10-Q 1 y67941e10vq.txt FORM 10-Q FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D. C. 20549 QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended SEPTEMBER 30, 2004 COMMISSION FILE NUMBER 1-6571 SCHERING-PLOUGH CORPORATION (Exact name of registrant as specified in its charter) New Jersey 22-1918501 (State or other jurisdiction of incorporation) (I.R.S. Employer 2000 Galloping Hill Road Identification No.) Kenilworth, NJ (908) 298-4000 (Address of principal executive offices) (Registrant's telephone 07033 number, (Zip Code) including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES [X] NO [ ] Common Shares Outstanding as of September 30, 2004: 1,472,762,054 PART I. FINANCIAL INFORMATION Item 1. Financial Statements SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES STATEMENTS OF CONDENSED CONSOLIDATED OPERATIONS (UNAUDITED) (Amounts in millions, except per share figures)
Three Months Nine Months Ended Ended September 30, September 30, ---------------------- ---------------------- 2004 2003 2004 2003 ------- ------- ------- ------- Net sales $ 1,978 $ 1,998 $ 6,088 $ 6,386 ------- ------- ------- ------- Cost of sales 711 652 2,241 2,094 Selling, general and administrative 892 873 2,785 2,653 Research and development 378 382 1,201 1,074 Other expense (income), net 34 41 112 49 Special charges 26 350 138 370 Equity (income) from cholesterol joint venture (95) (24) (249) (21) ------- ------- ------- ------- Income/(loss) before income taxes 32 (276) (140) 167 Income taxes (expense)/benefit (6) 11 28 (77) ------- ------- ------- ------- Net income/(loss) $ 26 $ (265) $ (112) $ 90 ------- ------- ------- ------- Preferred stock dividends 12 - 12 - ------- ------- ------- ------- Net income/(loss) available to common shareholders $ 14 $ (265) $ (124) $ 90 ======= ======= ======= ======= Diluted earnings/(loss) per common share $ .01 $ (.18) $ (.08) $ .06 ======= ======= ======= ======= Basic earnings/(loss) per common share $ .01 $ (.18) $ (.08) $ .06 ======= ======= ======= ======= Dividends per common share $ .055 $ .17 $ .165 $ .51 ======= ======= ======= =======
See notes to condensed consolidated financial statements. 2 SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED) (Dollars in millions, except per share figures)
September 30, December 31, 2004 2003 ------------- ------------ Assets Cash and cash equivalents $ 4,685 $ 4,218 Short-term investments 881 587 Accounts receivable, net 1,342 1,329 Inventories 1,516 1,651 Deferred income taxes 460 472 Prepaid expenses and other current assets 550 890 --------------- -------- Total current assets 9,434 9,147 Property, plant and equipment 6,843 6,817 Less accumulated depreciation 2,391 2,290 --------------- -------- Property, net 4,452 4,527 Goodwill 214 218 Other intangible assets, net 241 401 Other assets 762 809 --------------- -------- Total assets $ 15,103 $ 15,102 =============== ======== Liabilities and Shareholders' Equity Accounts payable $ 926 $ 1,030 Short-term borrowings and current portion of long-term debt 866 1,023 Other accrued liabilities 1,942 2,556 --------------- -------- Total current liabilities 3,734 4,609 Long-term debt 2,392 2,410 Other long-term liabilities 729 746 --------------- -------- Total long-term liabilities 3,121 3,156 Shareholders' Equity: Mandatory convertible preferred shares - $1 par value; issued - 28,750,000; $50 per share face value 1,438 - Common shares - $.50 par value; issued:2,029,686,377 1,015 1,015 Paid-in capital 1,251 1,272 Retained earnings 10,452 10,918 Accumulated other comprehensive loss (469) (426) --------------- -------- Total 13,687 12,779 Less treasury shares: 2004 - 556,924,323 shares; 2003 - 558,666,318 shares, at cost 5,439 5,442 --------------- -------- Total shareholders' equity 8,248 7,337 --------------- -------- Total liabilities and shareholders' equity $ 15,103 $ 15,102 =============== ========
See notes to condensed consolidated financial statements. 3 SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES STATEMENTS OF CONDENSED CONSOLIDATED CASH FLOWS FOR THE NINE MONTHS ENDED SEPTEMBER 30, (UNAUDITED) (Amounts in millions)
2004 2003 ------- ------- Operating Activities: Net (loss)/income $ (112) $ 90 Adjustments to reconcile net (loss)/income to net cash provided by operating activities: Tax refund from loss carryback 404 - Tax matters (473) - Special charges (124) 370 Depreciation and amortization 325 297 Changes in assets and liabilities: Accounts receivable (36) 594 Inventories 103 (207) Prepaid expenses and other assets 17 27 Accounts payable and other liabilities (95) (796) ------- ------- Net cash provided by operating activities 9 375 ------- ------- Investing Activities: Capital expenditures (299) (462) Proceeds from transfer of license 118 35 Purchases of investments (294) (212) Other, net (3) 5 ------- ------- Net cash used for investing activities (478) (634) ------- ------- Financing Activities: Cash dividends paid to common shareholders (243) (750) Net change in short-term borrowings (173) 1,136 Proceeds from preferred stock issuance, net 1,394 - Other, net (42) 10 ------- ------- Net cash provided by financing activities 936 396 ------- ------- Effect of exchange rates on cash and cash equivalents - 1 ------- ------- Net increase in cash and cash equivalents 467 138 Cash and cash equivalents, beginning of period 4,218 3,521 ------- ------- Cash and cash equivalents, end of period $ 4,685 $ 3,659 ======= =======
See notes to condensed consolidated financial statements. 4 SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) Basis of Presentation These unaudited condensed consolidated financial statements included herein have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission for reporting on Form 10-Q. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. Certain prior year amounts have been reclassified to conform to the current year presentation. These statements should be read in conjunction with the accounting policies and notes to consolidated financial statements included in the Company's 2003 Annual Report on Form 10-K. In the opinion of management, the financial statements reflect all adjustments necessary for a fair statement of the operations and financial position for the interim periods presented. Revenue Recognition The Company's pharmaceutical products are sold to direct purchasers (e.g., wholesalers, retailers and certain health maintenance organizations). Price discounts and rebates on such sales are paid to federal and state agencies as well as to indirect purchasers and other market participants (e.g., managed care organizations that indemnify beneficiaries of health plans for their pharmaceutical costs and pharmacy benefit managers). The Company recognizes revenue when title and risk of loss passes to the purchaser and when reliable estimates of the following can be determined: i. commercial discount and rebate arrangements; ii. rebate obligations under certain Federal and state governmental programs and; iii. sales returns in the normal course of business. When recognizing revenue the Company estimates and records the applicable commercial and governmental discounts and rebates as well as sales returns that have been or are expected to be granted or made for products sold during the period. These amounts are deducted from sales for that period. Estimates recorded in prior periods are re-evaluated as part of this process. If reliable estimates of these items can not be made, the Company defers the recognition of revenue. Special Charges Special charges for the three months ended September 30, 2004 totaled $26 million, primarily relating to employee termination costs. Special charges for the nine months ended September 30, 2004 totaled $138 million, comprised of $111 million in employee termination costs and $27 million in asset impairment charges. For the nine month period ended September 30, 2003, special charges totaled $370 million, comprised of $20 million of asset impairment charges and $350 million in increased litigation reserves. 5 Employee Termination Costs In August 2003, the Company announced a global workforce reduction initiative. The first phase of this initiative was a Voluntary Early Retirement Program in the United States. Under this program, eligible employees in the United States had until December 15, 2003, to elect early retirement and receive an enhanced retirement benefit. Approximately 900 employees elected to retire under the program, of which approximately 750 employees retired at or near year-end 2003 and approximately 150 employees have staggered retirement dates in the future. The total cost of this program is estimated to be $191 million, comprised of increased pension costs of $108 million, increased post-retirement health care costs of $57 million, vacation payments of $4 million and costs related to accelerated vesting of stock grants of $22 million. For employees with staggered retirement dates in the future, these amounts are being recognized as a special charge over the employees' remaining service periods. This delayed expense recognition follows the guidance in Statement of Financial Accounting Standards (SFAS) No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." Amounts recognized, relating to this program, during the three and nine months ended September 30, 2004 were $2 million and $19 million, respectively, with cumulative costs recognized of $183 million through September 30, 2004. Amounts expected to be recognized during the remainder of 2004 and 2005 are $1 million and $7 million, respectively. In addition to the Voluntary Early Retirement Program in the United States, the Company recognized $23 million and $92 million, respectively, of other employee severance costs for the three and nine months ended September 30, 2004. Asset Impairment Charges Asset impairment charges have been recognized in accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." For the nine months ended September 30, 2004, the Company recognized asset impairment charges of $27 million, based on discounted cash flows. The asset impairments primarily related to the anticipated exit from a small European research-and-development facility. For the nine month period ended September 30, 2003, the Company recognized asset impairment charges of $20 million related to manufacturing facility assets. Litigation Charges During the three and nine months ended September 30, 2003, the Company recognized $350 million of litigation charges primarily as a result of the investigations into the Company's sales and marketing practices (see "Legal, Environmental and Regulatory Matters" footnote for additional information). 6 Summary of Selected Special Charges The following summarizes the activity in the accounts related to employee termination costs and asset impairment charges ($ in millions):
Employee Asset Termination Impairment Costs Charges ----------- ---------- Special charges accrual balance at December 31, 2003 $ 29 $ - Special charges incurred during nine months ended September 30, 2004 111 27 Write-offs - (27) Credit to retirement benefit plan liability (19) - Cash disbursements (78) - ----- ------ Special charges accrual balance at September 30, 2004 $ 43 $ - ===== ======
The balance at September 30, 2004 for employee termination costs represents the value of stock grants ($22 million) not yet distributed and severance payments remaining to be paid ($21 million) as of September 30, 2004. Strategic Agreement In September 2004, the Company announced that it entered into a strategic agreement with Bayer Pharmaceuticals Corporation ("Bayer") intended to enhance the companies' pharmaceutical resources. Commencing in October 2004, in the United States and Puerto Rico, the Company will market, sell and distribute Bayer's primary care products including Avelox (moxifloxacin HCl) and Cipro (ciprofloxacin HCl) under an exclusive license agreement. The Company will pay Bayer substantial royalties on these products based on sales. Also commencing in October 2004, the Company will assume Bayer's responsibilities for U.S. commercialization activities related to the erectile dysfunction medicine Levitra (vardenafil HCl) under Bayer's co-promotion agreement with GlaxoSmithKline PLC. The Company will report its share of Levitra's results as alliance revenue. Additionally, under the terms of the agreement, Bayer will support the promotion of certain of the Company's oncology products in the United States and key European markets for a defined period of time. In Japan, upon regulatory approval, Bayer will co-market the Company's cholesterol absorption inhibitor ZETIA (ezetimibe). This arrangement does not include the rights to any future cholesterol combination product. This agreement with Bayer potentially restricts the Company from marketing products in the United States that would compete with any of the products under the strategic alliance. As a result, the Company expects that it may need to sublicense rights to garenoxacin, the quinolone antibacterial agent that the Company licensed from Toyama Chemical Co. Ltd. ("Toyama"). The Company is exploring its options with regard to garenoxacin and 7 will continue to fulfill its commitments to Toyama under its arrangement, including taking the product through regulatory approval. The Toyama arrangement is discussed in further detail in the "Product License" footnote below. Product License On June 21, 2004, the Company entered into a collaboration and license agreement with Toyama. Under the terms of the agreement, the Company has acquired the exclusive worldwide rights, excluding Japan, Korea and China, to develop, use and sell garenoxacin, Toyama's quinolone antibacterial agent currently in development. In connection with the execution of the agreement, the Company incurred a charge in the second quarter of 2004 for an up-front fee of $80 million to Toyama. This amount has been expensed and reported in "Research and development" for the nine months ended September 30, 2004 in the Statements of Condensed Consolidated Operations. Inventories Inventories consisted of ($ in millions):
September 30, December 31, 2004 2003 ------------- ------------ Finished products $ 551 $ 664 Goods in process 659 648 Raw materials and supplies 306 339 ------ ------ Total inventories $1,516 $1,651 ====== ======
Other Intangible Assets The components of the balance sheet caption "Other intangible assets, net" are as follows ($ in millions):
September 30, 2004 December 31, 2003 ---------------------------------- ---------------------------------- Gross Gross Carrying Accumulated Carrying Accumulated Amount Amortization Net Amount Amortization Net -------- ------------ --- -------- ------------ --- Patents and licenses $418 $277 $141 $614 $318 $296 Trademarks and other 143 43 100 143 38 105 ---- ---- ---- ---- ---- ---- Total other intangible assets $561 $320 $241 $757 $356 $401 ==== ==== ==== ==== ==== ====
These intangible assets are amortized on the straight-line method over their respective useful lives. In the nine months ended September 30, 2004, the Company did not make any payments that were capitalized for patent and licensing rights. For the three months ended September 30, 2004 the net carrying amount of patents and 8 licenses was reduced by approximately $118 million as a result of Bristol-Myers Squibb's reacquisition of co- promotion rights of TEQUIN in the U.S. In the nine months ended September 30, 2003, the Company paid $11 million for patent and licensing rights. These amounts are being amortized over approximately 9 years. The residual value of intangible assets is estimated to be zero. Amortization expense related to other intangible assets for the nine months ended September 30, 2004 and 2003 was $30 million and $41 million, respectively. Other intangible assets are reviewed to determine their recoverability by comparing their carrying values to their expected undiscounted future cash flows when events or circumstances warrant such a review. Full year amortization expense in each of the next five years is estimated to be approximately $40 million per year based on the intangible assets recorded as of September 30, 2004. Accounting for Stock-Based Compensation The following table reconciles net income/(loss) and earnings/(loss) per common share (EPS), as reported, for the three and nine months ended September 30, 2004 and 2003 to pro forma net income/(loss) and EPS, as if the Company had expensed the grant date fair value of both stock options and deferred stock units as permitted by SFAS No. 123, "Accounting for Stock-Based Compensation." These pro forma amounts may not be representative of the initial impact of adopting SFAS No. 123 since, as amended, it permits alternative methods of adoption. ($ in millions, except per share figures):
Three months Nine months ended ended -------------------------- ------------------------- Sept 30, Sept 30, Sept 30, Sept 30, 2004 2003 2004 2003 ------- -------- -------- ------- Net income/(loss), as reported $ 26 $ (265) $ (112) $ 90 Add back: Expense included in reported net income/(loss) for deferred stock units, net of tax 8 14 28 38 Deduct: Pro forma expense as if both stock options and deferred stock units were charged against net income/(loss), net of tax (24) (33) (77) (95) ------ ------- ------- ------ Pro forma net income/(loss) using the fair value method $ 10 $ (284) $ (161) $ 33 ====== ======= ======= ====== Diluted earnings/(loss) per common share: Diluted earnings/(loss) per common share, as reported $ .01 $ (.18) $ (.08) $ .06 Pro forma diluted earnings/(loss) per common share using the fair value method .00 (.19) (.12) .02 Basic earnings/(loss) per common share: Basic earnings/(loss) per common share, as reported $ .01 $ (.18) $ (.08) $ .06 Pro forma basic earnings/(loss) per common share using the fair value method .00 (.19) (.12) .02
Basic and diluted earnings/(loss) per common share are calculated based on net income/(loss) available to common shareholders. 9 Other expense (income), net The components of other expense (income), net are as follows ($ in millions):
Three Months Nine Months Ended Ended September 30, September 30, 2004 2003 2004 2003 ---- ---- ----- ---- Interest cost incurred $ 44 $ 26 $ 144 $ 56 Less: amount capitalized on construction (5) (2) (14) (7) ---- ---- ----- ---- Interest expense 39 24 130 49 Interest income (20) (9) (50) (37) Foreign exchange (gains) losses - (1) 5 1 Other, net 15 27 27 36 ---- ---- ----- ---- Total $ 34 $ 41 $ 112 $ 49 ==== ==== ===== ====
