ ------------ ------------ (Unaudited) CURRENT ASSETS: Cash and cash equivalents $ 43,539 $ 40,193 Accounts receivable, less allowances of $2,339 at February 28, 2005 and $1,682 at November 30, 2004 40,810 32,098 Inventories 21,976 21,690 Refundable income taxes 2,530 4,702 Deferred income taxes 4,699 4,308 Prepaid expenses and other current assets 6,552 3,683 ------------ ------------ Total current assets 120,106 106,674 ------------ ------------ PROPERTY, PLANT AND EQUIPMENT, NET 28,354 28,765 ------------ ------------ OTHER NONCURRENT ASSETS: Patents, trademarks and other purchased product rights, net 222,236 225,560 Debt issuance costs, net 4,984 5,174 Other 5,897 5,551 ------------ ------------ Total other noncurrent assets 233,117 236,285 ------------ ------------ TOTAL ASSETS $ 381,577 $ 371,724 ============ ============
The accompanying notes are an integral part of these condensed consolidated financial statements. 3 CHATTEM, INC. AND SUBSIDIARIES ------------------------------ CONDENSED CONSOLIDATED BALANCE SHEETS ------------------------------------- (In thousands)
FEBRUARY 28, NOVEMBER 30, LIABILITIES AND SHAREHOLDERS' EQUITY 2005 2004 ------------------------------------ ------------ ------------ (Unaudited) CURRENT LIABILITIES: Current maturities of long-term debt $ -- $ -- Accounts payable and other 16,303 13,341 Accrued liabilities 22,579 23,763 ------------ ------------ Total current liabilities 38,882 37,104 ------------ ------------ LONG-TERM DEBT, less current maturities 200,000 200,000 ------------ ------------ DEFERRED INCOME TAXES 27,917 25,732 ------------ ------------ OTHER NONCURRENT LIABILITIES 1,804 1,776 ------------ ------------ COMMITMENTS AND CONTINGENCIES (Note 18) SHAREHOLDERS' EQUITY: Preferred shares, without par value, authorized 1,000, none issued -- -- Common shares, without par value, authorized 50,000, issued and outstanding 19,850 at February 28, 2005 and 19,882 at November 30, 2004 84,620 85,949 Retained earnings 32,553 23,888 ------------ ------------ 117,173 109,837 Unamortized value of restricted common shares issued (3,835) (2,386) Cumulative other comprehensive income, net of tax: Interest rate cap adjustment (347) (316) Foreign currency translation adjustment (17) (23) ------------ ------------ Total shareholders' equity 112,974 107,112 ------------ ------------ TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 381,577 $ 371,724 ============ ============
The accompanying notes are an integral part of these condensed consolidated financial statements. 4 CHATTEM, INC. AND SUBSIDIARIES ------------------------------ CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS ----------------------------------------------- (Unaudited and in thousands, except per share amounts)
FOR THE THREE MONTHS ENDED --------------------------- FEBRUARY 28, FEBRUARY 29, 2005 2004 ------------ ------------ REVENUES: Net sales $ 71,480 $ 60,927 Royalties 51 310 ------------ ------------ Total revenues 71,531 61,237 ------------ ------------ COSTS AND EXPENSES: Cost of sales 20,260 16,952 Advertising and promotion 20,351 18,532 Selling, general and administrative 11,884 10,635 Litigation settlement 2,755 194 ------------ ------------ Total costs and expenses 55,250 46,313 ------------ ------------ INCOME FROM OPERATIONS 16,281 14,924 ------------ ------------ OTHER INCOME (EXPENSE): Interest expense (3,495) (4,755) Investment and other income, net 147 45 Loss on early extinguishment of debt -- (11,309) ------------ ------------ Total other income (expense) (3,348) (16,019) ------------ ------------ INCOME (LOSS) BEFORE INCOME TAXES 12,933 (1,095) PROVISION FOR (BENEFIT FROM) INCOME TAXES 4,268 (383) ------------ ------------ NET (LOSS) INCOME $ 8,665 $ (712) ============ ============ NUMBER OF COMMON SHARES: Weighted average outstanding - basic 19,648 19,099 ============ ============ Weighted average and potential dilutive outstanding 20,489 19,881 ============ ============ NET INCOME (LOSS) PER COMMON SHARE: Basic $ .44 $ (.04) ============ ============ Diluted $ .42 $ (.04) ============ ============
The accompanying notes are an integral part of these condensed consolidated financial statements. 5 CHATTEM, INC. AND SUBSIDIARIES ------------------------------ CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS ----------------------------------------------- (Unaudited and in thousands, except per share amount)
FOR THE THREE MONTHS ENDED --------------------------- FEBRUARY 28, FEBRUARY 29, 2005 2004 ------------ ------------ OPERATING ACTIVITIES: Net income (loss) $ 8,665 $ (712) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation and amortization 1,624 1,537 Deferred income taxes 1,778 1,982 Tax benefit realized from stock option plans 186 1,083 Loss on early extinguishment of debt -- 11,309 Other, net 361 -- Changes in operating assets and liabilities: Accounts receivable (8,712) (9,108) Inventories (286) (9) Refundable income taxes 2,172 (3,752) Prepaid expenses and other current assets 382 2,092 Accounts payable and accrued liabilities 1,778 (101) ------------ ------------ Net cash provided by operating activities 7,948 4,321 ------------ ------------ INVESTING ACTIVITIES: Purchases of property, plant and equipment (456) (491) Purchases of patents, trademarks and other product rights -- (17) Decrease (increase) in other assets, net 524 (490) ------------ ------------ Net cash provided by (used in) investing activities 68 (998) ------------ ------------ FINANCING ACTIVITIES: Repayment of long-term debt -- (182,280) Proceeds from long-term debt -- 200,000 Proceeds from borrowings under revolving credit facility -- 25,000 Repayment of policy loans (1,031) -- Proceeds from exercise of stock options 187 1,453 Repurchase of common shares (3,514) (319) Increase in debt issuance costs -- (5,678) Debt retirement costs -- (6,946) Restricted cash -- (32,227) ------------ ------------ Net cash used in financing activities (4,358) (997) ------------ ------------ EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS (312) 26 ------------ ------------ CASH AND CASH EQUIVALENTS: Increase for the period 3,346 2,352 At beginning of period 40,193 26,931 ------------ ------------ At end of period $ 43,539 $ 29,283 ============ ============ SCHEDULE OF NON-CASH INVESTING AND FINANCING ACTIVITIES: Issuance of 50 and 70 shares of restricted common stock at a value of $35.37 and $19.98 per share in 2005 and 2004, respectively $ 1,768 $ 1,399 PAYMENTS FOR: Interest $ 1,003 $ 6,378 Taxes $ 85 $ 108
The accompanying notes are an integral part of these condensed consolidated financial statements. 6 CHATTEM, INC. AND SUBSIDIARIES ------------------------------ NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS ---------------------------------------------------- (UNAUDITED) All monetary and share amounts are expressed in thousands. 1. BASIS OF PRESENTATION --------------------- The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and 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 generally accepted accounting principles for complete financial statements. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes thereto included in our Annual Report on Form 10-K for the year ended November 30, 2004. The accompanying unaudited consolidated financial statements, in the opinion of management, include all adjustments necessary for a fair presentation. All such adjustments are of a normal recurring nature. 2. CASH AND CASH EQUIVALENTS ------------------------- We consider all short-term deposits and investments with original maturities of three months or less to be cash equivalents. 3. RECLASSIFICATIONS ----------------- Certain prior year amounts have been reclassified to conform to the current period's presentation. 4. RECENT ACCOUNTING PRONOUNCEMENTS -------------------------------- In December 2003, the Financial Accounting Standards board ("FASB") issued Interpretation No. 46R, "Consolidation of Variable Interest Entities" ("FIN 46R"), which supercedes Interpretation No. 46, "Consolidation of Variable Interest Entities" issued in January 2003. FIN 46R requires a company to consolidate a variable interest entity ("VIE"), as defined, when the company will absorb a majority of the VIE's expected losses, receives a majority of the VIE's expected residual returns or both. FIN 46R also requires consolidation of existing, non-controlled affiliates if the VIE is unable to finance its operations without investor support, or where the other investors do not have exposure to the significant risks and rewards of ownership. FIN 46R applies immediately to a VIE created or acquired after January 31, 2003. For a VIE created before February 1, 2003, FIN 46R applies in the first fiscal year or interim period beginning after March 15, 2004, our third fiscal quarter beginning June 1, 2004. Application of FIN 46R is also required in financial statements that have interests in structures that are commonly referred to as special-purpose entities for periods ending after December 15, 2003. The adoption of FIN 46R did not have an impact on our financial position, results of operations or cash flows. In November 2004, the FASB issued Statement of Financial Accounting Standards ("SFAS") No. 151, "Inventory Costs" ("SFAS 151"). SFAS 151 amends the guidance in Accounting Research Bulletin No. 43, Chapter 4, "Inventory Pricing", to clarify that abnormal amounts of idle facility expense, freight, handling costs and wasted materials (spoilage) should be recognized as current-period charges and requires the allocation of fixed production overheads to inventory based on normal capacity of the production facilities. This statement is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The adoption of SFAS 151 is not expected to have an impact on our financial position, results of operations or cash flows. In November 2004, the Emerging Issues Task Force ("EITF") reached a consensus on Issue No. 03-13, "Applying the Conditions in Paragraph 42 of FASB Statement No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" in Determining Whether to Report Discontinued Operations" ("EITF 03-13"). Under the consensus, the approach for assessing whether cash flows of the component have been eliminated from the ongoing operations of the entity focuses on whether continuing cash flows are direct or indirect cash flows. Cash flows of the component would not be eliminated if the continuing cash flows to the entity are considered direct cash flows. The consensus should be applied to a component of an enterprise that is either disposed of or classified as held for sale in fiscal periods beginning after December 15, 2004. The adoption of EITF 03-13 is not expected to have an impact on our financial position, results of operations or cash flows. In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based Payment" ("SFAS 123R"), which is a revision of SFAS No. 123, "Accounting for Stock-Based Compensation". SFAS 123R supercedes APB Opinion 7 No. 25, "Accounting for Stock Issued to Employees" and amends SFAS No. 95, "Statement of Cash Flows". SFAS 123R focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions and requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Accordingly, the adoption of SFAS 123R's fair value method will have a significant impact on our results of operations, although it will have no impact on our overall financial position. The impact of the adoption of SFAS 123R cannot be predicted at this time because it will depend on the levels of share-based payments granted in the future. However, had we adopted SFAS 123R in prior periods the impact of that standard would have approximated the impact of SFAS 123 as described in the disclosure of proforma net income and earnings per share in Note 5. SFAS 123R also requires the benefits of tax deductions in excess of recognized compensation costs to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While we cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of operating cash flows recognized in prior periods for such excess tax deductions were not material to our consolidated financial position or results of operations. This statement is effective for our interim periods beginning after June 15, 2005. In December 2004, the FASB issued SFAS 153, "Exchanges of Nonmonetary Assets" ("SFAS 153"). SFAS 153 amends the guidance in APB Opinion No. 29, "Accounting for Nonmonetary Transactions" to eliminate certain exceptions to the principle that exchanges of nonmonetary assets be measured based on the fair value of the assets exchanged. SFAS 153 eliminates the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. This statement is effective for nonmonetary asset exchanges in fiscal years beginning after June 15, 2005. The adoption of SFAS 153 is not expected to have an impact on our financial position, results of operations or cash flows. 5. STOCK-BASED COMPENSATION ------------------------ Our 1998 Non-Statutory Stock Option Plan provides for the issuance of up to 1,400 shares of common stock to key employees, while the 1999 Non-Statutory Stock Option Plan for Non-Employee Directors allows for the issuance of up to 200 shares of common stock. The 2000 Non-Statutory Stock Option Plan provides for the issuance of up to 1,500 shares of common stock. The 2003 Stock Incentive Plan provides for the issuance of up to 1,500 shares of common stock. Options vest ratably over four years and are exercisable for a period of up to ten years from the date of grant. For SFAS No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123") purposes, as amended by SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure", the fair value of each option grant has been estimated as of the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions for grants in 2005 and 2004: expected dividend yield of 0%, expected volatility of 57% and 53%, respectively, risk-free interest rates of 4.38% and 3.97%, respectively, and expected lives of approximately five and six years, respectively. Had compensation expense for stock option grants been determined based on the fair value at the grant dates consistent with the method prescribed by SFAS 123, our net income (loss) and net income (loss) per share would have been adjusted to the pro forma amounts for the three months ended February 28, 2005 and February 29, 2004, respectively, as indicated below: 2005 2004 ---------- ---------- Net income (loss): As reported $ 8,665 $ (712) Fair value method compensation cost, net (1,278) (861) ---------- ---------- Pro forma $ 7,387 $ (1,573) ========== ========== Net income (loss) per share, basic: As reported $ .44 $ (.04) Pro forma $ .38 $ (.08) Net income (loss) per share, diluted: As reported $ .42 $ (.04) Pro forma $ .36 $ (.08) 8 6. EARNINGS PER SHARE ------------------ The following table presents the computation of per share earnings for the three months ended February 28, 2005 and February 29, 2004, respectively: 2005 2004 ---------- ---------- NET INCOME (LOSS) $ 8,665 $ (712) ========== ========== NUMBER OF COMMON SHARES: Weighted average outstanding 19,648 19,099 Issued upon assumed exercise of outstanding stock options 762 712 Effect of issuance of restricted common shares 79 70 ---------- ---------- Weighted average and potential dilutive outstanding (1) 20,489 19,881 ========== ========== NET INCOME (LOSS) PER COMMON SHARE: Basic $ .44 $ (.04) ========== ========== Diluted $ .42 $ (.04) ========== ========== (1) Because their effects are anti-dilutive, excludes shares issuable under stock option plans and restricted stock issuance whose grant price was greater than the average market price of common shares outstanding as follows: 0 and 62 shares for the three months ended February 28, 2005 and February 29, 2004, respectively. 