10-K 1 kv10k.txt ------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended March 31, 2005 Commission file number 1-9601 K-V PHARMACEUTICAL COMPANY (Exact name of registrant as specified in its charter) 2503 South Hanley Road St. Louis, Missouri 63144 (314) 645-6600 DELAWARE 43-0618919 (State of Incorporation) (IRS Employer Identification No.) Securities Registered Pursuant to Section 12(b) of the Act: Class A Common Stock, par value $.01 per share New York Stock Exchange Class B Common Stock, par value $.01 per share New York Stock Exchange Securities Registered Pursuant to Section 12(g) of the Act: 7% Cumulative Convertible Preferred, par value $.01 per share Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. [X] Yes [ ] No Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes X No --- --- The aggregate market value of the shares of Class A and Class B Common Stock held by nonaffiliates of the registrant as of September 30, 2004, the last business day of the registrant's most recently completed second fiscal quarter, was $502,350,165 and $144,631,685, respectively. As of June 9, 2005, the registrant had outstanding 35,962,654 and 13,322,699 shares of Class A and Class B Common Stock, respectively, exclusive of treasury shares. DOCUMENTS INCORPORATED BY REFERENCE Part III: Portions of the definitive proxy statement of the registrant (to be filed pursuant to Regulation 14A for registrant's 2005 Annual Meeting of Shareholders, which involves the election of directors), are incorporated by reference into Items 10, 11, 12, 13 and 14 to the extent stated in such items. CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION This Form 10-K, including the documents that we incorporate herein by reference, contains various forward-looking statements within the meaning of the United States Private Securities Litigation Reform Act of 1995 ("PSLRA"), which may be based on or include assumptions, concerning our operations, future results and prospects. Such statements may be identified by the use of words like "plans," "expect," "aim," "believe," "projects," "anticipate," "commit," "intend," "estimate," "will," "should," "could," and other expressions that indicate future events and trends. All statements that address expectations or projections about the future, including without limitation, statements about our strategy for growth, product development, regulatory approvals, market position, expenditures and financial results, are forward-looking statements. All forward-looking statements are based on current expectations and are subject to risk and uncertainties. In connection with the "safe harbor" provisions, we provide the following cautionary statements identifying important economic, political and technology factors which, among others, could cause the actual results or events to differ materially from those set forth or implied by the forward-looking statements and related assumptions. Such factors include (but are not limited to) the following: (1) changes in the current and future business environment, including interest rates and capital and consumer spending; (2) the difficulty of predicting FDA approvals, including the timing, and that any period of exclusivity may not be realized; (3) acceptance and demand for new pharmaceutical products; (4) the impact of competitive products and pricing; (5) new product development and launch, including but limited to the possibility that any product launch may be delayed or that product acceptance may be less than anticipated; (6) reliance on key strategic alliances; (7) the availability of raw materials; (8) the regulatory environment; (9) fluctuations in operating results; (10) the difficulty of predicting international regulatory approval, including the timing; (11) the difficulty of predicting the pattern of inventory movements by our customers; (12) the impact of competitive response to our sales, marketing and strategic efforts; (13) risks that we may not ultimately prevail in our litigation; and (14) the risks detailed from time to time in our filings with the Securities and Exchange Commission. This discussion is by no means exhaustive, but is designed to highlight important factors that may impact the Company's outlook. Because the factors referred to above, as well as the statements included under the captions "Narrative Description of Business," "Risk Factors," "Management's Discussion and Analysis of Financial Condition and Results of Operations," and elsewhere in this Form 10-K, could cause actual results or outcomes to differ materially from those expressed in any forward-looking statements made by us or on our behalf, you should not place undue reliance on any forward-looking statements. Further, any forward-looking statement speaks only as of the date on which it is made and, unless applicable law requires to the contrary, we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events. New factors emerge from time to time, and it is not possible for us to predict which factors will arise, when they will arise and/or their effects. In addition, we cannot assess the impact of each factor on our business or financial condition or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. 2 ITEM 1. BUSINESS -------- (a) GENERAL DEVELOPMENT OF BUSINESS ------------------------------- Unless the context otherwise indicates, when we use the words "we," "our," "us," "our company" or "KV" we are referring to K-V Pharmaceutical Company and its wholly-owned subsidiaries, including Ther-Rx Corporation, ETHEX Corporation and Particle Dynamics, Inc. We were incorporated under the laws of Delaware in 1971 as a successor to a business originally founded in 1942. Victor M. Hermelin, our Chairman and founder, invented and obtained initial patents for early controlled release and enteric coating which became part of our core business and a platform for future drug delivery emphasis. We develop advanced drug delivery technologies which enhance the effectiveness of new therapeutic agents, existing pharmaceutical products and prescription nutritional products. We have developed and patented a wide variety of drug delivery and formulation technologies which are primarily focused in four principal areas: SITE RELEASE(R) bioadhesives; tastemasking; oral controlled release; and oral quick dissolving tablets. We incorporate these technologies in the products we market to control and improve the absorption and utilization of active pharmaceutical compounds. In 1990, we established a generic marketing capability through a wholly-owned subsidiary, ETHEX Corporation ("ETHEX"), which we believe makes us one of the only drug delivery research and development companies that also markets "technologically distinguished" generic products. In 1999, we established a wholly-owned subsidiary, Ther-Rx Corporation ("Ther-Rx"), to market branded pharmaceuticals directly to physician specialists. Our wholly-owned subsidiary, Particle Dynamics, Inc. ("PDI"), was acquired in 1972. Through PDI, we develop and market specialty value-added raw materials, including drugs, directly compressible and microencapsulated products, and other products used in the pharmaceutical, nutritional, food, personal care and other markets. (b) SIGNIFICANT BUSINESS DEVELOPMENTS --------------------------------- In September 2004, we made a settlement payment in the amount of $16.5 million to resolve all previously pending claims between us and Healthpoint, Ltd. without the admission of any liability. The settlement was fully reserved by us in September 2002 and therefore had no impact on our earnings in fiscal 2005. In December 2004, we increased our available credit facilities to $140.0 million. The revised credit facilities provide for an increase from $40.0 million to $80.0 million in our revolving line of credit along with an increase from $25.0 million to $60.0 million in the supplemental credit line that is available for financing acquisitions. These credit facilities expire in October 2006 and December 2005, respectively. In January 2005, Ther-Rx introduced its second New Drug Application, or NDA, approved product, Clindesse(TM), the first approved single-dose therapy for bacterial vaginosis. Similar to Gynazole-1(R), our vaginal antifungal cream product, Clindesse(TM) incorporates our proprietary VagiSite(R) bioadhesive drug delivery technology. During fiscal 2005, we entered into two separate licensing agreements for the right to market both Gynazole-1(R) and Clindesse(TM) in Spain, Portugal, Andorra, and Mexico. These arrangements expanded Gynazole-1's future international presence beyond the over 50 markets in Europe, Latin America, the Middle East, Asia, Indonesia, the People's Republic of China, Australia and New Zealand covered in other previously signed licensing agreements. Also, during fiscal 2005, we received our second regulatory approval to market Gynazole-1(R) into an international market. 3 In April 2005, the Company completed the purchase of a 260,000 square foot building in the St. Louis metropolitan area for $11.8 million. The property had been leased by the Company since April 2000 and will continue to function as the Company's main distribution facility. The purchase price was paid with cash on hand. In May 2005, we entered into a long-term product development and marketing license agreement with Strides Arcolab, Ltd, (Strides) an Indian generic pharmaceutical developer and manufacturer, for exclusive marketing rights in the United States and Canada for 10 new generic drugs. Under the agreement, Strides will be responsible for developing, submitting for regulatory approval and manufacturing the 10 products and we will be responsible for exclusively marketing the products in the territories covered by the agreement. Under a separate agreement, we invested $11.3 million in Strides' redeemable preferred stock. In May 2005, the Company and FemmePharma, Inc. (FemmePharma) mutually agreed to terminate the license agreement we entered into with them in April 2002. As part of this transaction, we acquired all of the common stock of FemmePharma for $25.0 million after certain assets of the entity had been distributed to FemmePharma's other shareholders. Included in our acquisition of FemmePharma are the worldwide marketing rights to an endometriosis product that has successfully completed Phase II clinical trials. This product was originally part of the licensing arrangement with FemmePharma that provided us, among other things, marketing rights for the product principally in the United States. In accordance with the new agreement, we are assuming responsibility for conducting the Phase III clinical study, have acquired worldwide licensing rights of the endometriosis product, are no longer responsible for milestone payments and royalties specified in the original licensing agreement, and have secured exclusive worldwide rights for use of the FemmePharma technology for vaginal anti-infective products. We believe the Phase III clinical study for the endometriosis product will begin during fiscal 2006. In connection with this transaction, we expect to incur a charge of approximately $30.0 million in the first quarter of fiscal 2006, which includes the write-off of the $25.0 million payment plus preferred stock investments previously made, and which principally relates to in-process research and development. (c) INDUSTRY SEGMENTS ----------------- We operate principally in three industry segments, consisting of branded products marketing, specialty generics marketing and specialty raw materials marketing. Revenues are derived primarily from directly marketing our own technologically distinguished generic/non-branded and brand-name products. Revenues may also be received in the form of licensing revenues and/or royalty payments based upon a percentage of the licensee's sales of the product, in addition to manufacturing revenues, when marketing rights to products using our advanced drug delivery technologies are licensed. See Note 20 to our consolidated financial statements. (d) NARRATIVE DESCRIPTION OF BUSINESS --------------------------------- OVERVIEW We are a fully integrated specialty pharmaceutical company that develops, acquires, manufactures and markets technologically distinguished branded and generic/non-branded prescription pharmaceutical products. We have a broad range of dosage form capabilities including tablets, capsules, creams, liquids and ointments. We conduct our branded pharmaceutical operations through Ther-Rx and our generic/non-branded pharmaceutical operations through ETHEX. Through PDI, we also develop, manufacture and market technologically advanced, value-added raw material products for the pharmaceutical, nutritional, personal care, food and other markets. We have a broad portfolio of drug delivery technologies which we leverage to create technologically distinguished brand name and specialty generic/non-branded products. We have developed and patented 15 drug delivery and formulation technologies primarily in four principal areas: SITE RELEASE(R) bioadhesives, oral controlled release, tastemasking, and oral quick dissolving tablets. We incorporate these technologies in the products we market to control and improve the absorption and utilization of active pharmaceutical compounds. 4 These technologies provide a number of benefits, including reduced frequency of administration, reduced side effects, improved drug efficacy, enhanced patient compliance and improved taste. We have a long history of developing drug delivery technologies. In the 1950's, we received what we believe to be the first patents for sustained release delivery systems which enhance the convenience and effectiveness of pharmaceutical products. In our early years, we used our technologies to develop products for other drug marketers. Our technologies have been used in several well known products including Actifed(R) 12-hour, Sudafed(R) SA, Centrum Jr.(R) and Kaopectate(R) Chewable. Since the 1990's, we have chosen to focus our drug development expertise on internally developed products for our branded and generic/non-branded pharmaceutical businesses. For example, since its inception in March 1999, our Ther-Rx business has successfully launched seven internally developed branded pharmaceutical products, all of which incorporate our drug delivery technologies. We have also introduced technology-improved versions for three of the branded products acquired by us. Furthermore, most of the internally developed generic/non-branded products marketed by our ETHEX business incorporate one or more of our drug delivery technologies. Our drug delivery technology allows us to differentiate our products in the marketplace, both in the branded and generic/non-branded pharmaceutical areas. We believe that this differentiation provides substantial competitive advantages for our products, allowing us to establish a strong record of growth and profitability and a leadership position in certain segments of our industry. From 1998 to 2005, we have grown net revenues and net income at compounded annual growth rates of 17.6% and 17.1%, respectively. Ther-Rx has grown substantially since its inception in March 1999 and continues to gain market share in its women's healthcare family of products. Also, by focusing on the development and marketing of technology-distinguished, multisource drugs, over half of the more than 140 specialty generic/non-branded products sold by our ETHEX subsidiary are market leaders in the multisource-brand market. THER-RX -- OUR BRAND NAME PHARMACEUTICAL BUSINESS We established Ther-Rx in 1999 to market brand name pharmaceutical products which incorporate our proprietary technologies. Since its inception, Ther-Rx has introduced over 10 products into two principal therapeutic categories - women's health and oral hematinics - where physician specialists can be reached using a highly focused sales force. By targeting physician specialists, we believe Ther-Rx can compete successfully without the need for a sales force as large as pharmaceutical companies with less specialized product lines. Ther-Rx's net revenues grew from $82.9 million in fiscal 2004 to $90.1 million in fiscal 2005 and represented 29.7% of our fiscal 2005 total net revenues. We established our women's healthcare franchise through the August 1999 acquisition of PreCare(R), a prescription prenatal vitamin, from UCB Pharma, Inc. Since the acquisition, Ther-Rx has reformulated the original product using proprietary technologies, and subsequently has launched five internally developed products as extensions to the PreCare(R) product line. Building upon the PreCare(R) acquisition, we have developed a line of proprietary products which makes Ther-Rx the leading provider of branded prescription prenatal vitamins in the United States. The first of our internally developed, patented line extensions to PreCare(R) was PreCare(R) Chewables, the world's first prescription chewable prenatal vitamin. PreCare(R) Chewables addressed a longstanding challenge to improve pregnant women's compliance with prenatal vitamin regimens by alleviating the difficulty that patients experience in swallowing large prenatal pills. Ther-Rx's second internally developed product, PremesisRx(TM), is an innovative prenatal prescription product that incorporates our controlled release Vitamin B(6). This product is designed for use in conjunction with a physician-supervised program to reduce pregnancy-related nausea and vomiting, which is experienced by 50% to 90% of women who become pregnant. The third product, PreCare(R) Conceive(TM), is the first product designed as a prescription nutrional pre-conception supplement. The fourth 5 product, PrimaCare(R), is the first prescription prenatal/postnatal nutritional supplement with essential fatty acids specially designed to help provide nutritional support for women during pregnancy, postpartum recovery and throughout the childbearing years. The fifth product, PrimaCare(R) ONE, was launched in fiscal 2005 as a proprietary line extension to PrimaCare(R) and is the first prenatal product to contain essential fatty acids in a one-dose-per-day dosage form. All of the products in the PreCare(R) product line have been formulated to contain 1 mg. of folic acid, which has been shown to reduce the incidence of fetal neural tube defects by at least 50%. In June 2000, Ther-Rx launched its first NDA approved product, Gynazole-1(R), the only one-dose prescription cream treatment for vaginal yeast infections. Gynazole-1(R) incorporates our patented drug delivery technology, VagiSite(R), the only clinically proven and Federal Food and Drug Administration, or FDA, approved controlled release bioadhesive system. Since its launch, the product has gained a 31.5% market share in the U.S. prescription vaginal antifungal cream market. In addition, we have entered into licensing agreements for the right to market Gynazole-1(R) in over 50 markets in Europe, Latin America, the Middle East, Asia, Indonesia, the People's Republic of China, Australia, New Zealand and Mexico. We also received, during fiscal 2005, our second regulatory approval to market Gynazole-1(R) into an international market. In January 2005, Ther-Rx introduced its second NDA approved product, Clindesse(TM), the first approved single-dose therapy for bacterial vaginosis. Similar to Gynazole-1(R), Clindesse(TM) incorporates our proprietary VagiSite(R) bioadhesive drug delivery technology. Since its launch, Clindesse(TM) has garnered 13.1% of the intravaginal bacterial vaginosis market in the United States. We have also entered into licensing agreements for the right to market Clindesse(TM) in Spain, Portugal, Andorra, Brazil and Mexico. We established our hematinic product line by acquiring two leading hematinic brands, Chromagen(R) and Niferex(R), in March 2003. We re-launched technology-improved versions of these products mid-way through fiscal 2004. In fiscal 2005, the reformulated hematinic brands have generated 64.8% growth in new prescription volume compared to new prescription volume in the prior year. Ther-Rx's cardiovascular product line consists of Micro-K(R), an extended-release potassium supplement used to replenish electrolytes, primarily in patients who are on medication which depletes the levels of potassium in the body. We acquired Micro-K(R) in March 1999 from the pharmaceutical division of Wyeth. Based on the addition of new products and our expectation of continued growth in our branded business, Ther-Rx expanded its branded sales force by 80 specialty sales representatives and sales management personnel in fiscal 2004 and Ther-Rx added an additional 30 specialty sales representatives late in fiscal 2005. Ther-Rx's sales force focuses on physician specialists who are identified through available market research as frequent prescribers of our prescription products. Ther-Rx also has a corporate sales and marketing management team dedicated to planning and managing Ther-Rx's sales and marketing efforts. ETHEX -- OUR TECHNOLOGICALLY DISTINGUISHED GENERIC/NON-BRANDED DRUG BUSINESS We established ETHEX, currently our largest business segment, in 1990 to utilize our portfolio of drug delivery systems to develop and market hard-to-copy generic/non-branded pharmaceuticals. We believe many of our ETHEX products enjoy higher gross margins than other generic pharmaceutical companies due to our approach of selecting products that benefit from our proprietary drug delivery systems and our specialty manufacturing capabilities. These advantages can act as barriers to entry which may limit competition and reduce the rate of price erosion typically experienced in the generic market. ETHEX's net revenues were $191.9 million for fiscal 2005, which represented 63.2% of our total net revenues. We have incorporated our proprietary drug delivery technology in many of our generic/non-branded pharmaceutical products. For example, we have included METER RELEASE(R), one of our proprietary controlled 6 release technologies, into the only generic equivalent to Norpace(R) CR, an antiarrhythmic that is taken twice daily. Further, we have used our KV/24(R) once daily technology in the generic equivalent to IMDUR(R), a cardiovascular drug that is taken once per day. In addition, utilizing our specialty manufacturing expertise and a sublingual delivery system, we produced and marketed the first non-branded alternative to Nitrostat(R) sublingual, an anti-angina product which historically has been difficult to manufacture. To capitalize on ETHEX's unique product capabilities, we continue to expand our ETHEX product portfolio. Over the past two years, we have introduced more than 20 new generic/non-branded products and have a number of products currently in development to be marketed by ETHEX. Since January 1, 2004, we have received six new Abbreviated New Drug Application, or ANDA, approvals. We also anticipate receipt of ANDA approvals for Diltiazem and Levothyroxine, among other products, in fiscal 2006. In addition to our internal marketing efforts, we have licensed the exclusive rights to co-develop and market more than 15 products with other drug delivery companies. These products are generic equivalents to brand name products with aggregate annual sales totaling over $4 billion and, subject to completion of development and regulatory approvals, are expected to be launched at various times beginning in fiscal 2006 and continuing through fiscal 2008. In fiscal 2005, we began marketing the 50mg/200mg strength of Carbidopa-Levodopa, the generic equivalent to Sinemet(R), under a co-development licensing agreement with another drug delivery company. By focusing our efforts on the development and marketing of technology-distinguished, multisource drugs, over half of the more than 140 specialty generic/non-branded products sold by our ETHEX subsidiary are leaders in their respective multisource-brand markets. ETHEX primarily focuses on the therapeutic categories of cardiovascular, women's health, pain management and respiratory, leveraging our expertise in developing and manufacturing products in these areas. In addition, we pursue opportunities outside of these categories where we also may differentiate our products based upon our proprietary drug delivery systems and our specialty manufacturing expertise. CARDIOVASCULAR. ETHEX currently markets over 40 products in its cardiovascular line, including products to treat angina, arrhythmia and hypertension, as well as for potassium supplementation. The cardiovascular line accounted for 44.6% of ETHEX's net revenues in fiscal 2005. PAIN MANAGEMENT. ETHEX currently markets over 20 products in its pain management line. Included in this line are several controlled substance drugs, such as morphine, hydromorphone and oxycodone. The pain management line accounted for 18.6% of ETHEX's net revenues in fiscal 2005. RESPIRATORY. ETHEX currently markets over 30 products in its respiratory line, which consists primarily of cough/cold products. ETHEX is the leading provider on a unit basis of prescription cough/cold products in the United States today. The cough/cold line accounted for 15.2% of ETHEX's net revenues in fiscal 2005. WOMEN'S HEALTH CARE. ETHEX currently markets over 20 products in its women's healthcare line, all of which are prescription prenatal vitamins. Based on the number of units sold, ETHEX is the leading provider of prescription prenatal vitamins in the United States. The women's healthcare line accounted for 10.5% of ETHEX's net revenues in fiscal 2005. OTHER THERAPEUTICS. In addition to our core therapeutic lines, ETHEX markets over 30 products in the gastrointestinal, dermatological, anti-anxiety, digestive enzyme and dental categories. ETHEX has a dedicated sales and marketing team, which includes an outside sales team of regional managers and national account managers and an inside sales team. The outside sales force calls on wholesalers and distributors 7 and national drugstore chains, as well as hospitals, nursing homes, independent pharmacies and mail order firms. The inside sales force calls on independent pharmacies to create pull-through at the wholesale level. PDI - OUR VALUE-ADDED RAW MATERIAL BUSINESS PDI develops and markets specialty raw material products for the pharmaceutical, nutritional, food and personal care industries. Its products include value-added active drug molecules, vitamins, minerals and other raw material ingredients that provide benefits such as improved taste, altered or controlled release profiles, enhanced product stability or more efficient and other manufacturing process advantages. PDI is also a significant supplier of value-added raw material for our Ther-Rx and ETHEX businesses. Net revenues for PDI were $18.3 million in fiscal 2005, which represented 6.0% of our total net revenues. PDI currently offers three distinct lines of specialty raw material products: o DESCOTE(R) is a family of microencapsulated tastemasked vitamins and minerals for use in chewable nutritional products, quick dissolve dosage forms, foods, children's vitamins and other products. o DESTAB(TM) is a family of direct compression products that enables pharmaceutical manufacturers to produce tablets and caplets more efficiently and economically. o MicroMask(TM) is a family of products designed to alleviate problems associated with swallowing tablets. This is accomplished by offering superior tasting, chewable or quick dissolving dosage forms of medication. BUSINESS STRATEGY Our goal is to enhance our position as a leading fully integrated specialty pharmaceutical company that utilizes its expanding drug delivery expertise to bring technologically distinguished brand name and generic/non-branded products to market. Our strategies incorporate the following key elements: INTERNALLY DEVELOP BRAND NAME PRODUCTS. We apply our existing drug delivery technologies, research and development and manufacturing expertise to introduce new products which can expand our existing franchises. In January 2005, Ther-Rx introduced its second NDA approved product, Clindesse(TM), the first approved single-dose therapy for bacterial vaginosis. Similar to Gynazole-1(R), Clindesse(TM) incorporates our proprietary VagiSite(R) bioadhesive drug delivery technology. We plan to continue to use our research and development, manufacturing and marketing expertise to create unique brand name products within our core therapeutic areas and we currently have a number of new products in clinical development. CAPITALIZE ON ACQUISITION OPPORTUNITIES. We actively seek acquisition opportunities for both Ther-Rx and ETHEX. Ther-Rx continually looks for platform acquisition opportunities similar to PreCare(R) around which we can build franchises. We believe that consolidation among large pharmaceutical companies, coupled with cost-containment pressures, has increased the level of sales necessary for an individual product to justify active marketing and promotion. This has led large pharmaceutical companies to focus their marketing efforts on drugs with higher volume sales, newer or novel drugs which have the potential for high volume sales and products which fit within core therapeutic or marketing priorities. As a result, major pharmaceutical companies increasingly have sought to divest small or non-strategic product lines, which can be profitable for specialty pharmaceutical companies like us. In making acquisitions, we apply several important criteria in our decision-making process. We pursue products with the following attributes: o products which we believe have relevance for treatment of significant clinical needs; 8 o promotionally sensitive maintenance drugs which require continual use over a long period of time, as opposed to more limited use products for acute indications; o products which are predominantly prescribed by physician specialists, which can be cost-effectively marketed by our focused sales force; and o products which we believe have potential for technological enhancements and line extensions based upon our drug delivery technologies. FOCUS SALES EFFORTS ON HIGH VALUE NICHE MARKETS. We focus our Ther-Rx sales efforts on niche markets where we believe we can target a relatively narrow physician audience. Because our products are sold to specialty physician groups that tend to be relatively concentrated, we believe that we can address these markets cost effectively with a focused sales force. Based on the addition of new products and our expectation of continued growth in our branded business, Ther-Rx expanded its branded sales force by 80 specialty sales representatives and sales management personnel in fiscal 2004 and Ther-Rx added an additional 30 specialty sales representatives late in fiscal 2005. We plan to continue to build our sales force as necessary to accommodate current and future expansions of our product lines. PURSUE ATTRACTIVE GROWTH OPPORTUNITIES WITHIN THE GENERIC INDUSTRY. We plan to continue introducing generic and non-branded alternatives to select drugs whose patents have expired, particularly when we can add value through our drug delivery technologies. Such generic or off-patent pharmaceutical products are generally sold at significantly lower prices than the branded product. Accordingly, generic pharmaceuticals provide a cost-efficient alternative to users of branded products. We believe the health care industry will continue to support growth in the generic pharmaceutical market and that industry trends favor generic product expansion into the managed care, long-term care and government contract markets. We further believe that we are uniquely positioned to capitalize on this growing market given our large base of proprietary drug delivery technologies and our proven ability to lead the therapeutic categories we enter. ADVANCE EXISTING AND DEVELOP NEW DRUG DELIVERY TECHNOLOGIES. We believe our drug delivery platform of 15 distinguished technologies has unique breadth and depth. These technologies have enabled us to create innovative products, including Gynazole-1(R) and Clindesse(TM), which incorporate VagiSite(TM), our proprietary bioadhesive controlled release system. In addition, our tastemasking and controlled release systems are incorporated into our prenatal vitamins, providing them with differentiated benefits over other products on the market. We plan to continue to develop our drug delivery technologies and have various technologies currently under development, such as: TransCell(R) for oral esophageal delivery of bioactive peptides and proteins that are normally degraded by stomach enzymes or first-pass liver effects; PulmoSite(TM) which applies bioadhesive and controlled release characteristics to drug agents that are inhaled for either local action in the lung or for systemic absorption; and Ocusite(TM) for the delivery of active agents by a bioadhesive topical application to the eye. OUR PROPRIETARY DRUG DELIVERY TECHNOLOGIES We believe we are a leader in the development of proprietary drug delivery systems and formulation technologies which enhance the effectiveness of new therapeutic agents, existing pharmaceutical products and nutritional supplements. We have used many of these technologies to successfully commercialize technologically distinguished branded and generic/non-branded products. Additionally, we continue to invest our resources in the development of new technologies. The following describes our principal drug delivery technologies. SITE RELEASE(R) TECHNOLOGIES. SITE RELEASE(R) is our largest family of technologies and includes eight systems designed specifically for oral, topical or interorificial use. These systems rely on controlled bioadhesive properties to optimize the delivery of drugs to either wet mucosal tissue or the skin and are the subject of issued 9 patents and pending patent applications. Of the technologies developed, products using the VagiSite(TM) and DermaSite(TM) technologies have been successfully commercialized. Our fully developed technologies include the following: o VagiSite(TM) is a controlled release bioadhesive delivery system that incorporates advanced polyphasic principles to create a bioemulsion system delivering therapeutic agents to the vagina. We have outlicensed VagiSite(TM) for sale in international markets for the treatment of vaginal infections. VagiSite(TM) technology is used in Gynazole-1(R), a one-dose prescription cream treatment for vaginal yeast infections and Clindesse(TM), a one-dose prescription cream treatment for bacterial vaginosis. o DermaSite(TM) is a semi-solid SITE RELEASE(R) configuration for topical applications to the skin. The bioadhesive and controlled release properties of the delivery platform have made possible the development of products requiring a significantly reduced frequency of application. DermaSite(TM) technology is used in Dermarin-L(TM), a topical antifungal product being marketed by the leading over-the-counter pharmaceutical company in Japan, Taisho Pharmaceutical, Ltd. o OraSite(R) is a controlled release mucoadhesive delivery system administered orally in a solid or liquid form. A drug formulated with the OraSite(R) technology may be formulated as a liquid or as a lozenge in which the dosage form liquefies upon insertion and adheres to the mucosal surface of the mouth, throat and esophagus. OraSite(R) possesses characteristics particularly advantageous to therapeutic categories such as oral hygiene, sore throat and periodontal and upper gastrointestinal tract disorders. o OraSert(TM) is a solid dosage-form application system specifically designed for localized delivery of active agents to the oral tissues. The product is formulated as a "cough drop" type tablet, which immediately liquefies upon placement in the mouth and bioadheres to mucosal tissue in the mouth, throat and esophagus. OraSert(TM) possesses characteristics particularly advantageous to therapeutic applications such as periodontal disease, respiratory conditions, pharyngeal conditions and upper gastrointestinal tract disorders. o BioSert(TM) is a bioadhesive delivery system in a solid insert formulation for vaginal or rectal administration, similar in appearance to a vaginal or rectal suppository, which can be used for both local and systemic delivery of drugs. The BioSert(TM) dosage form liquefies and bioadheres to vaginal or rectal tissues, which is of particular benefit when a patient can no longer tolerate orally administered medications. We are currently developing several drug products that utilize the BioSert(TM) technology, including non-steroidal anti-inflammatory drugs, or NSAIDs, and antifungals for a local effect and opioids for a systemic effect. In addition, the following SITE RELEASE(R) technologies are currently under development: o Trans-Cell(R) is a novel bioadhesive, controlled release delivery system that may permit oral delivery of bioactive peptides and proteins that are normally degraded by stomach enzymes or first-pass liver effects. This technology was specifically designed to provide an oral delivery alternative to biotechnology and other compounds that currently are delivered as injections or infused. o OcuSite(TM) is a liquid, microemulsion delivery system intended for topical applications in the eye. The microemulsion formulation lends optical clarity to the application and is particularly well suited for ophthalmic use. The bioadhesive and controlled release properties of this delivery system allow for reduced dosing regimentation. o PulmoSite(TM) applies bioadhesive and controlled release characteristics to drug agents that are to be inhaled for either local action to the lung or for systemic absorption. 10 ORAL CONTROLLED RELEASE TECHNOLOGIES. The technological preeminence of our advanced drug delivery systems was established in the development of our three oral controlled release technologies, all of which have been commercialized. Our systems can be individually designed to achieve the desired release profile for a given drug. The release profile is dependent on many parameters, such as drug solubility, protein binding and site of absorption. Some of the products utilizing our oral controlled release systems in the market include Isosorbide-5-Mononitrate (an AB rated generic equivalent to IMDUR(R)) and Disopyramide Phosphate (an AB rated generic equivalent of Norpace(R) CR). Our patented technologies include the following: o KV/24(R) is a multi-particulate drug delivery system that encapsulates one or more drug compounds into spherical particles which release the active drug or drugs systemically over an 18- to 24-hour period, permitting the development of once-a-day drug formulations. We believe that our KV/24(R) oral dosing system is the only commercialized 24-hour oral controlled release system that is successfully able to incorporate more than one active compound. o METER RELEASE(R) is a polymer-based drug delivery system that offers different release characteristics than KV/24(R) and is used for products that require drug release rates of between eight and 12 hours. We have developed METER RELEASE(R) systems in tablet, capsule and caplet form that have been commercialized in ETHEX products in the cardiovascular, gastrointestinal and upper respiratory product categories. o MICRO RELEASE(R) is a microparticulate formulation that encapsulates therapeutic agents, employing smaller particles than KV/24(R) and METER RELEASE(R). This system is used to extend the release of drugs in the body where precise release profiles are less important. MICRO RELEASE(R) has been commercialized in prescription products marketed by ETHEX and Ther-Rx as well as over-the-counter nutritional products. TASTEMASKING TECHNOLOGIES. Our tastemasking technologies improve the taste of unpleasant drugs. Our three patented tastemasking systems can be applied to liquids, chewables or dry powders. We first introduced tastemasking technologies in 1991 and have utilized them in a number of Ther-Rx and ETHEX products, including PreCare(R) Chewables and most of the liquid products that are sold in ETHEX's cough/cold line. Our patented technologies include the following: o LIQUETTE(R) is a tastemasking system that incorporates unpleasant tasting drugs into a hydrophilic and lipophilic polymer matrix to suppress the taste of a drug. This technology is used for mildly to moderately distasteful drugs where low manufacturing costs are particularly important. o FlavorTech(R) is a liquid formulation technology designed to reduce the objectionable taste of a wide variety of therapeutic products. FlavorTech(R) technology has been used in cough/cold syrup products sold by ETHEX and has special application to other products, such as antibiotic, geriatric and pediatric pharmaceuticals. o MicroMask(TM) is a tastemasking technology that incorporates a dry powder, microparticulate approach to reducing objectionable tastes by sequestering the unpleasant drug agent in a specialized matrix. This formulation technique has the effect of "shielding" the drug from the taste receptors without interfering with the dissolution and ultimate absorption of the agent within the gastrointestinal tract. MicroMask(TM) is a more potent tastemasking technology than LIQUETTE(R) and has been used in connection with two Ther-Rx products. QUICK DISSOLVING TECHNOLOGY. Our quick dissolving oral tablet technology provides the ability to tastemask, yet dissolves in the mouth in a matter of seconds. Most other quick-dissolving technologies offer either quickness at the expense of poor tastemasking or excellent tastemasking at the expense of quickness. While still under development, this system allows for a drug to be quickly dissolved in the mouth, and can be combined with tastemasking capabilities that offer a unique dosage form for the most bitter tasting drug compounds. We have been issued patents and have patents pending for this system with the U.S. Patent and Trademark Office, or PTO. 11 SALES AND MARKETING Ther-Rx has a national sales and marketing infrastructure which includes approximately 240 sales representatives dedicated to promoting and marketing our branded pharmaceutical products to targeted physician specialists. Based on the addition of new products and our expectation of continued growth in our branded business, Ther-Rx expanded its branded sales force by 80 specialty sales representatives and sales management personnel in fiscal 2004 and added an additional 30 specialty sales representatives late in fiscal 2005. Ther-Rx's sales force focuses on physician specialists who are identified through available market research as frequent prescribers of our prescription products. Ther-Rx also has a corporate sales and marketing management team dedicated to planning and managing Ther-Rx's sales and marketing efforts. We attempt to increase sales of our branded pharmaceutical products through physician sales calls and promotional efforts, including sampling, advertising and direct mail. For acquired branded products, we generally increase the level of physician sales calls and promotion relative to the previous owner. For example, with the PreCare(R) prenatal sales efforts, we increased the level of physician sales calls and sampling to the highest prescribers of prenatal vitamins. We also have enhanced our PreCare(R) brand franchise by launching five more line extensions to address unmet needs, including the launch of PreCare(R) Chewables, Premesis Rx(TM), PreCare(R) Conceive(TM), PrimaCare(R) and PrimaCare(R) ONE. The PreCare(R) product line enables us to deliver a full range of nutritional products for physicians to prescribe to women in their childbearing years. In addition, we added to our women's health care family of products in June 2000 with the introduction of our first NDA approved product, Gynazole-1(R), the only one-dose prescription cream treatment for vaginal yeast infections. In fiscal 2004, we further expanded our branded product offerings when we launched technology improved versions of the Chromagen(R) and Niferex(R) oral hematinic product lines that were acquired at the end of fiscal 2003. In January 2005, we introduced our second NDA approved product, Clindesse(TM), the first approved single-dose therapy for bacterial vaginosis. By offering multiple products to the same group of physician specialists, we are able to maximize the effectiveness of our experienced sales force. ETHEX has an experienced sales and marketing team, which includes an outside sales team, regional account managers, national account managers and an inside sales team. The outside sales force calls on wholesalers, distributors and national drugstore chains, as well as hospitals, nursing homes, mail order firms and independent pharmacies. The inside sales team calls on independent pharmacies to create pull-through at the wholesale level. We believe that industry trends favor generic product expansion into the managed care, long-term care and government contract markets. Further, we believe that our competitively priced, technology-distinguished generic/non-branded products can fulfill the increasing need of these markets to contain costs and improve patient compliance. Accordingly, we intend to continue to devote significant marketing resources to the penetration of those markets. Particle Dynamics has a specialized technical sales group that calls on the leading companies in the pharmaceutical, nutritional, personal care, food and other markets in the United States. During fiscal 2005, our three largest customers accounted for 27%, 16% and 12% of gross revenues. These customers were McKesson Drug Company, Cardinal Health and Amerisource Corporation, respectively. In fiscal 2004 and 2003, these customers accounted for gross revenues of 25%, 16% and 13% and 23%, 14% and 18%, respectively. Although we sell internationally, we do not have material operations or sales in foreign countries and our sales are not subject to significant geographic concentration. 