Cash paid for interest, net of amounts capitalized, was $85 million for the nine months ended September 30, 2004. Cash paid for interest, net of amounts capitalized, was $27 million for the nine months ended September 30, 2003. Consent Decree On May 17, 2002, the Company announced that it had reached an agreement with the FDA for a consent decree to resolve issues involving the Company's compliance with current Good Manufacturing Practices (cGMP) at certain manufacturing facilities in New Jersey and Puerto Rico. The U.S. District Court for the District of New Jersey approved and entered the consent decree on May 20, 2002. Under terms of the consent decree, the Company agreed to pay a total of $500 million to the U.S. government in two equal installments of $250 million; the first installment was paid in May 2002, and the second installment was paid in May 2003. As previously reported, the Company accrued a $500 million provision for this consent decree in the fourth quarter of 2001. The consent decree requires the Company to complete a number of actions. In the event certain actions agreed upon in the consent decree are not satisfactorily completed on time, the FDA may assess payments for each deadline missed. The consent decree required the Company to develop and submit for FDA's concurrence comprehensive cGMP Work Plans for the Company's manufacturing facilities in New Jersey and Puerto Rico that are covered by the decree. The Company received FDA concurrence with its proposed cGMP Work Plans on May 14, 2003. The cGMP Work Plans contain a number of Significant Steps whose timely and satisfactory completion are subject to payments of $15,000 per business day for each deadline missed. These payments may not exceed $25 million for 2002, and $50 million for each of the years 2003, 2004 and 2005. These payments are subject to an overall cap of $175 million. In connection with its discussions with FDA regarding the Company's cGMP Work Plans, and pursuant to the terms of the decree, the Company and FDA entered into a letter agreement dated April 14, 2003. In the letter agreement, the Company and FDA agreed to extend by six months the time period during which the Company may incur payments as described above with respect to certain of the Significant Steps whose due dates are 10 December 31, 2005. The letter agreement does not increase the yearly or overall caps on payments described above. In addition, the decree requires the Company to complete programs of revalidation of the finished drug products and bulk active pharmaceutical ingredients manufactured at the covered manufacturing facilities. The Company is required under the consent decree to complete its revalidation programs for bulk active pharmaceutical ingredients by September 30, 2005, and for finished drugs by December 31, 2005. In general, the timely and satisfactory completion of the revalidations are subject to payments of $15,000 per business day for each deadline missed, subject to the caps described above. However, if a product scheduled for revalidation has not been certified as having been validated by the last date on the validation schedule, the FDA may assess a payment of 24.6 percent of the net domestic sales of the uncertified product until the validation is certified. Any such payment would not be subject to the caps described above. Further, in general, if a product scheduled for revalidation under the consent decree is not certified within six months of its scheduled date, the Company must cease production of that product until certification is obtained. The completion of the Significant Steps in the Work Plans and the completion of the revalidation programs are subject to third-party expert certification, which must be accepted by the FDA. The consent decree provides that if the Company believes that it may not be able to meet a deadline, the Company has the right, upon the showing of good cause, to request extensions of deadlines in connection with the cGMP Work Plans and revalidation programs. However, there is no guarantee that FDA will grant any such requests. Although the Company believes it has made significant progress in meeting its obligations under the consent decree, it is possible that (1) the Company may fail to complete a Significant Step or a revalidation by the prescribed deadline; (2) the third party expert may not certify the completion of the Significant Step or revalidation; or (3) the FDA may disagree with an expert's certification of a Significant Step or revalidation. In such a case, it is possible that the FDA may assess payments as described above. The Company would expense any payments assessed under the decree if and when incurred. The consent decree contains a sunset provision that permits the Company to petition the Court to dissolve the decree if, during any five year period following the entry of the decree (May 20, 2002), FDA has not notified the Company that there has been a significant violation of FDA law, regulations, or the decree. If these conditions are satisfied, the decree states that FDA will not oppose the Company's petition. The earliest the Company would be in a position to submit such a petition would be May, 2007 (five years after the entry of the decree). However, the Company cannot predict at this time when or how long FDA may take to complete a review of the Company's completion of its cGMP Work Plans and validation program requirements under the decree. Also, as noted in the "Legal, Environmental and Regulatory Matters" footnote below, in April 2003, the Company received notice of a False Claims Act complaint brought by an individual purporting to act on behalf of the U.S. government against it and approximately 25 other pharmaceutical companies in the U.S. District Court for the Northern District of Texas. The complaint alleges that the pharmaceutical companies, including the Company, have defrauded the United States by having made sales to various federal governmental agencies of drugs that were allegedly manufactured in a manner that did not comply with current Good Manufacturing Practices. The Company and the other defendants filed a motion to dismiss the second amended complaint in this action on April 12, 2004. 11 Equity Income from Cholesterol Joint Venture The Company and Merck have agreements to jointly develop and market ZETIA (ezetimibe) as a once-daily monotherapy, as co-administration of ZETIA with statins, and VYTORIN, a once-daily fixed-combination tablet of ezetimibe and simvastatin (Zocor), Merck's cholesterol-modifying medicine. The agreements also involve the development and marketing of a once-daily, fixed-combination tablet containing CLARITIN and Singulair. Singulair is Merck's once-daily leukotriene receptor antagonist for the treatment of asthma and seasonal allergic rhinitis. In January 2002, Schering-Plough/Merck Pharmaceuticals reported on results of Phase III clinical trials of a fixed-combination tablet containing CLARITIN and Singulair, which did not demonstrate sufficient added benefits in the treatment of seasonal allergic rhinitis. The agreements generally provide for equal sharing of development costs and for co-promotion of approved products by each company in the United States and in most other countries of the world, except Japan. In Japan, no agreement with Merck exists (see "Strategic Agreement" footnote above for information regarding the Company's agreement with Bayer to co-market ZETIA in Japan). In general, co-promotion provides that each company will provide equal physician marketing efforts and that each company will bear the cost of its own sales force in marketing the products. In general, the agreements provide that the venture will operate in a "virtual" mode to the maximum degree possible by relying on the respective infrastructures of the two companies. However, the companies have agreed to share certain costs, but these costs are limited to a portion of the costs of manufacturing, the cost of a specialty sales force and certain specially identified promotion costs. It should be noted that the Company incurs substantial costs, such as selling, general and administrative costs, that are not reflected in "Equity (income) from cholesterol joint venture" and are borne by the overall cost structure of the Company. The agreements do not provide for any jointly owned facilities and, as such, products resulting from the collaboration will be manufactured in facilities owned by either Merck or the Company. During 2003, the Company earned a milestone of $20 million that relates to certain European approvals of ZETIA, and in the first quarter of 2004 the Company earned an additional $7 million milestone relating to the approval of ezetimibe/simvastatin in Mexico. Under certain other conditions, as specified in the agreements, Merck could pay additional milestones to the Company totaling $125 million. The Company utilizes the equity method of accounting for the cholesterol joint venture. Under that method, the Company records its share of the operating profits less its share of the research and development costs in "Equity (income) from cholesterol joint venture" in the Statements of Condensed Consolidated Operations. Operating profit in the context of the joint venture represents net sales, less cost of sales, direct promotion expenses and other costs that the Company and Merck may agree to share. Operating profit excludes the cost of the Company's sales forces throughout the world, as well as the many indirect costs incurred by the Company to support the manufacturing, marketing and management of ZETIA and VYTORIN. As such, the amount reported as "Equity (income) from cholesterol joint venture" represents the contribution the Company receives from the joint venture to fund the costs incurred by the Company that are not shared with Merck. "Equity (income) from cholesterol joint venture" totaled $95 million for the three months ended September 30, 2004. "Equity (income) from cholesterol joint venture" totaled $249 million for the nine months ended September 30, 2004, which includes the $7 million milestone earned for the Mexico approval. U.S. ZETIA sales exceeded a pre-defined annual sales level, as stipulated in the joint venture contract, during the second 12 quarter of 2004. As a result, profit from the U.S. sales of ZETIA will be split 50/50 for the remainder of the year, down from a previously higher profit split. As discussed above, the Company accounts for the Merck/Schering-Plough Cholesterol Partnership under the equity method of accounting. As such the Company's net sales do not include the sales of this joint venture. The joint venture launched VYTORIN in the U.S. market during the third quarter of 2004. In order to ensure immediate product availability at the pharmacy level, purchasers were offered limited, one-time distribution allowances, as well as, extended payment terms on their first orders. Substantially all of the approximately $42 million of VYTORIN net sales made by the joint venture in the third quarter were made under these initial terms. Subsequent sales of product were made under customary terms, which do not have such allowances or extended payment terms. The level of trade inventories for VYTORIN in the U.S. distribution channel is expected to be at normal levels by year-end 2004. Revenue from the sales of VYTORIN is recognized by the joint venture when title and risk of loss has passed to the customer. To date, management of the joint venture has been able to make reliable estimates of product returns, rebates and other discounts for VYTORIN by using the historical experiences of comparable product launches in the U.S. marketplace. Borrowings On November 26, 2003, the Company issued $1.25 billion aggregate principal amount of 5.3 percent senior unsecured notes due 2013 and $1.15 billion aggregate principal amount of 6.5 percent senior unsecured notes due 2033. Interest is payable semi-annually. The net proceeds from this offering were $2.37 billion. Upon issuance, the notes were rated A3 by Moody's Investors Service, Inc. (Moody's), and A+ (on CreditWatch with negative implications) by Standard & Poor's Rating Services (S&P). The interest rates payable on the notes are subject to adjustment as follows: If the rating assigned to a particular series of notes by either Moody's or S&P changes to a rating set forth below, the interest rate payable on that series of notes will be the initial interest rate (5.3 percent for the notes due 2013 and 6.5 percent for the notes due 2033) plus the additional interest rate set forth below for each rating assigned by Moody's and S&P.
Additional Additional Moody's Rating Interest Rate S&P Rating Interest Rate -------------- ------------- ------------- -------------- Baa 1 0.25% BBB+ 0.25% Baa2 0.50% BBB 0.50% Baa3 0.75% BBB- 0.75% Ba 1 or below 1.00% BB+ or below 1.00%
In no event will the interest rate for any of the notes increase by more than 2 percent above the initial coupon rates of 5.3 percent and 6.5 percent, respectively. If either Moody's or S&P subsequently upgrades its ratings, the interest rates will be correspondingly reduced, but not below 5.3 percent or 6.5 percent, respectively. Furthermore, the interest rate payable on a particular series of notes will return to 5.3 percent and 6.5 percent, respectively, and the rate adjustment provisions will permanently cease to apply if, following a downgrade by both Moody's and S&P below A3 or A-, respectively, both Moody's and S&P raise their rating to A3 and A-, respectively, or better. On July 14, 2004, Moody's lowered its rating of the notes to "Baa1" and, accordingly, the interest payable on each note will increase by 25 basis points, respectively, effective December 1, 2004. Therefore, on December 1, 2004, the interest rate payable on the notes due 2013 will increase from 5.3% to 5.55%, and the interest rate 13 payable on the notes due 2033 will increase from 6.5% to 6.75%. This adjustment to the interest rate payable on the notes will increase the Company's interest expense by $6 million annually. The notes are redeemable in whole or in part, at the Company's option at any time, at a redemption price equal to the greater of (1) 100 percent of the principal amount of such notes or (2) the sum of the present values of the remaining scheduled payments of principal and interest discounted using the rate of treasury notes with comparable remaining terms plus 25 basis points for the 2013 notes or 35 basis points for the 2033 notes. Credit Facilities The Company has two revolving credit facilities totaling $1.5 billion. Both facilities are from a syndicate of major financial institutions. The most recently negotiated facility (May 2004) is a $1.25 billion, five-year credit facility. This facility matures in May 2009 and requires the Company to maintain a total debt to total capital ratio of no more than 60 percent. The second credit facility provides a $250 million line of credit through its maturity date in May 2006 and requires the Company to maintain a total debt to total capital ratio of no more than 60 percent anytime the Company is rated at or below Baa3 by Moody's and BBB- by S&P. These facilities are available for general corporate purposes and are considered as support for the Company's commercial paper borrowings. These facilities do not require compensating balances; however, a nominal commitment fee is paid. At September 30, 2004, no funds were drawn under either of these facilities. Shelf Registration On May 11, 2004, the Company's shelf registration, as amended, was declared effective by the SEC. The shelf registered for issuance up to $2 billion in various debt and equity securities. Subsequently, the Company issued $1.438 billion face amount of mandatory convertible preferred stock on August 10, 2004 under the shelf. As of September 30, 2004, $563 million principal amount of securities remain registered and unissued. See below for additional information on the preferred stock issuance. Mandatory Convertible Preferred Stock On August 10, 2004, the Company issued 28,750,000 shares of 6% mandatory convertible preferred stock with a face value of $1.438 billion. Net proceeds to the Company were $1.39 billion after deducting commissions, discounts and other underwriting expenses. The proceeds are being used for general corporate purposes, including the reduction of commercial paper borrowings. The mandatory conversion date of the shares is September 14, 2007. On this date, each share will automatically convert into between 2.2451 and 2.7840 common shares of the Company depending on the average closing price of the Company's common shares over a period immediately preceding the mandatory conversion date, as defined in the prospectus. The preferred shareholders may elect to convert at anytime prior to September 14, 2007 at the minimum conversion ratio of 2.2451 common shares per share of the preferred stock. Additionally, if at anytime prior to the mandatory conversion date, the closing price of the Company's common shares exceeds $33.41 (for at least 20 trading days within a period of 30 consecutive trading days) the Company may elect to cause the conversion of all, but not less than all, of the preferred shares then outstanding at the same minimum conversion ratio of 2.2451 common shares for each preferred share. The preferred stock accrues dividends at an annual rate of 6% on shares outstanding. The dividends are cumulative from the date of issuance and, to the extent the Company is legally permitted to pay dividends and the Board of Directors declares a dividend payable, the Company will pay dividends on each dividend payment 14 date. The dividend payment dates are March 15, June 15, September 15 and December 15, with the first dividend to be paid on December 15, 2004, if so declared by the Board of Directors. A dividend was declared by the Board of Directors on September 28, 2004, payable on December 15, 2004. Credit Ratings Changes in Credit Ratings On February 18, 2004, S&P downgraded the Company's senior unsecured debt ratings to "A-" from "A." At the same time, S&P also lowered the Company's short-term corporate credit and commercial paper rating to "A-2" from "A-1." The Company's S&P rating outlook remains negative. On March 3, 2004, S&P assigned the shelf registration, which was declared effective on May 11, 2004, a preliminary rating of "A-" for senior unsecured debt and a preliminary subordinated debt rating of "BBB+". As of September 30, 2004, $563 million remains registered and unissued under the shelf registration. On April 29, 2004, Moody's placed the Company's senior unsecured credit rating of "A3" on its Watchlist for possible downgrade based upon concerns related to market share declines, litigation risks and a high degree of reliance on the success of VYTORIN. On July 14, 2004, Moody's lowered the Company's senior unsecured credit rating from "A3" to "Baa1", lowered the Company's senior unsecured shelf registration rating from "(P)A3" to "(P)Baa1", lowered the Company's subordinated shelf registration rating from "(P)Baa1" to "(P)Baa2", lowered the Company's cumulative and non-cumulative preferred stock shelf registration rating from "(P)Baa2" to "(P)Baa3", confirmed the Company's "P-2" commercial paper rating and removed the Company from the Watchlist. Moody's rating outlook for the Company is negative. On November 20, 2003, Fitch Ratings (Fitch) downgraded the Company's senior unsecured and bank loan ratings to "A-" from "A+," and its commercial paper rating to "F-2" from "F-1." The Company's rating outlook remained negative. In announcing the downgrade, Fitch noted that the sales decline in the Company's leading product franchise, the INTRON franchise, was greater than anticipated, and that it was concerned that total Company growth is reliant on the performance of two key growth drivers, ZETIA and REMICADE, in the near term. On August 4, 2004, Fitch affirmed the Company's "A-" senior unsecured and bank loan rating and the "F-2" commercial paper rating, and reiterated the negative outlook. Comprehensive Income (Loss) Total comprehensive income (loss) for the three months ended September 30, 2004 and 2003 was $45 million and $(267) million, respectively. Total comprehensive income (loss) for the nine months ended September 30, 2004 and 2003 was $(155) million and $206 million, respectively. 15 Earnings Per Common Share The following table reconciles the components of the basic and diluted EPS computations (amounts in millions):
Three Months Nine Months Ended Ended September 30, September 30, EPS Numerator: 2004 2003 2004 2003 ----- ------- ------ ------ Net income/(loss) $ 26 $ (265) $ (112) $ 90 Less: Preferred stock dividends 12 - 12 - ----- ------- ------ ------ Net income/(loss) available to common shareholders $ 14 $ (265) $ (124) $ 90 ----- ------- ------ ------ EPS Denominator: Average shares outstanding 1,472 1,469 1,472 1,469 for basic EPS Dilutive effect of options and deferred stock units 3 - - 1 ----- ------- ------ ------ Average shares outstanding for diluted EPS 1,475 1,469 1,472 1,470 ----- ------- ------ ------
For the nine months ended September 30, 2004, the equivalent of 88 million common shares issuable under the Company's stock incentive plans were excluded from the computation of diluted EPS because their effect would have been antidilutive. Also, 42 million of common shares obtainable upon conversion of the Company's mandatory convertible preferred stock were excluded from the computation of diluted EPS because their effect would have been antidilutive. See "Mandatory Convertible Preferred Stock" footnote above for additional information. Retirement Plans and Other Post-Retirement Benefits The Company has defined benefit pension plans covering eligible employees in the United States and certain foreign countries, and the Company provides post-retirement health care benefits to its eligible U.S. retirees and their dependents. The components of net pension expense were as follows ($ in millions):
Three months ended Nine months ended September 30, September 30, ------------------ --------------- 2004 2003 2004 2003 ----- ----- ----- ----- Service cost $ 25 $ 24 $ 74 $ 69 Interest cost 33 29 99 85 Expected return on plan assets (37) (40) (113) (117) Amortization, net 9 - 25 - Termination benefits (1) 1 - 12 - Settlement (1) 1 - 5 - ----- ----- ----- ----- Net pension expense $ 32 $ 13 $ 102 $ 37 ===== ===== ===== =====
16 The components of other post-retirement benefits expense were as follows ($ in millions):
Three months ended Nine months ended September 30, September 30, -------------------- -------------------- 2004 2003 2004 2003 -------- -------- ------- -------- Service cost $ 1 $ 2 $ 8 $ 7 Interest cost 2 4 15 12 Expected return on plan assets (1) (4) (9) (12) Amortization, net - - 2 - Termination benefits (1) - - 2 - -------- -------- -------- -------- Net other post-retirement benefits expense $ 2 $ 2 $ 18 $ 7 ======== ======== ======== ========
(1) Termination benefits and Settlement costs primarily relate to the matters discussed in the "Special Charges" footnote. In accordance with FASB Staff Position No. 106-2, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003" (the "Medicare Act"), the Company began accounting for the effect of the federal subsidy under the Medicare Act in the third quarter of 2004. As a result, the Company's accumulated benefit obligation for other post-retirement benefits was reduced by $51 million, and the Company's net other post-retirement benefits expense was reduced by $5 million for the nine months ended September 30, 2004. The reduction in the other post-retirement benefits expense consists of reductions in service cost, interest cost and net amortization of $1 million, $2 million and $2 million, respectively. Segment Data ($ in millions) The Company has three reportable segments: Prescription Pharmaceuticals, Consumer Health Care and Animal Health. The segment sales and profit data that follow are consistent with the Company's current management reporting structure, established in the second quarter of 2003. The Prescription Pharmaceuticals segment discovers, develops, manufactures and markets human ethical pharmaceutical products. The Consumer Health Care segment develops, manufactures and markets OTC, foot care and sun care products, primarily in the United States. The Animal Health segment discovers, develops, manufactures and markets animal health products. Net sales by segment:
Three months ended Nine months ended September 30, September 30, --------------------------- --------------------------- 2004 2003 2004 2003 ------------ ------------ ------------ ------------ Prescription Pharmaceuticals $ 1,556 $ 1,585 $ 4,681 $ 5,101 Consumer Health Care 239 243 868 802 Animal Health 183 170 539 483 ------------ ------------ ------------ ------------ Consolidated net sales $ 1,978 $ 1,998 $ 6,088 $ 6,386 ============ ============ ============ ============