7. ADVERTISING EXPENSES -------------------- We incur significant expenditures on television, radio and print advertising to support our nationally branded over-the-counter ("OTC") health care products and toiletries. Customers purchase products from us with the understanding that the brands will be supported by our extensive media advertising. This advertising supports the retailers' sales effort and maintains the important brand franchise with the consuming public. Accordingly, we consider our advertising program to be clearly implicit in our sales arrangements with our customers. Therefore, we believe it is appropriate to allocate a percentage of the necessary supporting advertising expenses to each dollar of sales by charging a percentage of sales on an interim basis based upon anticipated annual sales and advertising expenditures (in accordance with Accounting Principles Board Opinion No. 28, "Interim Financial Reporting") and adjusting that accrual to the actual expenses incurred at the end of the year. 8. SHIPPING AND HANDLING --------------------- Shipping and handling costs of $1,857 and $1,434 are included in selling expenses for the three months ended February 28, 2005 and February 29, 2004, respectively. 9. PATENT, TRADEMARKS AND OTHER PURCHASED PRODUCT RIGHTS ----------------------------------------------------- The carrying value of trademarks, which are not subject to amortization under the provisions of SFAS No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"), was $221,654 and $224,797 as of February 28, 2005 and November 30, 2004, respectively. The gross carrying amount of intangible assets subject to amortization at February 28, 2005 and November 30, 2004, which consist primarily of non-compete agreements, was $2,139 and $2,400, respectively. The related accumulated amortization of intangible assets at February 28, 2005 and November 30, 2004 was $1,557 and $1,637, respectively. Amortization of our intangible assets subject to amortization under the provisions of SFAS 142 for the three months ended February 28, 2005 and February 29, 2004 was $73 and $77, respectively. Estimated annual amortization expense for these assets for the years ended November 30, 2006, 2007, 2008, 2009 and 2010 is $290, $123, $40, $20 and $0 respectively. 9 On February 28, 2005, we entered into an agreement to sell the trademark and product rights of our SELSUN business in certain countries in Africa and Asia. As a result of the sale, $3,143 of indefinite-lived assets and $108 of intangible assets subject to amortization were retired, which resulted in an insignificant loss. 10. INVENTORIES ----------- Inventories consisted of the following as of February 28, 2005 and November 30, 2004: 2005 2004 ---------- ---------- Raw materials and work in process $ 11,656 $ 10,728 Finished goods 11,753 12,395 Excess of current cost over LIFO values (1,433) (1,433) ---------- ---------- Total inventories $ 21,976 $ 21,690 ========== ========== 11. ACCRUED LIABILITIES ------------------- Accrued liabilities consisted of the following as of February 28, 2005 and November 30, 2004: 2005 2004 ---------- ---------- Interest $ 5,415 $ 3,152 Salaries, wages and commissions 1,490 4,886 Product advertising and promotion 5,568 3,750 Litigation settlement and legal fees 8,568 10,046 Other 1,538 1,929 ---------- ---------- Total accrued liabilities $ 22,579 $ 23,763 ========== ========== 12. LONG-TERM DEBT -------------- Long-term debt consisted of the following as of February 28, 2005 and November 30, 2004: 2005 2004 ---------- ---------- Revolving Credit Facility due 2009 at a variable rate of 6.0% as of February 28, 2005 and November 30, 2004, respectively $ -- $ -- Floating Rate Senior Notes due 2010 at a variable rate of 5.38% and 4.78% as of February 28, 2005 and November 30, 2004, respectively 75,000 75,000 7.0% Senior Subordinated Notes due 2014 125,000 125,000 ---------- ---------- Total long-term debt 200,000 200,000 Less: current maturities -- -- ---------- ---------- Total long-term debt, net of current maturities $ 200,000 $ 200,000 ========== ========== On February 26, 2004, we entered into a new Senior Secured Revolving Credit Facility that matures February 26, 2009 (the "Revolving Credit Facility") with Bank of America, N.A. that provided an initial borrowing capacity of $25,000 and an additional $25,000, subject to successful syndication. On March 9, 2004, we entered into a new commitment agreement with a syndicate of commercial banks led by Bank of America, N.A., as agent, that enables us to borrow up to a total of $50,000 under the Revolving Credit Facility. Borrowings under our Revolving Credit Facility bear interest at LIBOR plus applicable percentages of 1.75% to 2.50% or a base rate (the higher of the federal funds rate plus 0.5% or the prime rate) plus applicable percentages of 0.25% to 1.0%. The applicable percentages are calculated based on our leverage ratio. As of February 28, 2005, no amounts were outstanding under the Revolving Credit Facility, and the variable rate was 6.0%. Borrowings under our Revolving Credit Facility are secured by substantially all of our assets, except real property, and shares of capital stock of our domestic subsidiaries held by us and by the assets of the guarantors (our domestic subsidiaries). The Revolving Credit Facility contains covenants, representations, warranties and other agreements by us that are customary in credit agreements and security instruments relating to financings of this type. The significant financial covenants include fixed charge coverage ratio, leverage ratio, senior secured leverage ratio, net worth and brand value calculations. On March 29, 2005, we had no borrowings outstanding under our Revolving Credit Facility. 10 On March 28, 2002, we obtained a $60,000 senior secured credit facility from a syndicate of commercial banks led by Bank of America, N.A., as agent (the "Credit Facility"). The Credit Facility included a $15,000 revolving credit line and a $45,000 term loan. The remaining balance of the term loan under the Credit Facility was repaid as part of the refinancing transactions discussed herein, and the revolving credit line under the Credit Facility was terminated on February 26, 2004. On February 10, 2004, we commenced a cash tender offer and consent solicitation for the $204,538 outstanding principal amount of our 8.875% Senior Subordinated Notes due 2008 (the "8.875% Subordinated Notes"). The consent solicitation expired on February 24, 2004, and a total of approximately $174,530, or approximately 85.3% of the 8.875% Subordinated Notes, were tendered and accepted for payment on February 26, 2004. The remaining principal outstanding, call premium, accrued interest and interest to call date amounting to $32,227 was placed in escrow with the indenture trustee to fund the purchase of additional 8.875% Subordinated Notes tendered prior to March 9, 2004, the expiration date of the tender offer, and the redemption of the remaining 8.875% Subordinated Notes not tendered. The remaining 8.875% Subordinated Notes not tendered in such offer were called in accordance with their terms on April 1, 2004 at a redemption price of 102.9583% of their aggregate principal amount. On April 1, 2004, the remaining amount held in escrow was released for payment and all outstanding 8.875% Subordinated Notes were redeemed. The completion of our refinancing of the Credit Facility and purchase of approximately $174,530 of our 8.875% Subordinated Notes that were tendered on February 26, 2004 resulted in a loss on early extinguishment of debt of $11,309 in the first quarter of fiscal 2004. Also in the second quarter of fiscal 2004, we recorded a loss on early extinguishment of debt of $1,649 related to the redemption of the remaining $30,008 of our 8.875% Subordinated Notes. Due to our refinancing transactions, in the first quarter of fiscal 2004 tender premiums and related fees of $6,946 were paid and net debt issuance costs of $4,363 were written off and charged to loss on early extinguishment of debt in the Condensed Consolidated Statements of Operations. In addition, new debt issuance costs of $5,678 were capitalized. Also on February 26, 2004, we issued and sold $75,000 of Floating Rate Senior Notes due March 1, 2010 (the "Floating Rate Notes") and $125,000 of 7.0% Senior Subordinated Notes due March 1, 2014 (the "7.0% Subordinated Notes"), the proceeds of which were used to purchase our 8.875% Subordinated Notes and refinance the Credit Facility as discussed above. The Floating Rate Notes bear interest at a three-month LIBOR plus 3.00% per year (5.38% as of February 28, 2005). Interest payments are due quarterly in arrears commencing on June 1, 2004. On March 8, 2004, we entered into an interest rate cap agreement effective June 1, 2004 with decreasing annual notional principal amounts of $15,000 beginning March 1, 2006 and cap rates ranging from 4.0% to 5.0% over the life of the agreement. We paid a $1,375 premium to enter into the interest rate cap agreement, which will be amortized over the life of the agreement. The current portion of the premium on the interest rate cap agreement of $189 is included in prepaid expenses and other current assets, and the long-term portion of $642 is included in other noncurrent assets. The amortized value of the premium on the interest rate cap was compared to its fair value as of February 28, 2005, and a charge of $347, net of tax, was recorded to other comprehensive income. The fair value of the interest rate cap agreement is valued by a third party. The interest rate cap agreement terminates on March 1, 2010. Our domestic subsidiaries are guarantors of the Floating Rate Notes. The guarantees of the Floating Rate Notes are unsecured senior obligations of the guarantors and rank equally with all of the current and future unsecured senior debt of the guarantors. The guarantees of the Floating Rate Notes effectively rank junior to any secured debt of the guarantors, including the guarantors' guarantee of our indebtedness under the Revolving Credit Facility. At any time after March 1, 2005, we may redeem any of the Floating Rate Notes upon not less than 30 nor more than 60 days' notice at redemption prices (expressed in percentages of principal amount), plus accrued and unpaid interest, if any, and liquidated damages, if any, to the applicable redemption rate, if redeemed during the twelve-month periods beginning March 1, 2005 at 102.0%, March 1, 2006 at 101.0% and March 1, 2007 and thereafter at 100.0%. At any time prior to March 1, 2005, we may redeem up to 35.0% of the aggregate principal amount of the Floating Rate Notes (including any additional Floating Rate Notes) at a redemption price of 100.0% of the principal amount thereof, plus a premium equal to the interest rate per annum on the Floating Rate Notes applicable on the date on which notice of the redemption is given, together with accrued and unpaid interest and liquidated damages, if any, with the net cash proceeds of one or more qualified equity offerings; provided, that (i) at least 65.0% of the aggregate principal amount of Floating Rate Notes remains outstanding immediately after the occurrence of each redemption (excluding Floating Rate Notes held by us and our subsidiaries); and (ii) the redemption must occur within 90 days of the date of the closing of such qualified equity offering. Interest payments on the 7.0% Subordinated Notes are due semi-annually in arrears on March 1 and September 1, commencing on September 1, 2004. Our domestic subsidiaries are guarantors of the 7.0% Subordinated Notes. The guarantees of the 7.0% Subordinated Notes are unsecured senior subordinated obligations of the guarantors. At any time after March 1, 2009, we may redeem any of the 7.0% Subordinated Notes upon not less than 30 nor more than 60 days' notice at redemption prices (expressed in percentages of principal amount), plus accrued and unpaid interest, if any, and liquidation damages, if any, to the applicable redemption rate, if redeemed during the twelve-month periods beginning 11 March 1, 2009 at 103.500%, March 1, 2010 at 102.333%, March 1, 2011 at 101.167% and March 1, 2012 and thereafter at 100.000%. At any time prior to March 1, 2007, we may redeem up to 35% of the aggregate principal amount of the 7.0% Subordinated Notes (including any additional 7.0% Subordinated Notes) at a redemption price of 107.0% of the principal amount thereof, plus accrued and unpaid interest and liquidated damages, if any, thereon to the applicable redemption rate, with the net cash proceeds of one or more qualified equity offerings; provided, that (i) at least 65.0% of the aggregate principal amount of the 7.0% Subordinated Notes remains outstanding immediately after the occurrence of such redemption (excluding 7.0% Subordinated Notes held by us and our subsidiaries); and (ii) the redemption must occur within 90 days of the date of the closing of such qualified equity offering. The indentures governing the Floating Rate Notes and 7.0% Subordinated Notes, among other things, limit our ability and the ability of our restricted subsidiaries to: (i) borrow money or sell preferred stock, (ii) create liens, (iii) pay dividends on or redeem or repurchase stock, (iv) make certain types of investments, (v) sell stock in our restricted subsidiaries, (vi) restrict dividends or other payments from restricted subsidiaries, (vii) enter into transactions with affiliates, (viii) issue guarantees of debt and (ix) sell assets or merge with other companies. In addition, if we experience specific kinds of changes in control, we must offer to purchase the Floating Rate Notes and 7.0% Subordinated Notes at 101.0% of their principal amount plus accrued and unpaid interest. The future maturities of long-term debt outstanding as of February 28, 2005 are as follows: 2006 -- 2007 -- 2008 -- 2009 -- 2010 75,000 Thereafter 125,000 ---------- $ 200,000 ========== 13. COMPREHENSIVE INCOME -------------------- Comprehensive income consisted of the following components for the three months ended February 28, 2005 and February 29, 2004, respectively: 2005 2004 ---------- ---------- Net income $ 8,665 $ (712) Other - interest rate cap adjustment (31) -- Other - foreign currency translation adjustment 6 270 ---------- ---------- Total $ 8,640 $ (442) ========== ========== 14. STOCK BUYBACK ------------- In January 2005, our board of directors increased the total authorization to repurchase our common stock under our stock buyback program to $30,000. In the first quarter of fiscal 2005, we repurchased 103 shares for $3,514. All repurchased shares were retired and returned to unissued. We, however, are limited in our ability to repurchase shares due to restrictions under the terms of our Revolving Credit Facility, Floating Rate Notes and 7.0% Subordinated Notes. Subsequent to February 28, 2005, we have repurchased 116 of our shares for $4,221. 