12 RESEARCH AND DEVELOPMENT We have long recognized that development of successful new products is critical to achieving our goal of sustainable growth over the long term. As such, our investment in research and development, which increased at a compounded annual growth rate of 26.2% over the past four fiscal years, reflects our continued commitment to develop new products and/or technologies through our internal development programs, and with our external strategic partners. Our research and development activities include the development of new and next generation drug delivery technologies, the formulation of brand name proprietary products and the development of technologically distinguished generic/non-branded versions of previously approved brand name pharmaceutical products. In fiscal 2005, 2004 and 2003, total research and development expenses were $23.5 million, $20.7 million and $19.1 million, respectively. In January 2005, Ther-Rx introduced its second NDA approved product, Clindesse(TM), the first approved single-dose therapy for bacterial vaginosis. Similar to Gynazole-1(R), Clindesse(TM) incorporates our proprietary VagiSite(R) bioadhesive drug delivery technology. Ther-Rx currently has a number of products in its research and development pipeline at various stages of development. We believe we have the technological expertise required to develop unique products to meet currently unmet needs in the area of women's health, as well as other therapeutic areas. To capitalize on ETHEX's unique product capabilities, we continue to expand our ETHEX product portfolio. Over the past two fiscal years, we have introduced more than 20 new generic/non-branded products and have a number of products currently in development to be marketed by ETHEX. Our development process typically consists of formulation, development and laboratory testing, and where required (1) preliminary bioequivalency studies of pilot batches of the manufactured product, (2) full scale bioequivalency studies using commercial quantities of the manufactured product and (3) submission of an ANDA to the FDA. We believe that, unlike many generic drug companies, we have the technical expertise required to develop generic substitutes for hard-to-copy branded pharmaceutical products. Since January 1, 2004, we have received six new ANDA approvals. We also anticipate receipt of ANDA approvals for Diltiazem and Levathyroxine, among other products, in fiscal 2006. In addition to our internal marketing efforts, we have licensed the exclusive rights to co-develop and market more than 15 products with other drug delivery companies. These products are generic equivalents to brand name products with aggregate annual sales totaling over $4 billion and, subject to completion of development and regulatory approvals, are expected to be launched at various times beginning in fiscal 2006 and continuing through fiscal 2008. In fiscal 2005, we began marketing the 50mg/200mg strength of Carbidopa-Levodopa, the generic equivalent to Sinemet(R), under a co-development licensing agreement with another drug delivery company. PDI currently has a number of products in its research and development pipeline at various stages of development. PDI applies its technologies to a diverse number of active and inactive chemicals for more efficient processing of materials to achieve benefits such as prolonged action of release, tastemasking, making materials more site specific and other benefits. Typically, the finished products into which the specialty raw materials are incorporated do not require FDA approval. We continually apply our scientific and development expertise to refine and enhance our existing drug delivery systems and formulation technologies and to create new technologies that may be used in our drug development programs. Certain of these technologies currently under development include advanced oral controlled release systems, quick dissolving oral delivery systems (with and without tastemasking characteristics) and transesophageal and intrapulmonary delivery technologies. 13 PATENTS AND OTHER PROPRIETARY RIGHTS We actively seek, when appropriate and available, protection for our products and proprietary information by means of U.S. and foreign patents, trademarks, trade secrets, copyrights, and contractual arrangements. Patent protection in the pharmaceutical field, however, can involve complex legal and factual issues. Moreover, broad patent protection for new formulations or new methods of use of existing chemical entities is sometimes difficult to obtain, primarily because the active ingredient and many of the formulation techniques have been known for some time. Consequently, some patents claiming new formulations or new methods of use for old drugs may not provide meaningful protection against competition. Nevertheless, we intend to seek patent protection when appropriate and available and otherwise to rely on regulatory-related exclusivity and trade secrets to protect certain of our products, technologies and other scientific information. There can be no assurance, however, that any steps taken to protect such proprietary information will be effective. Our policy is to file patent applications in appropriate situations to protect and preserve, for our own use, technology, inventions and improvements that we consider important to the development of our business. We currently hold domestic and foreign issued patents the last of which expires in fiscal 2022 relating to our controlled release, site-specific, quick dissolve and tastemasking technologies. We have been granted 33 U.S. patents and have 22 U.S. patent applications pending. In addition, we have 11 foreign issued patents and a total of 100 patent applications pending primarily in Canada, Europe, Australia, Japan, South America, Mexico and South Korea (see "We depend on our patents and other proprietary rights" under "Risk Factors" for additional information). We currently own more than 100 U.S. and foreign trademark registrations and have also applied for trademark protection for the names of our proprietary controlled-release, tastemasking, site-specific and quick dissolve technologies. We intend to continue to trademark new technology and product names as they are developed. To protect our trademark, domain name, and related rights, we generally rely on trademark and unfair competition laws, which are subject to change. Some, but not all, of our trademarks are registered in the jurisdictions where they are used. Some of our other trademarks are the subject of pending applications in the jurisdictions where they are used or intended to be used and others are not. MANUFACTURING AND FACILITIES We believe that our administrative, research, manufacturing and distribution facilities are an important factor in achieving our long-term growth objectives. All facilities at March 31, 2005, aggregating approximately 1.1 million square feet, are located in the St. Louis, Missouri area. We own approximately 600,000 square feet, with the balance under various leases at pre-determined annual rates under agreements expiring from fiscal 2006 through fiscal 2012, subject in most cases to renewal at our option. We manufacture drug products in liquid, semi-solid, tablet, capsule and caplet forms for distribution by Ther-Rx, ETHEX and our corporate licensees and value-added specialty raw materials for distribution by Particle Dynamics. We believe that all of our facilities are in material compliance with applicable regulatory requirements. We seek to maintain inventories at sufficient levels to support current production and sales levels. During fiscal 2005, we encountered no serious shortage of any particular raw materials, except that in the fourth quarter of fiscal 2005, we experienced a supply disruption of a key ingredient for our PrimaCare(R) ONE product. This interruption in production was temporary and has since been resolved. Although there can be no assurance that 14 raw material supply will not adversely affect our future operations, we do not believe that additional shortages will occur in the foreseeable future. COMPETITION Competition in the development and marketing of pharmaceutical products is intense and characterized by extensive research efforts and rapid technological progress. Many companies, including those with financial and marketing resources and development capabilities substantially greater than our own, are engaged in developing, marketing and selling products that compete with those that we offer. Our branded pharmaceutical products may also be subject to competition from alternate therapies during the period of patent protection and thereafter from generic equivalents. In addition, our generic/non-branded pharmaceutical products may be subject to competition from pharmaceutical companies engaged in the development of alternatives to the generic/non-branded products we offer or of which we undertake development. Our competitors may develop generic products before we do or may have pricing advantages over our products. In our specialty pharmaceutical businesses, we compete primarily on the basis of product efficacy, breadth of product line and price. We believe that our patents, proprietary trade secrets, technological expertise, product development and manufacturing capabilities will enable us to maintain a leadership position in the field of advanced drug delivery technologies and to continue to develop products to compete effectively in the marketplace. In addition, we compete with pharmaceutical companies that acquire branded product lines from other pharmaceutical companies. These competitors may have substantially greater financial and marketing resources than we do. Accordingly, our competitors may succeed in product line acquisitions that we seek to acquire. We also compete with drug delivery companies engaged in the development of alternative drug delivery systems. We are aware of a number of companies currently seeking to develop new non-invasive drug delivery systems, including oral delivery and transmucosal systems. Many of these companies may have greater research and development capabilities, experience, manufacturing, marketing, financial and managerial resources than we do. Accordingly, our competitors may succeed in developing competing technologies, obtaining FDA approval for products or gaining market acceptance more rapidly than we do. GOVERNMENT REGULATION All pharmaceutical manufacturers are subject to extensive regulation by the federal government, principally the FDA, and, to a lesser extent, by state, local and foreign governments. The Federal Food, Drug and Cosmetic Act, or FDCA, and other federal statutes and regulations govern or influence, among other things, the development, testing, manufacture, safety, labeling, storage, recordkeeping, approval, advertising, promotion, sale and distribution of pharmaceutical products. Pharmaceutical manufacturers are also subject to certain record keeping and reporting requirements, establishment registration and product listing, and FDA inspections. With respect to any non-biological "new drug" product with active ingredients not previously approved by the FDA, a prospective manufacturer must submit a full NDA, including complete reports of preclinical, clinical and other studies to prove the product's safety and efficacy. A full NDA may also need to be submitted for a drug product with a previously approved active ingredient if, among other things, the drug will be used to treat an indication for which the drug was not previously approved, or if the abbreviated procedure discussed below is otherwise not available. A manufacturer intending to conduct clinical trials in humans for a new drug may be required first to submit a Notice of Claimed Investigational Exception for a New Drug, or IND, to the FDA containing information relating to preclinical and clinical studies. INDs and full NDAs may be required to be filed to obtain approval of certain of our products, including those that do not qualify for abbreviated application procedures. The full NDA process, including clinical development and testing, is expensive and time consuming. The Drug Price Competition and Patent Restoration Act of 1984, known as the Hatch-Waxman Act, established ANDA procedures for obtaining FDA approval for generic versions of many non-biological drugs for which 15 patent or marketing exclusivity rights have expired and which are bioequivalent to previously approved drugs. "Bioequivalence" for this purpose, with certain exceptions, generally means that the proposed generic formulation is absorbed by the body at the same rate and extent as a previously approved "reference drug." Approval to manufacture these drugs is obtained by filing abbreviated applications, such as ANDAs. As a substitute for clinical studies, the FDA requires data indicating the ANDA drug formulation is bio-equivalent to a previously approved reference drug among other requirements. The same abbreviated application procedures apply to antibiotic drug products that are bio-equivalent to previously approved antibiotics, except that products containing certain older antibiotic ingredients are not subject to the special patent or marketing exclusivity protections afforded by the Hatch-Waxman Act to other drug products. The advantage of the ANDA approval mechanism, compared to an NDA, is that an ANDA applicant is not required to conduct preclinical and clinical studies to demonstrate that the product is safe and effective for its intended use and may rely, instead, on studies demonstrating bio-equivalence to a previously approved reference drug. In addition to establishing ANDA approval mechanisms, the Hatch-Waxman Act fosters pharmaceutical innovation through such incentives as non-patent exclusivity and patent restoration. The Act provides two distinct exclusivity provisions that either preclude the submission or delay the approval of an ANDA. A five-year exclusivity period is provided for new chemical compounds, and a three-year marketing exclusivity period is provided for changes to previously approved drugs which are based on new clinical investigations essential to the approval. The three-year marketing exclusivity period may be applicable to the approval of a novel drug delivery system. The marketing exclusivity provisions apply equally to patented and non-patented drug products, but do not apply to products containing antibiotic ingredients first submitted for approval on or before November 20, 1997. These provisions do not delay or otherwise affect the approvability of full NDAs even when effective ANDA approvals are not available. For drugs covered by patents, patent extension may be provided for up to five years as compensation for reduction of the effective life of the patent resulting from time spent in conducting clinical trials and in FDA review of a drug application. There has been substantial litigation in the biomedical, biotechnology and pharmaceutical industries with respect to the manufacture, use and sale of new products that are alleged to infringe outstanding patent rights. One or more patents cover most of the proprietary products for which we are developing generic versions. When we file an ANDA for such drug products, we will, in most cases, be required to certify to the FDA that any patent which has been listed with the FDA as covering the product is invalid or will not be infringed by our sale of our product. Alternatively, we could certify that we would not market our proposed product until the applicable patent expires. A patent holder may challenge a notice of noninfringement or invalidity by filing suit for patent infringement, which would, in most cases, prevent FDA approval until the suit is resolved or until at least 30 months has elapsed (or until the patent expires, whichever is earlier). Should any entity commence a lawsuit with respect to any alleged patent infringement by us, the uncertainties inherent in patent litigation would make the outcome of such litigation difficult to predict. In addition to marketing drugs which are subject to FDA review and approval, we market certain drug products in the United States without FDA approval under certain "grandfather" clauses and statutory and regulatory exceptions to the pre-market approval requirement for "new drugs" under the FDCA. A determination as to whether a particular product does or does not require FDA pre-market review and approval can involve consideration of numerous complex and imprecise factors. If a determination is made by the FDA that any product marketed without approval requires such approval, the FDA may institute enforcement actions, including product seizure, or an action seeking an injunction against further marketing and may or may not allow sufficient time to obtain the necessary approvals before it seeks to curtail further marketing. For example, in October 2002, the FDA sent warning letters to us and other manufacturers and distributors of unapproved prescription drug products containing the expectorant guaifenesin as a single entity in a solid oral extended-release dosage form. Citing the recent approval of one such product, the FDA warning letters asserted that the marketing of all such products without NDA or ANDA approval should stop. The FDA subsequently agreed to allow continued manufacture through May 2003 and sale through November 2003 of the products, and we complied with those deadlines. We are not in a position to predict whether or when the FDA might choose to raise similar objections 16 to the marketing without NDA or ANDA approval of another category or categories of drug products represented in our product lines. In the event such objections are raised, we could be required or could decide to cease distribution of additional products until pre-market approval is obtained. In addition, we may not be able to obtain any particular approval that may be required or such approval may not be obtained on a timely basis. In addition to obtaining pre-market approval for certain of our products, we are required to maintain all facilities in compliance with the FDA's current Good Manufacturing Practice, or cGMP, requirements. In addition to compliance with cGMP each pharmaceutical manufacturer's facilities must be registered with the FDA. Manufacturers must also be registered with the U.S. Drug Enforcement Administration or DEA, and similar state and local regulatory authorities if they handle controlled substances, and with the EPA and similar state and local regulatory authorities if they generate toxic or dangerous wastes, and must comply with other applicable DEA and EPA requirements. Noncompliance with applicable requirements can result in fines, recall or seizure of products, total or partial suspension of production and distribution, refusal of the government to enter into supply contracts or to approve NDA's, ANDA's or other applications and criminal prosecution. The FDA also has the authority to revoke for-cause drug approvals previously granted. The Prescription Drug Marketing Act, or PDMA, which amended various sections of the FDCA, requires, among other things, state licensing of wholesale distributors of prescription drugs under federal guidelines that include minimum standards for storage, handling and record keeping. All of our facilities are registered with the State of Missouri, where they are located, as required by Federal and Missouri law. The PDMA also imposes detailed requirements on the distribution of prescription drug samples such as those distributed by the Ther-Rx sales force. The PDMA sets forth substantial civil and criminal penalties for violations of these and other provisions. Many states also require registration of out-of-state drug manufacturers and distributors who sell products in their states, and may also impose additional requirements or restrictions on out-of-state firms. These requirements vary widely from state-to-state and are subject to change with little or no direct notice to potentially affected firms. We believe that we are currently in compliance in all material respects with applicable state requirements. However, in the event that we are found to have failed to comply with applicable state requirements, we may be subject to sanctions, including monetary penalties, and potential restrictions on our sales or other activities within particular states. For international markets, a pharmaceutical company is subject to regulatory requirements, inspections and product approvals substantially the same as those in the United States. In connection with any future marketing, distribution and license agreements that we may enter into, our licensees may accept or assume responsibility for such foreign regulatory approvals. The time and cost required to obtain these international market approvals may be greater or lesser than those required for FDA approval. Product development and approval within this regulatory framework take a number of years, involve the expenditure of substantial resources and is uncertain. Many drug products ultimately do not reach the market because they are not found to be safe or effective or cannot meet the FDA's other regulatory requirements. In addition, the current regulatory framework may change and additional regulatory or approval requirements may arise at any stage of our product development that may affect approval, delay the submission or review of an application or require additional expenditures by us. We may not be able to obtain necessary regulatory clearances or approvals on a timely basis, if at all, for any of our products under development, and delays in receipt or failure to receive such clearances or approvals, the loss of previously received clearances or approvals, or failure to comply with existing or future regulatory requirements could have a material adverse effect on our business. EMPLOYEES As of March 31, 2005, we employed a total of 1,072 employees. We are party to a collective bargaining agreement covering 119 employees that will expire December 31, 2009. We believe that our relations with our employees are good. 17 ENVIRONMENT We do not expect that compliance with Federal, state or local provisions regulating the discharge of materials into the environment or otherwise relating to the protection of the environment will have a material effect on our capital expenditures, earnings or competitive position. AVAILABLE INFORMATION We make available, free of charge through our Internet website (http://www.kvpharmaceutical.com), our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K and amendments to these reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after we electronically file these reports with, or furnish them to, the Securities and Exchange Commission, or SEC. Also, copies of our Corporate Governance Guidelines, Audit Committee Charter, Compensation Committee Charter, Nominating and Corporate Governance Committee Charter, Code of Ethics for Senior Executives and Standard of Business Ethics for all Directors and employees are available on our Internet website, and available in print to any stockholder who requests it. In addition, the SEC maintains an Internet website (http://www.sec.gov) that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. RISK FACTORS We operate in a rapidly changing environment that involves a number of risks, some of which are beyond our control. The following discussion highlights some of these risks and others are discussed elsewhere in this report. Additional risks presently unknown to us or that we currently consider immaterial or unlikely to occur could also impair our operations. These and other risks could materially and adversely affect our business, financial condition, operating results or cash flows. RISKS RELATED TO OUR BUSINESS OUR FUTURE GROWTH IS LARGELY DEPENDENT UPON OUR ABILITY TO DEVELOP NEW PRODUCTS. We need to continue to develop and commercialize new brand name products and generic products utilizing our proprietary drug delivery systems to maintain the growth of Ther-Rx, ETHEX and Particle Dynamics. To do this we will need to identify, develop and commercialize technologically enhanced branded products and identify, develop and commercialize drugs that are off-patent and that can be produced and sold by us as generic products using our drug delivery technologies. If we are unable to identify, develop and commercialize new products, we may need to obtain licenses to additional rights to branded or generic products, assuming they would be available for licensing, which could decrease our profitability. We cannot assure you that we will be successful in pursuing this strategy. IF WE ARE UNABLE TO COMMERCIALIZE PRODUCTS UNDER DEVELOPMENT, OUR FUTURE OPERATING RESULTS MAY SUFFER. Certain products we are developing will require significant additional development and investment, including preclinical and clinical testing, where required, prior to their commercialization. We expect that many of these products will not be commercially available for several years, if at all. We cannot assure you that such products or future products will be successfully developed, prove to be safe and effective in clinical trials (if required), meet applicable regulatory standards, or be capable of being manufactured in commercial quantities at reasonable cost. 18 OUR ACQUISITION STRATEGY MAY NOT BE SUCCESSFUL. We intend to continue to acquire pharmaceutical products, novel drug delivery technologies and/or companies that fit into our research, manufacturing, distribution or sales and marketing operations or that could provide us with additional products, technologies or sales and marketing capabilities. We may not be able to successfully identify, evaluate and acquire any such products, technologies or companies or, if acquired, we may not be able to successfully integrate such acquisitions into our business. We compete with many specialty pharmaceutical companies for products and product line acquisitions. These competitors may have substantially greater financial and managerial resources than we have. WE DEPEND ON OUR PATENTS AND OTHER PROPRIETARY RIGHTS AND CANNOT BE CERTAIN OF THEIR CONFIDENTIALITY AND PROTECTION. Our success depends, in large part, on our ability to protect our current and future technologies and products, to defend our intellectual property rights and to avoid infringing on the proprietary rights of others. We have been issued numerous patents in the United States and in certain foreign countries, which cover certain of our technologies, and have filed, and expect to continue to file, patent applications seeking to protect newly developed technologies and products. The pharmaceutical field is crowded and a substantial number of patents have been issued. In addition, the patent position of pharmaceutical companies can be highly uncertain and frequently involves complex legal and factual questions. As a result, the breadth of claims allowed in patents relating to pharmaceutical applications or their validity and enforceability cannot be predicted. Patents are examined for patentability at patent offices against bodies of prior art which by their nature may be incomplete and imperfectly categorized. Therefore, even presuming that the examiner has been able to identify and cite the best prior art available to him during the examination process, any patent issued to us could later be found by a court or a patent office during post issuance proceedings to be invalid in view of newly-discovered prior art or already considered prior art or other legal reasons. Furthermore, there are categories of "secret" prior art unavailable to any examiner, such as the prior inventive activities of others, which could form the basis for invalidating any patent. In addition, there are other reasons why a patent may be found to be invalid, such as an offer for sale or public use of the patented invention in the United States more than one year before the filing date of the patent application. Moreover, a patent may be deemed unenforceable if, for example, the inventor or the inventor's agents failed to disclose prior art to the PTO that they knew was material to patentability. The coverage claimed in a patent application can be significantly reduced before a patent is issued, either in the United States or abroad. Consequently, there can be no assurance that any of our pending or future patent applications will result in the issuance of patents. Patents issued to us may be subjected to further proceedings limiting their scope and may not provide significant proprietary protection or competitive advantage. Our patents also may be challenged, circumvented, invalidated or deemed unenforceable. Patent applications in the United States filed prior to November 29, 2000 are currently maintained in secrecy until and unless patents issue, and patent applications in certain other countries generally are not published until more than 18 months after they are first filed (which generally is the case in the United States for applications filed on or after November 29, 2000). In addition, publication of discoveries in scientific or patent literature often lags behind actual discoveries. As a result, we cannot be certain that we or our licensors will be entitled to any rights in purported inventions claimed in pending or future patent applications or that we or our licensors were the first to file patent applications on such inventions. Furthermore, patents already issued to us or our pending applications may become subject to dispute, and any dispute could be resolved against us. For example, we may become involved in re-examination, reissue or interference proceedings in the PTO, or opposition proceedings in a foreign country. The result of these proceedings can be the invalidation or substantial narrowing of our patent claims. We also could be subject to court proceedings that could find our patents invalid or unenforceable or could substantially narrow the scope of our patent claims. In addition, statutory differences in patentable subject matter may limit the protection we can obtain on some of our inventions outside of the United States. For example, methods of treating humans are not patentable in many countries outside of the United States. 19 These and other issues may prevent us from obtaining patent protection outside of the United States. Furthermore, once patented in foreign countries, the inventions may be subjected to mandatory working requirements and/or subject to compulsory licensing regulations. We also rely on trade secrets, unpatented proprietary know-how and continuing technological innovation that we seek to protect, in part by confidentiality agreements with licensees, suppliers, employees and consultants. These agreements may be breached by the other parties to these agreements. We may not have adequate remedies for any breach. Disputes may arise concerning the ownership of intellectual property or the applicability or enforceability of our confidentiality agreements and there can be no assurance that any such disputes would be resolved in our favor. Furthermore, our trade secrets and proprietary technology may become known or be independently developed by our competitors, or patents may not be issued with respect to products or methods arising from our research, and we may not be able to maintain the confidentiality of information relating to those products or methods. Furthermore, certain unpatented technology may be subject to intervening rights. WE DEPEND ON OUR TRADEMARKS AND RELATED RIGHTS. To protect our trademarks and goodwill associated therewith, domain name, and related rights, we generally rely on federal and state trademark and unfair competition laws, which are subject to change. Some, but not all, of our trademarks are registered in the jurisdictions where they are used. Some of our other trademarks are the subject of pending applications in the jurisdictions where they are used or intended to be used, and others are not. It is possible that third parties may own or could acquire rights in trademarks or domain names in the United States or abroad that are confusingly similar to or otherwise compete unfairly with our marks and domain names, or that our use of trademarks or domain names may infringe or otherwise violate the intellectual property rights of third parties. The use of similar marks or domain names by third parties could decrease the value of our trademarks or domain names and hurt our business, for which there may be no adequate remedy. THIRD PARTIES MAY CLAIM THAT WE INFRINGE ON THEIR PROPRIETARY RIGHTS, OR SEEK TO CIRCUMVENT OURS. We may be required to defend against charges of infringement of patents, trademarks or other proprietary rights of third parties. This defense could require us to incur substantial expense and to divert significant effort of our technical and management personnel, and could result in our loss of rights to develop or make certain products or require us to pay monetary damages or royalties to license proprietary rights from third parties. If a dispute is settled through licensing or similar arrangements, costs associated with such arrangements may be substantial and could include ongoing royalties. Furthermore, we cannot be certain that the necessary licenses would be available to us on acceptable terms, if at all. Accordingly, an adverse determination in a judicial or administrative proceeding or failure to obtain necessary licenses could prevent us from manufacturing, using, selling and/or importing in to the United States certain of our products. Litigation also may be necessary to enforce our patents against others or to protect our know-how or trade secrets. That litigation could result in substantial expense or put our proprietary rights at risk of loss, and we cannot assure you that any litigation will be resolved in our favor. There currently are two patent infringement lawsuits pending against us. Although we do not believe they will have a material adverse effect on our future financial condition or results of operations, we cannot assure you of that. WE MAY BE UNABLE TO MANAGE OUR GROWTH. Over the past ten years, our businesses and product offerings have grown substantially. This growth and expansion has placed, and is expected to continue to place, a significant strain on our management, operational and financial resources. To manage our growth, we must continue to (1) expand our operational, customer support and financial control systems and (2) hire, train and retain qualified personnel. We cannot assure you that 20 we will be able to adequately manage our growth. If we are unable to manage our growth effectively, our business, results of operations and financial condition could be materially adversely affected. WE MAY NOT OBTAIN REGULATORY APPROVAL FOR OUR NEW PRODUCTS ON A TIMELY BASIS, OR AT ALL. Many of our new products will require FDA approval. FDA approval typically involves lengthy, detailed and costly laboratory and clinical testing procedures, as well as the FDA's review and approval of the information submitted. We cannot assure you that the products we develop will be determined to be safe and effective in these testing procedures, or that they will be approved by the FDA. The FDA also has the authority to revoke for-cause drug approvals previously granted. WE MAY BE ADVERSELY AFFECTED BY THE CONTINUING CONSOLIDATION OF OUR DISTRIBUTION NETWORK AND THE CONCENTRATION OF OUR CUSTOMER BASE. Our principal customers are wholesale drug distributors, major retail drug store chains, independent pharmacies and mail order firms. These customers comprise a significant part of the distribution network for pharmaceutical products in the United States. This distribution network is continuing to undergo significant consolidation marked by mergers and acquisitions among wholesale distributors and the growth of large retail drug store chains. As a result, a small number of large wholesale distributors control a significant share of the market, and the number of independent drug stores and small drug store chains has decreased. We expect that consolidation of drug wholesalers and retailers will increase pricing and other competitive pressures on drug manufacturers. For the fiscal year ended March 31, 2005, our three largest customers accounted for 27%, 16% and 12% of our gross sales. The loss of any of these customers could materially and adversely affect our results of operations or financial condition. THE REGULATORY STATUS OF CERTAIN OF OUR GENERIC PRODUCTS MAY MAKE THEM SUBJECT TO INCREASED COMPETITION. Many of our products are manufactured and marketed without FDA approval. For example, our prenatal products, which contain folic acid, are sold as prescription multiple vitamin supplements. These types of prenatal vitamins are typically regulated by the FDA as prescription drugs, but are not covered by an NDA or ANDA. As a result, competitors may more easily and rapidly introduce products competitive with our prenatal and other products that have a similar regulatory status. One of the key motivations for challenging patents is the reward of a 180-day period of market exclusivity. Under the Hatch-Waxman Act, the developer of a generic version of a product which is the first to have its ANDA accepted for filing by the FDA, and whose filing includes a certification that the patent is invalid, unenforceable and/or not infringed (a so-called "Paragraph IV certification"), may be eligible to receive a 180-day period of generic market exclusivity. This period of market exclusivity provides the patent challenger with the opportunity to earn a risk-adjusted return on legal and development costs associated with bringing a product to market. In cases such as these where suit is filed by the manufacturer of the branded product, final FDA approval of an ANDA generally requires a favorable disposition of the suit, either by judgment that the patents at issue are invalid and/or not infringed or by settlement. There can be no assurance that we will ultimately prevail in these litigations, that we will receive final FDA approval of our ANDAs, or that any expectation of a period of generic exclusivity for certain of these products will actually be realized when and if resolution of the litigations and receipt of final approvals from the FDA occur. Since enactment of the Hatch-Waxman Act in 1984, the interpretation and implementation of the statutory provisions relating to the 180-day period of generic market exclusively have been the subject of controversy, court decisions, formal changes to FDA regulations and guidelines, and other changes in FDA interpretation. In addition, on December 8, 2003, significant changes were enacted in the statutory provisions themselves, some of which were retroactive and others of which apply only prospectively or to situations where the first ANDA filing with a Paragraph IV certification occurs after the date of enactment. These interpretations and changes, over time, 21 have had significant affects on the ability of sponsors of particular generic drug products to qualify for or utilize fully the 180-day generic marketing exclusivity period. These interpretations and changes have, in turn, affected the ability of sponsors of corresponding innovator drugs to market their branded products without any generic competition and the ability of sponsors of other generic versions of the same products to market their products in competition with the first generic applicant. Because application of these provisions, and any changes in them or in the applicable interpretations of them, depends almost entirely on the specific facts of the particular NDA and ANDA filings at issue, many of which are not in our control, we cannot predict whether any changes would, on balance, have a positive or negative effect on our business as a whole, although particular changes may have predictable, and potentially significant positive or negative affects on particular pipeline products. In addition, continuing uncertainty over the interpretation and implementation of the original Hatch-Waxman provisions, as well as the December 8, 2003 statutory revisions, is likely to continue to impair our ability to predict the likely exclusivity that we may be granted, or blocked by, based on the outcome of particular patent challenges in which we are involved. WE FACE THE RISK OF PRODUCT LIABILITY CLAIMS, FOR WHICH WE MAY BE INADEQUATELY INSURED. Manufacturing, selling and testing pharmaceutical products involve a risk of product liability. Even unsuccessful product liability claims could require us to spend money on litigation, divert management's time, damage our reputation and impair the marketability of our products. A successful product liability claim outside of or in excess of our insurance coverage could require us to pay substantial sums and adversely affect our results of operations and financial condition. We previously distributed several pharmaceutical products that contained phenylpropanolamine, or PPA, and that were discontinued in 2000 and 2001. We are presently named a defendant in a product liability lawsuit in federal court in Mississippi involving PPA. The suit originated out of a case, Virginia Madison, et al. v. Bayer Corporation, et al. The original suit was filed in December 2002, but was not served on us until February 2003. The case was originally filed in the Circuit Court of Hinds County, Mississippi, and was removed to the Federal District Court for the Southern District of Mississippi by then co-defendant Bayer Corporation. The case has been transferred to a Judicial Panel on Multi-District Litigation for PPA claims sitting in the Western District of Washington. The claims against us have been segregated into a lawsuit brought by Johnny Fulcher individually and on behalf of the wrongful death beneficiaries of Linda Fulcher, deceased, against the Company. It alleges bodily injury, wrongful death, economic injury, punitive damages, loss of consortium and/or loss of services from the use of our distributed pharmaceuticals containing PPA that have since been discontinued and/or reformulated to exclude PPA. In May 2004, the case was dismissed with prejudice by the Federal District Court for the Western District of Washington for a failure to timely file an individual complaint as required by certain court orders. The plaintiff filed a request for reconsideration which was opposed and subsequently denied by the Court in June 2004. In July 2004, the plaintiff filed a notice of appeal of the dismissal. We have opposed this appeal. We intend to vigorously defend our interests; however, we cannot give any assurance we will prevail. We have also been advised that one of our former distributor customers is being sued in Florida state court in a case captioned Darrian Kelly v. K-Mart et. al. for personal injury allegedly caused by ingestion of K-Mart diet caplets that are alleged to have been manufactured by us and to contain PPA. The distributor has tendered defense of the case to us and has asserted a right to indemnification for any financial judgment it must pay. We previously notified our product liability insurer of this claim in 1999, and we have demanded that the insurer assume our defense. The insurer has stated that it has retained counsel to secure additional factual information and will defer its coverage decision until that information is received. We intend to vigorously defend our interests; however, we cannot give any assurance that we will not be impleaded into the action, or that, if we are impleaded, that we would prevail. Our product liability coverage for PPA claims expired for claims made after June 15, 2002. Although we renewed our product liability coverage for coverage after June 15, 2002, that policy excludes future PPA claims in accordance with the standard industry exclusion. Consequently, as of June 15, 2002, we will provide for legal 22 defense costs and indemnity payments involving PPA claims on a going forward basis as incurred, including the Mississippi lawsuit that was filed after June 15, 2002. Moreover, we may not be able to obtain product liability insurance in the future for PPA claims with adequate coverage limits at commercially reasonable prices for subsequent periods. From time to time in the future, we may be subject to further litigation resulting from products containing PPA that we formerly distributed. We intend to vigorously defend our interests; however, we cannot give any assurances we will prevail. WE DEPEND ON LICENSES FROM OTHERS, AND ANY LOSS OF THESE LICENSES COULD HARM OUR BUSINESS, MARKET SHARE AND PROFITABILITY. We have acquired the rights to manufacture, use and/or market certain products. We also expect to continue to obtain licenses for other products and technologies in the future. Our license agreements generally require us to develop the markets for the licensed products. If we do not develop these markets, the licensors may be entitled to terminate these license agreements. We cannot be certain that we will fulfill all of our obligations under any particular license agreement for any variety of reasons, including insufficient resources to adequately develop and market a product, lack of market development despite our efforts and lack of product acceptance. Our failure to fulfill our obligations could result in the loss of our rights under a license agreement. Certain products we have the right to license are at certain stages of clinical tests and FDA approval. Failure of any licensed product to receive regulatory approval could result in the loss of our rights under its license agreement. OUR POLICIES REGARDING RETURNS, ALLOWANCES AND CHARGEBACKS, AND MARKETING PROGRAMS ADOPTED BY WHOLESALERS, MAY REDUCE OUR REVENUES IN FUTURE FISCAL PERIODS. Based on industry practice, generic product manufacturers, including us, have liberal return policies and have been willing to give customers post-sale inventory allowances. Under these arrangements, from time to time, we give our customers credits on our generic products that our customers hold in inventory after we have decreased the market prices of the same generic products. Therefore, if additional competitors enter the marketplace and significantly lower the prices of any of their competing products, we would likely reduce the price of our comparable products. As a result, we would be obligated to provide significant credits to our customers who are then holding inventories of such products, which could reduce sales revenue and gross margin for the period the credit is provided. Like our competitors, we also give credits for chargebacks to wholesale customers that have contracts with us for their sales to hospitals, group purchasing organizations, pharmacies or other retail customers. A chargeback is the difference between the price the wholesale customer pays and the price that the wholesale customer's end-customer pays for a product. Although we establish reserves based on our prior experience and our best estimates of the impact that these policies may have in subsequent periods, we cannot ensure that our reserves are adequate or that actual product returns, allowances and chargebacks will not exceed our estimates. INVESTIGATIONS OF THE CALCULATION OF AVERAGE WHOLESALE PRICES MAY ADVERSELY AFFECT OUR BUSINESS. Many government and third-party payors, including Medicare, Medicaid, health maintenance organizations, or HMOs, and managed care organizations, or MCOs, reimburse doctors and others for the purchase of certain prescription drugs based on a drug's average wholesale price, or AWP. In the past several years, state and federal government agencies have conducted ongoing investigations of manufacturers' reporting practices with respect to AWP, in which they have suggested that reporting of inflated AWP's have led to excessive payments for prescription drugs. Determination of AWP is complex and third party payors may disagree with our calculations. 