17 Profit by segment:
Three months ended Nine months ended September 30, September 30, -------------------- -------------------- 2004 2003 2004 2003 -------- -------- -------- -------- Prescription Pharmaceuticals $ 83 $ 80 $ 43 $ 496 Consumer Health Care 35 48 180 156 Animal Health 20 19 41 56 Corporate and other (1) (106) (423) (404) (541) -------- -------- -------- -------- Consolidated profit/(loss) before tax $ 32 $ (276) $ (140) $ 167 ======== ======== ======== ========
(1) For the three and nine months ended September 30, 2004, Corporate and other included special charges of $26 million and $138 million, respectively, related to the Voluntary Early Retirement Program, other employee severance costs and asset impairment charges (see "Special Charges" footnote for additional information). Special charges for the three months ended September 30, 2004 relate to the reportable segments as follows: Prescription Pharmaceuticals - $23 million, Consumer Health Care - $1 million and Corporate and other - $2 million. Special charges for the nine months ended September 30, 2004 relate to the reportable segments as follows: Prescription Pharmaceuticals - $119 million, Consumer Health Care - $3 million, Animal Health - $2 million and Corporate and other - $14 million. For the three and nine months ended September 30, 2003, Corporate and other included special charges of $350 million and $370 million, respectively, related to increased litigation reserves of $350 million and asset impairment charges of $20 million (see "Special Charges" footnote for additional information). Corporate and other also includes interest income and expense, foreign exchange gains and losses, headquarters expenses and other miscellaneous items. The accounting policies used for segment reporting are the same as those described in the "Summary of Significant Accounting Policies" in the Company's 2003 Annual Report. Sales of products comprising 10% or more of the Company's U.S. or international sales in the nine months ended September 30, 2004 were as follows ($ in millions):
U.S. International ---- ------------- CLARINEX $ 313 $ 218 NASONEX 271 178 OTC CLARITIN 344 - REMICADE - 535
The Company does not disaggregate assets on a segment basis for internal management reporting and, therefore, such information is not presented. 18 Legal, Environmental and Regulatory Matters Background The Company is involved in various claims and legal proceedings of a nature considered normal to its business, including product liability cases and Superfund sites discussed below. The Company adjusts its accrued liabilities to reflect the current best estimate of its probable loss exposure. Where no best estimate is determinable, the Company accrues the minimum amount within the most probable range of its liability. The recorded liabilities for the above matters at September 30, 2004, and the related expenses incurred during the nine months ended September 30, 2004 were not material. Expected insurance recoveries have not been considered in determining the costs for environmental-related liabilities. The Company believes that, except for the matters discussed in the remainder of this section, it is remote at this time that any material liability in excess of the amounts accrued will be incurred. With respect to the matters discussed in the remainder of this section, except where noted, it is not practicable to estimate a range of reasonably possible loss; where it is, a reserve has been included in the financial statements. Resolution of any or all of the matters discussed in the remainder of this section, individually or in the aggregate, could have a material adverse effect on the Company's results of operations or financial condition. The Company reviews the status of the matters discussed in the remainder of this section on an ongoing basis and from time to time may settle or otherwise resolve them on such terms and conditions as management believes are in the best interests of the Company. The Company is aware that settlements of matters of the types set forth in the remainder of this section, and in particular under "Investigations," frequently involve fines and/or penalties that are material to the financial condition and the results of operations of the entity entering into the settlement. There are no assurances that the Company will prevail in any of these matters, that settlements can be reached on acceptable terms (including the scope of release provided) or in amounts that do not exceed the amounts reserved. Even if an acceptable settlement were to be reached, there can be no assurance that further investigations or litigations will not be commenced raising similar type issues, potentially exposing the Company to additional material liabilities. Further, the Company cannot predict the timing of the resolution of these matters or their outcomes. Patent Matters PRIME PAC PRRS Patent. In January 2000, a jury found that the Company's PRIME PAC PRRS (Porcine Respiratory and Reproductive Syndrome) vaccine infringed a patent owned by Boehringer Ingelheim Vetmedica, Inc ("Boehringer Ingelheim"). An injunction was issued in August 2000 barring further sales of the Company's vaccine. On June 3, 2004, a jury in the United States District Court for the district of New Jersey awarded Boehringer Ingelheim $6.9 million plus interest in this matter. DR. SCHOLL'S FREEZE AWAY Patent. On July 26, 2004, OraSure Technologies filed an action in the U.S. District Court for the Eastern District of Pennsylvania alleging patent infringement by Schering-Plough Healthcare Products by its sale of DR. SCHOLL'S FREEZE AWAY wart removal product. The FREEZE AWAY product was launched in March 2004. For the nine months ended September 30, 2004, net sales of this product totaled approximately $16 million. United Kingdom Patent Infringement Action. On August 6, 2004, the Company brought a patent infringement action in the United Kingdom against Cipla Ltd. and Neolabs Ltd. following the defendants advising of their intent to pursue marketing of desloratadine in the United Kingdom. In 2003, the Company's sales of desloratadine in the United Kingdom were approximately $24.2 million. 19 Investigations Pennsylvania Investigation. On July 30, 2004, Schering-Plough Corporation, the U.S. Department of Justice and the U.S. Attorney's Office for the Eastern District of Pennsylvania announced settlement of the previously disclosed investigation by that Office. Under the settlement, Schering Sales Corporation, an indirect wholly owned subsidiary of Schering-Plough Corporation, has pleaded guilty to a single federal criminal charge concerning a payment to a managed care customer. As a result, Schering Sales Corporation will be excluded from participating in federal healthcare programs. The settlement will not affect the ability of Schering-Plough Corporation to participate in those programs. The aggregate settlement amount is $345.5 million in fines and damages, comprised of a $52.5 million fine to be paid by Schering Sales Corporation, and $293 million in civil damages to be paid by Schering-Plough Corporation. Schering-Plough Corporation will be credited with $53.6 million that was previously paid in additional Medicaid rebates against the civil damages amount, leaving a net settlement amount of $291.9 million. Of that amount, $177.5 million of the total settlement was paid in the third quarter of 2004. The remaining portion will be paid by March 4, 2005. Interest accrues on the unpaid balance at the rate of 4 percent. The payments have been and will be funded by cash from operations, borrowings and proceeds from the issuance of securities. There will be no impact on 2004 full year results related to the Pennsylvania settlement. Under the settlement, Schering-Plough Corporation also entered into a five year corporate integrity agreement with the Office of the Inspector General of the Department of Health and Human Services, under which Schering-Plough Corporation agreed to implement specific measures to promote compliance with regulations on issues such as marketing. Failure to comply can result in financial penalties. Details of the initiation and progress of the investigation can be found in the Company's prior 10-K and 10-Q reports beginning with the 10-K for 1999. The Company cannot predict the impact of this settlement, if any, on other outstanding investigations. AWP Investigations. The Company is responding to investigations by the Department of Health and Human Services, the Department of Justice and certain states into certain industry and Company practices regarding average wholesale price (AWP). These investigations include a Department of Justice review of the merits of a federal action filed by a private entity on behalf of the United States in the U.S. District Court for the Southern District of Florida, as well as an investigation by the U.S. Attorney's Office for the District of Massachusetts, regarding, inter alia, whether the AWP set by pharmaceutical companies for certain drugs improperly exceeds the average prices paid by dispensers and, as a consequence, results in unlawful inflation of certain government drug reimbursements that are based on AWP. In March 2001, the Company received a subpoena from the Massachusetts Attorney General's office seeking documents concerning the use of AWP and other pricing and/or marketing practices. The Company has also responded to subpoenas from the Attorney General of California concerning these matters. The Company is cooperating with these investigations. The outcome of these investigations could include the imposition of substantial fines, penalties and injunctive or administrative remedies. 20 Massachusetts Investigation. The U.S. Attorney's Office for the District of Massachusetts is investigating whether the Company's sales of a product manufactured under a private label arrangement with a managed care organization should have been included in the Company's Medicaid best price calculations. In early November 2002, the Company was served with two additional grand jury subpoenas by the U.S. Attorney for the District of Massachusetts. Among other information, the subpoenas seek a broad range of information concerning the Company's sales, marketing and clinical trial practices and programs with respect to INTRON A, REBETRON and TEMODAR; the Company's sales and marketing contacts with managed care organizations and doctors; and the Company's offering or provision of grants, honorariums or other items or services of value to managed care organizations, physician groups, doctors and educational institutions. The Company understands that this investigation is focused on whether certain sales, marketing and clinical trial practices and conduct related thereto, which in certain instances relate to the use of one or more of the above-mentioned products for indications for which FDA approval had not been obtained - so-called "off-label" uses - were in violation of federal laws and regulations with respect to off-label promotional activities. The investigation also appears to focus on whether drug samples, clinical trial grants and other items or services of value were given to providers to incentivize them to prescribe one or more of the above-mentioned products, including for "off-label" uses, in violation of the federal health care anti-kickback laws. In April 2004, the Company received an additional grand jury subpoena that requests documents concerning PROVENTIL, VANCERIL, VANCENASE, NITRO-DUR, IMDUR, K-DUR and CLARITIN. The subpoena requests (1) documents relating to dealings with certain managed care entities; (2) documents relating to all contracts where the price of one drug is dependent on the purchase of another; (3) documents relating to outside audits in the Medicaid best price area; and (4) documents concerning Warrick Pharmaceuticals ("Warrick"), the Company's generic subsidiary. The Company has received other subpoenas and informal document requests in this investigation. The Company has implemented certain changes to its sales, marketing and clinical trial practices and is continuing to review those practices to ensure compliance with relevant laws and regulations. The Company is cooperating with these investigations. Future sales of INTRON A, REBETRON and TEMODAR may be adversely affected, but the Company cannot at this time predict the ultimate impact, if any, on such sales. The outcome of these investigations could include the commencement of civil and/or criminal proceedings involving the imposition of substantial fines, penalties and injunctive or administrative remedies, including exclusion from government reimbursement programs. During the 2003 third quarter, the Company increased its litigation reserves related to the investigations by the U.S. Attorney's Office for the District of Massachusetts described in this paragraph and the investigation described above by the U.S. Attorney's Office for the Eastern District of Pennsylvania, by $350 million. The increased litigation reserves reflect an adjustment to the Company's estimate of its minimum liability relating to those investigations, in compliance with Generally Accepted Accounting Principles ("GAAP"). Under GAAP, companies are required to estimate and recognize a minimum liability when a loss is probable but no better estimate of the loss can be made. In the fourth quarter of 2002, the Company increased its litigation reserves by $150 million for the same matters. The litigation reserves at September 30, 2004 continue to reflect a minimum liability for the Massachusetts investigation. As noted above, the Pennsylvania investigation has been settled, and therefore, the remaining reserves reflect the agreed upon settlement amounts yet to be paid. The Company notes that its total reserves reflect an estimate and that any final settlement or adjudication of any of these matters could possibly be less than or could materially exceed the aggregate liability accrued by the Company and could have a materially adverse effect on the operations or financial condition of the Company. The Company cannot predict the timing of resolution of these matters or their outcomes. As reported in the 8-K filed May 30, 2003, Schering-Plough has disclosed that, in connection with the above-described investigations by the U.S. Attorney's Office for the District of Massachusetts into its sales, marketing and clinical trial practices, among other matters, on May 28, 2003, Schering Corporation, a wholly owned and significant operating subsidiary of Schering-Plough, received a letter (the "Boston Target Letter") from that 21 Office advising that Schering Corporation (including its subsidiaries and divisions) is a target of a federal criminal investigation with respect to four areas: 1. Providing remuneration, such as drug samples, clinical trial grants and other items or services of value, to managed care organizations, physicians and others to induce the purchase of Schering pharmaceutical products for which payment was made through federal health care programs; 2. Sale of misbranded or unapproved drugs, which the Company understands to mean drugs promoted for indications for which approval by the U.S. FDA had not been obtained (so-called "off-label uses"); 3. Submitting false pharmaceutical pricing information to the government for purposes of calculating rebates required to be paid to the Medicaid program, by failing to include prices of products under a repackaging arrangement with a managed care customer as well as the prices of free and nominally priced goods provided to that customer to induce the purchase of Schering products; and 4. Document destruction and obstruction of justice relating to the government's investigation. A "target" is defined in Department of Justice guidelines as a person as to whom the prosecutor or the grand jury has substantial evidence linking him or her to the commission of a crime and who, in the judgment of the prosecutor, is a putative defendant (U.S. Attorney's Manual, Section 9-11.151). Consumer Products Matter. The U.S. Department of Justice, Antitrust Division, is investigating whether the Company's Consumer Products Division entered into an agreement with another company to lower the commission rate of a consumer products broker. In February 2003, the Antitrust Division served a grand jury subpoena on the Company seeking documents for the first time. The Company is cooperating with the investigation. NITRO-DUR Investigation. In August 2003, the Company received a civil investigative subpoena issued by the Office of Inspector General of the U.S. Department of Health and Human Services, seeking documents concerning the Company's classification of NITRO-DUR for Medicaid rebate purposes, and the Company's use of nominal pricing and bundling of product sales. The Company is cooperating with the investigation. It appears that the subpoena is one of a number addressed to pharmaceutical companies concerning an inquiry into issues relating to the payment of government rebates. Securities and Class Action Litigation On February 15, 2001, the Company stated in a press release that the FDA had been conducting inspections of the Company's manufacturing facilities in New Jersey and Puerto Rico and had issued reports citing deficiencies concerning compliance with current Good Manufacturing Practices, primarily relating to production processes, controls and procedures. The next day, February 16, 2001, a lawsuit was filed in the U.S. District Court for the District of New Jersey against the Company and certain named officers alleging violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. Additional lawsuits of the same tenor followed. These complaints were consolidated into one action in the U.S. District Court for the District of New Jersey, and a lead plaintiff, the Florida State Board of Administration, was appointed by the Court on July 2, 2001. On October 11, 2001, a consolidated amended complaint was filed, alleging the same violations described in the second sentence of this paragraph and purporting to represent a class of shareholders who purchased shares of Company stock from May 9, 2000, through February 15, 2001. The Company's motion to dismiss the consolidated amended complaint was denied on May 24, 2002. On October 10, 2003, the Court certified the shareholder class. Discovery is ongoing. 