12 15. RETIREMENT PLANS AND POSTRETIREMENT HEALTH CARE BENEFITS -------------------------------------------------------- RETIREMENT PLANS We have a noncontributory defined benefit pension plan ("the Plan"), which covers substantially all employees as of December 31, 2000. The Plan provides benefits based upon years of service and the employee's compensation. Our contributions are based on computations by independent actuaries. Plan assets at February 28, 2005 and November 30, 2004 were invested primarily in United States government and agency securities and corporate debt and equity securities. In October 2000, our board of directors adopted an amendment to the Plan that freezes benefits of the Plan and prohibits new entrants to the Plan effective December 31, 2000. Net periodic pension cost for the three months ended February 28, 2005 and February 29, 2004 comprised the following components: 2005 2004 ---------- ---------- Service cost $ -- $ -- Interest cost on projected benefit obligation 152 155 Actual return on plan assets (212) (178) Net amortization and deferral 5 28 ---------- ---------- Net pension cost (benefit) $ (55) $ 5 ========== ========== No employer contributions were made for the three months ended February 28, 2005 and February 29, 2004, and no employer contributions are expected to be made in fiscal 2005. POSTRETIREMENT HEALTH CARE BENEFITS We maintain certain postretirement health care benefits for eligible employees. Employees become eligible for these benefits if they meet certain age and service requirements. We pay a portion of the cost of medical benefits for certain retired employees over the age of 65. Effective January 1, 1993, our contribution is a service-based percentage of the full premium. We pay these benefits as claims are incurred. Employer contributions expected for fiscal 2005 are approximately $70. Net periodic postretirement health care benefits cost for the three months ended February 28, 2005 and February 29, 2004, included the following components: 2005 2004 ---------- ---------- Service cost $ 18 $ 16 Interest cost on accumulated postretirement benefit obligation 21 20 Amortization of prior service cost 4 4 Amortization of net gain (4) (8) ---------- ---------- Net periodic postretirement benefits cost $ 39 $ 32 ========== ========== 16. INCOME TAXES ------------ We account for income taxes using the asset and liability approach as prescribed by SFAS No. 109, "Accounting for Income Taxes". This approach requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the consolidated financial statements or tax returns. Using the enacted tax rates in effect for the year in which the differences are expected to reverse, deferred tax assets and liabilities are determined based on the differences between the financial reporting and the tax basis of an asset or liability. We record income tax expense in our consolidated financial statements based on an estimated annual effective income tax rate. Our tax rate for the three months ended February 28, 2005 was 33%, as compared to 35% in the three months ended February 29, 2004. The lower rate for the three months ended February 28, 2005 reflects the implementation of a number of foreign and state tax planning initiatives, which include our determination during the third quarter of fiscal 2004 to reinvest indefinitely all undistributed earnings of Chattem Canada, a wholly-owned subsidiary. Undistributed earnings of Chattem Canada amounted to approximately $281 for the three months ended February 28, 2005. These earnings are considered to be reinvested indefinitely and, accordingly, no provision for U.S. federal and state 13 income taxes has been provided thereon. Upon distribution of those earnings in the form of dividends or otherwise, we would be subject to U.S. income taxes (subject to an adjustment for foreign tax credits). 17. PRODUCT SEGMENT INFORMATION --------------------------- Net sales of our domestic product categories within our single healthcare business segment for the three months ended February 28, 2005 and February 29, 2004 are as follows: 2005 2004 ---------- ---------- Topical analgesics $ 21,407 $ 15,712 Medicated skin care products 17,624 13,332 Dietary supplements 8,660 8,511 Medicated dandruff shampoos and conditioner 9,800 9,221 Other OTC and toiletry products 8,078 8,830 ---------- ---------- Total $ 65,569 $ 55,606 ========== ========== 18. COMMITMENTS AND CONTINGENCIES ----------------------------- GENERAL LITIGATION We were named as a defendant in a number of lawsuits alleging that the plaintiffs were injured as a result of ingestion of products containing phenylpropanolamine ("PPA"), which was an active ingredient in most of our DEXATRIM products until November 2000. The lawsuits filed in federal court were transferred to the United States District Court for the Western District of Washington before United States District Judge Barbara Jacobs Rothstein (IN RE PHENYLPROPANOLAMINE ("PPA") PRODUCTS LIABILITY LITIGATION, MDL NO. 1407). The remaining lawsuits were filed in state court in a number of different states. On April 13, 2004, we entered into a class action settlement agreement with representatives of the plaintiffs' settlement class, which provided for a national class action settlement of all DEXATRIM PPA claims, both federal and state. On November 12, 2004, Judge Barbara J. Rothstein of the United States District Court for the Western District of Washington entered a final order and judgment certifying the class and granting approval of the DEXATRIM PPA settlement. After the final judgment was entered, two parties who had objected to the settlement filed appeals challenging and seeking to set aside the final judgment. Both of these appeals have now been dismissed. The DEXATRIM PPA settlement includes claims against us involving alleged injuries by DEXATRIM products containing PPA that were alleged to have occurred after December 21, 1998, the date we acquired the DEXATRIM brand. In accordance with the terms of the class action settlement agreement, we previously published notice of the settlement and details as to the manner in which claims could be submitted. The deadline for submission of claims was July 7, 2004. A total of 391 claims were submitted prior to the claims deadline. Of these 391 claims, 173 alleged stroke as an injury and 218 alleged other non-stroke injuries. These claims will be valued pursuant to the agreed upon settlement matrix that is designed to evaluate and determine the settlement value of each claim. A total of 16 claimants elected to opt out of the class settlement and may continue to pursue claims for damages against us in separate lawsuits. We have settled eight of the opt out claims. In addition, we have learned that two of the remaining opt out claims have injury dates prior to December 21, 1998, for which we will seek indemnification from The DELACO Company ("DELACO"), successor to the Thompson Medical Company, Inc., which owned the brand prior to December 21, 1998. In accordance with the terms of the class action settlement agreement, $60,885 has been funded into a settlement trust from our first three layers of insurance coverage, as described below. In addition, on July 14, 2004, we entered into a settlement agreement with Sidmak Laboratories, Inc. ("Sidmak"), the manufacturer of DEXATRIM products containing PPA, pursuant to which Sidmak has agreed to contribute $10,000 into the settlement trust. To the extent the amount in the settlement trust is insufficient to fully fund the settlement, we will be required to make additional contributions to the settlement trust in the future. As described below, we have entered into a settlement agreement with Interstate Fire & Casualty Company ("Interstate") with regard to its $25,000 of coverage in excess of the insurance funds available in the settlement trust. We currently expect to use our cash on hand and proceeds of the Interstate policy to fund any required additional contributions to the settlement trust. If we are required to fund significant other liabilities related to the PPA litigation beyond the settlement trust and outside of our available insurance coverage from Interstate, either pursuant to the terms of the settlement, as a result of the opt out cases or otherwise, we will have significantly fewer sources of funds with which to satisfy such liabilities, and we may be unable to do so. We are also named as a defendant in approximately 206 lawsuits relating to DEXATRIM containing PPA which involve alleged injuries by DEXATRIM products containing PPA manufactured and sold prior to our acquisition of DEXATRIM on December 21, 1998. In these lawsuits, we are being defended on the basis of indemnification obligations assumed by DELACO. On February 12, 2004, DELACO filed a Chapter 11 bankruptcy petition in the United States Bankruptcy Court for the Southern District of New 14 York. Accordingly, it is uncertain whether DELACO will be able to indemnify us for claims arising from products manufactured and sold prior to our acquisition of DEXATRIM on December 21, 1998. However, DELACO is seeking to resolve all DEXATRIM cases with injury dates prior to December 21, 1998 as part of a liquidating Chapter 11 bankruptcy plan. We understand that DELACO's product liability insurance carriers and other sources are expected to fund this plan. As part of DELACO's bankruptcy plan, if finally approved, we expect the bankruptcy court to release us from liability in DEXATRIM cases with injury dates prior to December 21, 1998, although there can be no assurances in this regard. If DELACO achieves resolution of the pre-December 21, 1998 cases through its bankruptcy plan, we expect that the administrative process for DELACO's settlement will be similar to the process in our class action. We have filed a claim in DELACO's bankruptcy case in order to preserve our claims for indemnification against DELACO. As part of this Chapter 11 plan, we expect that after resolution of creditors' claims, DELACO will seek to liquidate and distribute all of its assets and will dissolve as a company. Our product liability insurance, as described below, would not apply to claims arising from products manufactured and sold prior to our acquisition of DEXATRIM. If the DELACO bankruptcy plan does not resolve these cases as we expect, we will also seek to defend ourselves in these lawsuits on the basis that we did not manufacture and sell products containing PPA prior to December 21, 1998. In the approximately 206 cases that have been filed against us for products manufactured and sold prior to December 21, 1998, approximately half of the plaintiffs are in cases filed in states that we believe do not under current law impose liability upon a successor. The remaining plaintiffs are in cases filed in states that may in some circumstances permit liability against a successor. Even in these cases, although there can be no assurances, we do not believe that successor liability would be imposed against us. The reasons for our belief, among others, are that we did not purchase all of DELACO's assets and DELACO continued to operate its remaining business after December 21, 1998; we did not cause DELACO's bankruptcy; and many plaintiffs included in cases filed in states that in some circumstances impose successor liability are actually residents of other states. We have reached an agreement with Kemper Indemnity Insurance Company ("Kemper") to settle its lawsuit that sought to rescind our policy for $50,000 of excess coverage for product liability claims. After giving effect to the settlement with Kemper, we have available for the claims against us related to the PPA litigation, through our first three layers of insurance coverage, approximately $60,885 of the $77,000 of product liability coverage provided by these insurance policies. The $60,885 of available coverage consists of $37,500 of insurance under the Kemper policy and approximately $23,385 under policies with two other insurance companies. As indicated above, this $60,885 of coverage has been funded into a settlement trust in accordance with the terms of the class action settlement agreement. We have also entered into a settlement agreement with Interstate with regard to Interstate's lawsuit to rescind its $25,000 of excess coverage for product liability claims relating to DEXATRIM products containing PPA. In accordance with the settlement agreement, Interstate will provide coverage of DEXATRIM PPA claims that are covered by its policy after $78,500 has been paid toward covered claims. Once the $78,500 threshold is met, Interstate will pay 100% of the next $4,000 of claims covered by its policy; 75% of the next $8,500 of such claims; and 50% of the last $12,500 of such claims. We are responsible for any claims not covered by the Interstate policy either because the alleged injury did not occur before May 31, 2001, or the claim was first made against us after May 31, 2004. Pursuant to the settlement agreement, we and Interstate have dismissed all claims and counterclaims filed against each other. Prior to the fourth quarter of fiscal 2004, we were unable to reasonably estimate the amount of liability related to the DEXATRIM litigation, due to the significant assumptions and uncertainty involved in estimating the value of cases involved. As a result of the final approval of the DEXATRIM PPA settlement on November 12, 2004 and the term sheet of settlement reached with Interstate on December 13, 2004, as of November 30, 2004 we were able to reasonably estimate the probable loss related to the DEXATRIM litigation. Based on the estimated litigation settlement costs relating to our DEXATRIM products, we have recorded an accrued liability in our Consolidated Balance Sheets as of February 28, 2005 and November 30, 2004 of $8,506 and $9,519, respectively. We currently do not expect to record any additional charges relative to the settlement costs of the PPA litigation, although we will continue to incur costs related to legal expenses. During the first fiscal quarter of 2005, we incurred and recorded $1,070 of legal expenses relating to the PPA settlement. We will record future PPA