23 KV and/or ETHEX have been named as defendants in certain multi-defendant cases alleging that the defendants reported improper or fraudulent pharmaceutical pricing information, i.e., AWP and/or Wholesale Acquisition Cost, or WAC, information, which caused the governmental plaintiffs to incur excessive costs for pharmaceutical products under the Medicaid program. Cases of this type have been filed against KV and/or ETHEX and other pharmaceutical manufacturer defendants by the State of Massachusetts, the State of Alabama, New York City, and approximately 25 counties in New York State (less than ten of which have been formally served on KV or ETHEX). The New York City case and all but one of the New York County cases have been transferred (or will be the subject of a notice of related action in order to effectuate transfer) to the Federal District Court for the District of Massachusetts for coordinated or consolidated pretrial proceedings under the Average Wholesale Price Multidistrict Litigation (MDL No. 1456). Each of these actions is in the early stages, and fact discovery has not yet begun in any of the cases other than the Alabama case, where the State's first discovery request has been filed. We intend to vigorously defend our interests in the actions described above; however, we cannot give any assurance we will prevail. We believe that various other governmental entities have commenced investigations into the generic and branded pharmaceutical industry at large regarding pricing and price reporting practices. Although we believe our pricing and reporting practices have complied in all material respects with our legal obligations, we cannot give any assurance that we would prevail if legal actions are instituted by these governmental entities. RISING INSURANCE COSTS COULD NEGATIVELY IMPACT PROFITABILITY. The cost of insurance, including workers' compensation, product liability and general liability insurance, has risen significantly in the past few years and is expected to continue to increase. In response, we may increase deductibles and/or decrease certain coverages to mitigate these costs. These increases, and our increased risk due to increased deductibles and reduced coverages, could have a negative impact on our results of operations, financial condition and cash flows. INCREASED INDEBTEDNESS MAY IMPACT OUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS. As a result of our issuance of 2.5% Contingent Convertible Subordinated Notes, or the Notes, in May 2003, our indebtedness increased by $200.0 million. In addition, we increased our available credit facilities in December 2004 to $140.0 million. The revised credit facilities provide for an increase from $40.0 million to $80.0 million in our revolving line of credit along with an increase from $25.0 million to $60.0 million in the supplemental credit line that is available for financing acquisitions. These credit facilities expire in October 2006 and December 2005, respectively. At March 31, 2005, we had no cash borrowings under either credit facility. Our level of indebtedness may have several important effects on our future operations, including: o we will be required to use a portion of our cash flow from operations for the payment of any principal or interest due on our outstanding indebtedness; o our outstanding indebtedness and leverage will increase the impact of negative changes in general economic and industry conditions, as well as competitive pressures; and o the level of our outstanding debt and the impact it has on our ability to meet debt covenants associated with our revolving line of credit arrangement may affect our ability to obtain additional financing for working capital, capital expenditures, acquisitions or general corporate purposes. General economic conditions, industry cycles and financial, business and other factors affecting our operations, many of which are beyond our control, may affect our future performance. As a result, our business might not continue to generate cash flow at or above current levels. If we cannot generate sufficient cash flow from operations in the future to service our debt, we may, among other things: o seek additional financing in the debt or equity markets; 24 o refinance or restructure all or a portion of our indebtedness; o sell selected assets; o reduce or delay planned capital expenditures; or o reduce or delay planned research and development expenditures. These measures might not be sufficient to enable us to service our debt. In addition, any financing, refinancing or sale of assets might not be available on economically favorable terms. Holders of the Notes may require us to offer to repurchase their Notes for cash upon the occurrence of a change in control or on May 16, 2008, 2013, 2018, 2023 and 2028. The source of funds for any repurchase required as a result of any such events will be our available cash or cash generated from operating activities or other sources, including borrowings, sales of assets, sales of equity or funds provided by a new controlling entity. The use of available cash to fund the repurchase of the Notes may impair our ability to obtain additional financing in the future. WE MAY HAVE FUTURE CAPITAL NEEDS AND FUTURE ISSUANCES OF EQUITY SECURITIES WILL RESULT IN DILUTION. We anticipate that funds generated internally, together with funds available under our credit facility, and the proceeds received from our Notes offering completed in May 2003, will be sufficient to implement our business plan for the foreseeable future, subject to additional needs as may arise if acquisition opportunities become available. We also may need additional capital if unexpected events occur or opportunities arise. Additional capital might be raised through the public or private sale of debt or equity securities. If we sell equity securities, holders of our common stock could experience dilution. Furthermore, those securities could have rights, preferences and privileges more favorable than those of the Class A or Class B common stock. We cannot assure you that additional funding will be available, or available on terms favorable to us. If the funding is not available, we may not be able to fund our expansion, take advantage of acquisition opportunities or respond to competitive pressures. WE MAY INCUR CHARGES FOR INTANGIBLE ASSET IMPAIRMENT. When we acquire the rights to manufacture and sell a product, we record the aggregate purchase price, along with the value of the product related liabilities we assume, as intangible assets. We use the assistance of valuation experts to help us allocate the purchase price to the fair value of the various intangible assets we have acquired. Then, we must estimate the economic useful life of each of these intangible assets in order to amortize their cost as an expense in our consolidated statement of income over the estimated economic useful life of the related asset. The factors that drive the actual economic useful life of a pharmaceutical product are inherently uncertain, and include patent protection, physician loyalty and prescribing patterns, competition by products prescribed for similar indications, future introductions of competing products not yet FDA approved, the impact of promotional efforts and many other issues. We use all of these factors in initially estimating the economic useful lives of our products, and we also continuously monitor these factors for indications of appropriate revisions. In assessing the recoverability of our intangible assets, we must make assumptions regarding estimated undiscounted future cash flows and other factors. If the estimated undiscounted future cash flows do not exceed the carrying value of the intangible assets we must determine the fair value of the intangible assets. If the fair value of the intangible assets is less than its carrying value, an impairment loss will be recognized in an amount equal to the difference. If these estimates or their related assumptions change in the future, we may be required to record impairment charges for these assets. We review intangible assets for impairment at least annually and whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If we determine that an intangible asset is impaired, a non-cash impairment charge would be recognized. 25 As circumstances after an acquisition can change, the value of intangible assets may not be realized by us. If we determine that an impairment has occurred, we would be required to write-off the impaired portion of the unamortized intangible assets, which could have a material adverse effect on our results of operations in the period in which the write-off occurs. For example, we expect to report a non-cash charge of approximately $30.0 million in the first quarter of fiscal 2006 reflecting primarily a write-off of in-process research and development costs in connection with our acquisition of FemmePharma and all of the worldwide marketing rights to an endometriosis product that has successfully completed Phase II clinical trials and was originally part of a licensing arrangement with FemmePharma. In addition, in the event of a sale of any of our assets, we cannot be certain that our recorded value of such intangible assets would be recovered. RISKS RELATED TO OUR INDUSTRY LEGISLATIVE PROPOSALS, REIMBURSEMENT POLICIES OF THIRD PARTIES, COST CONTAINMENT MEASURES AND HEALTH CARE REFORM COULD AFFECT THE MARKETING, PRICING AND DEMAND FOR OUR PRODUCTS. Various legislative proposals, including proposals relating to prescription drug benefits, could materially impact the pricing and sale of our products. Further, reimbursement policies of third parties may affect the marketing of our products. Our ability to market our products will depend in part on reimbursement levels for the cost of the products and related treatment established by health care providers, including government authorities, private health insurers and other organizations, such as HMOs and MCOs. Insurance companies, HMOs, MCOs, Medicaid and Medicare administrators and others are increasingly challenging the pricing of pharmaceutical products and reviewing their reimbursement practices. In addition, the following factors could significantly influence the purchase of pharmaceutical products, which could result in lower prices and a reduced demand for our products: o the trend toward managed health care in the United States; o the growth of organizations such as HMOs and MCOs; o legislative proposals to reform health care and government insurance programs; and o price controls and non-reimbursement of new and highly priced medicines for which the economic therapeutic rationales are not established. These cost-containment measures and health care reform proposals could affect our ability to sell our products. The reimbursement status of a newly approved pharmaceutical product may be uncertain. Reimbursement policies may not include some of our products. Even if reimbursement policies of third parties grant reimbursement status for a product, we cannot be sure that these reimbursement policies will remain in effect. Limits on reimbursement could reduce the demand for our products. The unavailability or inadequacy of third party reimbursement for our products could reduce or possibly eliminate demand for our products. We are unable to predict whether governmental authorities will enact additional legislation or regulation which will affect third party coverage and reimbursement that reduces demand for our products. Our ability to market generic pharmaceutical products successfully depends, in part, on the acceptance of the products by independent third parties, including pharmacies, government formularies and other retailers, as well as patients. We manufacture a number of prescription drugs which are used by patients who have severe health conditions. Although the brand-name products generally have been marketed safely for many years prior to our introduction of a generic/non-branded alternative, there is a possibility that one of these products could produce a side effect which could result in an adverse effect on our ability to achieve acceptance by managed care providers, 26 pharmacies and other retailers, customers and patients. If these independent third parties do not accept our products, it could have a material adverse effect on our financial condition and results of operations. EXTENSIVE INDUSTRY REGULATION HAS HAD, AND WILL CONTINUE TO HAVE, A SIGNIFICANT IMPACT ON OUR BUSINESS, ESPECIALLY OUR PRODUCT DEVELOPMENT, MANUFACTURING AND DISTRIBUTION CAPABILITIES. All pharmaceutical companies, including us, are subject to extensive, complex, costly and evolving regulation by the federal government, principally the FDA and, to a lesser extent, the DEA and state government agencies. The Federal Food, Drug and Cosmetic Act, the Controlled Substances Act and other federal statutes and regulations govern or influence the testing, manufacturing, packing, labeling, storing, record keeping, safety, approval, advertising, promotion, sale and distribution of our products. Failure to comply with applicable FDA or other regulatory requirements may result in criminal prosecution, civil penalties, injunctions, recall or seizure of products and total or partial suspension of production, as well as other regulatory actions against our products and us. We market certain drug products in the United States without FDA approval under certain "grandfather" clauses and statutory and regulatory exceptions to the pre-market approval requirement for "new drugs" under the Federal Food, Drug and Cosmetic Act, or the FDCA. A determination as to whether a particular product does or does not require FDA pre-market review and approval can involve consideration of numerous complex and imprecise factors. If a determination is made by the FDA that any product marketed without approval requires such approval, the FDA may institute enforcement actions, including product seizure, or an action seeking an injunction against further marketing and may or may not allow sufficient time to obtain the necessary approvals before it seeks to curtail further marketing. For example, in October 2002, FDA sent warning letters to us and other manufacturers and distributors of unapproved prescription drug products containing the expectorant guaifenesin as a single entity in a solid oral extended-release dosage form. Citing the recent approval of one such product, the FDA warning letters asserted that the marketing of all such products without NDA or ANDA approval should stop. The FDA subsequently agreed to allow continued manufacture through May 2003 and sale through November 2003 of the products, and we complied with those deadlines. We are not in a position to predict whether or when the FDA might choose to raise similar objections to the marketing without NDA or ANDA approval of another category or categories of drug products represented in our product lines. In the event such objections are raised, we could be required or could decide to cease distribution of additional products until pre-market approval is obtained. In addition, we may not be able to obtain any particular approval that may be required or such approvals may not be obtained on a timely basis. In addition to compliance with current Good Manufacturing Practice, or cGMP, requirements, drug manufacturers must register each manufacturing facility with the FDA. Manufacturers and distributors of prescription drug products are also required to be registered in the states where they are located and in certain states that require registration by out-of-state manufacturers and distributors. Manufacturers also must be registered with the Drug Enforcement Administration, or DEA, and similar applicable state and local regulatory authorities if they handle controlled substances, and with the Environmental Protection Agency, or EPA, and similar state and local regulatory authorities if they generate toxic or dangerous wastes, and must also comply with other applicable DEA and EPA requirements. We believe that we are currently in material compliance with cGMP and are registered with the appropriate state and federal agencies. Non-compliance with applicable cGMP requirements or other rules and regulations of these agencies can result in fines, recall or seizure of products, total or partial suspension of production and/or distribution, refusal of government agencies to grant pre-market approval or other product applications and criminal prosecution. Despite our ongoing efforts, cGMP requirements and other regulatory requirements, and related enforcement priorities and policies may evolve over time and we may not be able to remain continuously in material compliance with all of these requirements. From time to time, governmental agencies have conducted investigations of pharmaceutical companies relating to the distribution and sale of drug products to government purchasers or subject to government or third party reimbursement. We believe that we have marketed our products in compliance with applicable laws and 27 regulations. However, standards sought to be applied in the course of governmental investigations can be complex and may not be consistent with standards previously applied to our industry generally or previously understood by us to be applicable to our activities. The process for obtaining governmental approval to manufacture and market pharmaceutical products is rigorous, time-consuming and costly, and we cannot predict the extent to which we may be affected by legislative and regulatory developments. We are dependent on receiving FDA and other governmental or third-party approvals prior to manufacturing, marketing and shipping many of our products. Consequently, there is always the chance that we will not obtain FDA or other necessary approvals, or that the rate, timing and cost of such approvals, will adversely affect our product introduction plans or results of operations. In many instances we carry inventories of products in anticipation of launch, and if such products are not subsequently launched, we may be required to write-off the related inventory. OUR INDUSTRY IS HIGHLY COMPETITIVE. Numerous pharmaceutical companies are involved or are becoming involved in the development and commercialization of products incorporating advanced drug delivery systems. Our business is highly competitive, and we believe that competition will continue to increase in the future. Many pharmaceutical companies have invested, and are continuing to invest, significant resources in the development of proprietary drug delivery systems. In addition, several companies have been formed to develop specific advanced drug delivery systems. Many of these pharmaceutical and other companies who may develop drug delivery systems have greater financial, research and development and other resources than we do, as well as more experience in commercializing pharmaceutical and drug delivery products. Those companies may develop products using their drug delivery systems more rapidly than we do or develop drug delivery systems that are more effective than ours and thus may represent significant potential competitors. Our branded pharmaceutical business is subject to competition from larger companies with greater financial resources that can support larger sales forces. The ability of a sales force to compete is affected by the number of physician calls it can make, which is directly related to its size, the brand name recognition it has in the marketplace and its advertising and promotional efforts. We are not as well established in our branded product sales initiative as larger pharmaceutical companies and could be adversely affected by competition from companies with larger, more established sales forces and higher advertising and promotional expenditures. Our generic pharmaceutical business is also subject to competitive pressures from a number of companies, some of which have greater financial resources and broader product lines. To the extent that we succeed in being first to market with a generic/non-branded version of a significant product, our sales and profitability can be substantially increased in the period following the introduction of such product and prior to additional competitors' introduction of an equivalent product. Competition is generally on price, which can have an adverse effect on profitability as falling prices erode margins. In addition, the continuing consolidation of the customer base (wholesale distributors and retail drug chains) and the impact of managed care organizations will increase competition as suppliers compete for fewer customers. Consolidation of competitors will increase competitive pressures as larger suppliers are able to offer a broader product line. Further, companies continually seek new ways to defeat generic competition, such as filing applications for new patents to cover drugs whose original patent protection is about to expire, developing and marketing other dosage forms including patented controlled-release products or developing and marketing as over-the-counter products those branded products which are about to lose exclusivity and face generic competition. In addition to litigation over patent rights, pharmaceutical companies are often the subject of objections by competing manufacturers over the qualities of their branded or generic products and/or their promotional activities. For example, marketers of branded products have challenged the marketing of certain of our non-branded products that do not require FDA approval and are not rated for therapeutic equivalence. 28 Currently, the Company and ETHEX are named as defendants in ongoing litigation with Solvay Pharmaceuticals, Inc. regarding Solvay's allegations that ETHEX's comparative promotion of its Pangestyme(TM) CN 10 and Pangestyme(TM) CN 20 products to Solvay's Creon(R) 10 and Creon(R) 20 products resulted in false advertising and misleading statements under various Federal and state laws, and constituted unfair and deceptive trade practices. Discovery is active and the case is required to be ready for trial by February 1, 2006. The Company intends to vigorously defend its interests; however, it cannot give any assurance it will prevail. Competitors' objections also may be pursued in complaints before governmental agencies or courts. These objections can be very expensive to pursue or to defend, and the outcome of agency or court review of the issues raised is impossible to predict. In these proceedings, companies can be subjected to restrictions on their activities or to liability for alleged damages despite their belief that their products and procedures are in full compliance with appropriate standards. In addition, companies that pursue what they believe are legitimate complaints about competing manufacturers and/or their products may nevertheless be unable to obtain any relief. OUR INDUSTRY EXPERIENCES RAPID TECHNOLOGICAL CHANGE. The drug delivery industry is a rapidly evolving field. A number of companies, including major pharmaceutical companies, are developing and marketing advanced delivery systems for the controlled delivery of drugs. Products currently on the market or under development by competitors may deliver the same drugs, or other drugs to treat the same indications, as many of the products we market or are developing. The first pharmaceutical branded or generic/non-branded product to reach the market in a therapeutic area often obtains and maintains significant market share relative to later entrants to the market. Our products also compete with drugs marketed not only in similar delivery systems but also in traditional dosage forms. New drugs, new therapeutic approaches or future developments in alternative drug delivery technologies may provide advantages over the drug delivery systems and products that we are marketing, have developed or are developing. Changes in drug delivery technology may require substantial investments by companies to maintain their competitive position and may provide opportunities for new competitors to enter the industry. Developments by others could render our drug delivery products or other technologies uncompetitive or obsolete. If others develop drugs which are cheaper or more effective or which are first to market, sales or prices of our products could decline. RISKS RELATED TO OUR COMMON STOCK MANAGEMENT STOCKHOLDERS CONTROL OUR COMPANY. At March 31, 2005, our directors and executive officers beneficially own approximately 13% of our Class A Common Stock and approximately 60% of our Class B Common Stock. As a result, these persons control approximately 53% of the combined voting power represented by our outstanding securities. These persons will retain effective voting control of our company and are expected to continue to have the ability to effectively determine the outcome of any matter being voted on by our stockholders, including the election of directors and any merger, sale of assets or other change in control of our company. THE MARKET PRICE OF OUR STOCK HAS BEEN AND MAY CONTINUE TO BE VOLATILE. The market prices of securities of companies engaged in pharmaceutical development and marketing activities historically have been highly volatile. In addition, any or all of the following may have a significant impact on the market price of our common stock: announcements by us or our competitors of technological innovations or new commercial products; delays in the development or approval of products; developments or disputes concerning patent or other proprietary rights; publicity regarding actual or potential medical results relating to products marketed by us or products under development; regulatory developments in both the United States and foreign countries; publicity regarding actual or potential acquisitions; public concern as to the safety of drug 29 technologies or products; financial results which are different from securities analysts' forecasts; and economic and other external factors, as well as period-to-period fluctuations in our financial results. FUTURE SALES OF COMMON STOCK COULD ADVERSELY AFFECT THE MARKET PRICE OF OUR CLASS A OR CLASS B COMMON STOCK. As of March 31, 2005, an aggregate of 2,707,207 shares of our Class A common stock and 395,591 shares of our Class B common stock were issuable upon exercise of outstanding stock options under our stock option plans, and an additional 988,473 shares of our Class A common stock and 1,214,399 shares of Class B common stock were reserved for the issuance of additional options and shares under these plans. In addition, as of March 31, 2005, 8.7 million shares of Class A common stock were reserved for issuance upon conversion of $200.0 million principal amount of convertible notes, and 337,500 shares of our Class A common stock were reserved for issuance upon conversion of our outstanding 7% cumulative convertible preferred stock. Future sales of our common stock and instruments convertible or exchangeable into our common stock and transactions involving equity derivatives relating to our common stock, or the perception that such sales or transactions could occur, could adversely affect the market price of our common stock. This could, in turn, have an adverse effect on the trading price of the Notes resulting from, among other things, a delay in the ability of holders to convert their Notes into our Class A common stock. OUR CHARTER PROVISIONS AND DELAWARE LAW MAY HAVE ANTI-TAKEOVER EFFECTS. Our Amended Certificate of Incorporation authorizes the issuance of common stock in two classes, Class A common stock and Class B common stock. Each share of Class A common stock entitles the holder to one-twentieth of one vote on all matters to be voted upon by stockholders, while each share of Class B common stock entitles the holder to one full vote on each matter considered by the stockholders. In addition, our directors have the authority to issue additional shares of preferred stock and to determine the price, rights, preferences, privileges and restrictions of those shares without any further vote or action by the stockholders. The rights of the holders of common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. The existence of two classes of common stock with different voting rights and the ability of our directors to issue additional shares of preferred stock could make it more difficult for a third party to acquire a majority of our voting stock. Other provisions of our Amended Certificate of Incorporation and Bylaws, such as a classified board of directors, also may have the effect of discouraging, delaying or preventing a merger, tender offer or proxy contest, which could have an adverse effect on the market price of our Class A common stock. In addition, certain provisions of Delaware law applicable to our company could also delay or make more difficult a merger, tender offer or proxy contest involving our company, including Section 203 of the Delaware General Corporation Law, which prohibits a Delaware corporation from engaging in any business combination with any interested stockholder for a period of three years unless certain conditions are met. Our senior management is entitled to certain payments upon a change in control. All of our stock option plans provide for the acceleration of vesting in the event of a change in control of our company. 30 ITEM 2. PROPERTIES ---------- Our corporate headquarters is located at 2503 South Hanley Road in St. Louis County, Missouri, and contains approximately 40,000 square feet of floor space. We have a lease on the building for a period of ten years expiring December 31, 2006, with one five-year option to renew and a successive three-year renewal option. The building is leased from an affiliated partnership of an officer and director of the Company. In addition, we lease or own the facilities shown in the following table. All of these facilities are located in the St. Louis metropolitan area.
SQUARE LEASE RENEWAL FOOTAGE USAGE EXPIRES OPTIONS ----------------------------------------------------------------------------------------- 31,630 PDI Office/Mfg./Whse. 11/30/07 5 Years(1) 10,000 PDI/KV Lab/Whse. 11/30/05 None 15,000 KV/Ther-Rx Office 02/28/08 2 Years(3) 23,000 KV Office/R&D/Mfg. 12/31/06 5 Years(2) 122,350 KV Office/Whse./Lab Owned N/A 90,000 KV Mfg. Oper. Owned N/A 87,020 Under renovation(5) Owned N/A 302,940 Under renovation(6) Owned N/A 260,160 ETHEX/Ther-Rx/PDI Distribution(7) 04/30/12 5 Years(2) 40,000 KV Warehouse 11/30/05 1 Year(4) 128,960 ETHEX/PDI Office/Whse. 06/14/11 5 Years(2) ------- (1) One five-year option. (2) Two five-year options. (3) Two two-year options. (4) Two one-year options. (5) This facility is currently being renovated to provide an additional research lab facility. (6) This facility is currently being renovated into office space for ETHEX, Ther-Rx and certain KV administrative functions and production space for additional operations. We financed the purchase of this facility with a term loan secured by the facility. (7) On April 14, 2005, the Company completed the purchase of this building for $11.8 million. The property had been leased by the Company since April 2000 and will continue to function as the Company's main distribution facility. The purchase price of the building was paid with cash on hand.
Properties used in our operations are considered suitable for the purposes for which they are used and are believed to be adequate to meet our Company's needs for the reasonably foreseeable future. However, we will consider leasing or purchasing additional facilities from time to time, when attractive facilities become available, to accommodate the consolidation of certain operations and to meet future expansion plans. ITEM 3. LEGAL PROCEEDINGS ----------------- The Company and ETHEX are named as defendants in a case brought by CIMA LABS, Inc. and Schwarz Pharma, Inc. and styled CIMA LABS, Inc. et. al. v. KV Pharmaceutical Company et. al. filed in Federal District Court in Minnesota. It is alleged that the Company and ETHEX infringed on a CIMA patent in connection with the manufacture and sale of Hyoscyamine Sulfate Orally Dissolvable Tablets, 0.125 mg. The court has denied the plaintiffs' motion for a preliminary injunction, which allows ETHEX to continue marketing the product during the pendancy of the subject lawsuit. The Company has filed several motions for summary judgment requesting that the Court rule that the relevant patent is unenforceable, invalid or not infringed. These motions have been denied and the issues will be considered at trial. CIMA and Schwarz filed a summary judgment motion seeking the Court to rule that the patent is valid in the face of some prior art references cited by the Company as providing support for its invalidity defense. The Court granted the motion; however, the issue of invalidity based on prior art 31 that was not the subject of the motion will be tried. The Company intends to vigorously defend its interests; however, it cannot give any assurance it will prevail. The Company and ETHEX are named as defendants in a case brought by Solvay Pharmaceuticals, Inc. and styled Solvay Pharmaceuticals, Inc. v. ETHEX Corporation, filed in Federal District Court in Minnesota. In general, Solvay alleges that ETHEX's comparative promotion of its Pangestyme(TM) CN 10 and Pangestyme(TM) CN 20 products to Solvay's Creon(R) 10 and Creon(R) 20 products resulted in false advertising and misleading statements under various federal and state laws, and constituted unfair and deceptive trade practices. Discovery is active and the case is required to be trial ready by February 1, 2006. The Company intends to vigorously defend its interests; however, it cannot give any assurance it will prevail. KV previously distributed several pharmaceutical products that contained phenylpropanolamine, or PPA, and that were discontinued in 2000 and 2001. The Company is presently named a defendant in a product liability lawsuit in federal court in Mississippi involving PPA. The suit originated out of a case, Virginia Madison, et al. v. Bayer Corporation, et al. The original suit was filed in December 2002, but was not served on KV until February 2003. The case was originally filed in the Circuit Court of Hinds County, Mississippi, and was removed to the Federal District Court for the Southern District of Mississippi by then co-defendant Bayer Corporation. The case has been transferred to a Judicial Panel on Multi-District Litigation for PPA claims sitting in the Western District of Washington. The claims against the Company have been segregated into a lawsuit brought by Johnny Fulcher individually and on behalf of the wrongful death beneficiaries of Linda Fulcher, deceased, against the Company. It alleges bodily injury, wrongful death, economic injury, punitive damages, loss of consortium and/or loss of services from the use of the Company's distributed pharmaceuticals containing PPA that have since been discontinued and/or reformulated to exclude PPA. In May 2004, the case was dismissed with prejudice by the Federal District Court for the Western District of Washington for a failure to timely file an individual complaint as required by certain court orders. The plaintiff filed a request for reconsideration which was opposed and subsequently denied by the Court in June 2004. In July 2004, the plaintiff filed a notice of appeal of the dismissal. The Company has opposed this appeal. The Company intends to vigorously defend its interests; however, it cannot give any assurance it will prevail. The Company has also been advised that one of its former distributor customers is being sued in Florida state court in a case captioned Darrian Kelly v. K-Mart et. al. for personal injury allegedly caused by ingestion of K-Mart diet caplets that are alleged to have been manufactured by the Company and to contain PPA. The distributor has tendered defense of the case to the Company and has asserted a right to indemnification for any financial judgment it must pay. The Company previously notified its product liability insurer of this claim in 1999, and the Company has demanded that the insurer assume the Company's defense. The insurer has stated that it has retained counsel to secure additional factual information and will defer its coverage decision until that information is received. The Company intends to vigorously defend its interests; however, it cannot give any assurance that it will not be impleaded into the action, or that, if it is impleaded, that it would prevail. KV's product liability coverage for PPA claims expired for claims made after June 15, 2002. Although the Company renewed its product liability coverage for coverage after June 15, 2002, that policy excludes future PPA claims in accordance with the standard industry exclusion. Consequently, as of June 15, 2002, the Company will provide for legal defense costs and indemnity payments involving PPA claims on a going forward basis as incurred, including the Mississippi lawsuit that was filed after June 15, 2002. Moreover, the Company may not be able to obtain product liability insurance in the future for PPA claims with adequate coverage limits at commercially reasonable prices for subsequent periods. From time to time in the future, KV may be subject to further litigation resulting from products containing PPA that it formerly distributed. The Company intends to vigorously defend its interests; however, it cannot give any assurance it will prevail. After the Company filed ANDAs with the FDA seeking permission to market a generic version of the 50 mg, 100 mg, and 200 mg strengths of Toprol(R) XL in extended release capsule form, AstraZeneca filed lawsuits against KV for patent infringement under the provisions of the Hatch-Waxman Act. In the Company's Paragraph IV certification, KV contended that its proposed generic versions do not infringe AstraZeneca's patents. Pursuant to 32 the Hatch-Waxman Act, the filing date of the suit against the Company instituted an automatic stay of FDA approval of the Company's ANDA until the earlier of a judgment of non-infringement or invalidity, or 30 months from the date the application was filed. The Company has filed a motion for summary judgment with the Federal District Court in Missouri alleging, among other things, that AstraZeneca's patent is invalid. There is no trial setting. The Company intends to vigorously defend its interests; however, it cannot give any assurances it will prevail. The Company and/or ETHEX have been named as defendants in certain multi-defendant cases alleging that the defendants reported improper or fraudulent pharmaceutical pricing information, i.e., AWP and/or Wholesale Acquisition Cost, or WAC, information, which caused the governmental plaintiffs to incur excessive costs for pharmaceutical products under the Medicaid program. Cases of this type have been filed against the Company and/or ETHEX and other pharmaceutical manufacturer defendants by the State of Massachusetts, the State of Alabama, New York City, and approximately 25 counties in New York State (less than ten of which have been formally served on the Company or ETHEX). The New York City case and all but one of the New York County cases have been transferred (or will be the subject of a notice of related action in order to effectuate transfer) to the Federal District Court for the District of Massachusetts for coordinated or consolidated pretrial proceedings under the Average Wholesale Price Multidistrict Litigation (MDL No. 1456). Each of these actions is in the early stages, and fact discovery has not yet begun in any of the cases other than the Alabama case, where the State's first discovery request has been filed. The Company intends to vigorously defend its interests in the actions described above; however, it cannot give any assurance it will prevail. The Company believes that various other governmental entities have commenced investigations into the generic and branded pharmaceutical industry at large regarding pricing and price reporting practices. Although the Company believes its pricing and reporting practices have complied in all material respects with its legal obligations, it cannot give any assurances that it would prevail if legal actions are instituted by these governmental entities. On May 20, 2005 the Company was notified by the SEC that a non-public formal investigation was initiated that appears to relate to the Form 8-K disclosures the Company made on July 13, 2004. The Company is cooperating fully and believes the matter will be satisfactorily resolved. From time to time, the Company is involved in various other legal proceedings in the ordinary course of its business. These legal proceedings include various patent infringement actions brought by potential competitors with respect to products the Company proposes to market and for which it has submitted ANDA filings and provided notice of certification required under the provisions of the Act. While it is not feasible to predict the ultimate outcome of such other proceedings, the Company believes that the ultimate outcome of such other proceedings will not have a material adverse effect on its results of operations or financial position. There are uncertainties and risks associated with all litigation and there can be no assurance that the Company will prevail in any particular litigation. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS --------------------------------------------------- No matters were submitted to a vote of security holders during the fourth quarter of the Company's fiscal year ended March 31, 2005. 33 ITEM 4(A). EXECUTIVE OFFICERS OF THE REGISTRANT ------------------------------------ The following is a list of current executive officers of our Company, their ages, their positions with our Company and their principal occupations for at least the past five years.