22 In addition to the lawsuits described in the immediately preceding paragraph, two lawsuits were filed in the U.S. District Court for the District of New Jersey, and two lawsuits were filed in New Jersey state court against the Company (as a nominal defendant) and certain officers, directors and a former director seeking damages on behalf of the Company, including disgorgement of trading profits made by defendants allegedly obtained on the basis of material non-public information. The complaints in each of those four lawsuits relate to the issues described in the Company's February 15, 2001 press release, and allege a failure to disclose material information and breach of fiduciary duty by the directors. One of the federal court lawsuits also includes allegations related to the investigations by the U.S. Attorney's Offices for the Eastern District of Pennsylvania and the District of Massachusetts, the FTC's administrative proceeding against the Company, and the lawsuit by the state of Texas against Warrick, the Company's generic subsidiary. The U.S. Attorney's investigation and the FTC proceeding are described herein. The Texas litigation is described in previously filed Reports on Form 10-K and 10-Q. Each of these lawsuits is a shareholder derivative action that purports to assert claims on behalf of the Company, but as to which no demand was made on the Board of Directors and no decision has been made on whether the Company can or should pursue such claims. In August 2001, the plaintiffs in each of the New Jersey state court shareholder derivative actions moved to dismiss voluntarily the complaints in those actions, which motions were granted. The two shareholder derivative actions pending in the U.S. District Court for the District of New Jersey have been consolidated into one action, which is in its very early stages. On January 2, 2002, the Company received a demand letter dated December 26, 2001, from a law firm not involved in the derivative actions described above, on behalf of a shareholder who also is not involved in the derivative actions, demanding that the Board of Directors bring claims on behalf of the Company based on allegations substantially similar to those alleged in the derivative actions. On January 22, 2002, the Board of Directors adopted a Board resolution establishing an Evaluation Committee, consisting of three directors, to investigate, review and analyze the facts and circumstances surrounding the allegations made in the demand letter and the consolidated amended derivative action complaint described above, but reserving to the full Board authority and discretion to exercise its business judgment in respect of the proper disposition of the demand. The Committee engaged independent outside counsel to advise it and issued a report on the findings of its investigation to the independent directors of the Board in late October 2002. That report determined that the shareholder demand should be refused, and finding no liability on the part of any officers or directors. In November 2002, the full Board adopted the recommendation of the Evaluation Committee. The Company is a defendant in a number of purported nationwide or state class action lawsuits in which plaintiffs seek a refund of the purchase price of laxatives or phenylpropanolamine-containing cough/cold remedies ("PPA products") they purchased. Other pharmaceutical manufacturers are co-defendants in some of these lawsuits. In general, plaintiffs claim that they would not have purchased or would have paid less for these products had they known of certain defects or medical risks attendant with their use. In the litigation of the claims relating to the Company's PPA products, courts in the national class action suit and several state class action suits have denied certification and dismissed the suits. A similar application to deny class certification in New Jersey, the only remaining statewide class action suit involving the Company, was granted on September 30, 2004. Approximately 96 individual lawsuits relating to the laxative products, PPA products and recalled albuterol/VANCERIL/VANCENASE inhalers are also pending against the Company seeking recovery for personal injuries or death. In a number of these lawsuits punitive damages are claimed. On March 31, 2003, the Company was served with a putative class action complaint filed in the U.S. District Court in New Jersey alleging that the Company, Richard Jay Kogan (who resigned as Chairman of the Board November 13, 2002, and retired as Chief Executive Officer, President and Director of the Company April 20, 2003) and the Company's Employee Savings Plan (Plan) administrator breached their fiduciary obligations to certain participants in the Plan. In May 2003, the Company was served with a second putative class action complaint filed in the same court with allegations nearly identical to the complaint filed March 31, 2003. On 23 October 6, 2003, a consolidated amended complaint was filed, which names as additional defendants seven current and former directors and other corporate officers. The Court dismissed this complaint on June 29, 2004. On July 16, 2004, the plaintiffs filed a Notice of Appeal. On August 18, 2003, a lawsuit filed in the New Jersey Superior Court, Chancery Division, Union County, was served on the Company (as a nominal defendant) and the Company's outside directors, alleging breach of fiduciary duty by the directors relating to the Company's receipt of the Boston Target Letter described under the "Investigations" section in this footnote. This action was temporarily stayed pending adjudication of a separate but related action framed as a shareholder request for access to the Company's books and records and seeking documents and other information relating to the Massachusetts investigation. In March 2004, the Superior Court granted the Company's motion for summary judgment and dismissed the books and records action. On September 20, 2004, this case was dismissed by the Court upon consent of the parties. Antitrust and FTC Matters On April 2, 2001, the FTC started an administrative proceeding against the Company, Upsher-Smith, Inc. (Upsher-Smith) and Lederle. The complaint alleged anti-competitive effects from the settlement of patent lawsuits between the Company and Lederle, and the Company and Upsher-Smith. The lawsuits that were settled related to generic versions of K-DUR, the Company's long-acting potassium chloride product, which was the subject of Abbreviated New Drug Applications (ANDAs) filed by Lederle and Upsher-Smith. In June 2002, the administrative law judge overseeing the case issued a decision that the patent litigation settlements complied with the law in all respects and dismissed all claims against the Company. An appeal of this decision to the full Commission was filed by the FTC staff. On December 18, 2003, the full Commission issued an opinion that reversed a 2002 decision of an Administrative Law Judge who had found no violation of the antitrust laws, ruling instead that the Company's settlements did in fact violate those laws. The FTC's decision does not involve a monetary penalty. The Company has appealed the decision to a federal court of appeals. K-DUR is a potassium chloride supplement used by cardiac patients. Following the commencement of the FTC administrative proceeding, alleged class action suits were filed on behalf of direct and indirect purchasers of K-DUR against the Company, Upsher-Smith and Lederle in federal and state courts. These suits all allege essentially the same facts and claim violations of federal and state antitrust laws, as well as other state statutory and/or common law causes of action. On April 6, 2004, the court overseeing these actions in federal court remanded 19 of the approximately 40 lawsuits back to various state courts. On September 30, 2004, the federal court overseeing many of these cases denied the Company's motion to dismiss. Discovery is ongoing. Pricing Matters In December 2001, the Prescription Access Litigation project (PAL), a Boston-based group formed in 2001 to litigate against drug companies, filed a class action suit in Federal Court in Massachusetts against the Company. In September 2002, a consolidated complaint was filed in this court as a result of the coordination by the Multi-District Litigation Panel of all federal court AWP cases from throughout the country. The consolidated complaint alleges that the Company and Warrick Pharmaceuticals, the Company's generic subsidiary, conspired with providers to defraud consumers by reporting fraudulently high AWPs for prescription medications reimbursed by Medicare or third-party payers. The complaint seeks a declaratory judgment and unspecified damages, including treble damages. Included in the litigation described in the prior paragraph are lawsuits that allege that the Company and Warrick reported inflated AWPs for prescription pharmaceuticals and thereby caused state and federal entities and third-party payers to make excess reimbursements to providers. Some of these actions also allege that the Company 24 and Warrick failed to report accurate prices under the Medicaid Rebate Program and thereby underpaid rebates to some states. These actions, which began in October 2001, have been brought by state Attorneys General, private plaintiffs, nonprofit organizations and employee benefit funds. They allege violations of federal and state law, including fraud, antitrust, Racketeer Influenced Corrupt Organizations Act (RICO) and other claims. During the first quarter of 2004, the Company and Warrick were among five groups of companies put on an accelerated discovery track in the proceeding. In addition, Warrick and the Company are defendants in a number of such lawsuits in state courts. The actions are generally brought by states and/or political subdivisions and seek unspecified damages, including treble and punitive damages. SEC Inquiries and Related Litigation On September 9, 2003, the SEC and the Company announced settlement of the SEC enforcement proceeding against the Company and Richard Jay Kogan, former Chairman and Chief Executive Officer, regarding meetings held with investors the week of September 30, 2002, and other communications. Without admitting or denying the allegations, the Company agreed not to commit future violations of Regulation FD and related securities laws and paid a civil penalty of $1 million. Mr. Kogan paid a civil penalty of $50 thousand. On September 25, 2003, a lawsuit was filed in New Jersey Superior Court, Union County, against Richard Jay Kogan and the Company's outside Directors alleging breach of fiduciary duty, fraud and deceit and negligent misrepresentation, all relating to the alleged disclosures made during the meetings mentioned above. The Company removed this case to federal court. The case was remanded to state court. The Company has filed a motion to dismiss. Environmental The Company has responsibilities for environmental cleanup under various state, local and federal laws, including the Comprehensive Environmental Response, Compensation and Liability Act, commonly known as Superfund. At several Superfund sites (or equivalent sites under state law), the Company is alleged to be a potentially responsible party (PRP). Except where a site is separately disclosed, the Company believes that it is remote at this time that there is any material liability in relation to such sites. The Company estimates its obligations for cleanup costs for Superfund sites based on information obtained from the federal Environmental Protection Agency (EPA), an equivalent state agency and/or studies prepared by independent engineers, and on the probable costs to be paid by other PRPs. The Company records a liability for environmental assessments and/or cleanup when it is probable a loss has been incurred and the amount can be reasonably estimated. Residents in the vicinity of a publicly owned waste-water treatment plant in Barceloneta, Puerto Rico, have filed two lawsuits against the plant owner and operator, and numerous companies that discharge into the plant, including a subsidiary of the Company, for damages and injunctive relief relating to odors allegedly coming from the plant and connecting sewers. One of these lawsuits is a class action claiming damages of $600 million. No trial date has been set for these cases, but the matter has been submitted to mediation. The New Jersey Department of Environmental Protection sent the Company a letter, received September 24, 2003, stating that the Company "may be legally responsible for damages to natural resources" in the state. The Department has not adopted regulations covering how such liability is to be calculated, making it difficult to accurately predict the ultimate extent of the Company's exposure. On September 24, 2004, the Company, along with approximately 80 other parties, were named as third-party defendants in a complaint, alleging that it (and other parties) generated waste that was sent to the Burlington Environmental Management Services, Inc. Landfill ("BEMS Site"), located in Southampton Township, Burlington County, New Jersey. The complaint also indicates that the Company and the other 80 parties are 25 liable for costs expended to clean up the BEMS Site under New Jersey's Spill Compensation and Control Act (New Jersey's "Superfund" statute). The Company is currently investigating the allegations. Other Matters The Company is subject to pharmacovigilance reporting requirements in many countries and other jurisdictions, including the United States, the European Union (EU) and the EU member states. The requirements differ from jurisdiction to jurisdiction, but all include requirements for reporting adverse events that occur while a patient is using a particular drug in order to alert the manufacturer of the drug and the governmental agency to potential problems. During pharmacovigilance inspections by officials of the British and French medicines agencies conducted at the request of the European Agency for the Evaluation of Medicinal Products (EMEA), serious deficiencies in reporting processes were identified. The Company is taking urgent actions to rectify these deficiencies as quickly as possible. The Company does not know what action, if any, the EMEA or national authorities will take in response to these findings. Possible actions include further inspections, demands for improvements in reporting systems, criminal sanctions against the Company and/or responsible individuals and changes in the conditions of marketing authorizations for the Company's products. In April 2003, the Company received notice of a False Claims Act complaint brought by an individual purporting to act on behalf of the U.S. government against it and approximately 25 other pharmaceutical companies in the U.S. District Court for the Northern District of Texas. The complaint alleges that the pharmaceutical companies, including the Company, have defrauded the United States by having made sales to various federal governmental agencies of drugs that were allegedly manufactured in a manner that did not comply with current Good Manufacturing Practices. The Company and the other defendants filed a motion to dismiss the second amended complaint in this action on April 12, 2004. Tax Matters In October of 2001, IRS auditors asserted, in reports, that the Company is liable for additional tax for the 1990 through 1992 tax years. The reports allege that two interest rate swaps that the Company entered into with an unrelated party should be recharacterized as loans from affiliated companies. In April of 2004, the Company received a formal Notice of Deficiency (Statutory Notice) from the IRS asserting additional federal income tax due. The Company received bills related to this matter from the IRS on September 7, 2004. Payment in the amount of $194 million for income tax and $279 million for interest was made on September 13, 2004. The Company believes it has complied with all applicable rules and regulations and intends to file a suit for refund for the full amount of the tax and interest. The Company's tax reserves were adequate to cover the above-mentioned payments. 26 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Shareholders and Board of Directors of Schering-Plough Corporation: We have reviewed the accompanying condensed consolidated balance sheet of Schering-Plough Corporation and subsidiaries (the "Corporation") as of September 30, 2004, and the related statements of condensed consolidated operations for the three-month and nine-month periods ended September 30, 2004 and 2003, and the statements of condensed consolidated cash flows for the nine-month periods ended September 30, 2004 and 2003. These interim financial statements are the responsibility of the Corporation's management. We conducted our reviews in accordance with standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our reviews, we are not aware of any material modifications that should be made to such condensed consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America. We have previously audited, in accordance with standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Schering-Plough Corporation and subsidiaries as of December 31, 2003, and the related statements of consolidated operations, shareholders' equity, and cash flows for the year then ended (not presented herein); and in our report dated February 19, 2004, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 2003 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived. /s/Deloitte & Touche LLP Parsippany, New Jersey October 27, 2004 27 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Executive Summary About the Company: Schering-Plough is a research-based pharmaceutical company committed to discovering, developing, manufacturing and marketing new therapies and treatments to enhance human health. As a research-based pharmaceutical company, Schering-Plough invests substantial amounts of funds in scientific research with the goal of creating important medical and commercial value. There is a high rate of failure inherent in scientific research and, as a result, there is a high risk that the funds invested will not generate financial returns. Further compounding this risk profile is the fact that research has a long investment cycle. To bring a pharmaceutical compound from discovery phase to commercial phase may take a decade or more. Because of the high risk nature of research investments, financial resources typically must come from internal sources (operations and cash reserves) or from equity-type capital. The current state of the Company: During the past three years, the Company experienced a confluence of negative events that have strained and continue to strain the Company's financial resources. These negative events converged almost simultaneously and in large part caused a rapid, sharp and material decline in sales, a material increase in costs and material amounts of actual and potential payments for fines, settlements and penalties. These events have had a severe, negative impact on the Company. If this situation were to continue unmitigated, it may impair the Company's ability to invest in marketing and research efforts at historical levels. Throughout this period of time, the Company has held to its core strategy and continued to invest in sales and marketing and scientific research at historical levels. However, this level of investment is not sustainable without a significant increase in cash flow from operations. Unfortunately, increased sales of existing products and cost reductions alone cannot be expected to increase cash flow from operations sufficiently to offset the negative events. In order to maintain its current business model, the Company must introduce new products in the near term. There are two sources of new products: products acquired through acquisition and licensing arrangements, and products in the Company's late-stage research pipeline. With respect to acquisitions and licensing, there are limited opportunities for critical late-stage products, and these limited opportunities typically require substantial amounts of funding. The Company competes for these products against companies often with far greater financial resources than that of the Company. Due to the present financial situation, it will be challenging for the Company to acquire or license critical late-stage products that will have a positive material impact on operating cash flows. 28 With respect to products in the Company's late-stage research pipeline, there is only one product that was recently approved by the FDA, which could materially increase cash flow from operations. That product is VYTORIN, the combination of ZETIA, the Company's cholesterol absorption inhibitor, and Zocor, Merck & Co., Inc.'s (Merck) statin medication. The U.S. approval and commercial launch of VYTORIN enables the Company to expand its position in the approximately $25 billion cholesterol-reduction market, the single largest pharmaceutical market in the world. However, VYTORIN competes against other, well-established cholesterol-management products marketed by companies with financial resources much greater than that of the Company. The financial commitment to compete in this marketplace is shared with Merck; however, profits from VYTORIN are also shared with Merck. If VYTORIN does not provide a material amount of cash flow from operations, the Company would likely evaluate the need to examine strategic alternatives. With regard to an examination of strategic alternatives, the contracts with Merck for ZETIA and VYTORIN and the contract with Centocor, Inc. for REMICADE (exhibits 10 (r) and 10 (u), respectively, to the Company's 2003 Form 10-K) contain provisions dealing with a change of control, as defined in those contracts. These provisions could result in the aforementioned products being acquired by Merck or reverting back to Centocor, Inc., as the case may be. The negative events that converged to strain financial resources during the past three years are summarized as follows: - Since 2001, the Company has been working with the FDA to resolve issues involving the Company's compliance with current Good Manufacturing Practices (cGMP) at certain of its manufacturing sites in New Jersey and Puerto Rico. In 2002, the Company reached a formal agreement with the FDA for a consent decree. Under the terms of the consent decree, the Company has made payments totaling $500 million and agreed to revalidate the manufacturing processes at these sites. These manufacturing sites have remained opened throughout this period; however, the consent decree has placed significant additional controls on production and release of products from these sites, including review and third-party certification of production variances, and, for some products, review and third-party certification of batch production records. The third-party certifications and other cGMP improvement projects have resulted in higher costs as well as reduced output at these facilities. In addition, the Company has found it necessary to discontinue certain older products. The Company's research and development operations have also been negatively impacted by the decree because these operations share common facilities with the manufacturing operations. The Company's commitments under the GMP Work Plan and Validation Program required by the consent decree are scheduled for completion by December 31, 2005. However, the consent decree will not be lifted at that point. The decree will remain in place until the Company successfully petitions the court to have it lifted. Under the terms of the decree, the Company is allowed to petition the court to lift the decree if, after any five year period following the decree's entry in May 2002, the Company has not been notified by FDA of a significant violation of FDA law, regulation, or the decree. Thus, the earliest date by which the Company could petition the court to lift the decree is May 2007 (five years after the decree's entry). The Company has no assurance that the decree will be lifted at that time. The impact of the consent decree is discussed in more detail in the sections that follow. - Certain of the Company's sales and marketing practices are under investigation by the U.S. Attorney's Office in Massachusetts. This investigation poses significant financial and commercial risks to the Company. The Company announced settlement with the U.S. Attorney's Office for the Eastern District of Pennsylvania regarding that Office's investigation into the Company's sales and marketing practices. The settlement requires payments