related legal expenses in the period incurred. We maintain a significantly lower level of insurance coverage for all other potential claims relating to our products including DEXATRIM products containing ephedrine. For the current policy period, we are insured for product liability insurance for all of our other products, including DEXATRIM products containing ephedrine, for $10,000 through our captive insurance subsidiary, of which approximately $3,500 is funded as of March 29, 2005. We also have $40,000 of excess coverage through third party insurers. We were named as a defendant in four lawsuits alleging that the plaintiff was injured as a result of the ingestion of DEXATRIM containing ephedrine. In addition, three individuals who alleged injury caused by DEXATRIM containing ephedrine filed opt out 15 notices in the PPA class action settlement, but did not file lawsuits against us. In the first quarter of fiscal 2005, we reached a settlement with respect to two of the four pending lawsuits and the three opt out claims. Each of these settlements has been or will be funded by insurance coverage provided by our captive insurance subsidiary. After these settlements, there are two lawsuits currently pending against us related to DEXATRIM containing ephedrine. We recorded a litigation settlement charge of $1,685 in the first quarter of fiscal 2005 associated with ephedrine-related claims and legal expenses. On December 30, 2003, the United States Food and Drug Administration ("FDA") issued a consumer alert on the safety of dietary supplements containing ephedrine alkaloids and on February 6, 2004 published a final rule with respect to these products. The final rule prohibits the sale of dietary supplements containing ephedrine alkaloids because such supplements present an unreasonable risk of illness or injury. The final rule became effective on April 11, 2004. Although we discontinued the manufacturing and shipment of DEXATRIM containing ephedrine in September 2002, the FDA's final rule may result in additional lawsuits being filed against us alleging damages related to the use or purchase of DEXATRIM containing ephedrine. We previously were named in a class action filed in the United States District Court for the Southern District of New York seeking certification of a class consisting of New York residents who have purchased DEXATRIM Results or DEXATRIM Natural since January 2000. The class action lawsuit sought compensatory and punitive damages arising out of allegedly false advertising in connection with the sale of DEXATRIM Results and DEXATRIM Natural products. None of the plaintiffs in this action alleged personal injury as a result of the ingestion of a DEXATRIM product. On March 29, 2004, a stipulation was submitted to the court dismissing the case on jurisdictional grounds. Pursuant to the stipulation, the plaintiffs may re-file the class action in New York state court. These plaintiffs have not refiled this lawsuit as of March 29, 2005. We have been named as a defendant in a putative class action suit filed in the Superior Court of the State of California for the County of Los Angeles on February 11, 2004. The lawsuit seeks certification of classes consisting of residents of the United States, or residents of the State of California, who have purchased our BULLFROG sun care products during the past four years. The lawsuit seeks injunctive relief and compensatory damages under the California Business and Professions Code against us arising out of alleged deceptive, untrue or misleading advertising, and breach of warranty, in connection with the manufacturing, labeling, advertising, promotion and sale of BULLFROG products. The plaintiff has stipulated that the amount in controversy with respect to plaintiffs' individual claim and each member of the proposed class does not exceed $75. We filed an answer on June 28, 2004 and intend to defend vigorously the lawsuit. We have been named as a defendant in a putative class action suit filed in the Superior Court of the State of California, County of Los Angeles, on January 13, 2005. The lawsuit seeks injunctive relief, compensatory damages and attorney fees against us under the California Business and Professions code, arising out of alleged deceptive, untrue or misleading advertising and breech of express warranty in connection with the manufacturing, labeling, advertising, promotion and sale of certain DEXATRIM Natural products. The lawsuit seeks certification of a class consisting of all persons who purchased DEXATRIM Natural in California during the four year period prior to the filing of the lawsuit up to the date of any judgment obtained. The plaintiff has stipulated that the amount in controversy with individual claim and each member of the proposed class in the action does not exceed $75. We intend to defend vigorously the lawsuit. Other claims, suits and complaints arise in the ordinary course of our business involving such matters as patents and trademarks, product liability, environmental matters, employment law issues and other alleged injuries or damage. The outcome of such litigation cannot be predicted, but, in the opinion of management, based in part upon assessments from counsel, all such other pending matters are without merit or are of such kind or involve such other amounts as would not have a material adverse effect on our financial position, results of operations or cash flows if disposed of unfavorably. REGULATORY The FDA, the Drug Enforcement Administration and a number of state and local governments have enacted or proposed restrictions or prohibitions on the sale of products that contain ephedrine. Ephedrine can refer to the herbal substance derived from the plant ephedra or the plant heart leaf, which, until September 2002, was used in the manufacturing of some forms of DEXATRIM Natural and DEXATRIM Results, or synthetic ephedrine, an FDA regulated ingredient used in some OTC drug products, which has not been used in our products. These restrictions include the prohibition of OTC sales, required warnings or labeling statements, record keeping and reporting requirements, the prohibition of sales to minors, per transaction limits on the quantity of product that may be purchased and limitations on advertising and promotion. The enactment of further restrictions or prohibitions on sales, the perceived safety concerns related to ephedrine and the possibility of further regulatory action could result in an increase in the number of ephedrine related lawsuits filed including ones in which we are named as a defendant. In 1997, the FDA published a proposed rule on the use of dietary supplements containing ephedrine alkaloids. In June 2002, the United States Department of Health and Human Services ("HHS") proposed an expanded scientific evaluation of ephedra which led to the issuance of a report by the RAND-based Southern California Evidence-Based Practice Center (the "RAND Report"). The RAND Report concluded that ephedrine, ephedrine plus caffeine and ephedra-containing 16 dietary supplements with or without herbs containing caffeine all promote modest amounts of weight loss over the short term and use of ephedra or ephedrine plus caffeine is associated with an increased risk of gastrointestinal, psychiatric and autonomic symptoms. The adverse event reports contained a smaller number of more serious adverse events. Given the small number of such events, the RAND Report concluded that further study would be necessary to determine whether consumption of ephedra or ephedrine may be causally related to these serious adverse events. In connection with the RAND Report, HHS has sought public comment on whether additional measures are required concerning the sale and distribution of dietary supplements containing ephedrine alkaloids. On December 30, 2003, the FDA issued a consumer alert on the safety of dietary supplements containing ephedrine alkaloids and on February 6, 2004 published a final rule with respect to these products shortly. The final rule prohibits the sale of dietary supplements containing ephedrine alkaloids because such supplements present an unreasonable risk of illness or injury. The final rule became effective on April 11, 2004. Although we discontinued the manufacturing and shipment of DEXATRIM containing ephedrine in September 2002, the FDA's final rule may result in lawsuits in addition to those we currently have being filed against us alleging damages related to the use or purchase of DEXATRIM containing ephedrine. We were notified in October 2000 that the FDA denied a citizen petition submitted by Thompson Medical Company, Inc., the previous owner of SPORTSCREME and ASPERCREME. The petition sought a determination that 10% trolamine salicylate, the active ingredient in SPORTSCREME and ASPERCREME, was clinically proven to be an effective active ingredient in external analgesic OTC drug products and should be included in the FDA's yet-to-be finalized monograph for external analgesics. We have met with the FDA and submitted a proposed protocol study to evaluate the efficacy of 10% trolamine salicylate as an active ingredient in OTC external analgesic drug products. We are working to develop alternate formulations for SPORTSCREME and ASPERCREME in the event that the FDA does not consider the available clinical data to conclusively demonstrate the efficacy of trolamine salicylate when the OTC external analgesic monograph is finalized. If 10% trolamine salicylate is not included in the final monograph, we would likely be required to discontinue these products as currently formulated and remove them from the market after expiration of an anticipated grace period. If this occurred, we believe we could still market these products as homeopathic products and could also reformulate them using ingredients included in the FDA monograph. Certain of our topical analgesic products are currently marketed under an FDA tentative final monograph. The FDA has recently proposed that the final monograph exclude external analgesic products in patch, plaster or poultice form, unless the FDA receives additional data supporting the safety and efficacy of these products. On October 14, 2003, we submitted to the FDA information regarding the safety of our ICY HOT patches and arguments to support our product's inclusion in the final monograph. We have also participated in an industry effort coordinated by Consumer Healthcare Products Association ("CHPA") to establish with the FDA a protocol of additional research that will allow the patches to be marketed under the final monograph even if the final monograph does not explicitly allow them. The CHPA submission to FDA was made on October 15, 2003. Thereafter, in April 2004, we launched the ICY HOT Sleeve, a flexible, non-occlusive fabric patch with menthol levels consistent with the OTC monograph. If additional research is required either as a preliminary to final FDA monograph approval and/or as a requirement of future individual product sale, we may need to invest in a considerable amount of expensive testing and data analysis. Any preliminary cost may be shared with other patch manufacturers. Because the submissions made into the FDA docket have been forwarded from its OTC Division to its Dermatological Division within the Center for Drug Evaluation and Research ("CDER"), we believe that the monograph is unlikely to become final and take effect before mid-2006 and perhaps thereafter. If neither action described above is successful and the final monograph excludes such products, we will have to file an NDA in order to continue to market the ICY HOT Patch, ICY HOT Sleeve or similar delivery systems under our other topical analgesic brands. In such case, we would have to remove the existing products from the market one year from the effective date of the final monograph, pending FDA review and approval of an NDA. The preparation of an NDA would likely take us six to 18 months and would be expensive. It typically takes the FDA at least 12 months to rule on an NDA once it is submitted. We have responded to certain questions with respect to efficacy received from the FDA in connection with clinical studies for pyrilamine maleate, one of the active ingredients used in certain of the PAMPRIN and PREMSYN PMS products. While we addressed all of the FDA questions in detail, the final monograph for menstrual drug products, which has not yet been issued, will determine if the FDA considers pyrilamine maleate safe and effective for menstrual relief products. If pyrilamine maleate is not included in the final monograph, we would be required to reformulate the products to continue to provide the consumer with multi-symptom relief benefits. We have been actively monitoring the process and do not believe that either PAMPRIN or PREMSYN PMS will be materially adversely affected by the FDA review. We believe that any adverse finding by the FDA would likewise affect our principal competitors in the menstrual product category. We are also aware of the FDA's concern about the potential toxicity due to concomitant use of OTC and prescription drugs that contain the ingredient acetaminophen, an ingredient also found in PAMPRIN and PREMSYN PMS. We are participating in an industry-wide effort to reassure the FDA that the current recommended dosing regimen is safe and effective and that proper labeling and public education by both OTC and prescription drug companies are the best policies to abate the FDA's concern. There can be no assurance as to what action, if any, the FDA may take with respect to acetaminophen. 17 Our business is also regulated by the California Safe Drinking Water and Toxic Enforcement Act of 1986, known as Proposition 65. Proposition 65 prohibits businesses from exposing consumers to chemicals that the state has determined cause cancer or reproduction toxicity without first giving fair and reasonable warning unless the level of exposure to the carcinogen or reproductive toxicant falls below prescribed levels. From time to time, one or more ingredients in our products could become subject to an inquiry under Proposition 65. If an ingredient is on the state's list as a carcinogen, it is possible that a claim could be brought, in which case we would be required to demonstrate that exposure is below a "no significant risk" level for consumers. Any such claims may cause us to incur significant expense, and we may face monetary penalties or injunctive relief, or both, or be required to reformulate our product to acceptable levels. The State of California under Proposition 65 is also considering the inclusion of titanium dioxide on the state's list of suspected carcinogens. Titanium dioxide has a long history of widespread use as an excipient in prescription and OTC pharmaceuticals, cosmetics, dietary supplements and skin care products and is an active ingredient in our BULLFROG Superblock products. We have participated in an industry-wide submission to the State of California, facilitated through the CHPA, presenting evidence that titanium dioxide presents "no significant risk" to consumers. 19. CONDENSED CONSOLIDATING FINANCIAL STATEMENTS -------------------------------------------- The condensed consolidating financial statements, for the dates or periods indicated, of Chattem, Inc. ("Chattem"), Signal Investment & Management Co. ("Signal"), SunDex, LLC ("SunDex") and Chattem (Canada) Holdings, Inc. ("Canada"), the guarantors of the long-term debt of Chattem, and the non-guarantor direct and indirect wholly-owned subsidiaries of Chattem are presented below. Signal is 89% owned by Chattem and 11% owned by Canada. SunDex and Canada are wholly-owned subsidiaries of Chattem. The guarantees of Signal, SunDex and Canada are full and unconditional and joint and several. The guarantees of Signal, SunDex and Canada as of February 28, 2005 arose in conjunction with Chattem's Revolving Credit Facility and Chattem's issuance of the Floating Rate Notes and the 7.0% Subordinated Notes (See Note 12). The maximum amount of future payments the guarantors would be required to make under the guarantees as of February 28, 2005 is $200,000. 18 CHATTEM, INC. AND SUBSIDIARIES Note 19 CONDENSED CONSOLIDATING BALANCE SHEETS FEBRUARY 28, 2005 (Unaudited and in thousands)