NAME AGE POSITION HELD AND PAST EXPERIENCE ---------------------------------------------------------------------------------------------------------------------------------- Marc S. Hermelin 63 Vice Chairman of the Board of the Company since 1974; Chief Executive Officer from 1975 to February 1994 and since December 1994; Director and Vice President of Particle Dynamics, Inc. since 1974.(1) Alan G. Johnson 70 Director, Senior Vice President-Strategic Planning and Corporate Growth since September 1999 and Secretary of the Company; Chairman of Johnson Research & Capital, Inc., an investment banking and institutional research firm from January to September 1999; Member of the law firm Gallop, Johnson & Neuman, L.C. 1976 to 1998; Director of Siboney Corporation. Gerald R. Mitchell 65 Vice President and Chief Financial Officer since 1981. Richard H. Chibnall 49 Vice President, Finance since February 2000. Michael S. Anderson 56 Chief Executive Officer, Ther-Rx Corporation since February 2000. Jerald J. Wenker 43 President, Ther-Rx Corporation since June 2004; Vice President, Licensing and New Business Development, Abbot Corporation from January 2002 to April 2004; Vice President and General Manager, Anti-Infective Franchise Abbot Corporation from April 2000 to January 2002. Philip J. Vogt 48 President, ETHEX Corporation since February 2000. Ray F. Chiostri 71 Chairman and Chief Executive Officer, Particle Dynamics, Inc. since 1999. Paul T. Brady 42 President, Particle Dynamics, Inc. since 2003; Senior Vice President and General Manager, International Specialty Products Corporation from June 2002 to January 2003; Senior Vice President, Commercial Director, North and South America International Specialty Products from 2000 to 2002. Eric D. Moyermann 47 President, Pharmaceutical Manufacturing since February 2000. Executive officers of the Company serve at the pleasure of the Board of Directors. ---------- (1) Marc S. Hermelin is the son of Victor M. Hermelin, Chairman of the Board of Directors of the Company since 1971 and father of David S. Hermelin, a member of the Board of Directors since 2004.
34 PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS a) PRINCIPAL MARKET ---------------- Our Class A common stock and Class B common stock are traded on the New York Stock Exchange under the symbols KV.A and KV.B, respectively. b) APPROXIMATE NUMBER OF HOLDERS OF COMMON STOCK --------------------------------------------- The number of holders of record of Class A and Class B Common Stock as of June 9, 2005 was 786 and 389, respectively (not separately counting shareholders whose shares are held in "nominee" or "street" names, which are estimated to represent approximately 5,000 additional Class A common stock and Class B common stock shareholders combined). c) STOCK PRICE AND DIVIDEND INFORMATION ------------------------------------ The high and low closing sales prices of our Class A and Class B common stock during each quarter of fiscal 2005 and 2004, as reported on the New York Stock Exchange and as adjusted for the 3 for 2 stock split effective on September 8, 2003 were as follows:
CLASS A COMMON STOCK -------------------- FISCAL 2005 FISCAL 2004 ----------- ----------- QUARTER HIGH LOW HIGH LOW ------- -------------------- --------------------- First...................... $26.24 $22.25 $20.29 $12.61 Second..................... 23.11 15.31 23.49 17.91 Third...................... 22.14 18.18 27.67 22.22 Fourth..................... 23.20 19.78 27.51 22.10 CLASS B COMMON STOCK -------------------- FISCAL 2005 FISCAL 2004 ----------- ----------- QUARTER HIGH LOW HIGH LOW ------- -------------------- --------------------- First...................... $29.60 $25.00 $20.39 $12.63 Second..................... 25.05 16.35 23.53 18.09 Third...................... 22.77 18.65 27.77 22.31 Fourth..................... 23.49 20.42 29.40 22.60
Since 1980, we have not declared or paid any cash dividends on our common stock and we do not plan to do so in the foreseeable future. No dividends may be paid on Class A common stock or Class B common stock unless all dividends on the Cumulative Convertible Preferred Stock have been declared and paid. Dividends must be paid on Class A common stock when, and if, we declare and distribute dividends on the Class B common stock. Dividends of $70,000 were paid in fiscal 2005 and 2004 on 40,000 shares of outstanding Cumulative Convertible Preferred Stock. Also, $366,000, or $9.14 per share, of undeclared and unaccrued cumulative preferred dividends were paid on May 12, 2003. There were no undeclared and unaccrued cumulative preferred dividends at March 31, 2005. 35 Also, under the terms of our credit agreement, we may not pay cash dividends in excess of 25% of the prior fiscal year's consolidated net income. For the foreseeable future, we plan to use cash generated from operations for general corporate purposes, including funding potential acquisitions, research and development and working capital. Our board of directors reviews our dividend policy periodically. Any payment of dividends in the future will depend upon our earnings, capital requirements, financial condition and other factors considered relevant by our board of directors. See also Item 12 for information relating to the Company's equity compensation plans.
---------------------------------------------------------------------------------------------------------------------- Issuer Purchases of Equity Securities ---------------------------------------------------------------------------------------------------------------------- Period Total number of Average price paid Total number of Maximum number (or shares purchased per share shares purchased approximate dollar (a) as part of publicly value) of shares (or announced plans or units) that may yet programs be purchased under the plans or programs ---------------------------------------------------------------------------------------------------------------------- 1/1/05 - 1/31/05 188 $21.75 -- -- ---------------------------------------------------------------------------------------------------------------------- 2/1/05 - 2/28/05 104 $20.22 -- -- ---------------------------------------------------------------------------------------------------------------------- 3/1/05 - 3/31/05 64 $21.85 -- -- ---------------------------------------------------------------------------------------------------------------------- Total 356 $21.32 -- -- ---------------------------------------------------------------------------------------------------------------------- (a) Shares were purchased from employees upon their termination pursuant to the terms of the Company's stock option plan.
36 ITEM 6. SELECTED FINANCIAL DATA ----------------------- (in thousands, except per share data)
MARCH 31, -------------------------------------------------------------------- 2005 2004 2003 2002 2001 ---- ---- ---- ---- ---- BALANCE SHEET DATA: Total assets $558,317 $528,438 $352,668 $195,192 $151,417 Long-term debt 209,767 210,741 10,106 4,387 5,080 Shareholders' equity 292,702 257,749 260,616 158,792 125,942 INCOME STATEMENT DATA: YEARS ENDED MARCH 31, -------------------------------------------------------------------- 2005 2004 2003 2002 2001 ---- ---- ---- ---- ---- Net revenues $303,493 $283,941 $244,996 $204,105 $177,767 % Increase from prior period 6.9% 15.9% 20.0% 14.8% 24.5% Operating income(a)(b)(c) $ 52,412 $ 73,771 $ 42,929 $ 49,294 $ 37,972 Net income(a)(b)(c) 33,269 45,848 28,110 31,464 23,625 Net income per common share-diluted(d) (e) $ 0.63 $ 0.84 $ 0.55 $ 0.65 $ 0.49 Preferred stock dividends $ 70 $ 436 $ 70 $ 70 $ 420 --------------------------- (a) Operating income in fiscal 2005 included a $0.6 million net payment received by us in accordance with a legal settlement and additional income of $0.8 million for the reversal of a portion of the Healthpoint litigation reserve that remained after payment of the $16.5 million settlement amount and related litigation costs (see Note 11 in the accompanying Notes to Consolidated Financial Statements). The impact of these items, net of applicable income taxes, was to increase net income by $1.0 million and diluted earnings per share by $.02 in fiscal 2005. (b) Operating income in fiscal 2004 included a $3.5 million net payment received by us in accordance with a legal settlement (see Note 13 in the accompanying Notes to Consolidated Financial Statements) and an additional reserve of $1.8 million for attorney's fees associated with a lawsuit. The impact of these items, net of applicable income taxes, was to increase net income by $1.1 million and diluted earnings per share by $.02 in fiscal 2004. (c) Operating income in fiscal 2003 included a reserve of $16.5 million for potential damages associated with the Healthpoint litigation. The impact of the litigation reserve, net of applicable income taxes, was to reduce net income by $10.4 million and diluted earnings per share by $.20 in fiscal 2003. (d) Previously reported amounts give effect to the three-for-two stock splits effected in the form of a 50% stock dividend that occurred on September 29, 2003 and September 7, 2000. (e) Amounts for fiscal year 2004 have been restated to report shares issuable upon conversion of contingent convertible notes, which were issued in May 2003, pursuant to Emerging Issues Task Force (EITF) Issue No. 04-08, the Effect of Contingently Convertible Debt on Diluted Earnings per Share.
37 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS, -------------------------------------------------------------- AND LIQUIDITY AND CAPITAL RESOURCES ----------------------------------- Except for the historical information contained herein, the following discussion contains forward-looking statements that are subject to known and unknown risks, uncertainties, and other factors that may cause our actual results to differ materially from those expressed or implied by such forward-looking statements. These risks, uncertainties and other factors are discussed throughout this report and specifically under the captions "Cautionary Statement Regarding Forward-Looking Information" and "Risk Factors." In addition, the following discussion and analysis of the financial condition and results of operations should be read in conjunction with "Selected Financial Data" and our consolidated financial statements and notes thereto appearing elsewhere in this Form 10-K. BACKGROUND We are a fully integrated specialty pharmaceutical company that develops, acquires, manufactures and markets technologically- distinguished branded and generic/non-branded prescription pharmaceutical products. We have a broad range of dosage form capabilities, including tablets, capsules, creams, liquids and ointments. We conduct our branded pharmaceutical operations through Ther-Rx Corporation and our generic/non-branded pharmaceutical operations through ETHEX Corporation, which focuses principally on technologically-distinguished generic products. Through Particle Dynamics, Inc., we develop, manufacture and market technologically advanced, value-added raw material products for the pharmaceutical, nutritional, personal care, food and other markets. We have a broad portfolio of drug delivery technologies which we leverage to create technologically-distinguished brand name and specialty generic products. We have developed and patented 15 drug delivery and formulation technologies primarily in four principal areas: SITE RELEASE(R) bioadhesives, oral controlled release, tastemasking and oral quick dissolving tablets. We incorporate these technologies in the products we market to control and improve the absorption and utilization of active pharmaceutical compounds. These technologies provide a number of benefits, including reduced frequency of administration, reduced side effects, improved drug efficacy, enhanced patient compliance and improved taste. Our drug delivery technologies allow us to differentiate our products in the marketplace, both in the branded and generic pharmaceutical areas. We believe that this differentiation provides substantial competitive advantages for our products, allowing us to establish a strong record of growth and profitability and a leadership position in certain segments of our industry. RESULTS OF OPERATIONS In fiscal 2005, net revenues increased 6.9% as we experienced sales growth compared to fiscal 2004 in all three of our operating segments: branded products, specialty generics and specialty materials. Our sales growth in fiscal 2005 was constrained by slower than anticipated ANDA approvals by the FDA on two brand equivalent products that we expected to introduce in the fourth quarter of fiscal 2005 and delays in the timing of other certain approvals during the year. We expect these approvals will be received in the second half of fiscal 2006. Sales of our branded segment also were negatively impacted in the fourth quarter by a shortage of raw material for one of our products. The $10.3 million increase in gross profit was more than offset by an increase in operating expenses of $31.7 million. The increase in operating expenses was primarily due to: greater personnel expenses associated with an increase in management personnel and expansion of the branded sales force, an increase in branded marketing expense primarily related to the approval and introduction of the Company's second NDA product - Clindesse(TM), increases in professional fees and legal expenses, and an increase in research and development expense. As a result, net income decreased $12.6 million, or 27.4%, to $33.3 million compared to fiscal 2004. 38 FISCAL 2005 COMPARED TO FISCAL 2004 NET REVENUES BY SEGMENT ----------------------- YEARS ENDED MARCH 31, --------------------------------------- CHANGE --------------- ($ IN THOUSANDS): 2005 2004 $ % -------- -------- ------- ----- Branded products $ 90,085 $ 82,868 $ 7,217 8.7% as % of net revenues 29.7% 29.2% Specialty generics 191,870 181,455 10,415 5.7% as % of net revenues 63.2% 63.9% Specialty materials 18,345 16,550 1,795 10.8% as % of net revenues 6.0% 5.8% Other 3,193 3,068 125 4.1% ======== ======== ======= Total net revenues $303,493 $283,941 $19,552 6.9% The increase in branded product sales was due primarily to the introduction of Clindesse(TM) in the fourth quarter of fiscal 2005, continued growth of Gynazole-1(R) and increased sales of our two hematinic brands. The introduction of Clindesse(TM), a single-dose prescription cream therapy indicated to treat bacterial vaginosis, contributed $4.2 million of incremental sales during the fourth quarter of fiscal 2005. Since its launch in January 2005, Clindesse(TM) has garnered 13.1% of the intravaginal bacterial vaginosis market in the United States. Sales of Gynazole-1, our vaginal antifungal cream product, increased $2.7 million, or 14.4%, to $21.3 million during fiscal 2005 as our share of the prescription vaginal antifungal cream market increased to 31.5% at the end of fiscal 2005, from 26.9% at the end of the prior year. Sales from our two hematinic product lines, Chromagen(R) and Niferex(R), increased 22.6% to $25.4 million during fiscal 2005 as both product lines experienced significant growth in new prescriptions filled. During the year, new prescription growth for Chromagen(R) and Niferex(R) was 74.7% and 52.7%, respectively, compared to the prior year. Also included in branded product sales is the PreCare(R) product line which contributed $31.7 million of sales during fiscal 2005. Although sales of our PreCare(R) product line declined 2.7% during the year, the PreCare(R) family of products continued to be the leading branded line of prescription prenatal nutritional supplements in the United States. The $0.9 million decrease in sales of our PreCare(R) product line was partially the result of a temporary fourth quarter supply disruption of PrimaCare(R) ONE, our proprietary line extension to PrimaCare(R), that was launched in the second quarter. Prior to the occurrence of this supply issue, which has since been resolved, PrimaCare(R) ONE generated $4.1 million of incremental sales in fiscal 2005. The increase in branded product sales for fiscal 2005 was partially offset by a $2.2 million decline in sales of our Micro-K(R) product line. The growth in specialty generic sales resulted from $15.9 million of incremental sales volume from new product introductions, principally in our lower margin cough/cold product line, coupled with $8.8 million of increased sales volume from existing products in our cardiovascular and pain management product lines. These increases were offset in part by product price erosion of $14.3 million principally in the second half of the fiscal year, that resulted from pricing pressures on certain products in the cardiovascular, pain management and cough/cold product lines. Although specialty generic sales increased in fiscal 2005, we experienced a $9.0 million, or 18.2%, decline in sales for the three months ended March 31, 2005. This decrease resulted from a significant decline in cardiovascular products sales due in part to the absence of trade shows that occurred in the fourth quarter of the prior year and resulted in an unfavorable mix in product categories in the fourth quarter of fiscal 2005. The anticipated approval of Diltiazem and another product in the fourth quarter of fiscal 2005, would have more than offset the above decrease, had the approvals been received. We now expect them to be launched in the second half of fiscal 2006. 39 The increase in specialty material product sales was primarily due to renewed focus on expanding the specialty materials business, the addition of a new major customer in fiscal 2005 that resulted in $1.3 million of incremental sales and an increased emphasis on international markets that provided additional sales of $1.0 million in fiscal 2005. GROSS PROFIT BY SEGMENT ----------------------- YEARS ENDED MARCH 31, ----------------------------------------- CHANGE ----------------- ($ IN THOUSANDS): 2005 2004 $ % -------- -------- ------- ------- Branded products $ 78,844 $ 72,008 $ 6,836 9.5% as % of net revenues 87.5% 86.9% Specialty generics 113,084 110,180 2,904 2.6% as % of net revenues 58.9% 60.7% Specialty materials 6,394 4,789 1,605 33.5% as % of net revenues 34.9% 28.9% Other (2,511) (1,463) (1,048) (71.6)% ======== ======== ======= Total gross profit $195,811 $185,514 $10,297 5.6% as % of total net revenues 64.5% 65.3% The increase in gross profit was primarily attributable to the sales growth experienced by all three of our segments: branded products, specialty generics and specialty materials. The lower gross profit percentage on a consolidated basis primarily reflected the impact of price erosion on certain specialty generic products beginning in the second quarter and extending through the balance of fiscal 2005, offset in part by certain selective price increases taken near the end of the third quarter. The gross profit percentage decline experienced by the specialty generics segment was offset in part by a shift in the mix of branded product sales toward higher margin products with the introduction of Clindesse(TM) in the fourth quarter coupled with improved pricing and lower raw material costs at our specialty materials business. RESEARCH AND DEVELOPMENT ------------------------ YEARS ENDED MARCH 31, --------------------------------------- CHANGE --------------- ($ IN THOUSANDS): 2005 2004 $ % ------- ------- ------ ----- Research and development $23,538 $20,651 $2,887 14.0% as % of net revenues 7.8% 7.3% The increase in research and development expense primarily resulted from increased spending on bioequivalency studies for products in our internal development pipeline and higher personnel expenses related to the growth of our research and development staff. In May 2005, we announced an agreement with FemmePharma to terminate the license agreement we entered into with them in April 2002. As part of this transaction, we acquired FemmePharma for $25.0 million after the assets of the entity had been distributed to FemmePharma's other shareholders. Included in our acquisition of FemmePharma are all of the worldwide marketing rights to an endometriosis product that has successfully completed Phase II clinical trials and was originally part of the licensing arrangement with FemmePharma. In connection with this transaction, we expect to incur an in-process 40 research and development charge of approximately $30.0 million in the first quarter of fiscal 2006, which includes the write-off of the $25.0 million payment plus preferred stock investments previously made. SELLING AND ADMINISTRATIVE -------------------------- YEARS ENDED MARCH 31, --------------------------------------- CHANGE --------------- ($ IN THOUSANDS): 2005 2004 $ % -------- ------- ------- ----- Selling and administrative $116,638 $88,333 $28,305 32.0% as % of net revenues 38.4% 31.1% The increase in selling and administrative expense was due primarily to: greater personnel expenses resulting from an increase in management personnel ($4.3 million) and expansion of the branded sales force ($5.1 million including approximately $1.1 million for sales representatives added during the fourth quarter of fiscal 2005); a $2.2 million increase in branded marketing and promotions expense commensurate with the growth of the segment; a $2.9 million increase in rent, depreciation, insurance and utilities expense associated with expansion of our office facilities over the past two years; a $1.7 million increase in professional fees associated primarily with implementation of the internal control provisions of the Sarbanes-Oxley Act of 2002; a $1.2 million increase in legal expense; and $3.0 million of costs incurred in the fourth quarter to support the launch of Clindesse(TM). The increase in legal expense was due to an increase in litigation activity, which included various patent infringement actions brought by potential competitors with respect to products we propose to market and for which we have submitted ANDA filings and provided notice of certification required under the provisions of the Hatch-Waxman Act. AMORTIZATION OF INTANGIBLE ASSETS --------------------------------- YEARS ENDED MARCH 31, --------------------------------------- CHANGE --------------- ($ IN THOUSANDS): 2005 2004 $ % ------ ------ ---- ---- Amortization of intangible assets $4,653 $4,459 $194 4.4% as % of net revenues 1.5% 1.6% The increase in amortization of intangible assets was due primarily to the amortization of license costs incurred under a co-development arrangement in fiscal 2005. 41 LITIGATION ---------- YEARS ENDED MARCH 31, --------------------------------------- CHANGE --------------- ($ IN THOUSANDS): 2005 2004 $ % -------- -------- ----- ------- Litigation $(1,430) $(1,700) $270 (15.9)% The $1.4 million of income reflected in "Litigation" consists of a $0.6 million net payment received by us in accordance with a favorable legal settlement of vitamin antitrust litigation and $0.8 million related to the reversal of excess reserves related to the Healthpoint litigation (see Note 11 in the accompanying Notes to Consolidated Financial Statements). In the second quarter of the prior year, we received $3.5 million for settlement with a branded company of our claim that the branded company interfered with our right to a timely introduction of a generic product in a previous fiscal year. The impact of this payment was offset in part by an additional litigation reserve of $1.8 million related to attorneys' fees awarded in the Healthpoint matter, which subsequently was settled. OPERATING INCOME ---------------- YEARS ENDED MARCH 31, ----------------------------------------- CHANGE ----------------- ($ IN THOUSANDS): 2005 2004 $ % ------- ------- -------- ------- Operating income $52,412 $73,771 $(21,359) (29.0)% The decrease in operating income resulted primarily from a $28.3 million, or 32.0%, increase in selling and administrative expense coupled with a $2.9 million increase in research and development expense, offset in part by a $10.3 million increase in gross profit. INTEREST EXPENSE ---------------- YEARS ENDED MARCH 31, --------------------------------------- CHANGE --------------- ($ IN THOUSANDS): 2005 2004 $ % ------ ------ ------ ------ Interest expense $5,432 $5,865 $(433) (7.4)% The decrease in interest expense was primarily due to an increase in the level of capitalized interest recorded on capital projects that we have in process. 42 INTEREST AND OTHER INCOME ------------------------- YEARS ENDED MARCH 31, --------------------------------------- CHANGE --------------- ($ IN THOUSANDS): 2005 2004 $ % ------ ------ ---- ----- Interest and other income $3,048 $2,092 $956 45.7% The increase in interest and other income was primarily due to an increase in the weighted average interest rate earned on short-term investments, offset in part by a decline in the average balance of short-term investments. PROVISION FOR INCOME TAXES -------------------------- YEARS ENDED MARCH 31, ----------------------------------------- CHANGE ----------------- ($ IN THOUSANDS): 2005 2004 $ % ------- ------- -------- ------ Provision for income taxes $16,759 $24,150 $(7,391) (30.6)% effective tax rate 33.5% 34.5% The decrease in the provision for income taxes resulted from a corresponding decrease in income before taxes coupled with a decline in the effective tax rate. The decline in the effective tax rate primarily resulted from the implementation of various tax planning initiatives, as well as the generation of income tax credits at both the Federal and state levels. NET INCOME AND DILUTED EARNINGS PER SHARE ----------------------------------------- YEARS ENDED MARCH 31, ----------------------------------------- CHANGE ----------------- ($ IN THOUSANDS): 2005 2004 $ % ------- ------- --------- ------- Net income $33,269 $45,848 $(12,579) (27.4)% Diluted earnings per share 0.63 0.84 (0.21) (25.0)% The decrease in net income resulted primarily from a $28.3 million, or 32.0%, increase in selling and administrative expense coupled with a $2.9 million increase in research and development expense, offset in part by a $10.3 million increase in gross profit. 43 FISCAL 2004 COMPARED TO FISCAL 2003 NET REVENUES BY SEGMENT ----------------------- YEARS ENDED MARCH 31, ----------------------------------------- CHANGE ----------------- ($ IN THOUSANDS): 2004 2003 $ % -------- -------- ------- ------- Branded products $ 82,868 $ 43,677 $ 39,191 89.7% as % of net revenues 29.2% 17.8% Specialty generics 181,455 179,724 1,731 1.0% as % of net revenues 63.9% 73.4% Specialty materials 16,550 17,395 (845) (4.9)% as % of net revenues 5.8% 7.1% Other 3,068 4,200 (1,132) (27.0)% ======== ======== ======== Total net revenues $283,941 $244,996 $ 38,945 15.9% The increase in branded product sales was due primarily to continued growth of our women's healthcare family of products and the sales impact of products acquired by us on March 31, 2003. The increase was also impacted by a March 1, 2004 price increase instituted by Ther-Rx on all of its products. In anticipation of the scheduled price increase, customers made larger than normal purchases, which the Company limits to a 30-day supply and is consistent with prior price increase policies. This forward purchasing approximated $7.4 million during the fourth quarter. Sales from the women's healthcare product group increased $17.9 million, or 53.6%, in fiscal 2004. Included in the women's healthcare family of products is the PreCare(R) product line which contributed $11.8 million of incremental sales in fiscal 2004. This increase was attributable to increased sales volume associated with higher market shares for PrimaCare(R), our prescription prenatal/postnatal multivitamin and mineral supplement with essential fatty acids, and the PreCare(R) prenatal vitamin. The PreCare(R) family of products continues to be the leading branded line of prescription prenatal nutritional supplements in the United States as market share for the product line grew to 37.6% at the end of fiscal 2004 compared to 31.0% at the end of fiscal 2003. Sales of Gynazole-1(R), our vaginal antifungal cream product, increased $6.1 million, or 48.8%, during fiscal 2004 as our share of the prescription vaginal antifungal cream market increased to 26.9% at the end of fiscal 2004, from 18.1% at the end of the prior year. The increase in sales from our women's healthcare family of products was supplemented by $22.6 million of sales during fiscal 2004 from our two hematinic product lines, Chromagen(R) and Niferex(R), and the StrongStart(R) prenatal vitamin product line that we acquired at the end of fiscal 2003. Introduction of technology-improved versions of the hematinic products in the second quarter of fiscal 2004, generated 69% growth in new prescription volume. The increase in branded product sales for fiscal 2004 was partially offset by a $1.2 million decline in sales of the Micro-K(R) product line. The minimal growth in specialty generic sales resulted from $8.8 million of incremental sales volume from new product introductions, primarily in the cough/cold, cardiovascular and prenatal vitamin product lines, offset by a $7.3 million decline in sales volume from existing products primarily in our cough/cold product line. During fiscal 2004, we introduced 16 new products, including the February 2004 ANDA approval for four strengths of Benazepril Hydrochloride tablets (generic equivalent to Lotensin(R)). The decline in sales of existing cough/cold products was due primarily to an FDA order which required us and all manufacturers of unapproved single-ingredient, extended-release guaifenesin products to discontinue distribution of these products after November 2003. The FDA ruling affected five of our guaifenesin products that were first introduced when ANDA approval was not required. Also, we experienced slower than anticipated ANDA approvals by the FDA on a number of brand equivalent products that we expected to introduce in fiscal 2004. The decrease in specialty material product sales was primarily due to a slowdown in a major customer's business in the vitamin supplement market. The decrease in other revenue resulted from a smaller contract manufacturing customer base due to continued de-emphasis of this lower margin operation in our business strategy. 44 GROSS PROFIT BY SEGMENT ----------------------- YEARS ENDED MARCH 31, ------------------------------------------ CHANGE ------------------ ($ IN THOUSANDS): 2004 2003 $ % -------- -------- ------- -------- Branded products $ 72,008 $ 38,460 $33,548 87.2% as % of net revenues 86.9% 88.1% Specialty generics 110,180 106,854 3,326 3.1% as % of net revenues 60.7% 59.5% Specialty materials 4,789 5,720 (931) (16.3)% as % of net revenues 28.9% 32.9% Other (1,463) (565) (898) (158.9)% ======== ======== ======= Total gross profit $185,514 $150,469 $35,045 23.3% as % of total net revenues 65.3% 61.4% The increase in consolidated gross profit was primarily attributable to the sales growth experienced by the branded products and specialty generics segments, offset in part by a sales decline in the specialty materials segment. The increased gross profit percentage on a consolidated basis reflected a favorable shift in the mix of product sales toward higher margin branded products, which comprised a larger percentage of net revenues. The gross profit percentage decrease experienced by the branded products segment was due to the acquired hematinic products, which have a slightly lower gross margin than other products in the branded line. While the gross profit percentage in specialty generics increased for the fiscal year, the segment experienced a decline in gross profit as a percent of net revenues during the fourth quarter due to more competitive pricing and higher costs associated with a new product launch. Gross profit as a percent of net revenues also declined in the specialty raw materials segment during the fourth quarter as a result of unfavorable costs variances associated with lower production volume. RESEARCH AND DEVELOPMENT ------------------------ YEARS ENDED MARCH 31, --------------------------------------- CHANGE --------------- ($ IN THOUSANDS): 2004 2003 $ % ------- ------- ------ ---- Research and development $20,651 $19,135 $1,516 7.9% as % of net revenues 7.3% 7.8% The increase in research and development expense resulted from higher costs associated with the continued expansion of clinical testing for our product development efforts and increased personnel expenses related to the growth of our research and development staff. The increase in research and development expense was below management's expectation of greater spending due to rescheduling the timing of certain clinical studies. SELLING AND ADMINISTRATIVE -------------------------- YEARS ENDED MARCH 31, --------------------------------------- CHANGE --------------- ($ IN THOUSANDS): 2004 2003 $ % ------- ------- ------- ----- Selling and administrative $88,333 $69,584 $18,749 26.9% as % of net revenues 31.1% 28.4% 45 The increase in selling and administrative expense was due primarily to greater personnel expenses resulting from an increase in management personnel ($1.7 million) and expansion of the branded sales force ($4.9 million), an increase in rent, depreciation and utilities associated with recently added facilities ($2.5 million), and an increase in branded marketing expense ($3.7 million) commensurate with the growth of the segment and to support the launch and on-going promotion of technology-improved versions of the Chromagen(R) and Niferex(R) products we acquired at the end of fiscal 2003. We also experienced a $4.3 million increase in legal expense due to an increase in litigation activity coupled with the appeal of the Healthpoint litigation, Paragraph IV litigation and other matters. AMORTIZATION OF INTANGIBLE ASSETS --------------------------------- YEARS ENDED MARCH 31, --------------------------------------- CHANGE --------------- ($ IN THOUSANDS): 2004 2003 $ % ------ ------ ------- ----- Amortization of intangible assets $4,459 $2,321 $2,138 92.1% as % of net revenues 1.6% 0.9% The increase in amortization of intangible assets was due primarily to the amortization of trademarks acquired in the two product acquisitions completed on March 31, 2003. LITIGATION ---------- YEARS ENDED MARCH 31, ------------------------------------------ CHANGE ------------------ ($ IN THOUSANDS): 2004 2003 $ % -------- ------- --------- -------- Litigation $(1,700) $16,500 $(18,200) (110.3)% In September 2002, we recorded a litigation reserve of $16.5 million for potential damages associated with the adverse decision made by a federal court in Texas to uphold a jury verdict in a lawsuit against ETHEX. During fiscal 2004, we recorded an additional litigation reserve of $1.8 million related to this matter for attorney's fees awarded to the plaintiffs by the court. The impact of this reserve was more than offset by a $3.5 million net payment, received by us during fiscal 2004, for a settlement with a branded company of our claim that the branded company interfered with our right to a timely introduction of a generic product in a previous fiscal year. OPERATING INCOME ---------------- YEARS ENDED MARCH 31, --------------------------------------- CHANGE --------------- ($ IN THOUSANDS): 2004 2003 $ % ------- ------- ------- ----- Operating income $73,771 $42,929 $30,842 71.8% The increase in operating income resulted primarily from a $35.0 million, or 23.3%, increase in gross profit in fiscal 2004, offset in part by a $4.2 million increase in fiscal 2004 operating expenses. The $18.7 million increase in our fiscal 2004 selling and administrative expenses was primarily offset by the impact on fiscal 2003 operating 46 expenses of a $16.5 million litigation reserve established by us for potential damages associated with a lawsuit that was settled in fiscal 2005. INTEREST EXPENSE ---------------- YEARS ENDED MARCH 31, ----------------------------------------- CHANGE ----------------- ($ IN THOUSANDS): 2004 2003 $ % ------ ---- ------ -------- Interest expense $5,865 $325 $5,540 1,704.6% The increase in interest expense resulted primarily from the interest expense accrued on the $200.0 million of Convertible Subordinated Notes issued May 16, 2003. INTEREST AND OTHER INCOME ------------------------- YEARS ENDED MARCH 31, --------------------------------------- CHANGE --------------- ($ IN THOUSANDS): 2004 2003 $ % ------ ---- ------ ------ Interest and other income $2,092 $977 $1,115 114.1% The increase in interest and other income was due to the investment of $144.2 million of net proceeds from the May 2003 Convertible Subordinated Notes offering in short-term, highly liquid investments combined with the impact of an $82.3 million increase in short-term investments during fiscal 2003 from the proceeds of a secondary offering during that year. PROVISION FOR INCOME TAXES -------------------------- YEARS ENDED MARCH 31, --------------------------------------- CHANGE --------------- ($ IN THOUSANDS): 2004 2003 $ % ------- ------- ------ ----- Provision for income taxes $24,150 $15,471 $8,679 56.1% effective tax rate 34.5% 35.5% The increase in the provision for income taxes resulted from a corresponding increase in income before taxes. The decline in the effective tax rate primarily resulted from the implementation of various tax planning initiatives, as well as the generation of income tax credits at both the Federal and state levels. 47 NET INCOME AND DILUTED EARNINGS PER SHARE ----------------------------------------- YEARS ENDED MARCH 31, --------------------------------------- CHANGE --------------- ($ IN THOUSANDS): 2004 2003 $ % ------- ------- ------- ----- Net income $45,848 $28,110 $17,738 63.1% Diluted earnings per share 0.84 0.55 0.29 52.7% The increase in net income resulted primarily from a $38.9 million, or $15.9%, increase in our fiscal 2004 net revenues coupled with the impact on fiscal 2003 net income of a $16.5 million litigation reserve established by us in September 2002 for potential damages associated with a lawsuit that was settled in fiscal 2005. LIQUIDITY AND CAPITAL RESOURCES ------------------------------- Cash and cash equivalents and working capital were $159.8 million and $302.5 million, respectively, at March 31, 2005, compared to $191.6 million and $306.6 million, respectively, at March 31, 2004. Internally generated funds from product sales was the primary source of operating capital used in the funding of our businesses in fiscal 2005. Net cash flow from operating activities was $49.0 million in fiscal 2005 compared to $34.0 in fiscal 2004. Cash flow from operations was favorably impacted by net income adjusted for non-cash items and an increase in accounts payable related to the timing of payments, offset in part by the $18.3 million payment attributable to settlement of the Healthpoint litigation. In September 2004, we made a settlement payment in the amount of $16.5 million to resolve all previously pending claims between us and Healthpoint, Ltd. without the admission of any liability. The settlement was fully reserved by us in September 2002 and therefore had no impact on our earnings in fiscal 2005. The $0.8 million of income reflected in "Litigation" for the year ended March 31, 2005 represents a reversal of the portion of the Healthpoint litigation reserve that remained after payment of the settlement amount and related litigation costs. Net cash flow used in investing activities primarily consisted of capital expenditures of $63.6 million in fiscal 2005 compared to $21.8 million for the prior year. Capital expenditures in fiscal 2005 were primarily for building renovation projects and for purchasing machinery and equipment to upgrade and expand our pharmaceutical manufacturing and distribution capabilities. Other investing activities in fiscal 2005 included $10.6 million in purchases of marketable securities that are classified as available for sale. In the prior year, we made cash payments of $14.3 million in April 2003 to complete the acquisition of the Niferex(R) product line and $4.0 million in January 2004 to FemmePharma, Inc. to complete the licensing of certain trademark rights and to increase our equity investment in the company. Our debt balance was $210.7 million at March 31, 2005 compared to $218.7 million at March 31, 2004. In May 2003, we issued $200.0 million principal amount of Convertible Subordinated Notes that are convertible, under certain circumstances, into shares of our Class A common stock at an initial conversion price of $23.01 per share. The Convertible Subordinated Notes bear interest at a rate of 2.50% and mature on May 16, 2033. We are also obligated to pay contingent interest at a rate equal to 0.5% per annum during any six-month period commencing May 16, 2006, if the average trading price of the Notes per $1,000 principal amount for the five-trading day period ending on the third trading day immediately preceding the first day of the applicable six-month period equals $1,200 or more. We may redeem some or all of the Convertible Subordinated Notes at any time on or after May 21, 2006, at a redemption price, payable in cash, of 100% of the principal amount of the Convertible Subordinated Notes, plus accrued and unpaid interest (including contingent interest, if any) to the date of redemption. Holders may require us to repurchase all or a portion of their Convertible Subordinated Notes on May 16, 2008, 2013, 2018, 2023 and 2028, or upon a change in control, as defined in the indenture governing the Convertible Subordinated Notes, at 100% of the principal amount of the Convertible Subordinated Notes, plus accrued and unpaid interest (including contingent interest, if any) to the date of repurchase, payable in cash. The Convertible Subordinated Notes are subordinate to all of our existing and future senior obligations. On March 31, 48 2005, we repaid the second of two $7.0 million promissory notes entered into in conjunction with the Altana acquisition agreement (see Note 3 in the accompanying Notes to Consolidated Financial Statements). In December 2004, we increased our available credit facilities to $140.0 million. The revised agreement provided for an increase from $40.0 million to $80.0 million in our revolving line of credit along with an increase from $25.0 million to $60.0 million in the supplemental credit line that is available for financing acquisitions. These credit facilities expire in October 2006 and December 2005, respectively. The revolving and supplemental credit lines are unsecured and interest is charged at the lower of the prime rate or the one-month LIBOR rate plus 175 basis points. At March 31, 2005, we had $3.9 million in open letters of credit issued under the revolving credit line and no cash borrowings under either credit facility. The revised agreement contains substantially identical financial and other covenants, representations, warranties, conditions and default provisions as the replaced facility. The financial covenants impose minimum levels of earnings before interest, taxes, depreciation and amortization, a maximum funded debt ratio, a limit on capital expenditures and dividend payments, a minimum fixed charge coverage ratio and a maximum senior leverage ratio. As of March 31, 2005, we were in compliance with all of our covenants. The following table summarizes our contractual obligations (in thousands):
LESS THAN MORE THAN TOTAL 1 YEAR 1-3 YEARS 3-5 YEARS 5 YEARS ----- ------ --------- --------- ------- OBLIGATIONS AT MARCH 31, 2005 ----------------------------- Long-term debt obligations $210,740 $ 973 $3,853 $5,914 $200,000 Operating lease obligations 5,257 1,598 1,949 1,086 624 Other long-term obligations 4,477 - - - 4,477 --------------------------------------------------------------- Total contractual cash obligations(a) $220,474 $2,571 $5,802 $7,000 $205,101 --------------------------------------------------------------- (a) The Company has licensed the exclusive rights to co-develop and market various generic equivalent products with other drug delivery companies. These collaboration agreements require the Company to make up-front and ongoing payments as development milestones are attained. If all milestones remaining under these agreements were reached, payments by the Company could total up to $15,455.