by the Company totaling $345.5 million, of which $53.6 29 million was previously paid in 2003 as additional Medicaid rebates against the damages amount, leaving net payments of $291.9 million. During the third quarter of 2004, $177.5 million was paid related to this settlement. These matters are discussed in further detail in the "Legal, Environmental and Regulatory Matters" footnote included in the financial statements to this report. - In December 2002, the Company switched all formulations of CLARITIN in the United States from prescription to over-the-counter (OTC) status. This switch followed the loss of marketing exclusivity for the product. The average unit selling price for an OTC product is much lower than the price in the prescription market. Further, with the loss of marketing exclusivity, the Company faces additional competition from comparable brands and generics in the OTC marketplace. Prior to 2003, CLARITIN in the United States had been the Company's leading product in terms of sales, and even more so in terms of profit. As a result, the Company has experienced a rapid, sharp and material decline in earnings and cash flow beginning in 2003. - Market shares and sales levels for PEG-INTRON (pegylated interferon) and REBETOL (ribavirin) have fallen significantly, in a market that continues to contract. In late 2002, a competitor entered the hepatitis C marketplace with its own versions of pegylated interferon and ribavirin, and pursued aggressive pricing and marketing practices. Prior to the introduction of these competing products, the Company held a leading position in the hepatitis C market. As a result of the introduction of this competitor, earnings and cash flow from PEG-INTRON have been and may continue to be materially and negatively impacted. In addition, generic forms of REBETOL have been approved in the important U.S. market, also resulting in a material and negative impact on earnings and cash flow. - Sales of other important products have been negatively impacted by overall market conditions. For example, CLARINEX competes in a declining prescription antihistamine market and NASONEX competes in a market with little to no growth. - The Company's manufacturing sites operate well below optimum levels due to the sales declines and the reduction in output related to the consent decree. At the same time, overall costs of operating the manufacturing sites have increased due to the consent decree activities. The impact of this is a material increase in costs. At this time, the major investments in manufacturing capacity are not impaired; however, the Company continues to review the carrying value of these assets for indications of impairment. Future events and decisions may lead to asset impairment losses and accelerated depreciation due to shortened asset lives. In response to the above, a new management team was appointed during 2003. A program was initiated to reduce costs and to reinvest the savings into the business to stabilize market shares of key products and to help ensure the successful launch of VYTORIN. Due to the need to reinvest, the overall cost structure of the Company has not declined. During the third quarter of 2004, market share trends of certain products have begun to show early signs of sequential stabilization. However, overall markets for many of these products continue to contract. No assurance can be given that such stabilization will continue. The Company's ability to generate profits is dependent upon growing sales of existing products, successfully commercializing VYTORIN and controlling expenses. Through the first nine months of 2004, the Company has incurred a net loss of $112 million, which included pre-tax special charges of $138 million and pre-tax research and development charges of $80 million for product licensing fees related to the agreement with Toyama Chemical Co. Ltd. ("Toyama"). Management cannot give assurance that operations will generate profits in the near term, especially if VYTORIN is not a commercial success. 30 Net Sales Consolidated net sales for the third quarter totaled $2.0 billion, a decrease of $20 million or 1 percent compared with the same period in 2003. Consolidated net sales for the third quarter reflected a volume decline of 4 percent and a favorable foreign exchange rate impact of 3 percent. For the nine months, consolidated net sales decreased $298 million or 5 percent versus 2003. Consolidated net sales for the first nine months reflected a volume decline of 9 percent and a favorable foreign exchange rate impact of 4 percent. Net sales in the United States decreased 4 percent versus the third quarter of 2003 and 17 percent for the nine-month period. International sales advanced 1 percent for the third quarter and 5 percent year-to-date compared with the same periods in 2003. International sales included a favorable foreign exchange rate impact of 5 percent for the quarter and 8 percent for the first nine months. The Company accounts for the Merck/Schering-Plough cholesterol joint venture under the equity method of accounting. As such, the Company's net sales do not include the sales of this joint venture. Net sales for the third quarter and nine months ended September 30, were as follows: (Dollars in millions)
Third Quarter Nine Months ------------- ----------- 2004 2003 % 2004 2003 % ---- ---- - ---- ---- - GLOBAL PHARMACEUTICALS $1,556 $ 1,585 (2) $4,681 $ 5,101 (8) Remicade 188 142 33 535 382 40 Clarinex / Aerius 175 169 3 530 561 (6) Nasonex 153 114 34 449 368 22 PEG-Intron 132 172 (23) 425 641 (34) Temodar 121 90 35 309 237 31 Integrilin 94 79 18 245 260 (6) Intron A 81 103 (21) 239 302 (21) Claritin Rx * 67 68 (1) 240 247 (3) Rebetol 52 125 (58) 239 540 (56) Subutex 45 37 22 136 103 32 Elocon 42 41 2 127 121 5 Caelyx 39 30 32 109 78 39 CONSUMER HEALTH CARE 239 243 (1) 868 802 8 OTC 150 149 1 456 441 3 OTC Claritin 110 111 (1) 344 336 2 Foot Care 86 80 9 252 224 12 Sun Care 3 14 (79) 160 137 17 ANIMAL HEALTH 183 170 8 539 483 12 ------ ------- ---- ------ ------- ---- CONSOLIDATED NET SALES $1,978 $ 1,998 (1) $6,088 $ 6,386 (5) ------ ------- ---- ------ ------- ----
* Includes international sales of CLARITIN Rx only. Canadian sales of CLARITIN are now reported in the OTC line within Consumer Health Care. The prior period has been reclassified accordingly. Certain prior period amounts have been reclassified to conform to the current year presentation. Global net sales of CLARINEX (marketed as AERIUS in many countries outside the U.S.) for the treatment of seasonal outdoor allergies and year-round indoor allergies were $175 million in the third quarter of 2004, an increase of 3 percent versus the third quarter of 2003. Sales outside the U.S. climbed 39 percent to $57 million in the third quarter due to market share gains and continued conversion from prescription CLARITIN. U.S. 31 sales decreased 8 percent to $118 million in the third quarter due to the continued contraction in the U.S. prescription antihistamine market following the launch of OTC CLARITIN and other branded and non-branded nonsedating antihistamines coupled with market share declines. Global net sales of CLARINEX decreased 6 percent to $530 million for the nine-month period. International net sales of REMICADE, for the treatment of rheumatoid arthritis, Crohn's disease and ankylosing spondylitis, were up $46 million or 33 percent to $188 million in the third quarter and were up $153 million or 40 percent to $535 million for the first nine months. The increase was primarily due to greater medical use and expanded indications in European markets. Global net sales of NASONEX Nasal Spray, a once-daily corticosteroid nasal spray for allergies, rose 34 percent to $153 million in the third quarter primarily due to favorable trade inventory comparisons in the U.S. Global net sales increased 22 percent to $449 million for the first nine months primarily due to favorable trade inventory comparisons in the U.S. coupled with international sales growth, tempered by a decline in U.S. market share. International sales of NASONEX grew 23 percent to $48 million for the quarter and 23 percent to $178 million for the nine-month period due to market share gains and market growth. Global net sales of PEG-INTRON Powder for Injection, a pegylated interferon product for treating hepatitis C, decreased 23 percent to $132 million in the third quarter and decreased 34 percent to $425 million year-to-date due to ongoing market competition in a contracting market. Market share of PEG-INTRON has been declining, reflecting the entrance of a competitor's new products in the hepatitis C market in 2003. Global net sales of TEMODAR Capsules, for treating certain types of brain tumors, increased 35 percent to $121 million for the third quarter and increased 31 percent to $309 million year-to-date due to increased market penetration. Global net sales of INTRON A Injection, for chronic hepatitis B and C and other antiviral and anticancer indications, decreased 21 percent to $81 million for the third quarter and 21 percent to $239 million year-to-date due primarily to lower demand. In the third quarter and first nine months of 2004, global net sales of REBETOL Capsules for use in combination with INTRON or PEG-INTRON for treating hepatitis C, decreased 58 percent to $52 million and 56 percent to $239 million, respectively, due to ongoing competition including the launch of generic versions of REBETOL in the United States in April 2004 and increased price competition outside the U.S. International net sales of prescription CLARITIN decreased 1 percent to $67 million in the third quarter and decreased 3 percent to $240 million for the nine month period of 2004 due to the continued conversion to CLARINEX. Global net sales of INTEGRILIN Injection, a glycoprotein platelet aggregation inhibitor for the treatment of patients with acute coronary syndromes which is sold primarily in the U.S., increased 18 percent to $94 million for the third quarter due to increased patient utilization coupled with favorable U.S. trade inventory comparisons. Global net sales decreased 6 percent to $245 million for the first nine months of 2004 due to unfavorable changes in U.S. trade inventory levels. Millennium Pharmaceuticals, Inc. ("Millennium") and the Company have a co- promotion agreement for INTEGRILIN. Millennium notified the Company that it intends to exercise its right under the agreement to assume responsibilities for consumer service, managed care contracting, government reporting and physical distribution of INTEGRILIN. As a result, as early as the fourth quarter of 2005, the Company expects to cease recording sales of INTEGRILIN and would begin to record its share of the co-promotion profits as alliance revenue. This change in reporting would have no impact on earnings. 32 International sales of SUBUTEX, for the treatment of opiate addiction, increased 22 percent to $45 million in the third quarter and 32 percent to $136 million for the nine-month period due to increased market penetration. International net sales of CAELYX, for the treatment of ovarian cancer, metastatic breast cancer and Kaposi's sarcoma, increased 32 percent to $39 million for the third quarter and 39 percent to $109 million for the first nine months of 2004. The increase reflects the launch of expanded indications including the treatment of metastatic breast cancer in patients who are at increased cardiac risk. Contributing to the decline in global sales in the third quarter and first nine months of 2004 was the absence of LOSEC revenues in Europe, as the Company's agreement with AstraZeneca ended in the 2003 third quarter. LOSEC revenues were $52 million in the third quarter of 2003 and $130 million for the first nine months of 2003. Net sales of consumer health care products, which include OTC, foot care and sun care products, decreased $4 million or 1 percent in the third quarter. Sales of OTC CLARITIN for the third quarter of 2004 were $110 million, down 1 percent from $111 million in 2003. The decrease in sales was due to competition from branded and private label loratadine. For the year-to-date period of 2004, net sales of consumer health care products increased $66 million or 8 percent. Sales of foot care products increased 9 percent to $86 million in the third quarter and 12 percent to $252 million year-to-date due primarily to the successful launch of FREEZE AWAY, a wart-remover product. Net sales of sun care products increased $23 million or 17 percent year-to-date due to the timing of orders and shipments coupled with favorable weather conditions. Global net sales of animal health products increased 8 percent in the third quarter of 2004 to $183 million and 12 percent to $539 million for the nine-month period. Sales were favorably impacted by foreign exchange of 4 percent and 7 percent for the quarter and nine-month period, respectively. Costs and Expenses Cost of sales as a percentage of net sales increased to 35.9 and 36.8 percent for the third quarter and first nine months of 2004, respectively, versus 32.6 and 32.8 percent in the third quarter and nine-month period of 2003. The increase was primarily due to lower production volumes coupled with increased spending related to the FDA consent decree and efforts to upgrade the Company's global infrastructure. The absence of European LOSEC revenues in both the third quarter and nine months of 2004 contributed to the unfavorable comparison as well. Selling, general and administrative expenses increased $19 million or 2 percent to $892 million for the third quarter and increased $132 million or 5 percent to $2.8 billion for the first nine months of 2004. The increase was primarily due to higher sales force costs associated with the previously reported field force expansion coupled with the unfavorable impact of foreign exchange, tempered by lower promotional spending. The third quarter and year-to-date ratios to net sales of 45.1 and 45.7 percent, respectively, are higher than the 43.7 and 41.5 percent ratios in the respective prior year periods, primarily due to these increased costs coupled with the lower overall sales reported in the 2004 periods. 33 Research and development spending decreased 1 percent to $378 million in the third quarter and increased 12 percent to $1.2 billion year-to-date, representing 19.1 and 19.7 percent of net sales, respectively. The decrease in research and development spending for the third quarter is primarily due to the timing of spending on research programs. Research and development spending for the nine-month period of 2004 includes an $80 million charge in conjunction with the license from Toyama Chemical Company Ltd. for garenoxacin, a quinolone antibiotic currently in development. Other expense (income), net for the third quarter of 2004 decreased versus the third quarter of 2003 due primarily to provisions for asset write-offs in the prior year, offset by higher net interest expense. Other expense (income), net for the first nine months of 2004 reflects higher net interest expense. Interest expense increased primarily because the Company changed the composition of its debt portfolio. Prior to this change, the Company was financed entirely with short-term debt (primarily commercial paper). In the fourth quarter of 2003, the Company issued $2.4 billion of fixed-rate, long-term debt. Although the interest rate on the long-term debt is higher than the rate on short-term debt, this change in composition of the debt portfolio decreased the inherent risk associated with reliance on short-term financing. Interest expense also increased because overall borrowings have increased over the prior year. Partially offsetting the higher interest expense is an increase in interest income due to higher investment balances as well as the interest income from the investment of the proceeds from the August 2004 issuance of the mandatory convertible preferred shares. Special Charges Special charges for the three months ended September 30, 2004 totaled $26 million, primarily relating to employee termination costs. Special charges for the nine months ended September 30, 2004 were comprised of $111 million of employee termination costs and $27 million of asset impairment charges. For the nine month period ended September 30, 2003 special charges totaled $370 million, comprised of $350 million to increase litigation reserves and $20 million of asset impairment charges. Employee Termination Costs In August 2003, the Company announced a global workforce reduction initiative. The first phase of this initiative was a Voluntary Early Retirement Program (VERP) in the United States. The total cost of this program is estimated to be $191 million, comprised of increased pension costs of $108 million, increased post-retirement health care costs of $57 million, vacation payments of $4 million and costs related to accelerated vesting of stock grants of $22 million. Amounts recognized relating to this program during the third quarter and first nine months of 2004 were $2 million and $19 million, respectively, with cumulative costs of $183 million recognized through September 30, 2004. Amounts expected to be recognized during the remainder of 2004 and 2005 are $1 million and $7 million, respectively. In addition to the VERP, the Company recognized $23 million and $92 million of other employee severance costs in the third quarter and nine-month period of 2004, respectively, primarily outside the United States. Asset Impairment Charges The Company recognized $27 million of asset impairment charges in the first nine months of 2004, primarily related to the anticipated exit from a small European research-and-development facility. The Company recognized $20 million of asset impairment charges in the first nine months of 2003 related to manufacturing facility assets. 34 Litigation Charges During the three and nine months ended September 30, 2003, the Company recognized $350 million of litigation charges, primarily as a result of the investigations into the Company's sales and marketing practices (see "Legal, Environmental and Regulatory Matters" footnote for additional information). Equity Income from Cholesterol Joint Venture Global cholesterol franchise sales, which include ZETIA and VYTORIN, totaled $344 million in the 2004 third quarter and $780 million year-to-date compared with sales of $137 million and $306 million in the third quarter and first nine months of 2003, respectively. VYTORIN has now been approved in 11 countries and has completed the European Mutual Recognition Process (MRP) as of October 1, 2004. ZETIA has been approved in 71 countries. In the United States, more than 12 million prescriptions have been written for the product since its U.S. launch in November 2002, according to IMS Health. The Company utilizes the equity method of accounting for its cholesterol joint venture with Merck. Under that method, the Company records its share of the operating profits less its share of the research and development costs in "Equity (income) from cholesterol joint venture." Operating profit in the context of the joint venture represents net sales, less cost of sales, direct promotion expenses and other costs that the Company and Merck may agree to share. Operating profit excludes the cost of the Company's sales forces throughout the world, as well as the many indirect costs incurred by the Company to support the manufacturing, marketing and management of ZETIA and VYTORIN. As such, the amount reported as "Equity (income) from cholesterol joint venture" represents the contribution the Company receives from the joint venture to fund the costs incurred by the Company that are not shared with Merck. "Equity (income) from cholesterol joint venture," as defined, totaled $95 million in the third quarter of 2004 versus $24 million in the third quarter of 2003. For 2004 year-to-date, equity income from cholesterol joint venture totaled $249 million including a $7 million milestone earned as a result of the approval in Mexico of the ezetimibe/simvastatin product, versus $21 million for the first nine months of 2003. Net income/(loss) Net income/(loss) was income of $26 million for the 2004 third quarter versus a loss of ($265) million in 2003. Net income in the third quarter of 2004 includes pre-tax special charges of $26 million, as described above. Net loss in the third quarter of 2003 includes a non-tax deductible special charge of $350 million, as described above. Net income/(loss) was a loss of ($112) million for the first nine months of 2004 versus income of $90 million in 2003. Net loss for year-to-date 2004 includes a pre-tax research and development charge of $80 million for the license of garenoxacin from Toyama Chemical Company Ltd. as well as pre-tax special charges of $138 million, as described above. Net income for the first nine months of 2003 includes special charges of $370 million, as described above. Effective Tax Rate The effective tax rate was 20.0 percent in the third quarter and first nine months of 2004. The effective tax rate was 15.0 percent for the first nine months of 2003 excluding the $350 million non-tax deductible special charge in 2003 to increase litigation reserves. 