GUARANTOR NON-GUARANTOR SUBSIDIARY SUBSIDIARY ASSETS CHATTEM COMPANIES COMPANIES ELIMINATIONS CONSOLIDATED ------ ------------ ------------ ------------ ------------ ------------ CURRENT ASSETS: Cash and cash equivalents $ 29,026 $ 1,969 $ 12,544 $ -- $ 43,539 Accounts receivable, less allowances of $2,339 34,890 10,379 5,923 (10,382) 40,810 Interest receivable -- 619 -- (619) -- Inventories 17,143 2,391 2,442 -- 21,976 Refundable income taxes 2,530 -- -- -- 2,530 Deferred income taxes 4,699 -- -- -- 4,699 Prepaid expenses and other current assets 5,668 -- 884 -- 6,552 ------------ ------------ ------------ ------------ ------------ Total current assets 93,956 15,358 21,793 (11,001) 120,106 ------------ ------------ ------------ ------------ ------------ PROPERTY, PLANT AND EQUIPMENT, NET 27,319 775 260 -- 28,354 ------------ ------------ ------------ ------------ ------------ OTHER NONCURRENT ASSETS: Patents, trademarks and other purchased product rights, net 582 283,944 -- (62,290) 222,236 Debt issuance costs, net 4,984 -- -- -- 4,984 Investment in subsidiaries 257,166 33,000 70,266 (360,432) -- Note receivable -- 33,000 -- (33,000) -- Other 5,528 -- 369 -- 5,897 ------------ ------------ ------------ ------------ ------------ Total other noncurrent assets 268,260 349,944 70,635 (455,722) 233,117 ------------ ------------ ------------ ------------ ------------ TOTAL ASSETS $ 389,535 $ 366,077 $ 92,688 $ (466,723) $ 381,577 ============ ============ ============ ============ ============ LIABILITIES AND SHAREHOLDERS' EQUITY ------------------------------------ CURRENT LIABILITIES: Current maturities of long-term debt $ -- $ -- $ -- $ -- $ -- Accounts payable and other 10,299 -- 6,004 -- 16,303 Accrued liabilities 28,463 1,362 3,755 (11,001) 22,579 ------------ ------------ ------------ ------------ ------------ Total current liabilities 38,762 1,362 9,759 (11,001) 38,882 ------------ ------------ ------------ ------------ ------------ LONG-TERM DEBT, less current maturities 200,000 -- 33,000 (33,000) 200,000 ------------ ------------ ------------ ------------ ------------ DEFERRED INCOME TAXES 383 27,534 -- -- 27,917 ------------ ------------ ------------ ------------ ------------ OTHER NONCURRENT LIABILITIES 1,804 -- -- -- 1,804 ------------ ------------ ------------ ------------ ------------ INTERCOMPANY ACCOUNTS 35,607 (36,184) 577 -- -- ------------ ------------ ------------ ------------ ------------ SHAREHOLDERS' EQUITY: Preferred shares, without par value, authorized 1,000, none issued -- -- -- -- -- Common shares, without par value, authorized 50,000, issued and outstanding 19,850 84,620 -- -- -- 84,620 Share capital of subsidiaries -- 329,704 43,209 (372,913) -- Retained earnings 32,553 43,661 5,915 (49,576) 32,553 ------------ ------------ ------------ ------------ ------------ Total 117,173 373,365 49,124 (422,489) 117,173 ------------ ------------ ------------ ------------ ------------ Unamortized value of restricted common shares issued (3,835) -- -- -- (3,835) Cumulative other comprehensive income, net of taxes: Interest rate cap adjustment (347) -- -- -- (347) Foreign currency translation adjustment (12) -- 228 (233) (17) ------------ ------------ ------------ ------------ ------------ Total shareholders' equity 112,979 373,365 49,352 (422,722) 112,974 ------------ ------------ ------------ ------------ ------------ TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 389,535 $ 366,077 $ 92,688 $ (466,723) $ 381,577 ============ ============ ============ ============ ============
19 CHATTEM, INC. AND SUBSIDIARIES Note 19 CONDENSED CONSOLIDATING BALANCE SHEETS NOVEMBER 30, 2004 (In thousands)
GUARANTOR NON-GUARANTOR SUBSIDIARY SUBSIDIARY ASSETS CHATTEM COMPANIES COMPANIES ELIMINATIONS CONSOLIDATED ------ ------------ ------------ ------------ ------------ ------------ CURRENT ASSETS: Cash and cash equivalents $ 28,344 $ 1,967 $ 9,882 $ -- $ 40,193 Accounts receivable, less allowances of $1,682 26,727 8,733 5,376 (8,738) 32,098 Interest receivable -- 619 -- (619) -- Inventories 16,681 3,020 1,989 -- 21,690 Refundable income taxes 4,702 -- -- -- 4,702 Deferred income taxes 4,308 -- -- -- 4,308 Prepaid expenses and other current assets 3,489 -- 194 -- 3,683 ------------ ------------ ------------ ------------ ------------ Total current assets 84,251 14,339 17,441 (9,357) 106,674 ------------ ------------ ------------ ------------ ------------ PROPERTY, PLANT AND EQUIPMENT, NET 27,724 775 266 -- 28,765 ------------ ------------ ------------ ------------ ------------ OTHER NONCURRENT ASSETS: Patents, trademarks and other purchased product rights, net 763 287,087 -- (62,290) 225,560 Debt issuance costs, net 5,174 -- -- -- 5,174 Investment in subsidiaries 249,999 33,000 68,477 (351,476) -- Note receivable -- 33,000 -- (33,000) -- Other 4,681 -- 870 -- 5,551 ------------ ------------ ------------ ------------ ------------ Total other noncurrent assets 260,617 353,087 69,347 (446,766) 236,285 ------------ ------------ ------------ ------------ ------------ TOTAL ASSETS $ 372,592 $ 368,201 $ 87,054 $ (456,123) $ 371,724 ============ ============ ============ ============ ============ LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES: Current maturities of long-term debt $ -- $ -- $ -- $ -- $ -- Accounts payable and other 11,398 -- 1,943 -- 13,341 Accrued liabilities 27,435 1,107 4,578 (9,357) 23,763 ------------ ------------ ------------ ------------ ------------ Total current liabilities 38,833 1,107 6,521 (9,357) 37,104 ------------ ------------ ------------ ------------ ------------ LONG-TERM DEBT, less current maturities 200,000 -- 33,000 (33,000) 200,000 ------------ ------------ ------------ ------------ ------------ DEFERRED INCOME TAXES (511) 26,243 -- -- 25,732 ------------ ------------ ------------ ------------ ------------ OTHER NONCURRENT LIABILITIES 1,776 -- -- -- 1,776 ------------ ------------ ------------ ------------ ------------ INTERCOMPANY ACCOUNTS 25,382 (25,484) 102 -- -- ------------ ------------ ------------ ------------ ------------ SHAREHOLDERS' EQUITY: Preferred shares, without par value, authorized 1,000, none issued -- -- -- -- -- Common shares, without par value, authorized 50,000, issued and outstanding 19,882 85,949 -- -- -- 85,949 Share capital of subsidiaries -- 329,705 41,100 (370,805) -- Retained earnings 23,888 36,630 6,115 (42,745) 23,888 ------------ ------------ ------------ ------------ ------------ Total 109,837 366,335 47,215 (413,550) 109,837 ------------ ------------ ------------ ------------ ------------ Unamortized value of restricted common shares issued (2,386) -- -- -- (2,386) Cumulative other comprehensive income, net of taxes: Interest rate cap adjustment (316) -- -- -- (316) Foreign currency translation adjustment (23) -- 216 (216) (23) ------------ ------------ ------------ ------------ ------------ Total shareholders' equity 107,112 366,335 47,431 (413,766) 107,112 ------------ ------------ ------------ ------------ ------------ TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 372,592 $ 368,201 $ 87,054 $ (456,123) $ 371,724 ============ ============ ============ ============ ============
20 CHATTEM, INC. AND SUBSIDIARIES Note 19 CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS FOR THE THREE MONTHS ENDED FEBRUARY 28, 2005 (Unaudited and in thousands)
GUARANTOR NON-GUARANTOR SUBSIDIARY SUBSIDIARY CHATTEM COMPANIES COMPANIES ELIMINATIONS CONSOLIDATED ------------ ------------ ------------ ------------ ------------ TOTAL REVENUES $ 58,790 $ 19,062 $ 4,873 $ (11,194) $ 71,531 ------------ ------------ ------------ ------------ ------------ COSTS AND EXPENSES: Cost of sales 16,614 2,323 2,139 (816) 20,260 Advertising and promotion 15,459 3,803 1,089 -- 20,351 Selling, general and administrative 11,521 73 290 -- 11,884 Litigation settlement 1,070 -- 1,685 -- 2,755 Equity in subsidiary income (6,831) -- -- 6,831 -- ------------ ------------ ------------ ------------ ------------ Total costs and expenses 37,833 6,199 5,203 6,015 55,250 ------------ ------------ ------------ ------------ ------------ INCOME (LOSS) FROM OPERATIONS 20,957 12,863 (330) (17,209) 16,281 ------------ ------------ ------------ ------------ ------------ OTHER INCOME (EXPENSE): Interest expense (3,489) -- (623) 617 (3,495) Investment and other income, net 95 623 671 (1,242) 147 Royalties (9,017) (1,362) -- 10,379 -- Corporate allocations 715 (699) (16) -- -- ------------ ------------ ------------ ------------ ------------ Total other income (expense) (11,696) (1,438) 32 9,754 (3,348) ------------ ------------ ------------ ------------ ------------ INCOME (LOSS) BEFORE INCOME TAXES 9,261 11,425 (298) (7,455) 12,933 PROVISION FOR (BENEFIT FROM) INCOME TAXES 596 3,770 (98) -- 4,268 ------------ ------------ ------------ ------------ ------------ NET INCOME (LOSS) $ 8,665 $ 7,655 $ (200) $ (7,455) $ 8,665 ============ ============ ============ ============ ============
21 CHATTEM, INC. AND SUBSIDIARIES Note 19 CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS FOR THE THREE MONTHS ENDED FEBRUARY 29, 2004 (Unaudited and in thousands)
GUARANTOR NON-GUARANTOR SUBSIDIARY SUBSIDIARY CHATTEM COMPANIES COMPANIES ELIMINATIONS CONSOLIDATED ------------ ------------ ------------ ------------ ------------ TOTAL REVENUES $ 49,908 $ 16,549 $ 4,172 $ (9,392) $ 61,237 ------------ ------------ ------------ ------------ ------------ COSTS AND EXPENSES: Cost of sales 13,702 2,249 1,549 (548) 16,952 Advertising and promotion 16,376 1,177 979 -- 18,532 Selling, general and administrative 10,467 46 122 -- 10,635 Litigation settlement 194 -- -- -- 194 Equity in subsidiary income (8,309) -- -- 8,309 -- ------------ ------------ ------------ ------------ ------------ Total costs and expenses 32,430 3,472 2,650 7,761 46,313 ------------ ------------ ------------ ------------ ------------ INCOME FROM OPERATIONS 17,478 13,077 1,522 (17,153) 14,924 ------------ ------------ ------------ ------------ ------------ OTHER INCOME (EXPENSE): Interest expense (4,763) -- (611) 619 (4,755) Investment and other income, net 27 620 17 (619) 45 Loss on early extinguishment of debt (11,309) -- -- -- (11,309) Royalties (7,525) (1,319) -- 8,844 -- Corporate allocations 788 (759) (29) -- -- ------------ ------------ ------------ ------------ ------------ Total other income (expense) (22,782) (1,458) (623) 8,844 (16,019) ------------ ------------ ------------ ------------ ------------ (LOSS) INCOME BEFORE INCOME TAXES (5,304) 11,619 899 (8,309) (1,095) (BENEFIT FROM) PROVISION FOR INCOME TAXES (4,592) 4,067 142 -- (383) ------------ ------------ ------------ ------------ ------------ NET (LOSS) INCOME $ (712) $ 7,552 $ 757 $ (8,309) $ (712) ============ ============ ============ ============ ============
22 CHATTEM, INC. AND SUBSIDIARIES Note 19 CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS FOR THE THREE MONTHS ENDED FEBRUARY 28, 2005 (Unaudited and in thousands)
GUARANTOR NON-GUARANTOR SUBSIDIARY SUBSIDIARY CHATTEM COMPANIES COMPANIES ELIMINATIONS CONSOLIDATED ------------ ------------ ------------ ------------ ------------ OPERATING ACTIVITIES: Net income (loss) $ 8,665 $ 7,655 $ (200) $ (7,455) $ 8,665 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation and amortization 1,585 -- 39 -- 1,624 Deferred income taxes 487 1,291 -- -- 1,778 Tax benefit realized from stock option plans 186 -- -- -- 186 Other, net 49 -- 312 -- 361 Equity in subsidiary income (7,455) -- -- 7,455 -- Changes in operating assets and liabilities: Accounts receivable (11,307) 1,498 (547) 1,644 (8,712) Inventories (462) 628 (452) -- (286) Refundable income taxes 2,172 -- -- -- 2,172 Prepaid expenses and other current assets 1,072 -- (690) -- 382 Accounts payable and accrued liabilities (70) 255 3,237 (1,644) 1,778 ------------ ------------ ------------ ------------ ------------ Net cash provided by operating activities (5,078) 11,327 1,699 -- 7,948 ------------ ------------ ------------ ------------ ------------ INVESTING ACTIVITIES: Purchases of property, plant and equipment (423) -- (33) -- (456) (Increase) decrease in other assets, net 12 -- 512 -- 524 ------------ ------------ ------------ ------------ ------------ Net cash (used in) provided by investing activities (411) -- 479 -- 68 ------------ ------------ ------------ ------------ ------------ FINANCING ACTIVITIES: Repayment of policy loans (1,031) -- -- -- (1,031) Proceeds from exercise of stock options 187 -- -- -- 187 Repurchase of common shares (3,514) -- -- -- (3,514) Changes in intercompany accounts 10,529 (10,700) 171 -- -- Dividends paid -- (625) 625 -- -- ------------ ------------ ------------ ------------ ------------ Net cash provided by (used in) financing activities 6,171 (11,325) 796 -- (4,358) ------------ ------------ ------------ ------------ ------------ EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS -- -- (312) -- (312) ------------ ------------ ------------ ------------ ------------ CASH AND CASH EQUIVALENTS: Increase for the period 682 2 2,662 -- 3,346 At beginning of period 28,344 1,967 9,882 -- 40,193 ------------ ------------ ------------ ------------ ------------ At end of period $ 29,026 $ 1,969 $ 12,544 $ -- $ 43,539 ============ ============ ============ ============ ============
23 CHATTEM, INC. AND SUBSIDIARIES Note 19 CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS FOR THE THREE MONTHS ENDED FEBRUARY 29, 2004 (Unaudited and in thousands)