We believe our cash and cash equivalents balance, cash flows from operations and funds available under our credit facilities, will be adequate to fund operating activities for the presently foreseeable future, including the payment of short-term and long-term debt obligations, capital improvements, research and development expenditures, product development activities and expansion of marketing capabilities for the branded pharmaceutical business. In addition, we continue to examine opportunities to expand our business through the acquisition of or investment in companies, technologies, product rights, research and development and other investments that are compatible with our existing businesses. We intend to use our available cash to help in funding any acquisitions or investments. As such, cash has been invested in short-term, highly liquid instruments. We also may use funds available under our credit facility, or financing sources that subsequently become available, including the future issuances of additional debt or equity securities, to fund these acquisitions or investments. If we were to fund one or more such acquisitions or investments, our capital resources, financial condition and results of operations could be materially impacted in future periods. INFLATION Inflation may apply upward pressure on the cost of goods and services used by us in the future. However, we believe that the net effect of inflation on our operations during the past three years has been minimal. In addition, changes in the mix of products sold and the effect of competition has made a comparison of changes in selling prices less meaningful relative to changes in the overall rate of inflation over the past three fiscal years. 49 CRITICAL ACCOUNTING ESTIMATES Our consolidated financial statements are presented on the basis of U.S. generally accepted accounting principles. Our significant accounting policies are described in Note 2 in the accompanying notes to consolidated financial statements. Certain of our accounting policies are particularly important to the portrayal of our financial position and results of operations and require the application of significant judgment by our management. As a result, these policies are subject to an inherent degree of uncertainty. In applying these policies, we make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures. We base our estimates and judgments on historical experience, the terms of existing contracts, observance of trends in the industry, information that is obtained from customers and outside sources, and on various other assumptions that are believed to be reasonable and appropriate under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Although we believe that our estimates and assumptions are reasonable, actual results may differ significantly from our estimates. Changes in estimates and assumptions based upon actual results may have a material impact on our results of operations and/or financial condition. Our critical accounting estimates are described below. REVENUE AND PROVISION FOR SALES RETURNS AND ALLOWANCES. Revenue is ------------------------------------------------------ generally realized or realizable and earned when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the seller's price to the buyer is fixed or determinable, and collectibility is reasonably assured. Accordingly, we record revenue from product sales when title and risk of ownership have been transferred to the customer, which is typically upon shipment to the customer. We also enter into long-term agreements under which we assign marketing rights for the products we have developed to pharmaceutical marketers. Royalties under these arrangements are earned based on the sale of products. When we sell our products, we reduce the amount of revenue we recognize from such sales by an estimate of future product returns and sales allowances. Sales allowances include cash discounts, rebates, chargebacks, and other similar expected future payments relating to products sold in the current period. Factors that are considered in our estimates of future product returns and sales allowances include historical payment experience in relationship to revenues, estimated customer inventory levels, and current contract prices and terms with both direct and indirect customers. If actual future payments for product returns and sales allowances exceed the estimates we made at the time of sale, our financial position, results of operations and cash flows would be negatively impacted. The provision for chargebacks is the most significant and complex estimate used in the recognition of revenue. We establish contract prices for indirect customers who are supplied by our wholesale customers. A chargeback represents the difference between our invoice price to the wholesaler and the indirect customer's contract price, which is lower. We credit the wholesaler for purchases by indirect customers at the lower price. Accordingly, we record these chargebacks at the time we recognize revenue in connection with our sales to wholesalers. Provisions for estimating chargebacks are calculated primarily using historical chargeback experience, actual contract pricing and estimated wholesaler inventory levels. We continually monitor our assumptions, giving consideration to estimated wholesaler inventory levels and current pricing trends, and make adjustments to these estimates when we believe that the actual chargeback amounts payable in the future will differ from our original estimates. INVENTORY VALUATION. Inventories consist of finished goods held for ------------------- distribution, raw materials and work in process. Our inventories are stated at the lower of cost or market, with cost determined on the first-in, first-out basis. In evaluating whether inventory is to be stated at the lower of cost or market, we consider such factors as the amount of inventory on hand and in the distribution channel, estimated time required to sell existing inventory, remaining shelf life and current and expected market conditions, including levels of competition. We establish reserves, when necessary, for slow-moving and obsolete inventories based upon our historical experience and management's assessment of current product demand. INTANGIBLE ASSETS AND GOODWILL. Our intangible assets consist of ------------------------------ product rights, license agreements and trademarks resulting from product acquisitions and legal fees and similar costs relating to the development of 50 patents and trademarks. Intangible assets that are acquired are stated at cost, less accumulated amortization, and are amortized on a straight-line basis over their estimated useful lives. Upon approval, costs associated with the development of patents and trademarks are amortized on a straight-line basis over estimated useful lives ranging from five to 17 years. We determine amortization periods for intangible assets that are acquired based on our assessment of various factors impacting estimated useful lives and cash flows of the acquired products. Such factors include the product's position in its life cycle, the existence or absence of like products in the market, various other competitive and regulatory issues, and contractual terms. Significant changes to any of these factors may result in a reduction in the intangible asset's useful life and an acceleration of related amortization expense. We assess the impairment of intangible assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Some factors we consider important which could trigger an impairment review include the following: (1) significant underperformance relative to expected historical or projected future operating results; (2) significant changes in the manner of our use of the acquired assets or the strategy for our overall business; and (3) significant negative industry or economic trends. When we determine that the carrying value of an intangible asset may not be recoverable based upon the existence of one or more of the above indicators of impairment, we first perform an assessment of the asset's recoverability. Recoverability is determined by comparing the carrying amount of an intangible asset against an estimate of the undiscounted future cash flows expected to result from its use and eventual disposition. If the sum of the expected future undiscounted cash flows is less than the carrying amount of the intangible asset, an impairment loss is recognized based on the excess of the carrying amount over the estimated fair value of the intangible asset. CONTINGENCIES. The Company is involved in various legal ------------- proceedings, some of which involve claims for substantial amounts. An estimate is made to accrue for a loss contingency relating to any of these legal proceedings if it is probable that a liability was incurred as of the date of the financial statements and the amount of loss can be reasonably estimated. Because of the subjective nature inherent in assessing the outcome of litigation and because of the potential that an adverse outcome in legal proceedings could have a material impact on our financial position or results of operations, such estimates are considered to be critical accounting estimates. After review, it was determined at March 31, 2005 that for each of the various legal proceedings in which we are involved, the conditions mentioned above were not met. We will continue to evaluate all legal matters as additional information becomes available. RECENTLY ISSUED ACCOUNTING STANDARDS In March 2004, the EITF completed its discussion of and provided consensus guidance on Issue No. 03-06, Participating Securities and the Two-Class Method under FASB Statement No. 128, Earnings per Share. The consensus interpreted the definition of a "participating security," required the use of the two-class method in the calculation and disclosure of basic earnings per share for companies with participating securities or more than one class of common stock, and provided guidance on the allocation of earnings and losses for purposes of calculating basic earnings per share. Since the Company has two classes of common stock, this consensus has been applied in the calculation of basic earnings per share for all periods presented. There was no impact on diluted earnings per share as reported. In April 2004, the Financial Accounting Standards Board (FASB) issued FASB Staff Position No. 129-1 (FSP 129-1), Disclosure Requirements under FASB Statement No. 129, Disclosure of Information about Capital Structure, Relating to Contingently Convertible Securities. This FSP requires the disclosure provisions of Statement 129 to apply to all existing and newly created contingently convertible securities and to their potentially dilutive effects on earnings per share. The adoption of the disclosure provisions of FSP 129-1 did not have a material impact on the Company's financial condition or results of operations. In September 2004, the EITF reached a consensus that contingently convertible debt instruments should be included in diluted earnings per share computations (if dilutive) regardless of whether the market price trigger (or 51 other contingent feature) has been met. Additionally, the EITF stated that prior period earnings per share amounts presented for comparative purposes should be restated to conform to this consensus, which is effective for reporting periods ending after December 15, 2004. The consensus adopted by the EITF required the addition of approximately 8.7 million shares associated with the conversion of the Company's $200.0 million principal amount Convertible Subordinated Notes to the number of shares outstanding for the calculation of diluted earnings per share for all reported periods since the issuance of the Notes. In November 2004, the FASB issued SFAS No. 151, Inventory Costs, an Amendment to ARB No. 43, Chapter 4 which requires that abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) costs be recognized as current period charges. In addition, this statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. This statement is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company is currently determining the impact, if any, the adoption of this statement will have on its financial condition and results of operations. In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based Payment" (SFAS 123R), which replaces SFAS No. 123, "Accounting for Stock-Based Compensation," (SFAS 123) and supercedes APB Opinion No. 25, "Accounting for Stock Issued to Employees". SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. The pro forma disclosures previously permitted under SFAS 123 no longer will be an alternative to financial statement recognition. Under SFAS 123R, we must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at date of adoption. The transition methods include modified prospective and modified retrospective adoption options. Under the modified retrospective option, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The modified prospective method requires that compensation expense be recorded for all unvested stock options and restricted stock at the beginning of the first quarter of adoption of SFAS 123R, while the modified retrospective method would record compensation expense for all unvested stock options and restricted stock beginning with the first period restated. We are evaluating the requirements of SFAS 123R. We have not yet determined the method of adoption or the effect of adopting SFAS 123R, and we have not determined whether the adoption will result in amounts that are similar to the current pro forma disclosures under SFAS 123. In April 2005, the Securities and Exchange Commission announced an amendment to Regulation S-X to amend the date for compliance with SFAS 123R. The amendment requires each registrant that is not a small business issuer to adopt SFAS 123R in the first fiscal year commencing after June 15, 2005. As a result, we are required to adopt SFAS 123R beginning April 1, 2006. Adoption of SFAS 123R will have an impact on our consolidated financial statements, as we will be required to expense the fair value of our employee stock option grants rather than disclose the pro forma impact on our consolidated net income within the footnotes to our consolidated financial statements, as is our current practice. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK ---------------------------------------------------------- Our exposure to market risk is limited to fluctuating interest rates associated with variable rate indebtedness that is subject to interest rate changes. Advances to us under our credit facilities bear interest at a rate that varies consistent with increases or decreases in the publicly announced prime rate and/or the LIBOR rate with respect to LIBOR-related loans, if any. A material increase in such rates could significantly increase borrowing expenses. We did not have any cash borrowings under our credit facilities at March 31, 2005. In May 2003, we issued $200.0 million principal amount of Convertible Subordinated Notes. The interest rate on the Convertible Subordinated Notes is fixed at 2.50% per annum and not subject to market interest rate changes. Beginning May 16, 2006, we will become obligated to pay contingent interest at a rate equal to 0.5% per annum during any six-month period, if the average trading price of the Convertible Subordinated Notes per $1,000 principal amount for the five-trading day period ending on the third trading day immediately preceding the first day of the applicable six-month period equals $1,200 or more. 52 In April 2003, we entered into an $8.8 million term loan secured by a building under a floating rate loan with a bank. We also entered into an interest rate swap agreement with the same bank, which fixed the interest rate of the building mortgage at 5.31% for the term of the loan. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ------------------------------------------- 53 Report of Independent Registered Public Accounting Firm ------------------------------------------------------- The Board of Directors and Shareholders K-V Pharmaceutical Company: We have audited the accompanying consolidated balance sheet of K-V Pharmaceutical Company and subsidiaries as of March 31, 2005, and the related consolidated statements of income, comprehensive income, shareholders' equity, and cash flows for the year ended March 31, 2005. In connection with our audit of the consolidated financial statements, we have also audited the accompanying financial statement schedule. These consolidated financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of K-V Pharmaceutical Company and subsidiaries as of March 31, 2005, and the results of their operations and their cash flows for the year ended March 31, 2005, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule for the year ended March 31, 2005, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. As discussed in Note 2 to the consolidated financial statements, during fiscal 2005, the Company adopted the provisions of Emerging Issues Task Force (EITF) Issue No. 03-6 Participating Securities and the Two-Class Method under FASB Statement No. 128 and EITF Issue No. 04-8 The Effect of Contingently Convertible Instruments on Diluted Earnings per Share. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of internal control over financial reporting of K-V Pharmaceutical Company as of March 31, 2005, based on the criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated June 14, 2005 expressed an unqualified opinion on management's assessment of, and the effective operation of, internal control over financial reporting. /s/ KPMG LLP St. Louis, Missouri June 14, 2005 54 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Stockholders and Board of Directors of K-V Pharmaceutical Company We have audited the accompanying consolidated balance sheets of K-V Pharmaceutical Company and Subsidiaries as of March 31, 2004 and the related consolidated statements of income, shareholders' equity and cash flows for each of the two years in the period ended March 31, 2004. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of K-V Pharmaceutical Company and Subsidiaries at March 31, 2004, and the results of its operations and its cash flows for each of the two years in the period ended March 31, 2004, in conformity with accounting principles generally accepted in the United States of America. /s/ BDO Seidman, LLP Chicago, Illinois June 4, 2004 55 K-V PHARMACEUTICAL COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Dollars in thousands)
MARCH 31, --------------------- 2005 2004 ---- ---- ASSETS ------ CURRENT ASSETS: Cash and cash equivalents............................................................ $159,825 $191,581 Marketable securities................................................................ 45,694 35,330 Receivables, less allowance for doubtful accounts of $461 and $402 in 2005 and 2004, respectively.................................................... 62,361 65,872 Inventories, net..................................................................... 53,945 50,697 Prepaid and other assets............................................................. 9,530 6,591 Deferred tax asset................................................................... 5,827 8,037 -------- -------- Total Current Assets.............................................................. 337,182 358,108 Property and equipment, less accumulated depreciation................................ 131,624 75,777 Intangible assets and goodwill, net.................................................. 76,430 80,809 Other assets......................................................................... 13,081 13,744 -------- -------- TOTAL ASSETS......................................................................... $558,317 $528,438 ======== ======== LIABILITIES ----------- CURRENT LIABILITIES: Accounts payable..................................................................... $ 18,011 $ 12,650 Accrued liabilities.................................................................. 15,733 30,917 Current maturities of long-term debt................................................. 973 7,909 -------- -------- Total Current Liabilities......................................................... 34,717 51,476 Long-term debt....................................................................... 209,767 210,741 Other long-term liabilities.......................................................... 4,477 3,122 Deferred tax liability............................................................... 16,654 5,350 -------- -------- TOTAL LIABILITIES.................................................................... 265,615 270,689 -------- -------- COMMITMENTS AND CONTINGENCIES SHAREHOLDERS' EQUITY -------------------- 7% cumulative convertible Preferred Stock, $.01 par value; $25.00 stated and liquidation value; 840,000 shares authorized; issued and outstanding -- 40,000 shares at both 2005 and 2004 (convertible into Class A shares at a ratio of 8.4375 to one)...................................................... -- -- Class A and Class B Common Stock, $.01 par value;150,000,000 and 75,000,000 shares authorized, respectively; Class A - issued 39,059,428 and 36,080,583 at March 31, 2005 and 2004, respectively........................................................ 391 362 Class B - issued 13,422,101 and 16,148,739 at March 31, 2005 and 2004, respectively (convertible into Class A shares on a one-for-one basis)... 134 162 Additional paid-in capital........................................................... 128,182 123,828 Retained earnings.................................................................... 217,779 184,580 Accumulated other comprehensive loss................................................. (133) -- Less: Treasury stock, 3,111,003 shares of Class A and 92,902 shares of Class B Common Stock in 2005, and 3,035,948 shares of Class A and 80,142 shares of Class B Common Stock in 2004, at cost..................................................... (53,651) (51,183) -------- -------- TOTAL SHAREHOLDERS' EQUITY........................................................... 292,702 257,749 -------- -------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY........................................... $558,317 $528,438 ======== ======== SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
56 K-V PHARMACEUTICAL COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Dollars in thousands, except per share data)
YEARS ENDED MARCH 31, ----------------------------------- 2005 2004 2003 -------- -------- ------- Net revenues........................................................... $303,493 $283,941 $244,996 Cost of sales.......................................................... 107,682 98,427 94,527 -------- -------- -------- Gross profit........................................................... 195,811 185,514 150,469 -------- -------- -------- Operating expenses: Research and development............................................ 23,538 20,651 19,135 Selling and administrative.......................................... 116,638 88,333 69,584 Amortization of intangible assets................................... 4,653 4,459 2,321 Litigation.......................................................... (1,430) (1,700) 16,500 -------- -------- -------- Total operating expenses............................................... 143,399 111,743 107,540 -------- -------- -------- Operating income....................................................... 52,412 73,771 42,929 -------- -------- -------- Other expense (income): Interest expense.................................................... 5,432 5,865 325 Interest and other income........................................... (3,048) (2,092) (977) -------- -------- -------- Total other expense (income), net...................................... 2,384 3,773 (652) -------- -------- --------- Income before income taxes............................................. 50,028 69,998 43,581 Provision for income taxes............................................. 16,759 24,150 15,471 -------- -------- -------- Net income............................................................. $ 33,269 $ 45,848 $ 28,110 ======== ======== ======== Earnings per common share: Basic - Class A common.............................................. $ 0.71 $ 0.98 $ 0.59 Basic - Class B common.............................................. 0.59 0.82 0.50 Diluted............................................................. $ 0.63 $ 0.84 $ 0.55 ======== ======== ======= Weighted Average Shares Outstanding: Basic - Class A common.............................................. 34,228 33,046 33,997 Basic - Class B common.............................................. 15,005 15,941 15,803 Diluted............................................................. 59,468 58,708 51,561 SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
57 K-V PHARMACEUTICAL COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Dollars in thousands)
YEARS ENDED MARCH 31, --------------------------------- 2005 2004 2003 ------- ------- ------- Net income............................................................. $33,269 $45,848 $28,110 Other comprehensive income (loss): Unrealized loss on available for sale securities.................... (201) -- -- Less related taxes.................................................. 68 -- -- ------- ------- ------- Total unrealized loss on available for sale securities, net...... (133) -- -- ------- ------- ------- Total comprehensive income............................................. $33,136 $45,848 $28,110 ======= ======= ======= SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
58 K-V PHARMACEUTICAL COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
YEARS ENDED MARCH 31, 2005, 2004 AND 2003 ---------------------------------------------------------------------------- CLASS A CLASS B ADDITIONAL PREFERRED COMMON COMMON PAID IN TREASURY RETAINED STOCK STOCK STOCK CAPITAL STOCK EARNINGS ----- ----- ----- ------- ----- -------- (Dollars in thousands) BALANCE AT MARCH 31, 2002........................ $ -- $201 $108 $ 47,231 $ (49) $111,301 Net income....................................... -- -- -- -- -- 28,110 Dividends paid on preferred stock................ -- -- -- -- -- (70) Conversion of 175,000 Class B shares to Class A shares...................... -- 2 (2) -- -- -- Issuance of 3,285,000 Class A shares............. -- 33 -- 72,347 -- -- Sale of 40,461 Class A shares to employee profit sharing plan........................... -- -- -- 884 21 -- Stock Options exercised - 49,563 shares of Class A less 9,502 shares repurchased and 40,717 shares of Class B less 112 shares repurchased................................... -- -- -- 499 -- -- ---------------------------------------------------------------------------- BALANCE AT MARCH 31, 2003........................ -- 236 106 120,961 (28) 139,341 Net income....................................... -- -- -- -- -- 45,848 Dividends paid on preferred stock................ -- -- -- -- -- (436) Conversion of 117,187 Class B shares to Class A shares................................ -- 1 (1) -- -- -- Issuance of 27,992 Class A shares under product development agreement........... -- -- -- 505 -- -- Purchase of common stock for treasury............ -- -- -- -- (51,155) -- Three-for-two stock dividend..................... -- 120 53 -- -- (173) Stock Options exercised - 552,617 shares of Class A less 91,538 shares repurchased and 413,419 shares of Class B less 15,625 shares repurchased................................... -- 5 4 2,362 -- -- ---------------------------------------------------------------------------- BALANCE AT MARCH 31, 2004........................ -- 362 162 123,828 (51,183) 184,580 Net income....................................... -- -- -- -- -- 33,269 Dividends paid on preferred stock................ -- -- -- -- -- (70) Conversion of 2,783,537 Class B shares to Class A shares................................ -- 28 (28) -- -- -- Issuance of 14,679 Class A shares under product development agreement......................... -- -- -- 237 -- -- Purchase of common stock for treasury............ -- -- -- -- (2,468) -- Stock Options exercised - 180,629 shares of Class A and 56,899 shares of Class B.......... -- 1 -- 4,117 -- -- Unrealized loss on marketable securities available for sale, net of related taxes of $68........................................ -- -- -- -- -- -- ---------------------------------------------------------------------------- BALANCE AT MARCH 31, 2005........................ $ $391 $134 $128,182 $(53,651) $217,779 ============================================================================ ------------------------------- ACCUMULATED OTHER TOTAL COMPREHENSIVE SHAREHOLDERS' LOSS, NET EQUITY --------- ------ BALANCE AT MARCH 31, 2002........................ $ -- $158,792 Net income....................................... -- 28,110 Dividends paid on preferred stock................ -- (70) Conversion of 175,000 Class B shares to Class A shares...................... -- -- Issuance of 3,285,000 Class A shares............. -- 72,380 Sale of 40,461 Class A shares to employee profit sharing plan........................... -- 905 Stock Options exercised - 49,563 shares of Class A less 9,502 shares repurchased and 40,717 shares of Class B less 112 shares repurchased................................... -- 499 ------------------------------- BALANCE AT MARCH 31, 2003........................ -- 260,616 Net income....................................... -- 45,848 Dividends paid on preferred stock................ -- (436) Conversion of 117,187 Class B shares to Class A shares................................ -- -- Issuance of 27,992 Class A shares under product development agreement........... -- 505 Purchase of common stock for treasury............ -- (51,155) Three-for-two stock dividend..................... -- -- Stock Options exercised - 552,617 shares of Class A less 91,538 shares repurchased and 413,419 shares of Class B less 15,625 shares repurchased................................... -- 2,371 ------------------------------- BALANCE AT MARCH 31, 2004........................ -- 257,749 Net income....................................... -- 33,269 Dividends paid on preferred stock................ -- (70) Conversion of 2,783,537 Class B shares to Class A shares................................ -- -- Issuance of 14,679 Class A shares under product development agreement......................... -- 237 Purchase of common stock for treasury............ -- (2,468) Stock Options exercised - 180,629 shares of Class A and 56,899 shares of Class B.......... -- 4,118 Unrealized loss on marketable securities available for sale, net of related taxes of $68........................................ (133) (133) ------------------------------- BALANCE AT MARCH 31, 2005........................ $(133) $292,702 =============================== SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
59 K-V PHARMACEUTICAL COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands)
YEARS ENDED MARCH 31, --------------------------------------- 2005 2004 2003 -------- -------- -------- Operating Activities: Net income............................................................. $ 33,269 $ 45,848 $ 28,110 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation, amortization and other non-cash charges............... 13,904 12,663 7,773 Deferred income tax provision (benefit)............................. 13,582 8,691 (8,091) Deferred compensation............................................... 1,355 209 196 Litigation.......................................................... (843) 1,825 16,500 Changes in operating assets and liabilities: Decrease (increase) in receivables, net............................. 3,511 (8,487) (3,167) Increase in inventories............................................. (3,248) (9,977) (5,623) (Increase) decrease in prepaid and other assets..................... (3,520) (6,294) 496 (Decrease) increase in accounts payable and accrued................. liabilities...................................................... (8,980) (10,471) 7,127 -------- -------- -------- Net cash provided by operating activities.............................. 49,030 34,007 43,321 -------- -------- -------- Investing Activities: Purchase of property and equipment.................................. (63,622) (21,792) (16,113) Purchase of marketable securities................................... (10,565) (278) (35,052) Purchase of stock and intangible assets............................. - (4,000) (3,000) Product acquisition................................................. - (14,300) (13,000) -------- -------- -------- Net cash used in investing activities.................................. (74,187) (40,370) (67,165) -------- -------- -------- Financing Activities: Principal payments on long-term debt................................ (8,179) (8,237) (743) Dividends paid on preferred stock................................... (70) (436) (70) Proceeds from issuance of convertible notes......................... - 194,165 - Purchase of common stock for treasury............................... (2,468) (51,155) - Proceeds from issuance of common stock.............................. - - 72,380 Sale of common stock to employee profit sharing plan................ - - 905 Exercise of common stock options.................................... 4,118 2,371 499 -------- -------- -------- Net cash (used in) provided by financing activities.................... (6,599) 136,708 72,971 -------- -------- -------- (Decrease) increase in cash and cash equivalents....................... (31,756) 130,345 49,127 Cash and cash equivalents: Beginning of year................................................... 191,581 61,236 12,109 -------- -------- -------- End of year......................................................... $159,825 $191,581 $ 61,236 ======== ======== ======== Non-cash investing and financing activities: Term loan to finance building purchase.............................. $ - $ 8,800 $ - Term loans refinanced............................................... - - 1,738 Issuance of common stock under product development agreement........................................................ 237 505 - Payments due on product acquisitions................................ - - 15,983 Portion of product acquisition financed by promissory notes......... - - 13,234 SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
60 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands, except share and per share data) 1. DESCRIPTION OF BUSINESS ----------------------- K-V Pharmaceutical Company and its subsidiaries ("KV" or the "Company") are primarily engaged in the development, acquisition, manufacture, marketing and sale of technologically distinguished branded and generic/non-branded prescription pharmaceutical products. The Company was incorporated in 1971 and has become a leader in the development of advanced drug delivery and formulation technologies that are designed to enhance therapeutic benefits of existing drug forms. Through internal product development and synergistic acquisitions of products, KV has grown into a fully integrated specialty pharmaceutical company. The Company also develops, manufactures and markets technologically advanced, value-added raw material products for the pharmaceutical, nutritional, food and personal care industries. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ------------------------------------------ BASIS OF PRESENTATION --------------------- The Company's consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles. The consolidated financial statements include the accounts of KV and its wholly-owned subsidiaries. All material inter-company accounts and transactions have been eliminated in consolidation. Certain reclassifications, none of which affected net income or retained earnings, have been made to prior year amounts to conform to the current year presentation. USE OF ESTIMATES ---------------- The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results in subsequent periods may differ from the estimates and assumptions used in the preparation of the accompanying consolidated financial statements. The most significant estimates made by management include the determination of sales allowances, valuation of inventory balances, the determination of useful lives for intangible assets, and the evaluation of intangible assets and goodwill for impairment. Management periodically evaluates estimates used in the preparation of the consolidated financial statements and makes changes on a prospective basis when adjustments are necessary. CASH EQUIVALENTS ---------------- Cash equivalents consist of interest-bearing deposits that can be redeemed on demand and investments that have original maturities of three months or less. MARKETABLE SECURITIES --------------------- The Company's marketable securities consist of mutual funds comprised of U.S. government investments and auction rate securities. The Company classifies its marketable securities as available-for-sale securities with net unrealized gains or losses recorded as a separate component of stockholders' equity, net of any related tax effect. Auction rate securities generally have long-term stated maturities of 20 to 30 years. However, these 61 securities have certain economic characteristics of short-term investments due to a rate-setting mechanism and the ability to liquidate them through a Dutch auction process that occurs on pre-determined intervals of less than 90 days. The Company had previously classified its auction rate securities as cash and cash equivalents. In fiscal 2005, the Company reclassified $10,000 of auction rate securities from cash and cash equivalents to marketable securities because the underlying instrument has a maturity date in August 2030. Prior periods have been reclassified to provide consistent presentation. INVENTORIES ----------- Inventories consist of finished goods held for distribution, raw materials and work in process. Inventories are stated at the lower of cost or market, with the cost determined on the first-in, first-out (FIFO) basis. Reserves for obsolete, excess or slow moving inventory are established by management based on evaluation of inventory levels, forecasted demand, and market conditions. PROPERTY AND EQUIPMENT ---------------------- Property and equipment are stated at cost, less accumulated depreciation. Major renewals and improvements are capitalized, while routine maintenance and repairs are expensed as incurred. At the time properties are retired from service, the cost and accumulated depreciation are removed from the respective accounts and the related gains or losses are reflected in earnings. The Company capitalizes interest on qualified construction projects. Depreciation expense is computed over the estimated useful lives of the related assets using the straight-line method. The estimated useful lives are principally 10 years for land improvements, 10 to 40 years for buildings and improvements, 3 to 15 years for machinery and equipment, and 3 to 10 years for office furniture and equipment. Leasehold improvements are amortized on a straight-line basis over the shorter of the respective lease terms or the estimated useful life of the assets. The Company assesses property and equipment for impairment whenever events or changes in circumstances indicate that an asset's carrying amount may not be recoverable. INTANGIBLE ASSETS AND GOODWILL ------------------------------ Intangible assets consist of product rights, license agreements and trademarks resulting from product acquisitions and legal fees and similar costs relating to the development of patents and trademarks. Intangible assets that are acquired are stated at cost, less accumulated amortization, and are amortized on a straight-line basis over estimated useful lives of 20 years. Costs associated with the development of patents and trademarks are amortized on a straight-line basis over estimated useful lives ranging from 5 to 17 years. The Company evaluates its intangible assets for impairment whenever events or changes in circumstances indicate that an intangible asset's carrying amount may not be recoverable. Recoverability is determined by comparing the carrying amount of an intangible asset against an estimate of the undiscounted future cash flows expected to result from its use and eventual disposition. If the sum of the expected future undiscounted cash flows is less than the carrying amount of the intangible asset, an impairment loss is recognized based on the excess of the carrying amount over the estimated fair value of the intangible asset. Goodwill relates to the 1972 acquisition of the Company's specialty materials segment and is recorded net of accumulated amortization through March 31, 2002. In accordance with the Company's adoption of Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets, on April 1, 2002, amortization of goodwill was discontinued. Instead, goodwill is subject to at least an annual assessment of impairment on a fair value basis. If the Company determines through the assessment process that goodwill 62 has been impaired, the Company will record the impairment charge in its results of operations. The Company's test for goodwill impairment in fiscal 2005 determined there was no goodwill impairment. OTHER ASSETS ------------ Non-marketable equity investments for which the Company does not have the ability to exercise significant influence over operating and financial policies (generally less than 20% ownership) are accounted for using the cost method. Such investments are included in "Other assets" in the accompanying consolidated balance sheets and relate to the Company's $5,000 investment in the preferred stock of FemmePharma, Inc. (see Note 3). This investment is periodically reviewed for other-than-temporary declines in fair value. Other than temporary declines in fair value are identified by evaluating market conditions, the entity's ability to achieve forecast and regulatory submission guidelines, as well as the entity's overall financial condition. REVENUE RECOGNITION ------------------- Revenue is generally realized or realizable and earned when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the seller's price to the buyer is fixed or determinable, and the customer's payment ability has been reasonably assured. Accordingly, the Company records revenue from product sales when title and risk of ownership have been transferred to the customer, which is typically upon shipment to the customer. The Company also enters into long-term agreements under which it assigns marketing rights for the products it has developed to pharmaceutical marketers. Royalties under these arrangements are earned based on the sale of products. Concurrently with the recognition of revenue, the Company records estimated sales provisions for product returns, sales rebates, payment discounts, chargebacks, and other sales allowances. Sales provisions are established based upon consideration of a variety of factors, including but not limited to, historical relationship to revenues, historical payment and return experience, estimated customer inventory levels, customer rebate arrangements, and current contract sales terms with wholesale and indirect customers. The following briefly describes the nature of each provision and how such provisions are estimated. o Payment discounts are reductions to invoiced amounts offered to customers for payment within a specified period and are estimated utilizing historical customer payment experience. o Sales rebates are offered to certain customers to promote customer loyalty and encourage greater product sales. These rebate programs provide that, upon the attainment of pre-established volumes or the attainment of revenue milestones for a specified period, the customer receives credit against purchases. Other promotional programs are incentive programs periodically offered to customers. Due to the nature of these programs, the Company is able to estimate provisions for rebates and other promotional programs based on the specific terms in each agreement. o Consistent with common industry practices, the Company has agreed to terms with its customers to allow them to return product that is within a certain period of the expiration date. Upon recognition of revenue from product sales to customers, the Company provides for an estimate of product to be returned. This estimate is determined by applying a historical relationship of customer returns to amounts invoiced. o Generally, the Company provides credits to customers for decreases that are made to selling prices for the value of inventory that is owned by customers at the date of the price reduction. The Company has not contractually agreed to provide price adjustment credits to its customers; instead, the Company issues price adjustment credits at its discretion. Price 63 adjustment credits are estimated at the time the price reduction occurs. The amount is calculated based on an estimate of customer inventory levels. o KV has arrangements with certain parties establishing prices for the Company's products for which the parties independently select a wholesaler from which to purchase. Such parties are referred to as indirect customers. A chargeback represents the difference between the Company's invoice price to the wholesaler and the indirect customer's contract price, which is lower. Provisions for estimated chargebacks are calculated primarily using historical chargeback experience, actual contract pricing and estimated wholesaler inventory levels. Actual product returns, chargebacks and other sales allowances incurred are, however, dependent upon future events and may be different than the Company's estimates. The Company continually monitors the factors that influence sales allowance estimates and makes adjustments to these provisions when management believes that actual product returns, chargebacks and other sales allowances may differ from established allowances. Accruals for sales provisions are presented in the consolidated financial statements as reductions to net revenues and accounts receivable. Sales provisions totaled $133,475, $103,262 and $98,929 for the years ended March 31, 2005, 2004 and 2003, respectively. The reserve balances related to the sales provisions totaled $21,056 and $20,648 at March 31, 2005 and 2004, respectively, and are included in "Receivables, less allowance for doubtful accounts" in the accompanying consolidated balance sheets. CONCENTRATION OF CREDIT RISK ---------------------------- The Company extends credit on an uncollateralized basis primarily to wholesale drug distributors and retail pharmacy chains throughout the United States. As a result, the Company is required to estimate the level of receivables which ultimately will not be paid. The Company calculates this estimate based on prior experience supplemented by a customer specific review when it is deemed necessary. On a periodic basis, the Company performs evaluations of the financial condition of all customers to further limit its credit risk exposure. Actual losses from uncollectible accounts have historically been insignificant. The Company's three largest customers accounted for approximately 23%, 18% and 16%, and 31%, 16% and 11% of gross receivables at March 31, 2005 and 2004, respectively. For the year ended March 31, 2005, KV's three largest customers accounted for 27%, 16% and 12% of gross revenues. During the years ended March 31, 2004 and 2003, the Company's three largest customers accounted for gross revenues of 25%, 16% and 13% and 23%, 18% and 14%, respectively. The Company maintains cash balances at certain financial institutions that are greater than the FDIC insurable limit. SHIPPING AND HANDLING COSTS --------------------------- The Company classifies shipping and handling costs in cost of sales. The Company does not derive revenue from shipping. 64 RESEARCH AND DEVELOPMENT ------------------------ Research and development costs, including licensing fees for early stage development products, are expensed in the period incurred. The Company has licensed the exclusive rights to co-develop and market various products with other drug delivery companies. These collaborative agreements usually require the Company to pay up-front fees and ongoing milestone payments. When the Company makes an up-front or milestone payment, management evaluates the stage of the related product to determine the appropriate accounting treatment. If the product is considered to be beyond the early development stage but has not yet been approved by regulatory authorities, the Company will evaluate the facts and circumstances of each case to determine if a portion or all of the payment has future economic benefit and should be capitalized. Payments made to third parties subsequent to regulatory approval are capitalized with that cost generally amortized over the shorter of the patented life of the product or the term of the licensing agreement. The Company accrues estimated costs associated with clinical studies performed by contract research organizations based on the total of costs incurred through the balance sheet date. The Company monitors the progress of the trials and their related activities to the extent possible, and adjusts the accruals accordingly. These accrued costs are recorded as a component of research and development expense. ADVERTISING ----------- Costs associated with advertising are expensed in the period in which the advertising is used and these costs are included in selling and administrative expense. Advertising expenses totaled $10,885, $7,264 and $5,662 for the years ended March 31, 2005, 2004 and 2003, respectively. Advertising expense includes the cost of product samples given to physicians for marketing to their patients. LITIGATION ---------- The Company is subject to litigation in the ordinary course of business and to certain other contingencies (see Note 11). Legal fees and other expenses related to litigation and contingencies are recorded as incurred. The Company, in consultation with its legal counsel, also assesses the need to record a liability for litigation and contingencies on a case-by-case basis. Accruals are recorded when the Company determines that a loss related to a matter is both probable and reasonably estimable. DEFERRED FINANCING COSTS ------------------------ Deferred financing costs of $5,835 were incurred in connection with the issuance of the 2.5% Contingent Convertible Notes due 2033. These costs are being amortized into interest expense on a straight-line basis over the five-year period that ends on the first date the debt can be put by the holders to the Company. Accumulated amortization totaled $2,143 and $979 at March 31, 2005 and 2004, respectively. Deferred financing costs, net of accumulated amortization, are included in "Other Assets" in the accompanying consolidated balance sheet. EARNINGS PER SHARE ------------------ Basic earnings per share is calculated by dividing net income available to common shareholders for the period by the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed by dividing net income by the weighted average common shares and common share equivalents outstanding during the periods presented assuming the conversion of preferred shares and the exercise of all in-the-money stock options based on the treasury stock method. Common share equivalents 65 have been excluded from the computation of diluted earnings per share where their inclusion would be anti-dilutive. In June 2004, the Company adopted the guidance in Emerging Issues Task Force (EITF) Issue No. 03-6, Participating Securities and the Two-Class Method under FASB Statement No. 128. The pronouncement required the use of the two-class method in the calculation and disclosure of basic earnings per share and provided guidance on the allocation of earnings and losses for purposes of calculating basic earnings per share. Accordingly, all periods presented have been retroactively adjusted to give effect to such guidance. For purposes of calculating basic earnings per share, undistributed earnings are allocated to each class of common stock based on the contractual participation rights of each class of security. Holders of Class A common stock are entitled to receive dividends per share equal to 120% of the dividends per share paid on the Class B common stock. In December 2004, the Company adopted the guidance in EITF 04-8, The Effect of Contingently Convertible Instruments on Diluted Earnings per Share. The EITF consensus required that the impact of contingently convertible debt instruments be included in diluted earnings per share computations (if dilutive) regardless of whether the market price trigger (or other contingent feature) had been met. Additionally, the EITF stated that prior period earnings per share amounts presented for comparative purposes should be restated to conform to this consensus. INCOME TAXES ------------ Income taxes are accounted for under the asset and liability method where deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is established when it is more likely than not that some portion or all of the deferred tax assets will not be realized. 66 STOCK-BASED COMPENSATION ------------------------ The Company grants stock options for a fixed number of shares to employees with an exercise price greater than or equal to the fair value of the shares at the date of grant. As permissible under Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, the Company elected to continue to account for stock option grants to employees in accordance with Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees and related interpretations. APB 25 requires that compensation cost related to fixed stock option plans be recognized only to the extent that the fair value of the shares at the grant date exceeds the exercise price. Accordingly, no compensation expense is recognized for stock option awards granted to employees with exercise prices at or above fair value. Had the Company determined compensation expense using the fair value method prescribed by SFAS 123, the Company's net income and earnings per share would have been as follows:
YEARS ENDED MARCH 31, --------------------------------- 2005 2004 2003 ---- ---- ---- Net income, as reported........................ $33,269 $45,848 $28,110 Stock based employee compensation expense, net of related tax effects................... (640) (695) (815) ------- ------- ------- Pro forma net income........................... $32,629 $45,153 $27,295 ======= ======= ======= Earnings per share: Basic Class A common - as reported.......... $ 0.71 $ 0.98 $ 0.59 Basic Class A common - pro forma............ 0.70 0.97 0.58 Basic Class B common - as reported.......... 0.59 0.82 0.50 Basic Class B common - pro forma............ 0.58 0.80 0.48 Diluted - as reported....................... 0.63 0.84 0.55 Diluted - pro forma......................... 0.62 0.83 0.53
The weighted average fair value of the options has been estimated on the date of grant using the following weighted average assumptions for grants issued during the years ended March 31, 2005, 2004 and 2003, respectively: no dividend yield; expected volatility of 36%, 43% and 45% for Class A common stock; expected volatility of 33%, 39% and 45% for Class B common stock; risk-free interest rate of 3.65%, 3.00% and 2.40% per annum; and expected option terms ranging from 3 to 10 years for all three periods. Weighted averages are used because of varying assumed exercise dates. COMPREHENSIVE INCOME -------------------- Comprehensive income includes all changes in equity during a period except those that resulted from investments by or distributions to the Company's shareholders. Other comprehensive income refers to revenues, expenses, gains and losses that, under generally accepted accounting principles, are included in comprehensive income, but excluded from net income as these amounts are recorded directly as an adjustment to shareholders' equity. For the Company, other comprehensive income (loss) is comprised of the net changes in unrealized gains and losses on available-for-sale securities, net of applicable income taxes. FAIR VALUE OF FINANCIAL INSTRUMENTS ----------------------------------- The fair values of the Company's cash and cash equivalents, receivables, accounts payable and accrued liabilities approximate their carrying values due to the relatively short maturity of these items. The carrying 67 amount of all long-term financial obligations approximates their fair value because their terms are similar to those which can be obtained for similar financial instruments in the current marketplace. The Company's $5,000 investment in the preferred stock of FemmePharma, Inc. had a fair value of $19,200 and $11,840 at March 31, 2005 and 2004, respectively, based on an annual independent valuation analysis. Based on quoted market rates, the Company's $200,000 principal amount of Convertible Subordinated Notes had a fair value of $217,620 and $247,940 at March 31, 2005 and 2004, respectively. DERIVATIVE FINANCIAL INSTRUMENTS -------------------------------- In April 2003, the Company entered into an interest rate swap agreement with a major financial institution to hedge variable interest rate exposure related to a term loan with the same financial institution. Under the agreement, the Company fixed the interest rate of the debt at 5.31% per annum for the term of the loan. The swap is settled monthly and is recorded at each reporting date on the Company's consolidated balance sheet at fair value. Since the swap has not been designated as a hedge, any unrealized gains and losses are recognized in earnings. The Company's derivative financial instruments also consist of embedded derivatives related to the 2.5% Convertible Subordinated Notes due 2033. These embedded derivatives include certain conversion features and a contingent interest feature. Although the conversion features represent embedded derivative financial instruments, based on the de minimis value of these features at the time of issuance and at March 31, 2005, no value has been assigned to these embedded derivatives. The contingent interest feature provides unique tax treatment under the Internal Revenue Service's contingent debt regulations. In essence, interest accrues, for tax purposes, on the basis of the instrument's comparable yield (the yield at which the issuer would issue a fixed rate instrument with similar terms). NEW ACCOUNTING PRONOUNCEMENTS ----------------------------- In March 2004, the EITF completed its discussion of and provided consensus guidance on Issue No. 03-06, Participating Securities and the Two-Class Method under FASB Statement No. 128, Earnings per Share. The consensus interpreted the definition of a "participating security," required the use of the two-class method in the calculation and disclosure of basic earnings per share for companies with participating securities or more than one class of common stock, and provided guidance on the allocation of earnings and losses for purposes of calculating basic earnings per share. Since the Company has two classes of common stock, this consensus has been applied in the calculation of basic earnings per share for all periods presented. There was no impact on diluted earnings per share as reported. In April 2004, the FASB issued FASB Staff Position No. 129-1 (FSP 129-1), Disclosure Requirements under FASB Statement No. 129, Disclosure of Information about Capital Structure, Relating to Contingently Convertible Securities. This FSP requires the disclosure provisions of Statement 129 to apply to all existing and newly created contingently convertible securities and to their potentially dilutive effects on earnings per share. The adoption of the disclosure provisions of FSP 129-1 did not have a material impact on the Company's financial condition or results of operations. In September 2004, the EITF reached a consensus that contingently convertible debt instruments should be included in diluted earnings per share computations (if dilutive) regardless of whether the market price trigger (or other contingent feature) has been met. Additionally, the EITF stated that prior period earnings per share amounts presented for comparative purposes should be restated to conform to this consensus, which is effective for reporting periods ending after December 15, 2004. The consensus adopted by the EITF required 68 the addition of approximately 8.7 million shares associated with the conversion of the Company's $200,000 principal amount Convertible Subordinated Notes to the number of shares outstanding for the calculation of diluted earnings per share for all reported periods since the issuance of the Notes. In November 2004, the FASB issued SFAS No. 151, Inventory Costs, an Amendment to ARB No. 43, Chapter 4 which requires that abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) costs be recognized as current period charges. In addition, this statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. This statement is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company is currently determining the impact, if any, the adoption of this statement will have on its financial condition and results of operations. In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based Payment" (SFAS 123R), which replaces SFAS No. 123, "Accounting for Stock-Based Compensation" (SFAS 123), and supercedes APB Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. The pro forma disclosures previously permitted under SFAS 123 no longer will be an alternative to financial statement recognition. Under SFAS 123R, the Company must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at date of adoption. The transition methods include modified prospective and modified retrospective adoption options. Under the modified retrospective option, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The modified prospective method requires that compensation expense be recorded for all unvested stock options and restricted stock at the beginning of the first quarter of adoption of SFAS 123R, while the modified retrospective method would record compensation expense for all unvested stock options and restricted stock beginning with the first period restated. The Company is evaluating the requirements of SFAS 123R. The Company has not yet determined the method of adoption or the effect of adopting SFAS 123R, and it has not determined whether the adoption will result in amounts that are similar to the current pro forma disclosures under SFAS 123. In April 2005, the Securities and Exchange Commission announced an amendment to Regulation S-X to amend the date for compliance with SFAS 123R. The amendment requires each registrant that is not a small business issuer to adopt SFAS 123R in the first fiscal year commencing after June 15, 2005. As a result, the Company is required to adopt SFAS 123R beginning April 1, 2006. Adoption of SFAS 123R will have an impact on the Company's consolidated financial statements, as it will be required to expense the fair value of its employee stock option grants rather than disclose the pro forma impact on its consolidated net income within the footnotes to the Company's consolidated financial statements, as is its current practice. 69 3. ACQUISITIONS AND LICENSE AGREEMENT ---------------------------------- On March 31, 2003, the Company acquired from Schwarz Pharma (Schwarz) the product rights and trademarks to the Niferex(R) line of hematinic products for $14,300, plus expenses. The acquisition was financed with cash on hand. The purchase price was allocated to the trademark rights acquired and is being amortized over an estimated life of 20 years. On March 31, 2003, the Company acquired from a subsidiary of Altana Pharma AG (Altana) the world-wide product rights and trademarks to the Chromagen(R) line of hematinic products and the StrongStart(R) line of prenatal vitamin products for $27,000, plus expenses. The purchase price was allocated to the trademark rights acquired and is being amortized over an estimated life of 20 years. On April 18, 2002, the Company entered into an agreement with FemmePharma, Inc. (FemmePharma) whereby the Company was granted an exclusive license to manufacture and sell in North America and certain foreign markets intravaginal products and certain vaginal anti-infective products under development (the "License Agreement"). The initial product covered by the License Agreement was intended for use in the treatment of endometriosis using FemmePharma's patented PARDEL(TM) technology. In consideration for the rights and licenses received, the Company paid $2,000 for use of the PARDEL(TM) trademark (see Note 21). Under a separate agreement, the Company invested $2,000 in FemmePharma's convertible preferred stock in fiscal 2003 and made an additional $3,000 convertible preferred stock investment in January 2004 upon the completion of Phase II studies on the initial product covered by the License Agreement. The $5,000 investment has been accounted for using the cost method and is included in "Other assets" in the accompanying consolidated balance sheets (see Note 21). 4. MARKETABLE SECURITIES --------------------- The carrying amount of available-for-sale securities and their approximate fair values at March 31, 2005 and 2004 were as follows.
MARCH 31, 2005 -------------------------------------------------------------- GROSS GROSS UNREALIZED UNREALIZED FAIR COST GAINS LOSSES VALUE ---- ----- ------ ----- Auction rate securities......... $10,000 $ - $ - $10,000 Equity securities............... 35,895 - (201) 35,694 ------- ----- ----- ------- Total....................... $45,895 $ - $(201) $45,694 ======= ===== ===== ======= MARCH 31, 2004 -------------------------------------------------------------- GROSS GROSS UNREALIZED UNREALIZED FAIR COST GAINS LOSSES VALUE ---- ----- ------ ----- Auction rate securities......... $10,000 $ - $ - $10,000 Equity securities............... 25,330 - - 25,330 ------- ----- ----- ------- Total....................... $35,330 $ - $ - $35,330 ======= ===== ===== =======
70 The Company's marketable securities are classified as available-for-sale and are recorded at fair value based on quoted market prices using the specific identification method. These investments are classified as current as the Company has the ability to use them for current operating and investing purposes. There were no realized gains or losses for the years ended March 31, 2005, 2004 and 2003. At March 31, 2005, the Company has determined that its unrealized losses are temporary based on the de minimis amount of losses compared to cost and the duration of the losses being less than 12 months. The Company expects that all losses will be recovered, and intends to hold these marketable securities to recovery. If market conditions deteriorate, we may incur future impairments. Included in the Company's marketable securities at March 31, 2005 and 2004 are $10,000 of auction rate securities. Auction rate securities are investments with an underlying component of long-term debt or an equity instrument. These auction rate securities trade or mature on a shorter term than the underlying instrument based on an auction bid that resets the interest rate of the security. The auction or reset dates occur at intervals that are typically less than three months providing high liquidity to otherwise longer term investments. The Company had previously classified its auction rate securities as cash and cash equivalents. In fiscal 2005, the Company reclassified auction rate securities from cash and cash equivalents to marketable securities because the underlying instrument has a maturity date of August 2030. Prior periods have been reclassified to provide consistent presentation. 5. INVENTORIES ----------- Inventories as of March 31, consist of:
2005 2004 ---- ---- Finished goods..................... $30,521 $30,432 Work-in-process.................... 5,773 4,736 Raw materials...................... 17,651 15,529 ------- ------- $53,945 $50,697 ======= =======
6. PROPERTY AND EQUIPMENT ---------------------- Property and equipment as of March 31, consist of:
2005 2004 ---- ---- Land and improvements............... $ 2,030 $ 2,083 Building and building improvements.. 19,984 17,767 Machinery and equipment............. 41,399 43,442 Office furniture and equipment...... 14,871 15,051 Leasehold improvements.............. 9,985 11,338 Construction-in-progress............ 74,394 24,529 -------- -------- 162,663 114,210 Less accumulated depreciation....... (31,039) (38,433) -------- --------- Net property and equipment....... $131,624 $ 75,777 ======== ========
Capital additions to property and equipment were $63,622, $30,592 and $16,113 for the years ended March 31, 2005, 2004 and 2003, respectively. Depreciation of property and equipment was $7,775, $6,718 and $5,434 for the years ended March 31, 2005, 2004 and 2003, respectively. Property and equipment projects classified as construction-in- progress at March 31, 2005 are projected to be completed during the next 12 months at an estimated cost of $14,775. 71 During the years ended March 31, 2005 and 2004, the Company recorded capitalized interest on qualifying construction projects of $1,511 and $577, respectively. In fiscal 2003, the Company did not record any capitalized interest. 7. INTANGIBLE ASSETS AND GOODWILL ------------------------------ Intangible assets and goodwill as of March 31, consist of:
2005 2004 ------------------------------ ----------------------------- GROSS GROSS CARRYING ACCUMULATED CARRYING ACCUMULATED AMOUNT AMORTIZATION AMOUNT AMORTIZATION ------ ------------ ------ ------------ Product rights - Micro-K(R)..... $36,140 $(10,904) $36,140 $ (9,099) Product rights - PreCare(R)..... 8,433 (2,389) 8,433 (1,968) Trademarks acquired: Niferex(R)................... 14,834 (1,484) 14,834 (742) Chromagen(R)/StrongStart(R).. 27,642 (2,764) 27,642 (1,382) License agreements.............. 4,168 (120) 3,825 - Trademarks and patents.......... 2,814 (497) 2,980 (411) ------- -------- ------- -------- Total intangible assets..... 94,031 (18,158) 93,854 (13,602) Goodwill........................ 557 - 557 - ------- -------- ------- -------- $94,588 $(18,158) $94,411 $(13,602) ======= ======== ======= ========
As of March 31, 2005, the Company's intangible assets have a weighted average useful life of approximately 19 years. Amortization of intangible assets was $4,653, $4,459 and $2,321 for the years ended March 31, 2005, 2004 and 2003, respectively. Assuming no additions, disposals or adjustments are made to the carrying values and/or useful lives of the intangible assets, annual amortization expense on product rights, trademarks acquired and other intangible assets is estimated to be approximately $4,730 in each of the five succeeding fiscal years. 8. OTHER ASSETS ------------ Other assets as of March 31, consist of:
2005 2004 ---- ---- Cash surrender value of life insurance......... $ 2,822 $ 2,531 Preferred stock in FemmePharma................. 5,000 5,000 Deferred financing costs, net.................. 3,852 4,993 Deposits....................................... 1,407 1,220 ------- ------- $13,081 $13,744 ======= =======
72 9. ACCRUED LIABILITIES ------------------- Accrued liabilities as of March 31, consist of:
2005 2004 ---- ---- Salaries, wages, incentives and benefits....... $10,383 $ 6,160 Income taxes - current......................... - 2,409 Promotion expenses............................. 131 635 Litigation reserve............................. - 18,325 Other.......................................... 5,219 3,388 ------- ------- $15,733 $30,917 ======= =======
10. LONG-TERM DEBT -------------- Long-term debt as of March 31, consists of:
2005 2004 ---- ---- Industrial revenue bonds....................... $ - $ 205 Notes payable.................................. - 6,731 Building mortgages............................. 10,740 11,714 Convertible notes.............................. 200,000 200,000 -------- -------- 210,740 218,650 Less current portion........................... (973) (7,909) -------- -------- $209,767 $210,741 ======== ========
In December 2004, the Company increased its available credit facilities to $140,000. The revised agreement provides for an increase from $40,000 to $80,000 in the Company's revolving line of credit along with an increase from $25,000 to $60,000 in the supplemental credit line that is available for financing acquisitions. These credit facilities expire in October 2006 and December 2005, respectively. The revolving and supplemental credit lines are unsecured and interest is charged at the lower of the prime rate or the one-month LIBOR rate plus 175 basis points (4.61% at March 31, 2005). At March 31, 2005, the Company had no cash borrowings outstanding under either credit facility and $3,856 in open letters of credit issued under the credit facilities. The revised agreement contains substantially identical financial and other covenants, representations, warranties, conditions and default provisions as the replaced facility. The financial covenants impose minimum levels of earnings before interest, taxes, depreciation and amortization, a maximum funded debt ratio, a limit on capital expenditures and dividend payments, a minimum fixed charge coverage ratio and a maximum senior leverage ratio. As of March 31, 2005, the Company was in compliance with the covenants. The industrial revenue bonds, which paid interest at 7.35% per annum, matured serially through 2005 and were collateralized by certain property and equipment, as well as through a letter of credit, which was only accessible in case of default on the bonds. The bonds were paid in full in fiscal 2005. In April 2003, the Company financed the purchase of an $8.8 million building with a term loan secured by the property under a floating rate loan with a bank. The remaining principal balance plus any unpaid interest is due in April 2008. The Company also entered into an interest rate swap agreement with the same bank, which fixed the interest rate of the building mortgage at 5.31% for the term of the loan. At March 31, 2005, the Company's other two outstanding building mortgages bear interest at 7.57% and 6.27% and the remaining principal balances plus any unpaid interest are due in December 2006 and December 2007, respectively. 73 Notes payable related to a $7,000 unsecured promissory note that was entered into in conjunction with the Altana acquisition agreement (see Note 3) and was repaid on March 31, 2005. This note, which was non-interest bearing, was discounted using an imputed interest rate of 4.08%, which approximated the Company's borrowing rate for similar debt instruments at the time of the borrowing. The original discount on this note of $538 was amortized to interest expense over the two year term of the note. A second $7,000 unsecured promissory note entered into with Altana was repaid on March 31, 2004. On May 16, 2003, the Company issued $200,000 principal amount of Convertible Subordinated Notes (the "Notes") that are convertible, under certain circumstances, into shares of Class A common stock at an initial conversion price of $23.01 per share. The Notes, which are due May 16, 2033, bear interest that is payable on May 16 and November 16 of each year at a rate of 2.50% per annum. The Company also is obligated to pay contingent interest at a rate equal to 0.5% per annum during any six-month period from May 16 to November 15 and from November 16 to May 15, with the initial six-month period commencing May 16, 2006, if the average trading price of the Notes per $1,000 principal amount for the five trading day period ending on the third trading day immediately preceding the first day of the applicable six-month period equals $1,200 or more. As this contingent interest feature is based on the underlying trading price of the Notes, the contingent interest meets the criteria of and qualifies as an embedded derivative. At the time of issuance and at March 31, 2005, management determined that the fair value of this contingent interest embedded derivative was de minimis and, accordingly, no value has been assigned to this embedded derivative. The Company may redeem some or all of the Notes at any time on or after May 21, 2006, at a redemption price, payable in cash, of 100% of the principal amount of the Notes, plus accrued and unpaid interest, including contingent interest, if any. Holders may require the Company to repurchase all or a portion of their Notes on May 16, 2008, 2013, 2018, 2023 and 2028 or upon a change in control, as defined in the indenture governing the Notes, at a purchase price, payable in cash, of 100% of the principal amount of the Notes, plus accrued and unpaid interest, including contingent interest, if any. The Notes are subordinate to all of our existing and future senior obligations. The net proceeds to the Company were approximately $194.2 million, after deducting underwriting discounts, commissions and offering expenses. The Notes are convertible, at the holders' option, into shares of the Company's Class A common stock prior to the maturity date under the following circumstances: o during any quarter commencing after June 30, 2003, if the closing sale price of the Company's Class A common stock over a specified number of trading days during the previous quarter is more than 120% of the conversion price of the Notes on the last trading day of the previous quarter. The Notes are initially convertible at a conversion price of $23.01 per share, which is equal to a conversion rate of approximately 43.4594 shares per $1,000 principal amount of Notes; o if the Company has called the Notes for redemption; o during the five trading day period immediately following any nine consecutive day trading period in which the trading price of the Notes per $1,000 principal amount for each day of such period was less than 95% of the product of the closing sale price of our Class A common stock on that day multiplied by the number of shares of our Class A common stock issuable upon conversion of $1,000 principal amount of the Notes; or o upon the occurrence of specified corporate transactions. The Company has reserved 8,691,880 shares of Class A common stock for issuance in the event the Notes are converted into the Company's common shares. 74 The Notes, which are unsecured, do not contain any restrictions on the payment of dividends, the incurrence of additional indebtedness or the repurchase of the Company's securities, and do not contain any financial covenants. The aggregate maturities of long-term debt as of March 31, 2005 are as follows: Due in one year............... $ 973 Due in two years.............. 2,179 Due in three years............ 1,674 Due in four years............. 5,914 Due in five years............. - Thereafter.................... 200,000 -------- $210,740 ======== The Company paid interest, net of capitalized interest, of $4,156 during the year ended March 31, 2005. For the years ended March 31, 2004 and 2003, the Company paid interest of $3,215 and $389, respectively. 11. COMMITMENTS AND CONTINGENCIES ----------------------------- LEASES The Company leases manufacturing, office and warehouse facilities, equipment and automobiles under operating leases expiring through fiscal 2013. Total rent expense for the years ended March 31, 2005, 2004 and 2003 was $5,734, $5,246 and $4,785, respectively. Future minimum lease commitments under non-cancelable leases are as follows: 2006.......................... $1,598 2007.......................... 1,167 2008.......................... 782 2009.......................... 551 2010.......................... 535 Later years................... 624 A building leased by the Company on March 31, 2005 was purchased on April 14, 2005 (see Note 21). The future minimum lease payments under this lease were only included above through the date of the purchase. Payments that would have been due under this lease were $1,324 per year through April 2008 and $1,454 per year through April 2012. CONTINGENCIES The Company is currently subject to legal proceedings and claims that have arisen in the ordinary course of business. While the Company is not presently able to determine the potential liability, if any, related to such matters, the Company believes none of the matters it currently faces, individually or in the aggregate, will have a material adverse effect on its financial position or operations except for the specific cases described in "Litigation" below. The Company has licensed the exclusive rights to co-develop and market various generic equivalent products with other drug delivery companies. These collaboration agreements require the Company to make up-front and ongoing payments as development milestones are attained. If all milestones remaining under these agreements were reached, payments by the Company could total up to $15,455. 