35 Liquidity and Financial Resources - nine months ended September 30, 2004 Background The following background information presents the current state of the Company's liquidity and financial resources. At September 30, 2004, the majority of cash and cash equivalents and short-term investments shown in the accompanying balance sheet were held by wholly-owned, foreign-based subsidiaries. At the same time, substantially all of the debt shown in the accompanying balance sheet was owed by the parent company. In the past, this geographic disparity between the location of funds and the location of debt was not a pivotal issue for the Company. However, with the material decline in earnings following the loss of marketing exclusivity of CLARITIN in the United States, this geographic disparity has taken on more importance. On a consolidated basis, dividends and capital expenditures exceed cash generated from operations. This excess becomes particularly pronounced when disaggregated on a geographic basis. Foreign operations generate cash in excess of cash needs. However, U.S. operations have cash needs well in excess of cash generated in the U.S. The U.S. operations fund dividend payments, the vast majority of research and development costs and approximately half of the worldwide capital expenditures. In the past, these cash needs were funded primarily through operations. However, following the loss of marketing exclusivity of CLARITIN, U.S. profits declined materially and U.S. cash needs now exceed U.S. cash generation. Cash and cash equivalents, plus short-term investments, exceeded total debt at September 30, 2004 by $2.3 billion. However, as discussed above, the majority of cash is held by foreign-based subsidiaries, and the U.S. operations have cash needs and carry substantially all the debt. Generally, using the funds held by the foreign-based subsidiaries for the cash needs of the U.S.-based subsidiaries results in U.S. income tax payments. The amount of any U.S. income tax payments would depend upon a number of factors, including the amount of the funds used, whether the U.S. operations were generating taxable profits or losses and changes in U.S. tax laws (see discussion of the "American Jobs Creation Act of 2004" below). In 2003, the U.S. operations generated tax losses, primarily due to the decline of CLARITIN sales and the continued investment in research and development. For 2003, the entire amount of the U.S. tax losses was used to recoup taxes paid in previous years (carryback benefit). In 2004, management expects the U.S. operations to again generate tax losses. However, only a portion of these losses is expected to be used to recoup taxes paid in previous years because, under current law, the Company's U.S. carryback benefit will be exhausted. The amount of the expected 2004 loss in excess of that used to recoup taxes paid in previous years becomes available to reduce taxable income in the future (carryforward benefit). When the U.S. operations generate losses that cannot be used to recoup taxes paid in previous years, the Company has a choice. It can either use the carryforward benefits in future years, or utilize some or all of those losses to absorb taxable distributions to the U.S. of cash or other assets held by the foreign-based subsidiaries. Absorbing the U.S. operating losses in this manner allows a portion of the assets held by the foreign-based subsidiaries to become available for use in the U.S. operations without having to make additional U.S. income tax payments. See discussion of the "American Jobs Creation Act of 2004" below. 36 On October 22, 2004, the President signed the "American Jobs Creation Act of 2004" (the "Act"). A provision of this Act allows companies to repatriate funds held by foreign-based subsidiaries at a reduced tax rate under certain circumstances. The Company is currently evaluating the provisions of the Act and is investigating the repatriation of foreign-based subsidiaries' funds under its provisions. In 2005, and possibly beyond, the Company expects to finance a portion of its U.S. cash needs by accessing the funds held by foreign based subsidiaries. The Company expects to access these funds either by repatriating some of these amounts and utilizing some or all of its current U.S. operating losses or by repatriating funds under the provisions of the Act. If funds were to be repatriated under the Act, a tax payment would be due, albeit at a reduced rate. Any such tax payment will be accrued in future periods. Also, repatriation of funds under the Act will not reduce the Company's operating losses. These losses can be carried forward to offset future taxable income. Based on the provisions of the Act, a maximum of $9.2 billion of undistributed foreign earnings may be eligible for repatriation under the Act. As indicated above, the Company is considering the details of the Act. If a decision is made that some or all of the unremitted foreign earnings are no longer considered permanently reinvested, additional tax will be payable which could be recognized as early as the fourth quarter of 2004. Discussion of Cash Flow Cash provided by operating activities totaled $9 million for the first nine months of 2004. This amount includes the receipt of $404 million for a U.S. tax refund relating to the 2003 "carryback benefit" described above, the payment of $473 million to the U.S. government for a tax deficiency related to certain transactions entered into in 1991 and 1992 and the payment of $177.5 million under the settlement agreement with the U.S. Attorney's Office for the Eastern District of Pennsylvania. The final payment under the settlement agreement is $114.4 million, plus interest which accrues on the unpaid balance at 4 percent per year, due by March 4, 2005. (See the "Legal, Environmental and Regulatory Matters" footnote included in the financial statements to this report.) For the first nine months of 2004 operating activities provided minimal cash. As a result, capital expenditures and dividends were funded through the existing cash balances, borrowings and the mandatory convertible preferred stock issuance. As discussed above, this overall net use of cash occurred entirely in the U.S. operations. Foreign operations generated net cash of approximately $795 million through the first nine months, but the net use of cash in the U.S. totaled approximately $1.3 billion during this same period of time. Through the first nine months of 2004, the cash shortfall in the U.S. was funded with cash that was available in the U.S. at the beginning of the year, as well as with the proceeds received from the issuance of $1.438 billion of mandatory convertible preferred shares, discussed below, and U.S. commercial paper borrowings. In August 2004, the Company issued 6% mandatory convertible preferred stock (see "Mandatory Convertible Preferred Stock" footnote included in the financial statements to this report) and received net proceeds of $1.39 billion after deducting commissions, discounts and other underwriting expenses. The proceeds were used to reduce short-term commercial paper borrowings, for the payment of settlement amounts and litigation costs (as described above), funding of operating expenses, shareholder dividends and capital expenditures. The preferred 37 stock was issued under the Company's $2.0 billion shelf registration. As of September 30, 2004, $563 million remains registered and unissued under the shelf registration. For the remainder of 2004 and for 2005, the net use of cash in the U.S. operations is expected to continue. The Company expects to use commercial paper borrowings to fund the U.S. operations through the end of 2004. Beginning in early 2005, however, the Company expects to have to access the funds held by its foreign-based subsidiaries to fund its U.S. operations. The tax implications of accessing these funds is discussed above. The Company's credit rating could decline further. The impact of such decline could be reduced availability of commercial paper borrowing and would increase the interest rate on the Company's long-term debt. If this were to occur, the Company may have to seek short-term financing from other sources at higher interest rates than that of commercial paper, or to repatriate additional funds currently held by foreign affiliates that would incur additional U.S. income tax. Borrowings and Credit Facilities On November 26, 2003, the Company issued $1.25 billion aggregate principal amount of 5.3 percent senior unsecured notes due 2013 and $1.15 billion aggregate principal amount of 6.5 percent senior unsecured notes due 2033. Proceeds from this offering of $2.4 billion were used for general corporate purposes, including to repay commercial paper outstanding in the United States. Upon issuance, the notes were rated A3 by Moody's Investors' Service (Moody's) and A+ (on CreditWatch with negative implications) by Standard & Poor's (S&P). The interest rates payable on the notes are subject to adjustment. If the rating assigned to the notes by either Moody's or S&P is downgraded below "A3" or "A-," respectively, the interest rate payable on that series of notes will increase. See the "Borrowings" footnote included in the financial statements to this report for additional information. On July 14, 2004, Moody's lowered its rating on the notes to "Baa1". Accordingly, the interest payable on each note will increase 25 basis points, respectively, effective December 1, 2004. Therefore, on December 1, 2004, the interest rate payable on the notes due 2013 will increase from 5.3% to 5.55%, and the interest rate payable on the notes due 2033 will increase from 6.5% to 6.75%. This adjustment to the interest rate payable on the notes will increase the Company's interest expense by $6 million annually. The Company has two revolving credit facilities totaling $1.5 billion. Both facilities are from a syndicate of major financial institutions. The most recently negotiated facility (May 2004) is a $1.25 billion, five-year credit facility. This facility matures in May 2009 and requires the Company to maintain a total debt to total capital ratio of no more than 60 percent. The second credit facility provides a $250 million line of credit through its maturity date in May 2006 and requires the Company to maintain a total debt to total capital ratio of no more than 60 percent anytime the Company is rated at or below Baa3 by Moody's and BBB- by S&P. These facilities are available for general corporate purposes and are considered as support for the Company's commercial paper borrowings. These facilities do not require compensating balances; however, a nominal commitment fee is paid. At September 30, 2004, no funds were drawn under either of these facilities. At September 30, 2004, short-term borrowings totaled $866 million. Approximately 91 percent of this was outstanding commercial paper. The commercial paper ratings discussed below have not significantly affected the Company's ability to issue or rollover its outstanding commercial paper borrowings at this time. However, the Company believes the ability of commercial paper issuers, such as the Company, with one or more short-term credit ratings of "P-2" from Moody's, "A-2" from S&P and/or "F2" from Fitch Ratings (Fitch) to issue or rollover outstanding commercial paper can, at times, be less than that of companies with higher short-term 38 credit ratings. In addition, the total amount of commercial paper capacity available to such issuers is typically less than that of higher rated companies. The Company maintains sizable lines of credit with commercial banks, as well as cash and short-term investments held by foreign-based subsidiaries, to serve as alternative sources of liquidity and to support its commercial paper program. Credit Ratings On February 18, 2004, S&P downgraded the Company's senior unsecured debt ratings to "A-" from "A." At the same time, S&P also lowered the Company's short-term corporate credit and commercial paper rating to "A-2" from "A-1." The Company's S&P rating outlook remains negative. On May 11, 2004, the shelf registration, as amended, that allowed the Company to issue up to $2 billion in various debt and equity securities was declared effective by the SEC. On March 3, 2004, S&P assigned the shelf registration a preliminary rating of "A-" for senior unsecured debt and a preliminary subordinated debt rating of "BBB+". As of September 30, 2004, $563 million remains registered and unissued under the shelf registration. On April 29, 2004, Moody's placed the Company's senior unsecured credit rating of "A3" on its Watchlist for possible downgrade based upon concerns related to market share declines, litigation risks and a high degree of reliance on the success of VYTORIN. On July 14, 2004, Moody's lowered the Company's senior unsecured credit rating from "A3" to "Baa1", lowered the Company's senior unsecured shelf registration rating from "(P)A3" to "(P)Baa1", lowered the Company's subordinated shelf registration rating from "(P)Baa1" to "(P)Baa2", lowered the Company's cumulative and non-cumulative preferred stock shelf registration rating from "(P)Baa2" to "(P)Baa3", confirmed the Company's "P-2" commercial paper rating and removed the Company from the Watchlist. Moody's rating outlook for the Company is negative. See the "Borrowings and Credit Facilities" section above for a discussion of the impact of Moody's rating downgrade on the interest rates payable on the Company's long-term debt. On November 20, 2003, Fitch downgraded the Company's senior unsecured and bank loan ratings to "A-" from "A+," and its commercial paper rating to "F-2" from "F-1." The Company's rating outlook remained negative. In announcing the downgrade, Fitch noted that the sales decline in the Company's leading product franchise, the INTRON franchise, was greater than anticipated, and that it was concerned that total Company growth is reliant on the performance of two key growth drivers, ZETIA and REMICADE, in the near term. On August 4, 2004, Fitch affirmed the Company's "A-" senior unsecured rating and bank loan rating and the "F-2" commercial paper rating, and reitereated the negative outlook. Financial Arrangements Containing Credit Rating Downgrade Triggers The Company has an interest rate swap arrangement that contains a credit rating downgrade trigger. This arrangement requires the Company to maintain a long-term debt rating of at least "A2" by Moody's or "A" by S&P. Both S&P's and Moody's current credit ratings are below this specified minimum. As a result, the counterparty to the interest rate swap can elect early termination following a specified period, as described below. This arrangement utilizes two long-term interest rate swap contracts (each contract consisting of twenty individual confirmations). One contract is between a foreign-based subsidiary and a bank, and the other contract is between a U.S. subsidiary and the same bank. The two contracts have equal and offsetting terms and are covered by a master netting arrangement. The contract involving the foreign-based subsidiary permits the 39 subsidiary to prepay a portion of its future obligation to the bank, and the contract involving the U.S. subsidiary permits the bank to prepay a portion of its future obligation to the U.S. subsidiary. Interest is paid on the prepaid balances by both parties at market rates. Prepayments totaling $1.9 billion have been made under both contracts as of September 30, 2004 and December 31, 2003. The prepaid amounts have been netted in the preparation of the condensed consolidated balance sheet in accordance with Financial Accounting Standards Board (FASB) Interpretation No. 39, "Offsetting of Amounts Related to Certain Contracts." The arrangement provides that in the event the Company fails to maintain the required minimum credit ratings, the counterparty may terminate the transaction by designating an early termination date not earlier than 36-months following the date of such notice to terminate. Both S&P's and Moody's current credit ratings are below the specified minimum. As of this date the counterparty has not given the company notice to terminate. Early termination requires repayment of all prepaid amounts, and repayment must occur in the original tax jurisdiction in which the prepaid amounts were made. Accordingly, early termination would require the Company's U.S. subsidiary to repay $1.9 billion to the bank and for the bank to repay $1.9 billion to the Company's foreign-based subsidiary. The financial impact of early termination depends on the manner and extent to which the Company decides to finance its U.S. repayment obligation. The Company could finance its entire obligation by obtaining short- or long-term financing in the United States. (In this case, cash and debt would increase by equal amounts in the consolidated balance sheet.) However, the Company's ability to finance its obligation under the swaps will depend on the Company's credit ratings and business operations, as well as market conditions, at the time such financing is contemplated. Alternatively, the Company could repatriate to the United States some or all of the funds received by the foreign-based subsidiary. Repatriating funds could have U.S. income tax consequences depending primarily on profitability of the U.S. operations. Any such tax would be accrued against future earnings, and may result in the Company reporting a higher effective tax rate. Currently, the U.S. operations are generating tax losses. However, future tax losses may be insufficient to absorb any or all of the potential tax should the Company repatriate some or all of the funds received by the foreign-based subsidiary. Under the "American Jobs Creation Act of 2004" previously discussed in this "Liquidity and Financial Resources" section, the Company may be able to finance its U.S. repayment obligation by repatriating the funds received by the foreign-based subsidiary at a significantly reduced tax cost. As stated above, both S&P's and Moody's current credit ratings are below the specified minimum, however, termination of the transaction is not required to occur earlier than 36 months following the date on which the Company receives a termination notice from the counterparty. As of this date, the Company has not received a termination notice from the counterparty. Accordingly, early termination is not imminent. Due to this fact, as well as the alternative courses of action available to the Company in the event of early termination, the potential of early termination does not impact current liquidity and financial resources. 40 The Company had a second, unrelated interest rate swap arrangement that was terminated earlier in 2004 due to the Company's recent credit rating downgrade. The impact of the termination was not material. Additional Factors Influencing Operations In the United States, many of the Company's pharmaceutical products are subject to increasingly competitive pricing as managed care groups, institutions, government agencies and other groups seek price discounts. In most international markets, the Company operates in an environment of government-mandated cost-containment programs. In the U.S. market, the Company and other pharmaceutical manufacturers are required to provide statutorily defined rebates to various government agencies in order to participate in Medicaid, the veterans health care program and other government-funded programs. Several governments have placed restrictions on physician prescription levels and patient reimbursements, emphasized greater use of generic drugs and enacted across-the-board price cuts as methods to control costs. Since the Company is unable to predict the final form and timing of any future domestic or international governmental or other health care initiatives, including the passage of laws permitting the importation of pharmaceuticals into the United States, their effect on operations and cash flows cannot be reasonably estimated. Similarly, the effect on operations and cash flows of decisions of government entities, managed care groups and other groups concerning formularies and pharmaceutical reimbursement policies cannot be reasonably estimated. The Company cannot predict what net effect the Medicare prescription drug benefit will have on markets and sales. The program does not go into effect until 2006 and many of the Company's leading drugs are already covered under Medicare Part B (e.g., TEMODAR, INTEGRILIN and INTRON A). Others have a relatively small portion of their sales to the Medicare population (e.g., CLARINEX, the hepatitis C franchise). The Company could experience expanded utilization of ZETIA and VYTORIN and new drugs in the Company's R&D pipeline. Of greater consequence for the Company may be the legislation's impact on pricing, rebates and discounts. A significant portion of net sales are made to major pharmaceutical and health care products distributors and major retail chains in the United States. Consequently, net sales and quarterly growth comparisons may be affected by fluctuations in the buying patterns of major distributors, retail chains and other trade buyers. These fluctuations may result from seasonality, pricing, wholesaler buying decisions or other factors. 