GUARANTOR NON-GUARANTOR SUBSIDIARY SUBSIDIARY CHATTEM COMPANIES COMPANIES ELIMINATIONS CONSOLIDATED ------------ ------------ ------------ ------------ ------------ OPERATING ACTIVITIES: Net (loss) income $ (712) $ 7,552 $ 757 $ (8,309) $ (712) Adjustments to reconcile net (loss) income to net cash provided by operating activities: Depreciation and amortization 1,519 -- 18 -- 1,537 Deferred income taxes 303 1,679 -- -- 1,982 Tax benefit realized from stock option plans 1,083 -- -- -- 1,083 Loss on early extinguishment of debt 11,309 -- -- -- 11,309 Equity in subsidiary income (8,309) -- -- 8,309 -- Changes in operating assets and liabilities: Accounts receivable (8,844) (8,845) (264) 8,845 (9,108) Interest receivable -- (619) -- 619 -- Inventories (74) 22 43 -- (9) Refundable income taxes (3,752) -- -- -- (3,752) Prepaid expenses and other current assets 2,567 -- 25 (500) 2,092 Accounts payable and accrued liabilities 7,368 1,319 176 (8,964) (101) ------------ ------------ ------------ ------------ ------------ Net cash provided by operating activities 2,458 1,108 755 -- 4,321 ------------ ------------ ------------ ------------ ------------ INVESTING ACTIVITIES: Purchases of property, plant and equipment (485) -- (6) -- (491) Purchases of patents, trademarks and other product rights -- (17) -- -- (17) Increase in note receivable -- (33,000) -- 33,000 -- (Increase) decrease in other assets, net (760) -- 270 -- (490) ------------ ------------ ------------ ------------ ------------ Net cash (used in) provided by investing activities (1,245) (33,017) 264 33,000 (998) ------------ ------------ ------------ ------------ ------------ FINANCING ACTIVITIES: Repayment of long-term debt (182,280) -- -- -- (182,280) Proceeds from long-term debt 200,000 -- -- -- 200,000 Proceeds from borrowings under revolving credit facility 25,000 -- -- -- 25,000 Proceeds from exercise of stock options 1,453 -- -- -- 1,453 Repurchase of common shares (319) -- -- -- (319) Increase in debt issuance costs (5,678) -- -- -- (5,678) Debt retirement costs (6,946) -- -- -- (6,946) Restricted cash (32,227) -- -- -- (32,227) Intercompany debt proceeds, net -- -- 33,000 (33,000) -- Changes in intercompany accounts 882 31,915 (32,797) -- -- ------------ ------------ ------------ ------------ ------------ Net cash (used in) provided by financing activities (115) 31,915 203 (33,000) (997) ------------ ------------ ------------ ------------ ------------ EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS -- -- 26 -- 26 ------------ ------------ ------------ ------------ ------------ CASH AND CASH EQUIVALENTS: Increase for the period 1,098 6 1,248 -- 2,352 At beginning of period 18,702 1,964 6,265 -- 26,931 ------------ ------------ ------------ ------------ ------------ At end of period $ 19,800 $ 1,970 $ 7,513 $ -- $ 29,283 ============ ============ ============ ============ ============
24 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND ------------------------------------------------------------------------ RESULTS OF OPERATIONS --------------------- The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the audited consolidated financial statements and related notes thereto included in our 2004 Annual Report on Form 10-K filed with the Securities and Exchange Commission. This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. The actual results may differ materially from those anticipated in these forward-looking statements as a result of a number of factors, including, but not limited to, those described in our filings with the Securities and Exchange Commission. OVERVIEW We are a leading marketer and manufacturer of a broad portfolio of branded over-the-counter ("OTC") healthcare products, toiletries and dietary supplements including such categories as topical analgesics, medicated skin care products, medicated dandruff shampoos and conditioner, dietary supplements, and other OTC and toiletry products. Our portfolio of products includes well-recognized brands such as: o Topical analgesics such as ICY HOT and ASPERCREME; o Medicated skin care products such as GOLD BOND medicated skin care powder, cream, lotion, first aid, and foot care products; and PHISODERM medicated acne treatment products and skin cleansers; o SELSUN BLUE medicated dandruff shampoos and conditioner; o Dietary supplements including DEXATRIM, GARLIQUE and NEW PHASE; and o Other OTC and toiletry products such as PAMPRIN, a menstrual analgesic; HERPECIN-L, a lip care product; BENZODENT, a dental analgesic cream; and toiletries such as BULLFROG, a line of sunblocks; ULTRASWIM, a chlorine-removing shampoo; and SUN-IN, a hair lightener. Our products typically target niche markets that are often outside the core product areas of larger companies where we believe we can achieve and sustain significant market penetration through innovation and strong advertising and promotion support. Many of our products are among the U.S. market leaders in their respective categories. For example, our portfolio of topical analgesic brands and our GOLD BOND medicated body powders have the leading U.S. market share in these categories. We support our brands through extensive and cost-effective advertising and promotion, the expenditures for which represented approximately 29% of our total revenues in the first quarter of fiscal 2005. We sell our products nationally through mass merchandiser, drug and food channels principally utilizing our own sales force. Our net income (loss) margin (net income (loss)/total revenues) was 12.1% and (1.2%) for the first quarter of fiscal 2005 and 2004, respectively. Our net income (excluding debt extinguishment and litigation settlement charges) margin (net income (excluding debt extinguishment and litigation settlement charges)/total revenues) was 14.7% and 11.0% for the first quarter of fiscal 2005 and 2004, respectively. We believe that disclosure of net income (excluding debt extinguishment and litigation settlement charges) margin provides investors with useful information regarding our financial performance and allows for easier comparison with net income margin without the effect of the charges in prior periods. A reconciliation of net income (excluding debt extinguishment and litigation settlement charges) to net income is presented in the following table: FOR THE THREE MONTHS ENDED ------------------------------- FEBRUARY 28, FEBRUARY 29, 2005 2004 ------------ ------------ (dollars in thousands, except per share data) Net income (loss) $ 8,665 $ (712) Add: Loss on early extinguishment of debt -- 11,309 Litigation settlement charges 2,755 194 Benefit from income taxes (909) (4,026) ------------ ------------ Net income (excluding debt extinguishment and litigation settlement charges) $ 10,511 $ 6,765 ============ ============ Net income (excluding debt extinguishment and litigation settlement charges) per common share (diluted) $ .51 $ .34 ============ ============ Net income (excluding debt extinguishment and litigation settlement charges) margin 14.7% 11.0% ============ ============ 25 EBITDA, earnings before interest, taxes, depreciation and amortization, is a key non-GAAP financial measure used by us to measure operating performance but may not be comparable to similarly titled measures reported by other companies. The most directly comparable GAAP financial measure is net income. EBITDA and EBITDA (excluding litigation settlement charges) are used by us to supplement net income as an indicator of operating performance and not as an alternative to measures defined and required by U.S. generally accepted accounting principles. We consider EBITDA and EBITDA (excluding litigation settlement charges) as important indicators of our operational strength and performance, including our ability to pay interest, service debt and fund capital expenditures. EBITDA and EBITDA (excluding litigation settlement charges) should be considered in addition to, but not as a substitute for, operating income, net income and other measures of financial performance reported in accordance with U.S. generally accepted accounting principles. EBITDA is also one measure used in the calculation of certain ratios to determine our compliance with the terms of our Revolving Credit Facility. A reconciliation of EBITDA and EBITDA (excluding litigation settlement charges) to net income is presented in the following table:
FOR THE THREE MONTHS ENDED ------------------------------------------------------------------ DOLLAR PERCENTAGE FEBRUARY 28, FEBRUARY 29, INCREASE INCREASE 2005 2004 (DECREASE) (DECREASE) ------------ ------------ ------------ ------------ (dollars in thousands) Net income (loss) $ 8,665 $ (712) $ 9,377 1,317.0% Add: Provision for (benefit from) income taxes 4,268 (383) 4,651 1,214.4 Interest expense, net (1) 3,348 16,019 (12,671) (79.1) Depreciation and amortization less amounts included in interest 1,434 1,268 166 13.1 ------------ ------------ ------------ EBITDA $ 17,715 $ 16,192 $ 1,523 9.4 ============ ============ ============ Litigation settlement charges 2,755 194 2,561 1,320.1 ------------ ------------ ------------ EBITDA (excluding litigation settlement charges) $ 20,470 $ 16,386 $ 4,084 24.9 ============ ============ ============ EBITDA margin (EBITDA/total revenues) 24.8% 26.4% ============ ============ EBITDA (excluding litigation settlement charges) margin (EBITDA (excluding litigation settlement charges)/total revenues) 28.6% 26.8% ============ ============
(1) Fiscal 2004 includes a loss on early extinguishment of debt of $11.3 million. DEVELOPMENTS DURING FISCAL 2005 In the first quarter of fiscal 2005, we introduced the following product line extensions: ASPERCREME Odor-Free Therapy Back and Body Patch, GOLD BOND Ultimate Comfort Powder, PHISODERM pH2O, NEW PHASE Extra Strength, DEXATRIM Max and BULLFROG UV Defender. On December 13, 2004, we entered into a term sheet of settlement with Interstate Fire & Casualty Company ("Interstate") with regard to Interstate's lawsuit to rescind its $25.0 million of excess coverage for product liability claims relating to DEXATRIM products containing PPA. On March 18, 2005, we entered into a settlement and coverage-in-place agreement with Interstate consistent with the term sheet of settlement (the "Settlement Agreement"). In accordance with the Settlement Agreement, Interstate will provide coverage of DEXATRIM PPA claims that are covered by its policy after $78.5 million has been paid toward covered claims. Once the $78.5 million threshold is met, Interstate will pay 100% of the next $4.0 million of claims covered by its policy; 75% of the next $8.5 million of such claims; and 50% of the last $12.5 million of such claims. We are responsible for any claims not covered by the Interstate policy either because the alleged injury did not occur before May 31, 2001, or the claim was first made against us after May 31, 2004. In addition, under the Settlement Agreement, we and Interstate will dismiss all claims and counterclaims filed against each other, and we will release all claims against Interstate relating to the excess coverage product liability insurance. In the first quarter of fiscal 2005, we sold our SELSUN business in certain countries in Africa and Asia to The Mentholatum Co., Inc. We maintain our rights to SELSUN in Australia, New Zealand and worldwide (except India). The divested territory was not compatible with our strategic goals for the remainder of our international SELSUN operations and contributed only $1.3 million in net sales in fiscal 2004. 26 RESULTS OF OPERATIONS The following table sets forth, for the periods indicated, certain items from our Condensed Consolidated Statements of Operations expressed as a percentage of total revenues: FOR THE THREE MONTHS ENDED ------------------------------- FEBRUARY 28, FEBRUARY 29, 2005 2004 ------------ ------------ TOTAL REVENUES 100.0% 100.0% ------------ ------------ COSTS AND EXPENSES: Cost of sales 28.3 27.7 Advertising and promotion 28.5 30.2 Selling, general and administrative 16.6 17.4 Litigation settlement 3.8 0.3 ------------ ------------ Total costs and expenses 77.2 75.6 ------------ ------------ INCOME FROM OPERATIONS 22.8 24.4 ------------ ------------ OTHER INCOME (EXPENSE): Interest expense (4.9) (7.8) Investment and other income, net 0.2 0.1 Loss on early extinguishment of debt -- (18.5) ------------ ------------ Total other income (expense) (4.7) (26.2) ------------ ------------ INCOME (LOSS) BEFORE INCOME TAXES 18.1 (1.8) PROVISION FOR (BENEFIT FROM) INCOME TAXES 6.0 (0.6) ------------ ------------ NET INCOME (LOSS) 12.1% (1.2%) ============ ============ CRITICAL ACCOUNTING POLICIES The preparation of financial statements in accordance with U.S. generally accepted accounting principles requires management to use estimates. Several different estimates or methods can be used by management that might yield different results. The following are the significant estimates used by management in the preparation of the February 28, 2005 condensed consolidated financial statements: ALLOWANCE FOR DOUBTFUL ACCOUNTS As of February 28, 2005, an estimate was made of the collectibility of the outstanding accounts receivable balances. This estimate requires the utilization of outside credit services, knowledge about the customer and the customer's industry, new developments in the customer's industry and operating results of the customer as well as general economic conditions and historical trends. When all these facts are compiled, a judgment as to the collectibility of the individual account is made. Many factors can impact this estimate, including those noted in this paragraph. The adequacy of the estimated allowance may be impacted by the deterioration in the financial condition of a large customer, weakness in the economic environment resulting in a higher level of customer bankruptcy filings or delinquencies and the competitive environment in which the customer operates. During the first quarter of fiscal 2005, we performed a detailed assessment of the collectibility of trade accounts receivable and reduced our estimate of allowance for doubtful accounts by approximately $0.3 million, which resulted in a decrease to selling, general and administrative expense in our condensed consolidated financial statements. REVENUE RECOGNITION Revenue is recognized when our products are shipped to our customers. It is generally our policy across all classes of customers that all sales are final. As is common in the consumer products industry, customers return products for a variety of reasons including products damaged in transit, discontinuance of a particular size or form of product and shipping errors. As sales are recorded, we accrue an estimated amount for product returns, as a reduction of these sales, based upon our historical 27 experience and any known specific events that affect the accrual. We charge the allowance account resulting from this accrual with any authorized deduction from remittance by the customer or product returns upon receipt of the product. In accordance with industry practice, we allow our customers to return unsold sun care products (i.e. BULLFROG and SUN IN lines of products) at