75 LITIGATION ETHEX Corporation (ETHEX), a subsidiary of the Company, was a defendant in a lawsuit styled Healthpoint, Ltd. v. ETHEX Corporation, filed in federal court in San Antonio, Texas. The Company and ETHEX were also named as defendants in a second lawsuit brought by Healthpoint and others styled Healthpoint Ltd. v. ETHEX Corporation, filed in federal court in San Antonio, Texas. In September 2004, the Company made a settlement payment in the amount of $16,500 to resolve all previously pending claims between KV and Healthpoint without the admission of any liability. The settlement was fully reserved by the Company in September 2002 and therefore had no impact on KV's earnings for the year ended March 31, 2005. The $1,430 of income reflected in "Litigation" on the Company's consolidated income statement for the year ended March 31, 2005 represents a $587 net payment received by us in accordance with a settlement of vitamin antitrust litigation and $843 related to the reversal of the portion of the Healthpoint litigation reserve that remained after payment of the settlement amount and related litigation costs. The Company and ETHEX are named as defendants in a case brought by CIMA LABS, Inc. and Schwarz Pharma, Inc. and styled CIMA LABS, Inc. et. al. v. KV Pharmaceutical Company et. al. filed in Federal District Court in Minnesota. It is alleged that the Company and ETHEX infringed on a CIMA patent in connection with the manufacture and sale of Hyoscyamine Sulfate Orally Dissolvable Tablets, 0.125 mg. The court has denied the plaintiffs' motion for a preliminary injunction, which allows ETHEX to continue marketing the product during the pendancy of the subject lawsuit. The Company has filed several motions for summary judgment requesting that the Court rule that the relevant patent is unenforceable, invalid or not infringed. These motions have been denied and the issues will be considered at trial. CIMA and Schwarz filed a summary judgment motion seeking the court to rule that the patent is valid in the face of some prior art references cited by the Company as providing support for its invalidity defense. The Court granted the motion; however, the issue of invalidity based on prior art that was not the subject of the motion will be tried. The Company intends to vigorously defend its interests; however, it cannot give any assurance it will prevail. The Company and ETHEX are named as defendants in a case brought by Solvay Pharmaceuticals, Inc. and styled Solvay Pharmaceuticals, Inc. v. ETHEX Corporation, filed in Federal District Court in Minnesota. In general, Solvay alleges that ETHEX's comparative promotion of its Pangestyme(TM) CN 10 and Pangestyme(TM) CN 20 products to Solvay's Creon(R) 10 and Creon(R) 20 products resulted in false advertising and misleading statements under various federal and state laws, and constituted unfair and deceptive trade practices. Discovery is active and the case is required to be trial ready by February 1, 2006. The Company intends to vigorously defend its interests; however, it cannot give any assurance it will prevail. KV previously distributed several pharmaceutical products that contained phenylpropanolamine, or PPA, and that were discontinued in 2000 and 2001. The Company is presently named a defendant in a product liability lawsuit in federal court in Mississippi involving PPA. The suit originated out of a case, Virginia Madison, et al. v. Bayer Corporation, et al. The original suit was filed in December 2002, but was not served on KV until February 2003. The case was originally filed in the Circuit Court of Hinds County, Mississippi, and was removed to the Federal District Court for the Southern District of Mississippi by then co-defendant Bayer Corporation. The case has been transferred to a Judicial Panel on Multi-District Litigation for PPA claims sitting in the Western District of Washington. The claims against the Company have been segregated into a lawsuit brought by Johnny Fulcher individually and on behalf of the wrongful death beneficiaries of Linda Fulcher, deceased, against the Company. It alleges bodily injury, wrongful death, economic injury, punitive damages, loss of consortium and/or loss of services from the use of the Company's distributed pharmaceuticals containing PPA that have since been discontinued and/or reformulated to exclude PPA. In May 2004, the case was dismissed with prejudice by the Federal District Court for the Western District of Washington for a failure to timely file an individual complaint 76 as required by certain court orders. The plaintiff filed a request for reconsideration which was opposed and subsequently denied by the Court in June 2004. In July 2004, the plaintiff filed a notice of appeal of the dismissal. The Company has opposed this appeal. The Company intends to vigorously defend its interests; however, it cannot give any assurance it will prevail. The Company has also been advised that one of its former distributor customers is being sued in Florida state court in a case captioned Darrian Kelly v. K-Mart et. al. for personal injury allegedly caused by ingestion of K-Mart diet caplets that are alleged to have been manufactured by the Company and to contain PPA. The distributor has tendered defense of the case to the Company and has asserted a right to indemnification for any financial judgment it must pay. The Company previously notified its product liability insurer of this claim in 1999, and the Company has demanded that the insurer assume the Company's defense. The insurer has stated that it has retained counsel to secure additional factual information and will defer its coverage decision until that information is received. The Company intends to vigorously defend its interests; however, it cannot give any assurance that is will not be impleaded into the action, or that, if it is impleaded, that it would prevail. KV's product liability coverage for PPA claims expired for claims made after June 15, 2002. Although the Company renewed its product liability coverage for coverage after June 15, 2002, that policy excludes future PPA claims in accordance with the standard industry exclusion. Consequently, as of June 15, 2002, the Company will provide for legal defense costs and indemnity payments involving PPA claims on a going forward basis as incurred, including the Mississippi lawsuit that was filed after June 15, 2002. Moreover, the Company may not be able to obtain product liability insurance in the future for PPA claims with adequate coverage limits at commercially reasonable prices for subsequent periods. From time to time in the future, KV may be subject to further litigation resulting from products containing PPA that it formerly distributed. The Company intends to vigorously defend its interests; however, it cannot give any assurance it will prevail. After the Company filed ANDAs with the FDA seeking permission to market a generic version of the 50 mg, 100 mg, and 200 mg strengths of Toprol(R) XL in extended release capsule form, AstraZeneca filed lawsuits against KV for patent infringement under the provisions of the Hatch-Waxman Act. In the Company's Paragraph IV certification, KV contended that its proposed generic versions do not infringe AstraZeneca's patents. Pursuant to the Hatch-Waxman Act, the filing date of the suit against the Company instituted an automatic stay of FDA approval of the Company's ANDA until the earlier of a judgment, or 30 months from the date of the suit. The Company has filed a motion for summary judgment with the Federal District Court in Missouri alleging, among other things, that AstraZeneca's patent is invalid. There is no trial setting. The Company intends to vigorously defend its interests; however, it cannot give any assurance it will prevail. The Company and/or ETHEX have been named as defendants in certain multi-defendant cases alleging that the defendants reported improper or fraudulent pharmaceutical pricing information, i.e., Average Wholesale Price, or AWP, and/or Wholesale Acquisition Cost, or WAC, information, which caused the governmental plaintiffs to incur excessive costs for pharmaceutical products under the Medicaid program. Cases of this type have been filed against the Company and/or ETHEX and other pharmaceutical manufacturer defendants by the State of Massachusetts, the State of Alabama, New York City, and approximately 25 counties in New York State (less than ten of which have been formally served on the Company or ETHEX). The New York City case and all but one of the New York County cases have been transferred (or will be the subject of a notice of related action in order to effectuate transfer) to the Federal District Court for the District of Massachusetts for coordinated or consolidated pretrial proceedings under the Average Wholesale Price Multidistrict Litigation (MDL No. 1456). Each of these actions is in the early stages, and fact discovery has not yet begun in any of the cases other than the Alabama case, where the State's first discovery request has been filed. The Company intends to vigorously defend its interests in the actions described above; however, it cannot give any assurance it will prevail. The Company believes that various other governmental entities have commenced investigations into the generic and branded pharmaceutical industry at large regarding pricing and price reporting practices. Although the 77 Company believes its pricing and reporting practices have complied in all material respects with its legal obligations, it cannot give any assurance that it would prevail if legal actions are instituted by these governmental entities. On May 20, 2005, the Company was notified by the SEC that a non-public formal investigation was initiated that appears to relate to the Form 8-K disclosures the Company made on July 13, 2004. The Company is cooperating fully and believes the matter will be satisfactorily resolved. From time to time, the Company is involved in various other legal proceedings in the ordinary course of its business. These legal proceedings include various patent infringement actions brought by potential competitors with respect to products the Company proposes to market and for which it has submitted ANDA filings and provided notice of certification required under the provisions of the Act. While it is not feasible to predict the ultimate outcome of such other proceedings, the Company believes that the ultimate outcome of such other proceedings will not have a material adverse effect on its results of operations or financial position. There are uncertainties and risks associated with all litigation and there can be no assurance that the Company will prevail in any particular litigation. 12. EMPLOYMENT AGREEMENTS --------------------- The Company has employment agreements with certain officers and key employees which extend for one to five years. These agreements provide for base levels of compensation and, in certain instances, also provide for incentive bonuses and separation benefits. Also, the agreement with the Chief Executive Officer (CEO) contains provisions for partial salary continuation under certain conditions, contingent upon noncompete restrictions and providing consulting services to the Company as specified in the agreement. In addition, the CEO is entitled to receive retirement compensation paid in the form of a single annuity equal to 30% of the CEO's final average compensation payable each year beginning at retirement and continuing for the longer of 10 years or the life of the CEO. In accordance with this agreement, the Company recognized retirement expense of $1,355, $209 and $196 for the years ended March 31, 2005, 2004 and 2003, respectively. In fiscal 2005, the Company actuarily updated the appropriateness of the liability. 13. GAIN FROM LEGAL SETTLEMENT -------------------------- In September 2003, the Company received a payment from a branded pharmaceutical company in the amount of $4,000. The payment received by the Company was made in response to the Company's claim that the branded company violated federal antitrust laws and interfered with the Company's right to a timely introduction of a generic pharmaceutical product in a previous fiscal year. The payment was reflected by the Company in the "Litigation" line item of operating income and was recorded net of approximately $500 of attorney-related fees. 14. INCOME TAXES ------------ The income tax provisions for the years ended March 31, 2005, 2004 and 2003 were based on estimated Federal and state taxable income using the applicable statutory rates. The current and deferred Federal and state income tax provisions for the years ended March 31, 2005, 2004 and 2003 are as follows:
2005 2004 2003 ---- ---- ---- PROVISION Current Federal............................... $ 2,982 $14,184 $21,524 State................................. 195 1,275 2,038 ------- ------- ------- 3,177 15,459 23,562 ------- ------- ------- Deferred Federal............................... 12,473 7,792 (7,207) State................................. 1,109 899 (884) ------- ------- ------- 13,582 8,691 (8,091) ------- ------- ------- $16,759 $24,150 $15,471 ======= ======= =======
78 The reasons for the differences between the provision for income taxes and the expected Federal income taxes at the statutory rate are as follows:
2005 2004 2003 ---- ---- ---- Expected income tax expense................. $17,510 $24,499 $15,253 State income taxes, less Federal income tax benefit............... 847 1,413 750 Business credits............................ (1,080) (1,240) (370) Other ...................................... (518) (522) (162) ------- ------- ------- $16,759 $24,150 $15,471 ======= ======= =======
As of March 31, 2005 and 2004, the tax effect of temporary differences between the tax basis of assets and liabilities and their financial reporting amounts are as follows:
2005 2004 ------------------------- ------------------------ CURRENT NON-CURRENT CURRENT NON-CURRENT ------- ----------- ------- ----------- Fixed asset basis differences........ $ - $ (6,658) $ - $(4,870) Reserves for inventory and receivables....................... 5,510 - 5,313 - Vacation pay reserve................. 249 - 460 - Deferred compensation................ - 1,620 - 1,164 Amortization......................... - (2,121) - (1,644) Litigation reserve................... - - 6,704 - Convertible notes interest........... - (9,495) (4,566) - Other................................ 68 - 126 - ------ -------- ------- ------- Net deferred tax asset (liability) $5,827 $(16,654) $ 8,037 $(5,350) ====== ======== ======= =======
The Company paid income taxes of $8,769, $22,201, and $22,088 during the years ended March 31, 2005, 2004 and 2003, respectively. Included in "Prepaid and other assets" at March 31, 2005 in the accompanying consolidated balance sheet was income tax refunds receivable of $2,518. 15. EMPLOYEE BENEFITS ----------------- STOCK OPTION PLAN AND AGREEMENTS On August 30, 2002, the Company's shareholders approved KV's 2001 Incentive Stock Option Plan (the "2001 Plan"), which allows for the issuance of up to 3,000,000 shares of common stock. Prior to the approval of the 2001 Plan, the Company operated under the 1991 Incentive Stock Option Plan, as amended, which still allows for the issuance of up to 750,000 shares of common stock. Under the Company's stock option plans, options to acquire shares of common stock have been made available for grant to certain employees. Each option granted has an exercise price of not less than 100% of the market value of the common stock on the date of grant. The contractual life of each option is generally 10 years. The exercisability of the grants varies according to the individual options granted. In addition to these plans, the Company has issued stock options periodically to executives with employment agreements and to non-employee directors. At March 31, 2005, options to purchase 34,875 shares of stock were outstanding pursuant to employment agreements and grants to non-employee directors. 79 The following summary shows the transactions for the years ended March 31, 2005, 2004 and 2003 under option arrangements:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE ------------------- ------------------- AVERAGE AVERAGE NO. OF PRICE PER NO. OF PRICE PER SHARES SHARE SHARES SHARE ------ ----- ------ ----- Balance, March 31, 2002........... 3,198,579 $ 8.12 1,435,756 $ 7.41 Options granted................... 700,538 12.35 - - Options becoming exercisable...... - - 566,455 9.21 Options exercised................. (135,420) 5.26 (135,420) 5.26 Options canceled.................. (260,664) 11.67 (75,952) 10.97 --------- --------- Balance March 31, 2003............ 3,503,033 8.81 1,790,839 8.00 Options granted................... 677,313 19.56 - - Options becoming exercisable...... - - 541,924 12.17 Options exercised................. (966,036) 7.80 (966,036) 7.80 Options canceled.................. (437,502) 11.72 (132,869) 10.37 --------- --------- Balance March 31, 2004............ 2,776,808 11.33 1,233,858 9.71 Options granted................... 676,250 22.19 - - Options becoming exercisable...... - - 431,164 14.42 Options exercised................. (220,743) 6.44 (220,743) 6.44 Options canceled.................. (129,517) 16.30 (34,285) 13.35 --------- --------- Balance March 31, 2005............ 3,102,798 $13.84 1,409,994 $11.58 ========= =========
The weighted average fair value of options granted at market price was $3.29, $3.42, and $2.18 per share for the years ended March 31, 2005, 2004 and 2003, respectively. The weighted average fair value of options granted with an exercise price exceeding market price on the date of grant was $2.94, $1.97, and $0.14 per share for the years ended March 31, 2005, 2004 and 2003, respectively. The following table summarizes information about stock options outstanding at March 31, 2005:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE -------------------------------------------------------- ----------------------------- RANGE OF NUMBER WEIGHTED AVERAGE WEIGHTED NUMBER WEIGHTED EXERCISE OUTSTANDING LIFE AVERAGE EXERCISABLE AVERAGE PRICES AT 3/31/05 REMAINING EXERCISE PRICE AT 3/31/05 EXERCISE PRICE ------ ---------- --------- -------------- ---------- -------------- $ 0.82 - $ 5.00 365,186 1 Years $ 3.14 306,717 $ 3.06 $ 5.01 - $10.00 614,120 5 Years $ 7.37 308,035 $ 7.23 $10.01 - $15.00 795,534 6 Years $12.04 379,562 $12.07 $15.01 - $20.00 614,938 7 Years $17.79 252,405 $18.24 $20.01 - $27.50 713,020 8 Years $23.48 163,275 $24.32
PROFIT SHARING PLAN The Company has a qualified trustee profit sharing plan (the "Plan") covering substantially all non-union employees. The Company's annual contribution to the Plan, as determined by the Board of Directors, is discretionary and was $300, $400, and $375 for the years ended March 31, 2005, 2004 and 2003, respectively. The Plan includes features as described under Section 401(k) of the Internal Revenue Code. 80 The Company's contributions to the 401(k) investment funds are 50% of the first 7% of the salary contributed by each participant. Contributions of $1,547, $1,286, and $1,185 were made to the 401(k) investment funds during the years ended March 31, 2005, 2004 and 2003, respectively. Contributions are also made to multi-employer defined benefit plans administered by labor unions for certain union employees. Amounts charged to pension expense and contributed to these plans were $200, $202, and $231 for the years ended March 31, 2005, 2004 and 2003, respectively. HEALTH AND MEDICAL INSURANCE PLAN The Company contributes to health and medical insurance programs for its non-union and union employees. For non-union employees, the Company self-insures the first $150,000 of each employee's covered medical claims. Included in accrued liabilities in the consolidated balance sheets as of March 31, 2005 and 2004 were $20 and $450 of accrued health insurance reserves, respectively, for claims incurred but not reported. In fiscal 2005, the Company established a Voluntary Employees' Beneficiary Association for its non-union employees to fund payments made by the Company for covered medical claims. As a result of initially funding this plan, the Company's liability for claims incurred but not reported was reduced by $680. For union employees, the Company participates in a fully funded insurance plan sponsored by the union. Total health and medical insurance expense for the two plans was $9,431, $7,331, and $6,636 for the years ended March 31, 2005, 2004 and 2003, respectively. 16. RELATED PARTY TRANSACTIONS -------------------------- The Company currently leases certain real property from an affiliated partnership of an officer and director of the Company. Lease payments made for this property for the years ended March 31, 2005, 2004 and 2003 totaled $277, $271, and $269, respectively. 17. EQUITY TRANSACTIONS ------------------- As of March 31, 2005 and 2004, the Company had 40,000 shares of 7% Cumulative Convertible Preferred Stock (par value $.01 per share) outstanding at a stated value of $25 per share. The preferred stock is non-voting with dividends payable quarterly. The preferred stock is redeemable by the Company at its stated value. Each share of preferred stock is convertible into Class A common stock at a conversion price of $2.96 per share. The preferred stock has a liquidation preference of $25 per share plus all accrued but unpaid dividends prior to any liquidation distributions to holders of Class A or Class B common stock. No dividends may be paid on Class A or Class B common stock unless all dividends on the Cumulative Convertible Preferred Stock have been declared and paid. There were no undeclared and unaccrued cumulative preferred dividends at March 31, 2005 and 2004. Also, under the terms of its credit agreement, the Company may not pay cash dividends in excess of 25% of the prior fiscal year's consolidated net income. The Company has reserved 750,000 shares of Class A common stock for issuance under KV's 2002 Consultants Plan. These shares may be issued from time to time in consideration for consulting and other services provided to the Company by independent consultants. Since inception of this plan, the Company has issued 47,732 Class A shares as payment for certain milestones under product development agreements. Holders of Class A common stock are entitled to receive dividends per share equal to 120% of the dividends per share paid on the Class B common stock and have one-twentieth vote per share in the election of directors and on other matters. 81 Under the terms of the Company's current loan agreement (see Note 10), the Company has limitations on paying dividends, except in stock, on its Class A and Class B common stock. Payment of dividends may also be restricted under Delaware Corporation law. On September 8, 2003, the Company's Board of Directors declared a three-for-two stock split in the form of a 50% stock dividend of its common stock to shareholders of record on September 18, 2003, payable on September 29, 2003. Common stock was credited and retained earnings was charged for the aggregate par value of the shares issued. The stated par value of each share was not changed from $0.01. All per share data in this report has been restated to reflect the aforementioned three-for-two stock split in the form of a 50% stock dividend. In May 2003, the Company used $50,000 of the net proceeds from the Convertible Subordinated Notes issuance (see Note 10) to fund the repurchase of 2,000,000 shares of the Company's Class A common stock. 82 18. EARNINGS PER SHARE ------------------ The following table sets forth the computation of basic and diluted earnings per share:
2005 2004 2003 ---- ---- ---- Undistributed earnings: Net income ....................................... $33,269 $45,848 $28,110 Less - preferred stock dividends.................. (70) (436) (70) ------- ------- ------- Undistributed earnings - basic EPS................ 33,199 45,412 28,040 Add - preferred stock dividends................... 70 436 70 Add - interest expense on convertible notes, net of tax.............................. 4,099 3,507 - ------- ------- ------- Net income - diluted EPS.......................... $37,368 $49,355 $28,110 ======= ======= ======= Allocation of undistributed earnings: Class A common stock.............................. $24,316 $32,391 $20,211 Class B common stock.............................. 8,883 13,021 7,829 ------- ------- ------- Total allocated earnings - basic EPS........... $33,199 $45,412 $28,040 ======= ======= ======= Weighted average shares outstanding - basic: Class A common stock.............................. 34,228 33,046 33,997 Class B common stock.............................. 15,005 15,941 15,803 ------- ------- ------- Total weighted average shares outstanding - basic......................... 49,233 48,987 49,800 ------- ------- ------- Effect of dilutive securities: Employee stock options............................ 1,205 1,760 1,423 Convertible preferred stock....................... 338 338 338 Convertible notes................................. 8,692 7,623 - ------- ------- ------- Dilutive potential common shares............... 10,235 9,721 1,761 ------- ------- ------- Total weighted average shares outstanding - diluted....................... 59,468 58,708 51,561 ======= ======= ======= Basic earnings per share: Class A common stock.............................. $ 0.71 $ 0.98 $ 0.59 Class B common stock.............................. 0.59 0.82 0.50 Diluted earnings per share(1)........................ 0.63 0.84 0.55 ======= ======= ======= ----------------- (1) Excluded from the computation of diluted earnings per share are outstanding stock options whose exercise prices are greater than the average market price of the common shares for the period reported. For the years ended March 31, 2005, 2004 and 2003, options to purchase 712,770, 206,771 and 405,735 Class A and Class B common shares, respectively, were excluded from the computation.
83 19. QUARTERLY FINANCIAL RESULTS (UNAUDITED) ---------------------------------------
1ST 2ND 3RD 4TH QUARTER QUARTER QUARTER QUARTER YEAR ------- ------- ------- ------- ---- YEAR ENDED MARCH 31, 2005 ------------------------- Net sales.................................. $66,087 $79,322 $86,857 $71,227 $303,493 Gross profit............................... 42,353 52,466 56,922 44,070 195,811 Pretax income (loss)....................... 11,543 19,591 20,062 (1,168) 50,028 Net income (loss).......................... 7,561 12,676 13,552 (520) 33,269 Basic earnings per share: Class A common stock.................... 0.16 0.27 0.29 (0.01) 0.71 Class B common stock.................... 0.14 0.23 0.24 (0.01) 0.59 Diluted earnings per share................. 0.14 0.23 0.25 (0.01) 0.63 YEAR ENDED MARCH 31, 2004 ------------------------- Net sales.................................. $59,379 $71,019 $69,598 $83,945 $283,941 Gross profit............................... 38,389 46,879 46,837 53,409 185,514 Pretax income.............................. 13,291 18,978 17,874 19,855 69,998 Net income................................. 8,573 12,241 11,529 13,505 45,848 Basic earnings per share: Class A common stock.................... 0.17 0.27 0.25 0.29 0.98 Class B common stock.................... 0.14 0.22 0.21 0.24 0.82 Diluted earnings per share................. 0.16 0.22 0.21 0.24 0.84
84 20. SEGMENT REPORTING ----------------- The reportable operating segments of the Company are branded products, specialty generics and specialty materials. The Company has aggregated its branded product lines in a single segment because of similarities in regulatory environment, manufacturing processes, methods of distribution and types of customer. This segment includes patent-protected products and certain trademarked off-patent products that the Company sells and markets as brand pharmaceutical products. The specialty generics business segment includes off-patent pharmaceutical products that are therapeutically equivalent to proprietary products. The Company sells its brand and generic products primarily to pharmaceutical wholesalers, drug distributors and chain drug stores. The specialty materials segment is distinguished as a single segment because of differences in products, marketing and regulatory approval when compared to the other segments. Accounting policies of the segments are the same as the Company's consolidated accounting policies. Segment profits are measured based on income before taxes and are determined based on each segment's direct revenues and expenses. The majority of research and development expense, corporate general and administrative expenses, amortization and interest expense, as well as interest and other income, are not allocated to segments, but included in the "all other" classification. Identifiable assets for the three reportable operating segments primarily include receivables, inventory, and property and equipment. For the "all other" classification, identifiable assets consist of cash and cash equivalents, corporate property and equipment, intangible and other assets and all income tax related assets. The following represents information for the Company's reportable operating segments for fiscal 2005, 2004 and 2003.
FISCAL YEAR ENDED BRANDED SPECIALTY SPECIALTY ALL MARCH 31, PRODUCTS GENERICS MATERIALS OTHER ELIMINATIONS CONSOLIDATED --------- -------- -------- --------- ----- ------------ ------------ -------------------------------------------------------------------------------------------------------------------------------- NET REVENUES 2005 $90,085 $191,870 $18,345 $ 3,193 $ - $303,493 2004 82,868 181,455 16,550 3,068 - 283,941 2003 43,677 179,724 17,395 4,200 - 244,996 -------------------------------------------------------------------------------------------------------------------------------- SEGMENT PROFIT (LOSS) 2005 24,037 102,937 3,043 (79,989) - 50,028 2004 31,661 101,163 1,365 (64,191) - 69,998 2003 8,361 97,339 1,692 (63,811) - 43,581 -------------------------------------------------------------------------------------------------------------------------------- IDENTIFIABLE ASSETS 2005 25,015 66,834 8,001 459,625 (1,158) 558,317 2004 24,585 70,581 8,343 426,087 (1,158) 528,438 2003 7,819 69,303 8,797 267,907 (1,158) 352,668 -------------------------------------------------------------------------------------------------------------------------------- PROPERTY AND EQUIPMENT ADDITIONS 2005 2,463 - 318 60,841 - 63,622 2004 420 1,685 71 28,416 - 30,592 2003 634 116 143 15,220 - 16,113 -------------------------------------------------------------------------------------------------------------------------------- DEPRECIATION AND AMORTIZATION 2005 217 235 140 13,312 - 13,904 2004 332 123 141 12,067 - 12,663 2003 260 55 164 7,294 - 7,773 --------------------------------------------------------------------------------------------------------------------------------
Consolidated revenues are principally derived from customers in North America and substantially all property and equipment is located in St. Louis, Missouri. 85 21. SUBSEQUENT EVENTS ----------------- On April 14, 2005, the Company completed the purchase of a 260,000 square foot building for $11,800. The property had been leased by the Company since April 2000 and will continue to function as the Company's main distribution facility. The purchase of the building was financed with cash on hand. In May 2005, the Company and FemmePharma mutually agreed to terminate the license agreement they entered into in April 2002 (see Note 3). As part of this transaction, the Company acquired all of the common stock of FemmePharma for $25,000 after certain assets of the entity had been distributed to FemmePharma's other shareholders. Included in the Company's acquisition of FemmePharma are the worldwide marketing rights to an endometriosis product that has successfully completed Phase II clinical trials. This product was originally part of the licensing arrangement with FemmePharma that provided the Company, among other things, marketing rights for the product principally in the United States. In accordance with the new agreement, the Company is assuming responsibility for conducting the Phase III clinical study; has acquired worldwide licensing rights of the endometriosis product; is no longer responsible for milestone payments and royalties specified in the original licensing agreement; and has secured exclusive worldwide rights for use of the FemmePharma technology for vaginal anti-infective products. The Company believes the Phase III clinical study for the endometriosis product will begin during fiscal 2006. In connection with this transaction, the Company expects to incur a charge of approximately $30,000 in the first quarter of fiscal 2006, which includes the write-off of the $25,000 payment plus preferred stock investments previously made, and which principally relates to in-process research and development. In May 2005, the Company entered into a long-term product development and marketing license agreement with Strides Arcolab, Ltd, (Strides) an Indian generic pharmaceutical developer and manufacturer, for exclusive marketing rights in the United States and Canada for 10 new generic drugs. Under the agreement, Strides will be responsible for developing, submitting for regulatory approval and manufacturing the 10 products and the Company will be responsible for exclusively marketing the products in the territories covered by the agreement. Under a separate agreement, the Company invested $11,300 in Strides' redeemable preferred stock. 86 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND --------------------------------------------------------------- FINANCIAL DISCLOSURE -------------------- On August 17, 2004, the Company engaged KPMG LLP as its independent auditor. KMPG LLP replaced BDO Seidman LLP after their resignation which was reported in an 8-K filed July 13, 2004. There have been no disagreements with accountants on accounting or financial disclosure matters. ITEM 9A. CONTROLS AND PROCEDURES ----------------------- EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in its Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and that such information is accumulated and communicated to the Company's management, including its principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of its management, including its principal executive officer and principal financial officer, of the effectiveness of the design and operation of its disclosure controls and procedures. Based on the foregoing, the Company's principal executive officer and principal financial officer concluded that the Company's disclosure controls and procedures were effective as of the end of the period covered by this report. MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting. The Company's internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. The Company's internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding the prevention or timely detection of unauthorized acquisition, use or disposition of the Company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Management performed an assessment of the effectiveness of the Company's internal control over financial reporting as of March 31, 2005. Management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control - Integrated Framework. As a result of this assessment and based on the criteria set forth in the COSO framework, management has concluded that, as of March 31, 2005, the Company's internal control over financial reporting was effective. 87 Management's assessment of the effectiveness of the Company's internal control over financial reporting as of March 31, 2005 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report appearing herein. CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING There have been no changes in the Company's internal control over financial reporting, during the fiscal quarter ended March 31, 2005, that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. Report of Independent Registered Public Accounting Firm ------------------------------------------------------- The Board of Directors and Shareholders K-V Pharmaceutical Company: We have audited management's assessment, included in the accompanying Management's Report on Internal Control over Financial Reporting, that K-V Pharmaceutical Company maintained effective internal control over financial reporting as of March 31, 2005, based on the criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. 88 Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management's assessment that K-V Pharmaceutical Company maintained effective internal control over financial reporting as of March 31, 2005, is fairly stated, in all material respects, based on the criteria established in Internal Control--Integrated Framework issued by COSO. Also, in our opinion, K-V Pharmaceutical Company maintained, in all material respects, effective internal control over financial reporting as of March 31, 2005, based on criteria established in Internal Control--Integrated Framework issued by COSO. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of K-V Pharmaceutical Company and subsidiaries as of March 31, 2005, and the related consolidated statements of income, comprehensive income, shareholders' equity, and cash flows for the year ended March 31, 2005, and our report dated June 14, 2005 expressed an unqualified opinion on those consolidated financial statements. /s/ KPMG LLP St. Louis, Missouri June 14, 2005 89 ITEM 9B. OTHER INFORMATION ----------------- DEPARTURE OF DIRECTORS OR PRINCIPAL OFFICERS; ELECTION OF DIRECTORS; APPOINTMENT OF PRINCIPAL OFFICERS. On June 13, 2005, K-V Pharmaceutical Company (the "Registrant") designated Richard H. Chibnall, age 49, as its principal accounting officer. Mr. Chibnall has served as the Registrant's Vice President, Finance since February 2000 and will continue to serve in such position in addition to his duties as principal accounting officer. Gerald R. Mitchell, the Registrant's Vice President and Chief Financial Officer, formerly acted as both principal financial officer and principal accounting officer and will continue to serve as the Registrant's principal financial officer. Mr. Chibnall is employed by the Registrant pursuant to an employment agreement, dated December 22, 1995, as amended February 1, 2000, and April 1, 2005. Under the employment agreement, Mr. Chibnall is entitled to an annual base salary of $220,000, which may be increased from year to year, and certain separation benefits. Mr. Chibnall is also entitled to participate in any fringe benefits normally provided to employees of the Registrant at comparable employment levels. The employment agreement automatically renews for successive one-year periods until terminated under the terms of the agreement. Under the employment agreement, if Mr. Chibnall's employment is involuntarily terminated without cause by the Registrant (other than within two years after a change of control of the Registrant), Mr. Chibnall will be entitled to severance pay equal to one-half of his then current salary. He would also receive continuation of any health and welfare benefits for a period of 6 months following the involuntary termination. In addition, all stock options held by Mr. Chibnall would immediately vest and become exercisable. Except in the case of Mr. Chibnall's death or disability, if Mr. Chibnall's employment is involuntarily terminated with or without cause within two years after the occurrence of a change of control (as defined in the employment agreement), Mr. Chibnall is entitled to severance pay equal to one and one-half times the sum of his annual salary and 18 months' worth of bonus. Mr. Chibnall also would continue to receive health and welfare benefits for a period of 18 months after such a termination. All stock options held by Mr. Chibnall would immediately vest and become exercisable. The employment agreement also contains restrictive covenants preventing Mr. Chibnall from competing against the Registrant or soliciting customers or employees of the Registrant for a period of 24 months after termination of his employment. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT -------------------------------------------------- The information contained under the caption "INFORMATION CONCERNING NOMINEES AND DIRECTORS CONTINUING IN OFFICE" in the Company's definitive proxy statement to be filed pursuant to 90 Regulation 14(a) for its 2005 Annual Meeting of Shareholders, which involves the election of directors, is incorporated herein by this reference. Also see Item 4(a) of Part I hereof. ITEM 11. EXECUTIVE COMPENSATION ---------------------- The information contained under the captions "EXECUTIVE COMPENSATION" and "INFORMATION AS TO STOCK OPTIONS" in the Company's definitive proxy statement to be filed pursuant to Regulation 14(a) for its 2005 Annual Meeting of Shareholders is incorporated herein by this reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT -------------------------------------------------------------- The information contained under the captions "SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS" and "SECURITY OWNERSHIP OF MANAGEMENT" in the Company's definitive proxy statement to be filed pursuant to Regulation 14(a) for its 2005 Annual Meeting of Shareholders is incorporated herein by this reference. EQUITY COMPENSATION PLAN INFORMATION The following information regarding compensation plans of the Company is furnished as of March 31, 2005, the end of the Company's most recently completed fiscal year. EQUITY COMPENSATION PLAN INFORMATION REGARDING CLASS A COMMON STOCK --------------------------------------------------------------------------------------------------------------------
NUMBER OF SECURITIES REMAINING AVAILABLE FOR NUMBER OF SECURITIES TO BE FUTURE ISSUANCE UNDER ISSUED UPON EXERCISE OF WEIGHTED-AVERAGE EXERCISE EQUITY COMPENSATION PLANS OUTSTANDING OPTIONS, PRICE OF OUTSTANDING (EXCLUDING SECURITIES WARRANTS AND RIGHTS OPTIONS, WARRANTS AND RIGHTS REFLECTED IN COLUMN (a)) ------------------- ---------------------------- ------------------------ PLAN CATEGORY (a) (b) (c) Equity compensation plans approved by security holders(1) 2,700,457 $14.12 988,473 Equity compensation plans not approved by security holders(2) 6,750 $3.22 N/A --------- Total 2,707,207 $14.10 ========= (1) Consists of the Company's 2001 Incentive Stock Option Plan. See Note 15 of Notes to Consolidated Financial Statements. (2) Consists of options granted to non-employee members of the Board of Directors.