41 The market for pharmaceutical products is competitive. The Company's operations may be affected by technological advances of competitors, industry consolidation, patents granted to competitors, new products of competitors, new information from clinical trials of marketed products or post-marketing surveillance and generic competition as the Company's products mature. In addition, patent positions are increasingly being challenged by competitors, and the outcome can be highly uncertain. An adverse result in a patent dispute can preclude commercialization of products or negatively affect sales of existing products. The effect on operations of competitive factors and patent disputes cannot be predicted. The Company launched OTC CLARITIN in the United States in December 2002. Also in December 2002, a competing OTC loratadine product was launched in the United States and private-label competition was introduced. In November 2003, the FDA approved CLARITIN for the over-the-counter relief of hives. The Company continues to market CLARINEX (desloratadine) 5 mg Tablets for the treatment of allergic rhinitis, which combines the indication of seasonal allergic rhinitis with the indication of perennial allergic rhinitis, as well as the treatment of chronic idiopathic urticaria, or hives of unknown cause. The ability of the Company to capture and maintain market share for CLARINEX and OTC CLARITIN in the U.S. market will depend on a number of factors, including: additional entrants in the market for allergy treatments; clinical differentiation of CLARINEX from other allergy treatments and the perception of the extent of such differentiation in the marketplace; the pricing differentials among OTC CLARITIN, CLARINEX, other allergy treatments and generic OTC loratadine; the erosion rate of OTC CLARITIN and CLARINEX sales upon the entry of additional generic OTC loratadine products; and whether or not one or both of the other branded second-generation antihistamines are switched from prescription to OTC status. CLARINEX is experiencing intense competition in the prescription U.S. allergy market. The prescription allergy market has been shrinking since the OTC switch of CLARITIN in December 2002. The Company is implementing new marketing efforts to address market share performance for CLARINEX. The switch of CLARITIN to OTC status and the introduction of competing OTC loratadine has resulted in a rapid, sharp and material decline in CLARITIN sales in the United States and the Company's results of operations. U.S. sales of prescription CLARITIN products were $25 million or 0.3 percent of the Company's consolidated global sales in 2003 and $1.4 billion or 14 percent in 2002. Sales of CLARINEX in the United States and abroad have also been materially adversely affected by the presence of generic OTC loratadine and OTC CLARITIN. In light of the factors described above, management believes that the Company's December 2002 introduction of OTC CLARITIN, as well as the introduction of a competing OTC loratadine product in December 2002 and additional entrants of generic OTC loratadine products in the market, have had a rapid, sharp and material adverse effect on the Company's results of operations and will likely continue for an indeterminate period of time. Following settlement in 2003 of patent litigation by the Company involving three drug manufacturers, and dismissal of patent litigation relating to ribavirin patents that did not involve the Company, generic forms of ribavirin entered the U.S. market in April 2004. In October 2004, a third generic ribavirin was approved by the FDA. The generic forms of ribavirin compete with the Company's REBETOL (ribavirin) Capsules in the United States. The REBETOL patents are material to the Company's business. U.S. sales of REBETOL in 2003 were $306 million. For the nine months ended September 30, 2004, U.S. sales of REBETOL were $54 million. PEG-INTRON and REBETOL combination therapy for hepatitis C contributed substantially to sales in 2003 and 2002. During the fourth quarter of 2002, a competing pegylated interferon-based combination product, including a brand of ribavirin, received regulatory approval in most major markets, including the United States. 42 The overall market share of the hepatitis C franchise has declined sharply, reflecting this new market competition. Management believes that the ability of PEG-INTRON and REBETOL combination therapy to maintain market share will continue to be adversely affected by new competition in the hepatitis C marketplace. As a result of the introduction of a competitor for pegylated interferon and the introduction of generic ribavirin, the value of the Company's second most important product franchise has been severely diminished and earnings and cash flow have been materially and negatively impacted. In October 2002, Merck/Schering-Plough Pharmaceuticals announced that the FDA approved ZETIA (ezetimibe) 10 mg for use either by itself or together with statins for the treatment of elevated cholesterol levels. In March 2003, the Company announced that ezetimibe (EZETROL, as marketed in Europe) had successfully completed the European Union (EU) mutual recognition procedure (MRP). With the completion of the MRP process, the 15 EU member states as well as Iceland and Norway can grant national marketing authorization with unified labeling for EZETROL. EZETROL has been launched in many international markets. The Merck/Schering-Plough partnership also developed a once-daily tablet combining ezetimibe with simvastatin (Zocor), Merck's cholesterol-modifying medicine. Ezetimibe/simvastatin (INEGY, marketed as VYTORIN in the United States) completed the MRP in Europe on October 1, 2004. Ezetimibe/simvastatin has been approved for marketing in several countries, including Germany in April of 2004 and in Mexico in March of 2004. On July 23, 2004, Merck/Schering-Plough Pharmaceuticals announced that the FDA had approved VYTORIN. In September 2004, the Company announced that it entered into an agreement with Bayer Pharmaceuticals Corporation ("Bayer") intended to enhance the companies' pharmaceutical resources. The agreement was entered into by the Company primarily for strategic purposes. Commencing in October 2004, in the United States and Puerto Rico, the Company will market, sell and distribute Bayer's primary care products including Avelox (moxifloxacin HCl) and Cipro (ciprofloxacin HCl) under an exclusive license agreement. The Company will pay Bayer royalties in excess of 50% on these products based on sales, which will have an unfavorable impact on the Company's gross margin percentage. In addition, the Company expects to add 800-900 existing Bayer sales representatives to support these products. Also commencing in October 2004, the Company will assume Bayer's responsibilities for U.S. commercialization activities related to the erectile dysfunction medicine Levitra (vardenafil HCl) under Bayer's co-promotion agreement with GlaxoSmithKline PLC. The Company will report its share of Levitra's results as alliance revenue. Additionally, under the terms of the agreement, Bayer will support the promotion of certain of the Company's oncology products in the United States and key European markets for a defined period of time. In Japan, upon regulatory approval Bayer will co-market the Company's cholesterol absorption inhibitor ZETIA (ezetimibe). This arrangement does not include the rights to any future cholesterol combination product. ZETIA was filed with regulatory authorities in Japan during the fourth quarter of 2003. This agreement with Bayer potentially restricts the Company from marketing products in the United States that would compete with any of the products under the strategic alliance. As a result, the Company expects that it may need to sublicense rights to garenoxacin, the quinolone antibacterial agent that the Company licensed from 43 Toyama Chemical Co. Ltd. ("Toyama"). The Company is exploring its options with regard to garenoxacin and will continue to fulfill its commitments to Toyama under its arrangement, including taking the product through regulatory approval. Under the Bayer agreement, there will be a business integration and transition period during the remainder of 2004. The transaction is expected to be mildly dilutive in 2004 in terms of its impact on earnings per share. Uncertainties inherent in government regulatory approval processes, including, among other things, delays in approval of new products, formulations or indications, may also affect the Company's operations. The effect of regulatory approval processes on operations cannot be predicted. The Company is subject to the jurisdiction of various national, state and local regulatory agencies and is, therefore, subject to potential administrative actions. Of particular importance is the FDA in the United States. It has jurisdiction over all the Company's businesses and administers requirements covering the testing, safety, effectiveness, approval, manufacturing, labeling and marketing of the Company's products. From time to time, agencies, including the FDA, may require the Company to address various manufacturing, advertising, labeling or other regulatory issues, such as those noted below relating to the Company's current manufacturing issues. Failure to comply with governmental regulations can result in delays in the release of products, seizure or recall of products, suspension or revocation of the authority necessary for the production and sale of products, discontinuance of products, fines and other civil or criminal sanctions. Any such result could have a material adverse effect on the Company's financial position and its results of operations. Additional information regarding government regulation that may affect future results is provided in Part I, Item I, "Business," in the Company's annual report on Form 10-K for the fiscal year ended December 31, 2003. Additional information about cautionary factors that may affect future results is provided under the caption "Cautionary Factors That May Affect Future Results (Cautionary Statements Under the Private Securities Litigation Reform Act of 1995)" in this Management's Discussion and Analysis of Operations and Financial Condition. As noted in the "Consent Decree" footnote included in the financial statements to this report, on May 17, 2002, the Company announced that it had reached an agreement with the FDA for a consent decree to resolve issues involving the Company's compliance with current Good Manufacturing Practices at certain manufacturing facilities in New Jersey and Puerto Rico. The U.S. District Court for the District of New Jersey approved and entered the consent decree on May 20, 2002. Under terms of the consent decree, the Company agreed to pay a total of $500 million to the U.S. government in two equal installments of $250 million; the first installment was paid in May 2002 and the second installment was paid in May 2003. As previously reported, the Company accrued a $500 million provision for this consent decree in the fourth quarter of 2001. The consent decree requires the Company to complete a number of actions. In the event certain actions agreed upon in the consent decree are not satisfactorily completed on time, the FDA may assess payments for each deadline missed. The consent decree required the Company to develop and submit for FDA's concurrence comprehensive cGMP Work Plans for the Company's manufacturing facilities in New Jersey and Puerto Rico that are covered by the decree. The Company received FDA concurrence with its proposed cGMP Work Plans on May 14, 2003. The cGMP Work Plans contain a number of Significant Steps whose timely and satisfactory completion are subject to payments of $15,000 per business day for each deadline missed. These payments may not exceed $25 million for 2002, and $50 million for each of the years 2003, 2004 and 2005. These payments are subject to an overall cap of $175 million. 44 In connection with its discussions with FDA regarding the Company's cGMP Work Plans, and pursuant to the terms of the decree, the Company and the FDA entered into a letter agreement dated April 14, 2003. In the letter agreement the Company and the FDA agreed to extend by six months the time period during which the Company may incur payments as described above with respect to certain of the Significant Steps whose due dates are December 31, 2005. The letter agreement does not increase the yearly or overall caps on payments described above. In addition, the decree requires the Company to complete programs of revalidation of the finished drug products and bulk active pharmaceutical ingredients manufactured at the covered manufacturing facilities. The Company is required under the consent decree to complete its revalidation programs for bulk active pharmaceutical ingredients by September 30, 2005, and for finished drugs by December 31, 2005. In general, the timely and satisfactory completion of the revalidations are subject to payments of $15,000 per business day for each deadline missed, subject to the caps described above. However, if a product scheduled for revalidation has not been certified as having been validated by the last date on the validation schedule, the FDA may assess a payment of 24.6 percent of the net domestic sales of the uncertified product until the validation is certified. Any such payment would not be subject to the caps described above. Further, in general, if a product scheduled for revalidation under the consent decree is not certified within six months of its scheduled date, the Company must cease production of that product until certification is obtained. The completion of the Significant Steps in the Work Plans and the completion of the revalidation programs are subject to third-party expert certification, which must be accepted by the FDA. The consent decree provides that if the Company believes that it may not be able to meet a deadline, the Company has the right, upon the showing of good cause, to request extensions of deadlines in connection with the cGMP Work Plans and revalidation programs. However, there is no guarantee that FDA will grant any such requests. Although the Company believes it has made significant progress in meeting its obligations under the consent decree, it is possible that (1) the Company may fail to complete a Significant Step or a revalidation by the prescribed deadline; (2) the third party expert may not certify the completion of the Significant Step or revalidation; or (3) the FDA may disagree with an expert's certification of a Significant Step or revalidation. In such a case, it is possible that the FDA may assess payments as described above. The Company would expense any payments assessed under the decree if and when incurred. In addition, the failure to meet the terms of the consent decree could result in delays in approval of new products, seizure or recall of products, suspension or revocation of the authority necessary for the production and sale of products, fines and other civil or criminal sanctions. In April 2003, the Company received notice of a False Claims Act complaint brought by an individual purporting to act on behalf of the U.S. government against it and approximately 25 other pharmaceutical companies in the U.S. District Court for the Northern District of Texas. The complaint alleges that the pharmaceutical companies, including the Company, have defrauded the United States by having made sales to various federal governmental agencies of drugs that were allegedly manufactured in a manner that did not comply with current Good Manufacturing Practices. The Company and the other defendants filed a motion to dismiss the second amended complaint in this action on April 12, 2004. The Company is subject to pharmacovigilance reporting requirements in many countries and other jurisdictions, including the United States, the European Union (EU) and the EU member states. The requirements differ from 45 jurisdiction to jurisdiction, but all include requirements for reporting adverse events that occur while a patient is using a particular drug in order to alert the manufacturer of the drug and the governmental agency to potential problems. During pharmacovigilance inspections by officials of the British and French medicines agencies conducted at the request of the European Agency for the Evaluation of Medicinal Products (EMEA), serious deficiencies in reporting processes were identified. The Company is taking urgent actions to rectify these deficiencies as quickly as possible. The Company does not know what action, if any, the EMEA or national authorities will take in response to these findings. Possible actions include further inspections, demands for improvements in reporting systems, criminal sanctions against the Company and/or responsible individuals and changes in the conditions of marketing authorizations for the Company's products. As described more specifically in the "Legal, Environmental and Regulatory Matters" footnote included in the financial statements to this report, to which the reader of this report is directed, the pricing, sales and marketing programs and arrangements, and related business practices of the Company and other participants in the health care industry are under increasing scrutiny from federal and state regulatory, investigative, prosecutorial and administrative entities. These entities include the Department of Justice and its U.S. Attorney's Offices, the Office of Inspector General of the Department of Health and Human Services, the FDA, the Federal Trade Commission (FTC) and various state Attorneys General offices. Many of the health care laws under which certain of these governmental entities operate, including the federal and state "anti-kickback" statutes and statutory and common law "false claims" laws, have been construed broadly by the courts and permit the government entities to exercise significant discretion. In the event that any of those governmental entities believes that wrongdoing has occurred, one or more of them could institute civil or criminal proceedings, which, if instituted and resolved unfavorably, could subject the Company to substantial fines, penalties and injunctive or administrative remedies, including exclusion from government reimbursement programs, and the Company also cannot predict whether any investigations will affect its marketing practices or sales. Any such result could have a material adverse effect on the Company, its financial condition or its results of operations. Critical Accounting Policies Revenue Recognition The Company's pharmaceutical products are sold to direct purchasers (e.g., wholesalers, retailers and certain health maintenance organizations). Price discounts and rebates on such sales are paid to federal and state agencies as well as to indirect purchasers and other market participants (e.g., managed care organizations that indemnify beneficiaries of health plans for their pharmaceutical costs and pharmacy benefit managers). The Company recognizes revenue when title and risk of loss passes to the purchaser and when reliable estimates of the following can be determined: i. commercial discount and rebate arrangements; ii. rebate obligations under certain Federal and state governmental programs and; iii. sales returns in the normal course of business. When recognizing revenue the Company estimates and records the applicable commercial and governmental discounts and rebates as well as sales returns that have been or are expected to be granted or made for products sold during the period. These amounts are deducted from sales for that period. Estimates recorded in prior 46 periods are re-evaluated as part of this process. If reliable estimates of these items can not be made, the Company defers the recognition of revenue. Revenue recognition for new products is based on specific facts and circumstances including estimated acceptance rates from established products with similar marketing characteristics. Absent the ability to make reliable estimates of rebates, discounts and returns, the Company would defer revenue recognition. Product discounts granted are based on the terms of arrangements with direct, indirect and other market participants as well as market conditions, including prices charged by competitors. Rebates are estimated based on sales terms, historical experience, trend analysis and projected market conditions in the various markets served. The Company evaluates market conditions for products or groups of products primarily through the analysis of wholesaler and other third party sell-through and market research data as well as internally generated information. Data and information provided by purchasers and obtained from third parties are subject to inherent limitations as to their accuracy and validity. Sales returns are generally estimated and recorded based on historical sales and returns information, analysis of recent wholesale purchase information, consideration of stocking levels at wholesalers and forecasted demand amounts. Products that exhibit unusual sales or return patterns due to dating, competition or other marketing matters are specifically investigated and analyzed as part of the formulation of accruals. During 2004, the Company entered into agreements with the major U.S. pharmaceutical wholesalers. These agreements deal with a number of commercial issues, such as product returns, timing of payment, processing of chargebacks and the quantity of inventory held by these wholesalers. With respect to the quantity of inventory held by these wholesalers, these agreements provide a financial disincentive for these wholesalers to acquire quantities of product in excess of what is necessary to meet current patient demand. Through the use of this monitoring and the above noted agreements, the Company expects to avoid situations where the Company's shipments of product are not reflective of current demand. Rebates, Discounts and Returns Rebate accruals for Federal and state governmental programs were $131 million at September 30, 2004 and $127 million at December 31, 2003. Commercial discounts and other rebate accruals were $144 million at September 30, 2004 and $211 million at December 31, 2003, respectively. These and other rebate accruals are established in the period the related revenue was recognized resulting in a reduction to sales and the establishment of a liability, which is included in other accrued liabilities. In the case of the governmental rebate programs, the Company's payments involve interpretations of relevant statutes and regulations. These interpretations are subject to challenges and changes in interpretive guidance by governmental authorities. The result of such a challenge or change could affect whether the estimated governmental rebate amounts are ultimately sufficient to satisfy the Company's obligations. Additional information on governmental inquiries focused in part on the calculation of rebates is contained in the "Legal, Environmental and Regulatory Matters" footnote included in the financial statements to this report. In addition, it is possible that, as a result of governmental challenges or changes in interpretive guidance, actual rebates could materially exceed amounts accrued. 47 The following summarizes the activity in the accounts related to accrued rebates, sales returns and discounts:
Three Months Nine Months Ended Ended September 30, 2004 September 30, 2004 Accrued Rebates / Returns / Discounts, Beginning of Period $ 452 $ 487 ----- ----- Provision for Rebates 100 309 Payments (123) (372) ----- ----- (23) (63) ----- ----- Provision for Returns 14 39 Returns (1) (24) ----- ----- 13 15 ----- ----- Provision for Discounts 21 143 Discounts granted (38) (157) ----- ----- (17) (14) ----- ----- Accrued Rebates / Returns / Discounts, End of Period $ 425 $ 425 ===== =====
Management makes estimates and uses assumptions in recording the above accruals. Actual amounts may differ from these estimates. Adjustments to estimated amounts during the above periods were not significant. Refer to "Management's Discussion and Analysis of Operations and Financial Condition" in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2003 for disclosures regarding the Company's other critical accounting policies. 48 Disclosure Notice Cautionary Factors That May Affect Future Results (Cautionary Statements Under the Private Securities Litigation Reform Act of 1995) Management's Discussion and Analysis of Financial Condition and Results of Operations and other sections of this report and other written reports and oral statements made from time to time by the Company may contain "forward-looking statements" within the meaning of the Securities Litigation Reform Act of 1995. Forward-looking statements relate to expectations or forecasts of future events. They use words such as "anticipate," "believe," "could," "estimate," "expect," "forecast," "project," "intend," "plan," "potential," "will," and other words and terms of similar meaning in connection with a discussion of potential future events, circumstances or future operating or financial performance. You can also identify forward-looking statements by the fact that they do not relate strictly to historical or current facts. In particular, forward-looking statements include statements relating to future actions, ability to access the capital markets, prospective products, the status of product approvals, future performance or results of current and anticipated products, sales efforts, development programs, estimates of rebates, discounts and returns, expenses and programs to reduce expenses, the cost of and savings from reductions in work force, the outcome of contingencies such as litigation and investigations, growth strategy and financial results. Any or all forward-looking statements here or in other publications may turn out to be wrong. Actual results may vary materially, and there are no guarantees about Schering-Plough's financial and operational performance or the performance of Schering-Plough stock. Schering-Plough does not assume the obligation to update any forward-looking statement. Many factors could cause actual results to differ from Schering-Plough's forward-looking statements. These factors include inaccurate assumptions and a broad variety of other risks and uncertainties, including some that are known and some that are not. Although it is not possible to predict or identify all such factors, they may include the following: - A significant portion of net sales are made to major pharmaceutical and health care products distributors and major retail chains in the United States. Consequently, net sales and quarterly growth comparisons may be affected by fluctuations in the buying patterns of major distributors, retail chains and other trade buyers. These fluctuations may result from seasonality, pricing, wholesaler buying decisions or other factors. - Competitive factors, including technological advances attained by competitors, patents granted to competitors, new products of competitors coming to the market, new indications for competitive products, and generic, prescription and/or OTC products that compete with products of Schering-Plough or the Merck/Schering-Plough Pharmaceuticals joint venture (such as competition from OTC statins, like the one approved for use in the U.K. for which impact in the cholesterol reduction market is not yet known). - Increased pricing pressure both in the United States and abroad from managed care organizations, institutions and government agencies and programs. In the United States, among other developments, consolidation among customers may increase pricing pressures and may result in various customers having greater influence over prescription decisions through formulary decisions and other policies. - The potential impact of the Medicare Prescription Drug, Improvement and Modernization Act of 2003; possible other U.S. legislation or regulatory action affecting, among other things, pharmaceutical pricing and reimbursement, including Medicaid and Medicare, involuntary approval of prescription medicines for over-the-counter use; and other health care reform initiatives and drug importation legislation. 49 Legislation or regulations in markets outside the U.S. affecting product pricing, reimbursement or access. Laws and regulations relating to trade, antitrust, monetary and fiscal policies, taxes, price controls and possible nationalization. - Patent positions can be highly uncertain and patent disputes are not unusual. An adverse result in a patent dispute can preclude commercialization of products or negatively impact sales of existing products or result in injunctive relief and payment of financial remedies. - Uncertainties of the FDA approval process and the regulatory approval and review processes in other countries, including, without limitation, delays in approval of new products. - Failure to meet Good Manufacturing Practices established by the FDA and other governmental authorities can result in delays in the approval of products, release of products, seizure or recall of products, suspension or revocation of the authority necessary for the production and sale of products, fines and other civil or criminal sanctions. The resolution of manufacturing issues with the FDA discussed in Schering-Plough's 10-Ks, 10-Qs and 8-Ks are subject to substantial risks and uncertainties. These risks and uncertainties, including the timing, scope and duration of a resolution of the manufacturing issues, will depend on the ability of Schering-Plough to assure the FDA of the quality and reliability of its manufacturing systems and controls, and the extent of remedial and prospective obligations undertaken by Schering-Plough. - Difficulties in product development. Pharmaceutical product development is highly uncertain. Products that appear promising in development may fail to reach market for numerous reasons. They may be found to be ineffective or to have harmful side effects in clinical or pre-clinical testing, they may fail to receive the necessary regulatory approvals, they may turn out not to be economically feasible because of manufacturing costs or other factors or they may be precluded from commercialization by the proprietary rights of others. - Efficacy or safety concerns or new information from clinical trials of marketed products or post-marketing surveillance, whether or not scientifically justified, leading to recalls, withdrawals or declining sales. - Major products such as CLARITIN, CLARINEX, INTRON A, PEG-INTRON, REBETOL Capsules, REMICADE and NASONEX accounted for a material portion of Schering-Plough's 2003 revenues. If any major product were to become subject to a problem such as loss of patent protection, OTC availability of the Company's product or a competitive product (as has been disclosed for CLARITIN and its current and potential OTC competition), previously unknown side effects; if a new, more effective treatment should be introduced; generic availability of competitive products; or if the product is discontinued for any reason, the impact on revenues could be significant. Also, such information about important new products, such as ZETIA and VYTORIN, or important products in our pipeline, may impact future revenues. Further, the launch of VYTORIN may negatively impact sales of ZETIA. - Unfavorable outcomes of government (local and federal, domestic and international) investigations, litigation about product pricing, product liability claims, other litigation and environmental concerns could preclude commercialization of products, negatively affect the profitability of existing products, materially and adversely impact Schering-Plough's financial condition and results of operations, or contain conditions that impact business operations, such as exclusion from government reimbursement programs. - Economic factors over which Schering-Plough has no control, including changes in inflation, interest rates and foreign currency exchange rates. - Instability, disruption or destruction in a significant geographic region - due to the location of manufacturing facilities, distribution facilities or customers - regardless of cause, including war, terrorism, riot, civil insurrection or social unrest; and natural or man-made disasters, including famine, flood, fire, earthquake, storm or disease. - Changes in tax laws including changes related to taxation of foreign earnings. 50 - Changes in accounting standards promulgated by the American Institute of Certified Public Accountants, the Financial Accounting Standards Board, the SEC, or the Public Company Accounting Oversight Board that would require a significant change to Schering-Plough's accounting practices. Item 3. Quantitative and Qualitative Disclosures about Market Risk The Company is exposed to market risk primarily from changes in foreign currency exchange rates and, to a lesser extent, from interest rates and equity prices. Refer to "Management's Discussion and Analysis of Operations and Financial Condition" in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2003 for additional information. Item 4. Controls and Procedures Management, including the chief executive officer and the chief financial officer, has evaluated the Company's disclosure controls and procedures as of the end of the quarterly period covered by this Form 10-Q and has concluded that the Company's disclosure controls and procedures are effective. They also concluded that there were no changes in the Company's internal control over financial reporting that occurred during the Company's most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. 51 PART II. OTHER INFORMATION Item 1. Legal Proceedings Legal proceedings involving the Company are described in the 2003 10-K and the 2004 first and second quarter 10-Qs, together referred to as the "Reports" in this Legal Proceedings Item. Unless specifically indicated below, matters described in the Reports are still pending. The following description should be read together with the Reports. It covers material developments to previously reported proceedings and new legal proceedings involving the Company that arose since the August 3, 2004 filing date of the 2004 second quarter 10-Q. Patent Matters. United Kingdom Patent Infringement Action. On August 6, 2004, the Company brought a patent infringement action in the United Kingdom against Cipla Ltd. and Neolabs Ltd. following the defendants advising of their intent to pursue marketing of desloratadine in the United Kingdom. In 2003, the Company's sales of desloratadine in the United Kingdom were approximately $24.2 million. Investigations. Pennsylvania Investigation. On July 30, 2004, Schering-Plough Corporation, the U.S. Department of Justice and the U.S. Attorney's Office for the Eastern District of Pennsylvania announced settlement of the previously disclosed investigation by that Office. Under the settlement, Schering Sales Corporation, an indirect wholly owned subsidiary of Schering-Plough Corporation, has pleaded guilty to a single federal criminal charge concerning a payment to a managed care customer. As a result, Schering Sales Corporation will be excluded from participating in federal healthcare programs. The settlement will not affect the ability of Schering-Plough Corporation to participate in those programs. The aggregate settlement amount is $345.5 million in fines and damages, comprised of a $52.5 million fine to be paid by Schering Sales Corporation, and $293 million in civil damages to be paid by Schering-Plough Corporation. Schering-Plough Corporation will be credited with $53.6 million that was previously paid in additional Medicaid rebates against the civil damages amount, leaving a net settlement amount of $291.9 million. Of that amount, $177.5 million of the total settlement was paid in the third quarter of 2004. The remaining portion will be paid by March 4, 2005. Interest accrues on the unpaid balance at the rate of 4 percent. The payments have been and will be funded by cash from operations, borrowings and proceeds from the issuance of securities. There will be no impact on 2004 full year results related to the Pennsylvania settlement. Under the settlement, Schering-Plough Corporation also entered into a five year corporate integrity agreement with the Office of the Inspector General of the Department of Health and Human Services, under which Schering-Plough Corporation agreed to implement specific measures to promote compliance with regulations on issues such as marketing. Failure to comply can result in financial penalties. Details of the initiation and progress of the investigation can be found in the Company's prior 10-K and 10-Q reports beginning with the 10-K for 1999. The Company cannot predict the impact of this settlement, if any, on other outstanding investigations. Securities and Class Action Litigation. The Company is a defendant in a number of purported nationwide or state class action lawsuits in which plaintiffs seek a refund of the purchase price of laxatives or phenylpropanolamine-containing cough/cold remedies ("PPA products") they purchased. Other pharmaceutical 52 manufacturers are co-defendants in some of these lawsuits. In general, plaintiffs claim that they would not have purchased or would have paid less for these products had they known of certain defects or medical risks attendant with their use. In the litigation of the claims relating to the Company's PPA products, courts in the national class action suit and several state class action suits have denied certification and dismissed the suits. A similar application to deny class certification in New Jersey, the only remaining statewide class action suit involving the Company, was granted on September 30, 2004. Approximately 96 individual lawsuits relating to the laxative products, PPA products and recalled albuterol/VANCERIL/VANCENASE inhalers are also pending against the Company seeking recovery for personal injuries or death. In a number of these lawsuits punitive damages are claimed. SEC Inquiries and Related Litigation. On September 9, 2003, the SEC and the Company announced settlement of the SEC enforcement proceeding against the Company and Richard Jay Kogan, former Chairman and Chief Executive Officer, regarding meetings held with investors the week of September 30, 2002, and other communications. Without admitting or denying the allegations, the Company agreed not to commit future violations of Regulation FD and related securities laws and paid a civil penalty of $1 million. Mr. Kogan paid a civil penalty of $50 thousand. On September 25, 2003, a lawsuit was filed in New Jersey Superior Court, Union County, against Richard Jay Kogan and the Company's outside Directors alleging breach of fiduciary duty, fraud and deceit and negligent misrepresentation, all relating to the alleged disclosures made during the meetings mentioned above. The Company removed this case to federal court. The case was remanded to state court. The Company has filed a motion to dismiss. Environmental Matters. On September 24, 2004, the Company, along with approximately 80 other parties, were named as third-party defendants in a complaint, alleging that it (and other parties) generated waste that was sent to the Burlington Environmental Management Services, Inc. Landfill ("BEMS Site"), located in Southampton Township, Burlington County, New Jersey. The complaint also indicates that the Company and the other 80 parties are liable for costs expended to clean up the BEMS Site under New Jersey's Spill Compensation and Control Act (New Jersey's "Superfund" statute). The Company is currently investigating the allegations. Tax Matters. In October of 2001, IRS auditors asserted, in reports, that the Company is liable for additional tax for the 1990 through 1992 tax years. The reports allege that two interest rate swaps that the Company entered into with an unrelated party should be recharacterized as loans from affiliated companies. In April of 2004, the Company received a formal Notice of Deficiency (Statutory Notice) from the IRS asserting additional federal income tax due. The Company received bills from the IRS related to this matter on September 7, 2004. Payment in the amount of $194 million for income tax and $279 million of interest was made on September 13, 2004. The Company believes it has complied with all applicable rules and regulations and intends to file a suit for refund for the full amount of the tax and interest. The Company's tax reserves were adequate to cover the above-mentioned payments. 53 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds ISSUER PURCHASES OF EQUITY SECURITIES
Total Number of Maximum Number of Shares Purchased as Shares that May Yet Be Part of Publicly Purchased Under the Total Number of Average Price Paid Announced Plans or Plans or PERIOD Shares Purchased per Share Programs Programs ------ ---------------- ------------------ ------------------- ---------------------- January 1, 2004 through March 31, 2004 54,862 (1) $17.97 N/A N/A April 1, 2004 through June 30, 2004 0 0 N/A N/A July 1, 2004 through September 30, 2004 23,928 (1) $18.88 N/A N/A TOTAL 2004 78,790 $18.24
(1) All of the shares included in the table above were repurchased pursuant to the Company's stock incentive program and represent shares delivered to the Company by option holders for payment of the exercise price and tax withholding obligations in connection with stock options. Item 5. Other Information Regulatory Affairs Development: The Company sells numerous upper respiratory products which contain pseudoephedrine (PSE), an FDA approved ingredient for the relief of nasal congestion. The Company's annual sales of upper respiratory products which contain PSE totaled approximately $160 million in 2003 and approximately $152 million through September 2004. These products include all CLARITIN-D products as well as some DRIXORAL, CORICIDIN and CHLOR-TRIMETON products. The Company understands that PSE has been used in the illicit manufacture of methamphetamine, a dangerous and addictive drug. To date, we believe that twelve states and Canada have enacted regulations concerning the sale of PSE, including limiting the amount of these products that can be purchased at one time, or requiring that these products be located behind the counter, with the stated goal of deterring the illicit/illegal manufacture of methamphetamine. To date, the regulations have had no material impact on the Company's operations or financial results. Were such regulations to be adopted throughout the United States and in other countries that are key markets for the products, the impact of such regulations on the Company's sales of these specific products cannot be predicted. At this time, the Company has no information indicating that, based on these regulations, a material adverse impact on the Company's operations or financial condition is likely based on these regulations in the next several years. 54 Item 6. Exhibits Exhibits - The following Exhibits are filed with this document:
Exhibit Number Description ------------- ------------ 3(i) Restated Certificate of Incorporation 12 Computation of Ratio of Earnings to Fixed Charges 15 Awareness letter 31.1 Sarbanes-Oxley Act of 2002, Section 302 Certification for Chairman of the Board, Chief Executive Officer and President 31.2 Sarbanes-Oxley Act of 2002, Section 302 Certification for Executive Vice President and Chief Financial Officer 32.1 Sarbanes-Oxley Act of 2002, Section 906 Certification for Chairman of the Board, Chief Executive Officer and President 32.2 Sarbanes-Oxley Act of 2002, Section 906 Certification for Executive Vice President and Chief Financial Officer
55 SIGNATURE(S) 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. Schering-Plough Corporation (Registrant) Date: October 28, 2004 /s/Douglas J. Gingerella ------------------------- Douglas J. Gingerella Vice President and Controller (Duly Authorized Officer and Chief Accounting Officer) 56