the end of the sun care season. We record the sales at the time the products are shipped and title transfers. At the time of shipment, we also record a reduction in sales and an allowance on our balance sheet for anticipated returns based upon an estimated return level. The level of returns may fluctuate from our estimates due to several factors including weather conditions, customer inventory levels and competitive conditions. Each percentage point change in our return rate would impact our net sales by approximately $0.2 million. As a result of higher sales volumes in the first quarter of fiscal 2005 and 2004, we increased our estimate of seasonal returns by approximately $0.1 million and $0.2 million, respectively, which resulted in a decrease to net sales in our condensed consolidated financial statements. During the first quarter of fiscal 2005, as a result of our estimate of customer inventory levels and based on historical non-seasonal product returns, we increased our estimate of non-seasonal returns by approximately $0.6 million, which resulted in a decrease to net sales in our condensed consolidated financial statements, as compared to a $0.2 million decrease in our estimate in the first quarter of fiscal 2004. We routinely enter into agreements with our customers to participate in promotional programs. These programs generally take the form of coupons, temporary price reductions, scan downs, display activity and participations in advertising vehicles provided uniquely by the customer. The ultimate cost of these programs is often variable based on the number of units actually sold. Estimated unit sales of a product under a promotional program are used to estimate the total cost of the program, which is recorded as a reduction of sales. Actual results can differ from the original estimate. We also consider customer delays in requesting promotional program payments when evaluating the required accrual. Many customers audit programs significantly after the date of performance to determine the actual amount due and make a claim for reimbursement at that time. As a result, changes in the unit sales trends under promotional programs as well as the timing of payments could result in changes in the accrual. During the first quarter of fiscal 2005 and 2004, primarily as a result of the sales volume impact on variable based programs, we increased our estimate of promotional accruals by approximately $0.5 million and $1.0 million, respectively, which resulted in a decrease to net sales in our condensed consolidated financial statements. INCOME TAXES We account for income taxes using the asset and liability approach as prescribed by Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes". This approach requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in our condensed consolidated financial statements or tax returns. Using the enacted tax rates in effect for the year in which the differences are expected to reverse, deferred tax assets and liabilities are determined based on the differences between the financial reporting and the tax basis of an asset or liability. We record income tax expense in our condensed consolidated financial statements based on an estimated annual effective income tax rate. Our tax rate for the three months ended February 28, 2005 was 33%, as compared to 35% in the three months ended February 29, 2004, respectively. The lower rates for the three months ended February 28, 2005 reflect the implementation of a number of foreign and state tax planning initiatives, which include our determination during the third quarter of fiscal 2004 to reinvest indefinitely all undistributed earnings of Chattem Canada, a wholly-owned subsidiary. Undistributed earnings of Chattem Canada amounted to approximately $281 for the three months ended February 28, 2005. These earnings are considered to be reinvested indefinitely and, accordingly, no provision for U.S. federal and state income taxes has been provided thereon. Upon distribution of those earnings in the form of dividends or otherwise, we would be subject to U.S. income taxes (subject to an adjustment for foreign tax credits). For a summary of our significant accounting policies, see Note 2 of Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended November 30, 2004 filed with the Securities and Exchange Commission. 28 COMPARISON OF THREE MONTHS ENDED FEBRUARY 28, 2005 AND FEBRUARY 29, 2004 To facilitate discussion of our operating results for the three months ended February 28, 2005 and February 29, 2004, we have included the following selected data from our Condensed Consolidated Statements of Operations:
INCREASE (DECREASE) ------------------------ 2005 2004 AMOUNT PERCENTAGE ---------- ---------- ---------- ---------- (dollars in thousands) Domestic net sales $ 65,569 $ 55,606 $ 9,963 17.9% International revenues (including royalties) 5,962 5,631 331 5.9 Total revenues 71,531 61,237 10,294 16.8 Cost of sales 20,260 16,952 3,308 19.5 Advertising and promotion expense 20,351 18,532 1,819 9.8 Selling, general and administrative expense 11,884 10,635 1,249 11.7 Litigation settlement 2,755 194 2,561 1,320.1 Interest expense 3,495 4,755 (1,260) (26.5) Loss on early extinguishment of debt -- (11,309) nm nm Net income (loss) 8,665 (712) 9,377 1,317.0
DOMESTIC NET SALES Domestic net sales for the three months ended February 28, 2005 increased $10.0 million or 17.9% as compared to the comparable period of 2004. A comparison of domestic net sales for the categories of products included in our portfolio of OTC healthcare products is as follows:
INCREASE (DECREASE) ------------------------ 2005 2004 AMOUNT PERCENTAGE ---------- ---------- ---------- ---------- (dollars in thousands) Topical analgesics $ 21,407 $ 15,712 $ 5,695 36.2% Medicated skin care products 17,624 13,332 4,292 32.2 Dietary supplements 8,660 8,511 149 1.8 Medicated dandruff shampoos and conditioner 9,800 9,221 579 6.3 Other OTC and toiletry products 8,078 8,830 (752) (8.5) ---------- ---------- ---------- Total $ 65,569 $ 55,606 $ 9,963 17.9 ========== ========== ==========
Net sales growth in the topical analgesic category was led by 53% and 50% increases in sales of ASPERCREME and ICY HOT, respectively. ASPERCREME'S sales increase was driven by the launch of the Odor-Free Therapy Back and Body Patch. ICY HOT continued to benefit from the ICY HOT Medicated Sleeve and the effective advertising campaign featuring Shaquille O'Neal. Net sales growth in this category also resulted from 13% and 10% increases in SPORTSCREME and CAPZASIN sales, respectively. The overall sales growth in this category was partially offset by a decline in sales of FLEXALL as competition from inside and outside the category increased and media support was curtailed. Net sales growth in the medicated skin care products category resulted from a 42% increase in the GOLD BOND franchise. GOLD BOND sales growth was attributable to 70%, 52%, 23% and 20% increases from the lotion, foot care, powder and cream product lines, respectively. The increase in sales from the GOLD BOND lotion line of products was attributable to the continuing strength of GOLD BOND ULTIMATE Healing Skin Therapy Lotion. The increase in net sales of GOLD BOND foot resulted from increased distribution, GOLD BOND cream benefited from an effective advertising campaign, and GOLD BOND powder sales were driven by the launch of GOLD BOND ULTIMATE Comfort Powder. Net sales growth in the dietary supplements category was led by a 34% increase in sales of NEW PHASE as a result of the introduction of NEW PHASE Extra Strength. The increase in net sales of NEW PHASE was partially offset by a 7% decline in sales of GARLIQUE. Domestic net sales of SELSUN BLUE medicated dandruff shampoo increased due to an effective advertising campaign. The decrease in net sales for the other OTC and toiletry products category was due primarily to sales decreases of PAMPRIN and PREMSYN, which both lost distribution at a major retailer during the second quarter of fiscal 2004. The decrease was partially offset by an increase in net sales of SUN-IN as a result of expanded distribution. 29 Domestic sales variances were principally the result of changes in unit sales volumes with the exception of certain selected products, for which we implemented a unit sales price increase. INTERNATIONAL REVENUES For the first quarter of fiscal 2005, international revenues increased $0.3 million or 5.9% as compared to the first quarter of fiscal 2004 due principally to strengthening sales of SELSUN in certain European and Middle Eastern countries. Sales variances for international operations were principally the result of changes in unit sales volumes. COST OF SALES Cost of sales as a percentage of total revenues was 28.3% for the first quarter of fiscal 2005 as compared to 27.7% for the first quarter of fiscal 2004. Gross margin of 71.7% was attributable to favorable product mix, purchasing and manufacturing efficiencies and ongoing cost savings programs. ADVERTISING AND PROMOTION EXPENSE Advertising and promotion expenses in the first quarter of fiscal 2005 increased $1.8 million or 9.8% as compared to the same quarter of fiscal 2004 and were 28.5% of total revenues for the three months ended February 28, 2005 compared to 30.2% for the comparable period of fiscal 2004. The decrease in advertising and promotion expense as a percentage of revenues of 1.7% represents a more effective use of advertising to generate sales. Increases in advertising and promotion expenditures in the current period were recorded for ICY HOT, ASPERCREME, CAPZASIN, DEXATRIM, SELSUN BLUE, GARLIQUE, NEW PHASE and GOLD BOND powder, lotion and foot care lines. Decreases in advertising and promotion expenditures were recognized for FLEXALL, PHISODERM, PAMPRIN and PREMSYN. SELLING, GENERAL AND ADMINISTRATIVE EXPENSE Selling, general and administrative expenses increased $1.2 million or 11.7% as compared to the same quarter of fiscal 2004. Selling, general and administrative expenses were 16.6% and 17.4% of total revenues for the first quarter of fiscal 2005 and 2004, respectively. An increase in sales was primarily responsible for the increase in selling expense. In addition, freight expenses increased due to an increase in fuel costs. The increase in general and administrative expenses was largely a result of increased compensation and insurance expense. LITIGATION SETTLEMENT CHARGES Litigation settlement charges were $2.8 million in the first quarter of fiscal 2005. This expense was attributable to incurring $1.1 million of legal expenses relating to the DEXATRIM PPA settlement, and $1.7 million associated with DEXATRIM ephedrine-related claims and legal expenses. INTEREST EXPENSE Interest expense decreased $1.3 million or 26.5% in the first quarter of fiscal 2005 as compared to the same quarter of fiscal 2004. The decrease was largely the result of lower interest rates and a reduction in outstanding debt as a result of our debt refinancing completed during the first quarter of fiscal 2004. Until our indebtedness is reduced substantially, interest expense will continue to represent a significant percentage of our total revenues. LOSS ON EARLY EXTINGUISHMENT OF DEBT During the first quarter of fiscal 2004, we retired $174.5 million principal amount of our 8.875% Subordinated Notes and the remaining outstanding balance of our Credit Facility, which resulted in a loss on early extinguishment of debt of $11.3 million. LIQUIDITY AND CAPITAL RESOURCES ------------------------------- We have historically financed our operations with a combination of internally generated funds and borrowings. Our principal uses of cash are for operating expenses, servicing long-term debt, acquisitions, working capital, repurchases of our common stock, payment of income taxes and capital expenditures. Cash of $7.9 million and $4.3 million was provided by operations for the three months ended February 28, 2005 and February 29, 2004, respectively. The increase in cash flows from operations over the prior period was primarily attributable to an increase in refundable income taxes and accounts payable. In addition, prepaid expenses and other assets decreased as a result of an increase in prepaid advertising in the first quarter of fiscal 2005. 30 Investing activities provided cash of $68,000 and used cash of $1.0 million in the three months ended February 28, 2005 and February 29, 2004, respectively. The usage of cash in the first quarter of fiscal 2004 was primarily due to the increase in cash surrender value related to executive and director insurance policies. Financing activities used cash of $4.4 million and $1.0 million in the three months ended February 28, 2005 and February 29, 2004, respectively. The increase in cash used in the current period was primarily attributable to the $3.5 million repurchase of common stock and the repayment of loans related to executive and director life insurance policies as compared to the prior period reflecting the refinancing transaction. In January 2005, our board of directors increased the total authorization to repurchase our common stock under our stock buyback program to $30.0 million. In the first quarter of fiscal 2005, we repurchased 102,500 shares for $3.5 million. All repurchased shares were retired and returned to unissued. We, however, are limited in our ability to repurchase shares due to restrictions under the terms of our Revolving Credit Facility, Floating Rate Notes and 7.0% Subordinated Notes. Subsequent to February 28, 2005, we have repurchased 115,800 of our shares for $4.2 million. FOREIGN OPERATIONS ------------------ Historically, our primary foreign operations have been conducted through our Canadian and United Kingdom ("U.K.") subsidiaries. Effective November 1, 2004, we transitioned our European business to Chattem Global Consumer Products Limited, a wholly-owned subsidiary located in Limerick, Ireland. The functional currencies of these subsidiaries are Canadian dollars, British pounds and Euros, respectively. Fluctuations in exchange rates can impact operating results, including total revenues and expenses, when translations of the subsidiary financial statements are made in accordance with SFAS No. 52, "Foreign Currency Translation". For the three months ended February 28, 2005 and February 29, 2004, these subsidiaries accounted for 7% of total revenues, respectively, and 5% and 3% of total assets, respectively. It has not been our practice to hedge our assets and liabilities in Canada, the U.K. and Ireland or our intercompany transactions due to the inherent risks associated with foreign currency hedging transactions and the timing of payments between us and our foreign subsidiaries. Following our acquisition of SELSUN BLUE, which is sold in approximately 70 foreign countries, our international business operations have expanded significantly, which will increase our exposure to fluctuations in foreign exchange