91 EQUITY COMPENSATION PLAN INFORMATION REGARDING CLASS B COMMON STOCK --------------------------------------------------------------------------------------------------------------------
NUMBER OF SECURITIES REMAINING AVAILABLE FOR NUMBER OF SECURITIES TO BE FUTURE ISSUANCE UNDER ISSUED UPON EXERCISE OF WEIGHTED-AVERAGE EXERCISE EQUITY COMPENSATION PLANS OUTSTANDING OPTIONS, PRICE OF OUTSTANDING (EXCLUDING SECURITIES WARRANTS AND RIGHTS OPTIONS, WARRANTS AND RIGHTS REFLECTED IN COLUMN (a)) ------------------- ---------------------------- ------------------------ PLAN CATEGORY (a) (b) (c) Equity compensation plans approved by security holders(1) 367,466 $13.08 1,214,399 Equity compensation plans not approved by security holders(2) 28,125 $4.82 N/A ------ Total 395,591 $12.49 ======= (1) Consists of the Company's 2001 Incentive Stock Option Plan. See Note 15 of Notes to Consolidated Financial Statements. (2) Consists of options granted to non-employee members of the Board of Directors.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ---------------------------------------------- The information contained under the caption "TRANSACTIONS WITH DIRECTORS AND EXECUTIVE OFFICERS" in the Company's definitive proxy statement to be filed pursuant to Regulation 14(a) for its 2005 Annual Meeting of Shareholders is incorporated herein by this reference. ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES -------------------------------------- The information contained under the caption "FEES PAID TO INDEPENDENT REGISTERED PUBLIC ACCOUNTANTS" in the Company's definitive proxy statement to be filed pursuant to Regulation 14(a) for its 2005 Annual Meeting of Shareholders is incorporated herein by this reference. 92 PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES --------------------------------------- (a) 1. Financial Statements: Page The following consolidated financial statements of the Company are included in Part II, Item 8: Report of Independent Registered Public Accounting Firm......... 54 Report of Independent Registered Public Accounting Firm......... 55 Consolidated Balance Sheets as of March 31, 2005 and 2004....... 56 Consolidated Statements of Income for the Years Ended March 31, 2005, 2004 and 2003............................................. 57 Consolidated Statements of Comprehensive Income for the Years Ended March 31, 2005, 2004 and 2003............................. 58 Consolidated Statements of Shareholders' Equity for the Years Ended March 31, 2005, 2004 and 2003............................. 59 Consolidated Statements of Cash Flows for the Years Ended March 31, 2005, 2004 and 2003................................... 60 Notes to Financial Statements................................... 61-86 Controls and Procedures......................................... 87 Evaluation of Disclosure Controls and Procedures................ 87 Management's Report on Internal Control over Financial Reporting....................................................... 87 Changes in Internal Control over Financial Reporting............ 88 Report of Independent Registered Public Accounting Firm......... 88 2. Financial Statement Schedules: Report of Independent Registered Public Accounting Firm regarding Financial Statement Schedule.......................... 94 Schedule II - Valuation and Qualifying Accounts................. 95 (b) Exhibits. See Exhibit Index on pages 97 through 104 of this Report. Management contracts and compensatory plans are designated on the Exhibit Index. (c) Financial Statement Schedules. 93 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Stockholders and Board of Directors of K-V Pharmaceutical Company The audits referred to in our report dated June 4, 2004, relating to the consolidated financial statements of K-V Pharmaceutical Company, which are included in Item 8 of this Form 10-K, included the audits of the accompanying financial statement schedule for the years ended March 31, 2004 and 2003. This financial statement schedule is the responsibility of the Company's management. Our responsibility is to express an opinion on this financial statement schedule based upon our audits. In our opinion, the 2004 and 2003 financial statement schedule presents fairly, in all material respects, the information set forth therein. /s/ BDO SEIDMAN, LLP Chicago, Illinois June 4, 2004 94 SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS
ADDITIONS BALANCE AT CHARGED TO AMOUNTS BALANCE BEGINNING COSTS AND CHARGED TO AT END OF YEAR EXPENSES RESERVES OF YEAR ------- -------- -------- ------- (in thousands) Year Ended March 31, 2003: Allowance for doubtful accounts............ $ 403 $ (81) $ (100) $ 422 Reserves for sales allowances.............. 18,958 98,929 88,229 29,658 Inventory obsolescence..................... 1,108 2,053 2,158 1,003 ------- -------- -------- ------- $20,469 $100,901 $ 90,287 $31,083 ======= ======== ======== ======= Year Ended March 31, 2004: Allowance for doubtful accounts............ $ 422 $ (20) $ - $ 402 Reserves for sales allowances.............. 29,658 103,262 112,272 20,648 Inventory obsolescence..................... 1,003 2,442 2,443 1,002 ------- -------- -------- ------- $31,083 $105,684 $114,715 $22,052 ======= ======== ======== ======= Year Ended March 31, 2005: Allowance for doubtful accounts............ $ 402 $ 235 $ 176 $ 461 Reserves for sales allowances.............. 20,648 133,475 133,067 21,056 Inventory obsolescence..................... 1,002 3,182 2,891 1,293 ------- -------- -------- ------- $22,052 $136,892 $136,134 $22,810 ======= ======== ======== =======
Financial statements of K-V Pharmaceutical Company (separately) are omitted because KV is primarily an operating company and its subsidiaries included in the financial statements are wholly-owned and are not materially indebted to any person other than through the ordinary course of business. 95 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. K-V PHARMACEUTICAL COMPANY Date: June 14, 2005 By /s/ Marc S. Hermelin ------- ----------------------------------- Vice Chairman of the Board and Chief Executive Officer (Principal Executive Officer) Date: June 14, 2005 By /s/ Gerald R. Mitchell ------- ----------------------------------- Vice President and Chief Financial Officer (Principal Financial Officer) Date: June 14, 2005 By /s/ Richard H. Chibnall ------- ----------------------------------- Vice President, Finance (Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on the dates indicated by the following persons on behalf of the Company and in their capacities as members of the Board of Directors of the Company: Date: June 14, 2005 By /s/ Marc S. Hermelin ----------------------------------- Marc S. Hermelin Date: June 14, 2005 By /s/ Victor M. Hermelin ----------------------------------- Victor M. Hermelin Date: June 14, 2005 By /s/ Norman D. Schellenger ----------------------------------- Norman D. Schellenger Date: June 14, 2005 By /s/ Alan G. Johnson ----------------------------------- Alan G. Johnson Date: June 14, 2005 By /s/ Kevin S. Carlie ----------------------------------- Kevin S. Carlie Date: June 14, 2005 By /s/ David A. Van Vliet ----------------------------------- David Van Vliet Date: June 14, 2005 By /s/ Jean M. Bellin ----------------------------------- Jean M. Bellin Date: June 14, 2005 By /s/ Terry B. Hatfield ----------------------------------- Terry B. Hatfield Date: June 14, 2005 By /s/ David S. Hermelin ----------------------------------- David S. Hermelin 96 EXHIBIT INDEX Exhibit No. Description ----------- ----------- 3(a) The Company's Certificate of Incorporation, which was filed as Exhibit 3(a) to the Company's Annual Report on Form 10-K for the year ended March 31, 1981, is incorporated herein by this reference. 3(b) Certificate of Amendment to Certificate of Incorporation of the Company, effective March 7, 1983, which was filed as Exhibit 3(c) to the Company's Annual Report on Form 10-K for the year ended March 31, 1983, is incorporated herein by this reference. 3(c) Certificate of Amendment to Certificate of Incorporation of the Company, effective June 9, 1987, which was filed as Exhibit 3(d) to the Company's Annual Report on Form 10-K for the year ended March 31, 1988, is incorporated herein by this reference. 3(d) Certificate of Amendment to Certificate of Incorporation of the Company, effective September 24, 1987, which was filed as Exhibit 3(f) to the Company's Annual Report on Form 10-K for the year ended March 31, 1988, is incorporated herein by this reference. 3(e) Certificate of Amendment to Certificate of Incorporation of the Company, effective July 17, 1986, which was filed as Exhibit 3(e) to the Company's Annual Report on Form 10-K for the year ended March 31, 1996, is incorporated herein by this reference. 3(f) Certificate of Amendment to Certificate of Incorporation of the Company, effective December 23, 1991, which was filed as Exhibit 3(f) to the Company's Annual Report on Form 10-K for the year ended March 31, 1996, is incorporated herein by this reference. 3(g) Certificate of Amendment to Certificate of Incorporation of the Company, effective September 3, 1998, which was filed as Exhibit 4(g) to the Company's Registration Statement on Form S-3 (Registration Statement No. 333-87402), filed May 1, 2002, is incorporated herein by this reference. 3(h) Bylaws of the Company, as amended through November 18, 1982, which was filed as Exhibit 3(e) to the Company's Annual Report on Form 10-K for the year ended March 31, 1993, is incorporated herein by this reference. 3(i) Amendment to Bylaws of the Company, effective July 2, 1984, which was filed as Exhibit 4(i) to the Company's Registration Statement on Form S-3 (Registration Statement No. 333-87402), filed May 1, 2002, is incorporated herein by this reference. 3(j) Amendment to Bylaws of the Company, effective December 4, 1986, which was filed as Exhibit 4(j) to the Company's Registration Statement on Form S-3 (Registration Statement No. 333-87402), filed May 1, 2002, is incorporated herein by this reference. 3(k) Amendment to Bylaws of the Company effective March 17, 1992, which was filed as Exhibit 4(k) to the Company's Registration Statement on Form S-3 (Registration Statement No. 333-87402), filed May 1, 2002, is incorporated herein by this reference. 3(l) Amendment to Bylaws of the Company effective November 18, 1992, which was filed as Exhibit 4(l) to the Company's Registration Statement on Form S-3 (Registration Statement No. 333-87402), filed May 1, 2002, is incorporated herein by this reference. 97 3(m) Amendment to Bylaws of the Company, effective December 30, 1993, which was filed as Exhibit 3(h) to the Company's Annual Report on Form 10-K for the year ended March 31, 1996, is incorporated herein by this reference. 3(n) Amendment to Bylaws of the Company, effective September 24, 2002, which was filed as Exhibit 4(n) to the Company's Registration Statement on Form S-3 (Registration Statement No. 333-106294), filed June 19, 2003, is incorporated herein by this reference. 4(a) Certificate of Designation of Rights and Preferences of 7% Cumulative Convertible preferred stock of the Company, effective June 9, 1987, and related Certificate of Correction, dated June 17, 1987, which was filed as Exhibit 4(f) to the Company's Annual Report on Form 10-K for the year ended March 31, 1987, is incorporated herein by this reference. 4(b) Loan Agreement dated June 18, 1997 between the Company and its subsidiaries and LaSalle National Bank ("LaSalle"), which was filed as Exhibit 4(i) to the Company's Annual Report on Form 10-K for the year ended March 31, 1997, is incorporated herein by this reference. 4(c) Revolving Note, dated June 18, 1997, by the Company and its subsidiaries in favor of LaSalle, which was filed as Exhibit 4(j) to the Company's Annual Report on Form 10-K for the year ended March 31, 1997, is incorporated herein by this reference. 4(d) Term Note, dated June 24, 1997, by the Company and its subsidiaries in favor of LaSalle, which was filed as Exhibit 4(k) to the Company's Annual Report on Form 10-K for the year ended March 31, 1997, is incorporated herein by this reference. 4(e) Reimbursement Agreement dated as of October 16, 1997, between the Company and LaSalle, which was filed as Exhibit 4(f) to the Company's Annual Report on Form 10-K for the year ended March 31, 1998, is incorporated herein by this reference. 4(f) Deed of Trust and Security Agreement dated as of October 16, 1997, between the Company and LaSalle, which was filed as Exhibit 4(g) to the Company's Annual Report on Form 10-K for the year ended March 31, 1998, is incorporated herein by this reference. 4(g) First Amendment, dated as of October 28, 1998, to Loan Agreement between the Company and its subsidiaries and LaSalle, which was filed as Exhibit 4(h) to the Company's Annual Report on Form 10-K for the year ended March 31, 1999, is incorporated herein by this reference. 4(h) Second Amendment, dated as of March 11, 1999, to Loan Agreement between the Company and its subsidiaries and LaSalle, which was filed as Exhibit 4(i) to the Company's Annual Report on Form 10-K for the year ended March 31, 1999, is incorporated herein by this reference. 4(i) Third Amendment, dated June 22, 1999, to Loan Agreement between the Company and its subsidiaries and LaSalle, which was filed as Exhibit 4(j) to the Company's Annual Report on Form 10-K for the year ended March 31, 2000, is incorporated herein by this reference. 98 4(j) Fourth Amendment, dated December 17, 1999, to Loan Agreement between the Company and its subsidiaries and LaSalle, which was filed as Exhibit 4(k) to the Company's Annual Report on Form 10-K for the year ended March 31, 2000, is incorporated herein by this reference. 4(k) Fifth Amendment, dated December 21, 2001, to Loan Agreement between the Company and its subsidiaries and LaSalle, which was filed as Exhibit 4(l) to the Company's Annual Report on Form 10-K for the year ended March 31, 2002, is incorporated herein by this reference. 4(l) Sixth Amendment, dated December 20, 2002, to Loan Agreement between the Company and its subsidiaries and LaSalle, which was filed as Exhibit 4(m) to the Company's Annual Report on Form 10-K for the year ended March 31, 2003, is incorporated herein by this reference. 4(m) Seventh Amendment, dated April 28, 2003, to Loan Agreement between the Company and its subsidiaries and LaSalle, which was filed as Exhibit 4(n) to the Company's Annual Report on Form 10-K for the year ended March 31, 2003, is incorporated herein by this reference. 4(n) Indenture dated as of May 16, 2003, by and between the Company and Deutsche Bank Trust Company Americas, filed on May 21, 2003, as Exhibit 4.1 to the Company's Current Report on Form 8-K, is incorporated herein by this reference. 4(o) Registration Rights Agreement dated as of May 16, 2003, by and between the Company and Deutsche Bank Securities, Inc., as representative of the several Purchasers, filed on May 21, 2003 as Exhibit 4.2 to the Company's Current Report on Form 8-K, is incorporated herein by this reference. 4(p) Eighth Amendment, dated June 30, 2003, to loan Agreement between the Company and its subsidiaries and LaSalle, which was filed as Exhibit 4(q) to the Company's Annual Report on Form 10-K for the year ended March 31, 2004, is incorporated herein by this reference. 4(q) Ninth Amendment, dated December 19, 2003, to Loan Agreement between the Company and its subsidiaries and LaSalle, which was filed as Exhibit 4(r) to the Company's Annual Report on Form 10-K for the year ended March 31, 2004, is incorporated herein by this reference. 4(r) Tenth Amendment, dated December 20, 2004, to Loan Agreement between the Company and its subsidiaries and LaSalle, filed on January 18, 2005, as Exhibit 10.1 to the Company's Current Report on Form 8-K, is incorporated herein by this reference. 4(s) Amended and Restated Loan Agreement, dated December 31, 2004, among the Company and its subsidiaries, LaSalle National Bank Association and Citibank, F.S.B., filed on January 18, 2005, as Exhibit 10.2 to the Company's Current Report on Form 8-K, is incorporated herein by this reference. 10(a)* First Amendment to and Restatement of the KV Pharmaceutical 1981 Employee Incentive Stock Option Plan, dated March 9, 1987 (the "Restated 1981 Option Plan"), which was filed as Exhibit 10(t) to the Company's Annual Report on Form 10-K for the year ended March 31, 1988, is incorporated herein by this reference. 10(b)* Second Amendment to the Restated 1981 Option Plan, dated June 12, 1987, which was filed as Exhibit 10(u) to the Company's Annual Report on Form 10-K for the year ended March 31, 1988, is incorporated herein by this reference. 10(c)* Revised Form of Stock Option Agreement, effective June 12, 1987, for the Restated 1981 Option Plan, which was filed as Exhibit 10(v) to the Company's Annual Report on Form 10-K for the year ended March 31, 1988, is incorporated herein by this reference. 99 10(d)* Consulting Agreement between the Company and Victor M. Hermelin, Chairman of the Board, dated October 30, 1978, as amended October 30, 1982, and Employment Agreement dated February 20, 1974, referred to therein (which was filed as Exhibit 10(m) to the Company's Annual Report on Form 10-K for the year ended March 31, 1983) and subsequent Amendments dated as of August 12, 1986, which was filed as Exhibit 10(f) to the Company's Annual Report on Form 10-K for the year ended March 31, 1987, and dated as of September 15, 1987 (which was filed as Exhibit 10(s) to the Company's Annual Report on Form 10-K for the year ended March 31, 1988), and dated October 25, 1988 (which was filed as Exhibit 10(n) to the Company's Annual Report on Form 10-K for the year ended March 31, 1989), and dated October 30, 1989 (which was filed as Exhibit 10(n) to the Company's Annual Report on Form 10-K for the year ended March 31, 1990), and dated October 30, 1990 (which was filed as Exhibit 10(n) to the Company's Annual Report on Form 10-K for the year ended March 31, 1991), and dated as of October 30, 1991 (which was filed as Exhibit 10(i) to the Company's Annual Report on Form 10-K for the year ended March 31, 1992), are incorporated herein by this reference. 10(e)* Restated and Amended Employment Agreement between the Company and Gerald R. Mitchell, Vice President, Finance, dated as of March 31, 1994, is incorporated herein by this reference. 10(f)* Employment Agreement between the Company and Raymond F. Chiostri, Corporate Vice-President and President-Pharmaceutical Division, which was filed as Exhibit 10(l) to the Company's Annual Report on Form 10-K for the year ended March 31, 1992, is incorporated herein by this reference. 10(g) Lease of the Company's facility at 2503 South Hanley Road, St. Louis, Missouri, and amendment thereto, between the Company as Lessee and Marc S. Hermelin as Lessor, which was filed as Exhibit 10(n) to the Company's Annual Report on Form 10-K for the year ended March 31, 1983, is incorporated herein by this reference. 10(h) Amendment to the Lease for the facility located at 2503 South Hanley Road, St. Louis, Missouri, between the Company as Lessee and Marc S. Hermelin as Lessor, which was filed as Exhibit 10(p) to the Company's Annual Report on Form 10-K for the year ended March 31, 1992, is incorporated herein by this reference. 10(i)* KV Pharmaceutical Company Fourth Restated Profit Sharing Plan and Trust Agreement dated September 18, 1990, which was filed as Exhibit 4.1 to the Company's Registration Statement on Form S-8 No. 33-36400, is incorporated herein by this reference. 10(j)* First Amendment to the KV Pharmaceutical Company Fourth Restated Profit Sharing Plan and Trust dated September 18, 1990, is incorporated herein by this reference. 10(k)* Employment Agreement between the Company and Marc S. Hermelin, Vice-Chairman, dated November 15, 1993, which was filed as Exhibit 10(u) to the Company's Annual Report on Form 10-K for the year ended March 31, 1994, is incorporated herein by this reference. 100 10(l)* Second Amendment dated as of June 1, 1995, to Employment Agreement between the Company and Marc S. Hermelin, which was filed as Exhibit 10(x) to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1996, is incorporated herein by this reference. 10(m)* Stock Option Agreement dated as of January 22, 1996, granting stock options to MAC & Co., which was filed as Exhibit 10(z) to the Company's Annual Report on Form 10-K for the year ended March 31, 1996, is incorporated herein by this reference. 10(n)* Third Amendment dated as of November 22, 1995, to Employment Agreement between the Company and Marc S. Hermelin, which was filed as Exhibit 10(aa) to the Company's Annual Report on Form 10-K for the year ended March 31, 1996, is incorporated herein by this reference. 10(o)* Stock Option Agreement dated as of November 22, 1995, granting a stock option to Victor M. Hermelin, which was filed as Exhibit 10(bb) to the Company's Annual Report on Form 10-K for the year ended March 31, 1996, is incorporated herein by this reference. 10(p)* Stock Option Agreement dated as of November 6, 1996, granting a stock option to Alan G. Johnson, which was filed as Exhibit 10(s) to the Company's Annual Report on Form 10-K for the year ended March 31, 2003, is incorporated herein by this reference. 10(q)* Fourth Amendment to and Restatement, dated as of January 2, 1997, of the KV Pharmaceutical Company 1991 Incentive Stock Option Plan, which was filed as Exhibit 10(y) to the Company's Annual Report on Form 10-K for the year ended March 31, 1997, is incorporated herein by this reference. 10(r)* Agreement between the Company and Marc S. Hermelin, Vice Chairman, dated December 16, 1996, with supplemental letter attached, which was filed as Exhibit 10(z) to the Company's Annual Report on Form 10-K for the year ended March 31, 1997, is incorporated herein by this reference. 10(s) Amendment to Lease dated February 17, 1997, for the facility located at 2503 South Hanley Road, St. Louis, Missouri, between the Company as Lessee and Marc S. Hermelin as Lessor, which was filed as Exhibit 10(aa) to the Company's Annual Report on Form 10-K for the year ended March 31, 1997, is incorporated herein by this reference. 10(t)* Stock Option Agreement dated as of January 3, 1997, granting a stock option to Marc S. Hermelin, which was filed as Exhibit 10(bb) to the Company's Annual Report on Form 10-K for the year ended March 31, 1999, is incorporated herein by this reference. 10(u)* Stock Option Agreement dated as of May 15, 1997, granting a stock option to Marc S. Hermelin, which was filed as Exhibit 10(cc) to the Company's Annual Report on Form 10-K for the year ended March 31, 1999, is incorporated herein by this reference. 101 10(v)* Amendment, dated as of October 30, 1998, to Employment Agreement between the Company and Marc S. Hermelin, which was filed as Exhibit 10(ee) to the Company's Annual Report on Form 10-K for the year ended March 31, 1999, is incorporated herein by this reference. 10(w) Exclusive License Agreement, dated as of April 1, 1999 between Victor M. Hermelin as licenser and the Company as licensee, which was filed as Exhibit 10(ff) to the Company's Annual Report on Form 10-K for the year ended March 31, 1999 is incorporated herein by this reference. 10(x)* Stock Option Agreement dated as of March 31, 1999, granting a stock option to Victor M. Hermelin, which was filed as Exhibit 10(aa) to the Company's Annual Report on Form 10-K for the year ended March 31, 2001, is incorporated by this reference. 10(y)* Stock Option Agreement dated as of March 31, 1999, granting a stock option to Norman D. Schellenger, which was filed as Exhibit 10(cc) to the Company's Annual Report on Form 10-K for the year ended March 31, 2003, is incorporated herein by this reference. 10(z)* Stock Option Agreement dated as of April 1, 1999, granting a stock option to Marc S. Hermelin, which was filed as Exhibit 10(gg) to the Company's Annual Report on Form 10-K for the year ended March 31, 2000, is incorporated by this reference. 10(aa)* Stock Option Agreement dated as of August 16, 1999, granting a stock option to Marc S. Hermelin, which was filed as Exhibit 10 (hh) to the Company's Annual Report on Form 10-K for the year ended March 31, 2000, is incorporated by this reference. 10(bb)* Stock Option Agreement dated as of October 13, 1999, granting a stock option to Alan G. Johnson, which was filed as Exhibit 10(ff) to the Company's Annual Report on Form 10-K for the year ended March 31, 2003, is incorporated herein by this reference. 10(cc)* Stock Option Agreement dated as of October 13, 1999, granting a stock option to Alan G. Johnson, which was filed as Exhibit 10(gg) to the Company's Annual Report on Form 10-K for the year ended March 31, 2003, is incorporated herein by this reference. 10(dd)* Stock Option Agreement dated as of October 13, 1999, granting a stock option to Alan G. Johnson, which was filed as Exhibit 10(hh) to the Company's Annual Report on Form 10-K for the year ended March 31, 2003, is incorporated herein by this reference. 10(ee)* Stock Option Agreement dated as of October 13, 1999, granting a stock option to Alan G. Johnson, which was filed as Exhibit 10(ii) to the Company's Annual Report on Form 10-K for the year ended March 31, 2003, is incorporated herein by this reference. 10(ff)* Amendment, dated December 2, 1999, to Employment Agreement between the Company and Marc S. Hermelin, Vice-Chairman, which was filed as Exhibit 10(ii) to the Company's Annual Report on Form 10-K for the year ended March 31, 2000, is incorporated by this reference. 10(gg)* Employment Agreement between the Company and Alan G. Johnson, Senior Vice-President, Strategic Planning and Corporate Growth, dated September 27, 1999, which was filed as Exhibit 10(jj) to the Company's Annual Report on Form 10-K for the year ended March 31, 2000, is incorporated by this reference. 102 10(hh)* Consulting Agreement, dated as of May 1, 1999, between the Company and Victor M. Hermelin, Chairman, which was filed as Exhibit 10(kk) to the Company's Annual Report on Form 10-K for the year ended March 31, 2000, is incorporated by this reference. 10(ii)* Stock Option Agreement dated as of June 1, 2000, granting a stock option to Marc S. Hermelin, which was filed as Exhibit 10(gg) to the Company's Annual Report on Form 10-K for the year ended March 31, 2001, is incorporated by this reference. 10(jj)* Stock Option Agreement dated as of June 1, 2000, granting a stock option to Marc S. Hermelin, which was filed as Exhibit 10(hh) to the Company's Annual Report on Form 10-K for the year ended March 31, 2001, is incorporated by this reference. 10(kk)* Stock Option Agreement dated as of April 9, 2001, granting a stock option to Kevin S. Carlie, which was filed as Exhibit 10(ii) to the Company's Annual Report on Form 10-K for the year ended March 31, 2002, is incorporated herein by this reference. 10(ll)* Stock Option Agreement dated as of April 9, 2001, granting a stock option to Marc S. Hermelin, which was filed as Exhibit 10(jj) to the Company's Annual Report on Form 10-K for the year ended March 31, 2002, is incorporated herein by this reference. 10(mm)* Stock Option Agreement dated as of April 9, 2001, granting a stock option to Marc S. Hermelin, which was filed as Exhibit 10(kk) to the Company's Annual Report on Form 10-K for the year ended March 31, 2002, is incorporated herein by this reference. 10(nn)* Stock Option Agreement dated as of July 26, 2002, granting a stock option to Marc S. Hermelin, which was filed as Exhibit 10(rr) to the Company's Annual Report on Form 10-K for the year ended March 31, 2003, is incorporated herein by this reference. 10(oo)* Stock Option Agreement dated as of October 21, 2002, granting a stock option to John P. Isakson, which was filed as Exhibit 10(ss) to the Company's Annual Report on Form 10-K for the year ended March 31, 2003, is incorporated herein by this reference. 10(pp) License Agreement by and between the Company and FemmePharma, Inc., dated as of April 18, 2002, which was filed as Exhibit 10(tt) to the Company's Annual Report on Form 10-K for the year ended March 31, 2003, is incorporated herein by this reference. 10(qq) Stock Purchase Agreement by and between the Company and FemmePharma, Inc., dated as of April 18, 2002, which was filed as Exhibit 10(uu) to the Company's Annual Report on Form 10-K for the year ended March 31, 2003, is incorporated herein by this reference. 10(rr) Product Acquisition Agreement by and between the Company and Schwarz Pharma dated as of March 31, 2003, which was filed as Exhibit 10(vv) to the Company's Annual Report on Form 10-K for the year ended March 31, 2003, is incorporated herein by this reference. 10(ss) Product Acquisition Agreement by and between the Company and Altana Inc. dated as of March 31, 2003, which was filed as Exhibit 10(ww) to the Company's Annual Report on Form 10-K for the year ended March 31, 2003, is incorporated herein by this reference. 10(tt)* Stock Option Agreement dated as of October 21, 2002, granting a stock option to John P. Isakson, which was filed as Exhibit 10(xx) to the Company's Annual Report on Form 10-K for the year ended March 31, 2003, is incorporated herein by this reference. 103 10 (uu)* Stock Option Agreement dated as of May 30, 2003, granting a stock option to Marc S. Hermelin, which was filed as Exhibit 10(yy) to the Company's Annual Report on Form 10-K for the year ended March 31, 2004, is incorporated herein by this reference. 10(vv)* Amendment, dated November 5, 2004, to Employment Agreement between the Company and Marc S. Hermelin, Vice-Chairman, which was filed as Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 2004, is incorporated herein by this reference. 10(ww) Agreement and Plan of Merger by and among K-V Pharmaceutical Company, Kestrel-Falcon Acquisition Corporation, FP1096, Inc., and FemmePharma Holding Company, Inc., dated as of May 4, 2005, filed herewith. 21 List of Subsidiaries, filed herewith. 23.1 Consent of KPMG LLP, filed herewith. 23.2 Consent of BDO Seidman, LLP, filed herewith. 31.1 Certification of Chief Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, is filed herewith. 31.2 Certification of Chief Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, is filed herewith. 32.1 Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, filed herewith. 32.2 Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, filed herewith. *Management contract or compensation plan. 104