rates. During fiscal 2004, a portion of these foreign sales was reflected as royalties, which have been paid to us in U.S. dollars. In addition, Abbott has continued to supply a portion of our international product, and beginning April 1, 2004, Abbott began billing us in local currencies. Historically, gains or losses from foreign currency transactions have not had a material impact on our operating results. (Losses) gains of $(10,000) and $34,000 for the three months ended February 28, 2005 and February 29, 2004, respectively, resulted from foreign currency transactions and are included in selling, general and administrative expenses in the Condensed Consolidated Statements of Operations. RECENT ACCOUNTING PRONOUNCEMENTS -------------------------------- In December 2003, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 46R, "Consolidation of Variable Interest Entities" ("FIN 46R"), which supercedes Interpretation No. 46, "Consolidation of Variable Interest Entities" issued in January 2003. FIN 46R requires a company to consolidate a variable interest entity ("VIE"), as defined, when the company will absorb a majority of the VIE's expected losses, receives a majority of the VIE's expected residual returns or both. FIN 46R also requires consolidation of existing, non-controlled affiliates if the VIE is unable to finance its operations without investor support, or where the other investors do not have exposure to the significant risks and rewards of ownership. FIN 46R applies immediately to a VIE created or acquired after January 31, 2003. For a VIE created before February 1, 2003, FIN 46R applies in the first fiscal year or interim period beginning after March 15, 2004, our third fiscal quarter beginning June 1, 2004. Application of FIN 46R is also required in financial statements that have interests in structures that are commonly referred to as special-purpose entities for periods ending after December 15, 2003. The adoption of FIN 46R did not have an impact on our financial position, results of operations or cash flows. In November 2004, the FASB issued SFAS No. 151, "Inventory Costs" ("SFAS 151"). SFAS 151 amends the guidance in Accounting Research Bulletin No. 43, Chapter 4, "Inventory Pricing", to clarify that abnormal amounts of idle facility expense, freight, handling costs and wasted materials (spoilage) should be recognized as current-period charges and requires the allocation of fixed production overheads to inventory based on normal capacity of the production facilities. This statement is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The adoption of SFAS 151 is not expected to have an impact on our financial position, results of operations or cash flows. In November 2004, the Emerging Issues Task Force ("EITF") reached a consensus on Issue No. 03-13, "Applying the Conditions in Paragraph 42 of FASB Statement No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" in Determining Whether to Report Discontinued Operations" ("EITF 03-13"). Under the consensus, the approach for assessing whether cash flows of the component have been eliminated from the ongoing operations of the entity focuses on whether 31 continuing cash flows are direct or indirect cash flows. Cash flows of the component would not be eliminated if the continuing cash flows to the entity are considered direct cash flows. The consensus should be applied to a component of an enterprise that is either disposed of or classified as held for sale in fiscal periods beginning after December 15, 2004. The adoption of EITF 03-13 is not expected to have an impact on our financial position, results of operations or cash flows. In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based Payment" ("SFAS 123R"), which is a revision of SFAS No. 123, "Accounting for Stock-Based Compensation". SFAS 123R supercedes APB Opinion No. 25, "Accounting for Stock Issued to Employees" and amends SFAS No. 95, "Statement of Cash Flows". SFAS 123R focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions and requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Accordingly, the adoption of SFAS 123R's fair value method will have a significant impact on our results of operations, although it will have no impact on our overall financial position. The impact of the adoption of SFAS 123R cannot be predicted at this time because it will depend on the levels of share-based payments granted in the future. However, had we adopted SFAS 123R in prior periods the impact of that standard would have approximated the impact of SFAS 123 as described in the disclosure of proforma net income and earnings per share in Note 5 to our condensed consolidated financial statements. SFAS 123R also requires the benefits of tax deductions in excess of recognized compensation costs to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While we cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of operating cash flows recognized in prior periods for such excess tax deductions were not material to our consolidated financial position or results of operations. This statement is effective for our interim periods beginning after June 15, 2005. In December 2004, the FASB issued SFAS 153, "Exchanges of Nonmonetary Assets" ("SFAS 153"). SFAS 153 amends the guidance in APB Opinion No. 29, "Accounting for Nonmonetary Transactions" to eliminate certain exceptions to the principle that exchanges of nonmonetary assets be measured based on the fair value of the assets exchanged. SFAS 153 eliminates the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. This statement is effective for nonmonetary asset exchanges in fiscal years beginning after June 15, 2005. The adoption of SFAS 153 is not expected to have an impact on our financial position, results of operations or cash flows. FORWARD LOOKING STATEMENTS -------------------------- Statements in this Quarterly Report on Form 10-Q which are not historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements involve risks, uncertainties and assumptions that could cause actual outcomes and results to differ materially from those expressed or projected. 32 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS ------------------------------------------------------------------- We are exposed to market risk from changes in interest rates and foreign currency exchange rates, which may adversely affect our results of operations and financial condition. We seek to minimize the risks from these interest rates and foreign currency exchange rate fluctuations through our regular operating and financing activities. Our exposure to interest rate risk currently consists of our Floating Rate Notes and our Revolving Credit Facility. The aggregate balance outstanding under the Floating Rate Notes as of February 28, 2005, was $75.0 million. The Floating Rate Notes bear interest at a three-month LIBOR plus 3.00% per year (5.38% as of February 28, 2005). Loans under our Revolving Credit Facility bear interest at LIBOR plus applicable percentages of 1.75% to 2.50% or a base rate (the higher of the federal funds rate plus 0.5% or the prime rate) plus applicable percentages of 0.25% to 1.0%. The applicable percentages are calculated based on our leverage ratio. As of February 28, 2005, no amounts were outstanding under the Revolving Credit Facility, and the variable rate on the Revolving Credit Facility was 6.0%. The 7.0% Subordinated Notes are fixed interest rate obligations. On March 8, 2004, we entered into an interest rate cap agreement effective June 1, 2004 with decreasing annual notional principal amounts of $15.0 million beginning March 1, 2006 and cap rates ranging from 4.0% to 5.0% over the life of the agreement. The amortized value of the premium on the interest rate cap was compared to its fair value as of February 28, 2005, and a charge of $0.3 million, net of tax, was recorded to other comprehensive income. The interest rate cap agreement terminates on March 1, 2010. The impact on our results of operations of a one-point rate change on the balance currently outstanding of our Floating Rate Notes for the next twelve months would be approximately $0.5 million, net of tax. We are subject to risk from changes in the foreign exchange rates relating to our Canadian, U.K. and Irish subsidiaries. Assets and liabilities of these subsidiaries are translated to U.S. dollars at year-end exchange rates. Income and expense items are translated at average rates of exchange prevailing during the year. Translation adjustments are accumulated as a separate component of shareholders' equity. Gains and losses, which result from foreign currency transactions, are included in the Condensed Consolidated Statements of Operations. In addition, Abbott has continued to supply a portion of our international product, and beginning April 1, 2004, Abbott began billing us in local currencies. The potential loss resulting from a hypothetical 10.0% adverse change in the quoted foreign currency exchange rate amounts to approximately $1.3 million as of February 28, 2005. This market risk discussion contains forward-looking statements. Actual results may differ materially from this discussion based upon general market conditions and changes in financial markets. ITEM 4. CONTROLS AND PROCEDURES ------------------------------- (a) Evaluation of Disclosure Controls and Procedures. Our Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of our disclosure controls and procedures (as such terms are defined in Rules 13(a)-15(e) and 15(d)-15(e)) under the Securities Exchange Act of 1934, as amended (the "Exchange Act") as of February 28, 2005 of this Form 10-Q (the "Evaluation Date"). Based on such evaluation, such officers have concluded that, as of the Evaluation Date, our disclosure controls and procedures are effective in alerting them on a timely basis to material information relating to us (including our consolidated subsidiaries) required to be included in our periodic filings under the Exchange Act. (b) Changes in Internal Controls. Since the Evaluation Date, there have not been any significant changes in our internal controls over financial reporting or in other factors that could significantly affect such controls. 33 PART II. OTHER INFORMATION -------------------------- ITEM 1. LEGAL PROCEEDINGS ------------------------- See Note 18 of Notes to Condensed Consolidated Financial Statements included in Part 1, Item 1 of this Report. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS ------------------------------------------------------------------- A summary of the common stock repurchase activity for our first quarter of fiscal 2005 is as follows:
TOTAL NUMBER OF MAXIMUM DOLLAR SHARES PURCHASED AS VALUE THAT MAY PART OF PUBLICLY YET BE PURCHASED TOTAL NUMBER OF AVERAGE PRICE ANNOUNCED PLANS UNDER THE PLANS PERIOD SHARES PURCHASED PAID PER SHARE(1) OR PROGRAMS(2) OR PROGRAMS ----------------------- ---------------- ---------------- ---------------- ---------------- December 1- December 31 500 $32.50 500 $14,950,220 January 1 - January 31 99,800 $34.24 99,800 $28,479,862 February 1 - February 28 2,200 $36.55 2,200 $28,399,452 Total First Quarter 102,500 $34.28 102,500 $28,399,452
(1) Average price paid per share includes broker commissions. (2) Our stock buyback program authorizing the purchase of up to $20.0 million of our common stock was announced in January 2004. In January 2005, our board of directors increased the total authorization to repurchase our common stock under our stock buyback program to $30.0 million. There is no expiration date specified for our stock buyback program. ITEM 3. DEFAULTS UPON SENIOR SECURITIES --------------------------------------- None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ----------------------------------------------------------- None. ITEM 5. OTHER INFORMATION ------------------------- None. 34 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K ---------------------------------------- (a) Exhibits (numbered in accordance with Item 601 of Regulation S-K): Exhibit Number Description -------------- ----------- 10.1 Final Settlement Trust Agreement among Chattem, Inc. and AmSouth Bank dated March 16, 2005 10.2 Settlement and Coverage-In-Place Agreement between Interstate Fire & Casualty Company and Chattem, Inc. effective March 18, 2005 10.3 First Amendment to Credit Agreement dated as of December 22, 2004 among Chattem, Inc., its domestic subsidiaries, identified lenders and Bank of America, N.A., as Agent 10.4 Waiver and Second Amendment to Credit Agreement dated as of February 25, 2005 among Chattem, Inc., its domestic subsidiaries, identified lenders and Bank of America, N.A., as Agent 31.1 Certification required by Rule 13a-14(a) under the Securities Exchange Act of 1934 31.2 Certification required by Rule 13a-14(a) under the Securities Exchange Act of 1934 32 Certification required by Rule 13a-14(b) under the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350 (b) During the first quarter ended February 28, 2005, we filed the following Form 8-K reports with the Securities and Exchange Commission: Form 8-K, filed December 20, 2004, announcing a term sheet of settlement between Chattem, Inc. and Interstate Fire & Casualty Company. Form 8-K, filed January 20, 2005, containing a copy of our press release announcing our financial results for the fourth fiscal quarter of 2004. 35 CHATTEM, INC. ------------- SIGNATURES ---------- Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. CHATTEM, INC. ------------------------------------------ (Registrant) Dated: April 1, 2005 /s/ A. Alexander Taylor II ------------- ------------------------------------------ A. Alexander Taylor II President, Chief Operating Officer and Director (Chief Operating Officer) Dated: April 1, 2005 /s/ Richard D. Moss ------------- ------------------------------------------ Richard D. Moss Vice President and Chief Financial Officer (Principal Financial Officer) 36 CHATTEM, INC. AND SUBSIDIARIES ------------------------------ EXHIBIT INDEX ------------- Exhibit Number Description of Exhibit -------------- ---------------------- 10.1 Final Settlement Trust Agreement among Chattem, Inc. and AmSouth Bank dated March 16, 2005 10.2 Settlement and Coverage-In-Place Agreement between Interstate Fire & Casualty Company and Chattem, Inc. effective March 18, 2005 10.3 First Amendment to Credit Agreement dated as of December 22, 2004 among Chattem, Inc., its domestic subsidiaries, identified lenders and Bank of America, N.A., as Agent 10.4 Waiver and Second Amendment to Credit Agreement dated as of February 25, 2005 among Chattem, Inc., its domestic subsidiaries, identified lenders and Bank of America, N.A., as Agent 31.1 Certification required by Rule 13a-14(a) under the Securities Exchange Act of 1934 31.2 Certification required by Rule 13a-14(a) under the Securities Exchange Act of 1934 32 Certification required by Rule 13a-14(b) under the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350 37