-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, TTptpnqEoWPxYKFgP/yCpWwySgbRLU17UPf0O/+J8Zju9NbSq1NXuYaGkvm8euUe 9b25LydoU3Q2/FtIk55fOw== 0001068800-08-000125.txt : 20080325 0001068800-08-000125.hdr.sgml : 20080325 20080325172855 ACCESSION NUMBER: 0001068800-08-000125 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 20060930 FILED AS OF DATE: 20080325 DATE AS OF CHANGE: 20080325 FILER: COMPANY DATA: COMPANY CONFORMED NAME: KV PHARMACEUTICAL CO /DE/ CENTRAL INDEX KEY: 0000057055 STANDARD INDUSTRIAL CLASSIFICATION: PHARMACEUTICAL PREPARATIONS [2834] IRS NUMBER: 430618919 STATE OF INCORPORATION: DE FISCAL YEAR END: 0331 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-09601 FILM NUMBER: 08710228 BUSINESS ADDRESS: STREET 1: 2503 S HANLEY RD CITY: ST LOUIS STATE: MO ZIP: 63144 BUSINESS PHONE: 3146456600 MAIL ADDRESS: STREET 1: 2503 S HANLEY RD CITY: ST LOUIS STATE: MO ZIP: 63144 10-Q 1 kvsep30-10q.txt UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 - ------------------------------------------------------------------------------- FORM 10-Q [ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO COMMISSION FILE NUMBER 1-9601 - ------------------------------------------------------------------------------- K-V PHARMACEUTICAL COMPANY (Exact name of registrant as specified in its charter) DELAWARE 43-0618919 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 2503 SOUTH HANLEY ROAD, ST. LOUIS, MISSOURI 63144 (Address of principal executive offices, including ZIP code) Registrant's telephone number, including area code: (314) 645-6600 - ------------------------------------------------------------------------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [ ] No [ X ] Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Act). Large accelerated filer [ X ] Accelerated filer [ ] Non-accelerated filer [ ] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes [ ] No [ X ] As of January 15, 2008, the registrant had outstanding 37,708,248 and 12,233,802 shares of Class A and Class B Common Stock, respectively. 1 EXPLANATORY NOTE REGARDING RESTATEMENT OF OUR CONSOLIDATED FINANCIAL STATEMENTS This Form 10-Q reflects the restatement of our consolidated balance sheets as of March 31, 2006 and September 30, 2005, the related consolidated statements of operations for the three and six months ended September 30, 2005, and the related consolidated statement of cash flows for the six months ended September 30, 2005. In our Form 10-K for the fiscal year ended March 31, 2007 to be filed with the Securities and Exchange Commission (the "2007 Form 10-K"), we are restating our consolidated balance sheet as of March 31, 2006, and the related consolidated statements of income, comprehensive income, shareholders' equity, and cash flows for the fiscal years ended March 31, 2006 and 2005. We have not amended, and we do not intend to amend, our previously filed Annual Reports on Form 10-K or Quarterly Reports on Form 10-Q for each of the fiscal years and fiscal quarters of 1996 through 2006. Our 2007 Form 10-K also reflects the restatement of Selected Financial Data in Item 6 as of March 31, 2005 and as of and for the fiscal years ended March 31, 2004 and 2003. We will also be filing a Quarterly Report on Form 10-Q for the quarter ended December 31, 2006, that contains the restatement of our consolidated financial statements for certain interim periods as discussed therein. On October 31, 2006, we announced that we had been served with a derivative lawsuit filed in St. Louis City Circuit Court alleging that certain stock option grants to current or former directors and officers between 1995 and 2002 were dated improperly. In accordance with our established corporate governance procedures, the Board of Directors referred this matter to the independent members of its Audit Committee (the "Special Committee" or "Committee"). Shortly thereafter, the Special Committee, assisted by independent legal counsel and forensic accounting experts engaged by the Committee, commenced an investigation of our stock option grant practices, with the objective of evaluating our accounting for stock options for compliance with U.S. Generally Accepted Accounting Principles ("GAAP") and with the terms of our related stock option plans over the period January 1, 1995 through October 31, 2006 (the "relevant period"). The investigation has now been completed and our Board of Directors received a final report on October 2, 2007 from the Special Committee based on facts disclosed in the course of the investigation and the advice of its independent legal counsel and forensic accounting experts. The Special Committee found that our previous accounting for stock-based compensation was not in accordance with GAAP and that corrections to our previous consolidated financial statements were required. We agreed with the Committee's findings and, as a result, our consolidated retained earnings as of March 31, 2006, incorporate an additional $16.3 million of stock-based compensation expense, including related payroll taxes, interest and penalties, net of $2.6 million in income tax benefits. In the course of the Special Committee's investigation, we were notified by the SEC staff that it had commenced an investigation with respect to the Company's stock option program. We have cooperated with the SEC staff and, among other things, provided them with copies of the Special Committee's report and all documents collected by the Committee in the course of its review. Recently, the SEC staff, pursuant to a formal order of investigation, has issued subpoenas for documents, most of which have already been produced to the SEC staff, and for testimony by certain employees. The Company expects that the production of any additional documents called for by the subpoena and the testimony of the employees will be completed by April 2008. In addition and as a separate matter, our consolidated retained earnings as of March 31, 2006, incorporate an additional $5.4 million of income tax expense to record additional liabilities associated with tax positions claimed on tax returns filed for fiscal years 2004, 2005 and 2006 that should have been recorded in accordance with GAAP, partially offset by certain expected tax refunds. This adjustment is not related to the accounting for stock-based compensation expense discussed above. In addition, our consolidated retained earnings as of March 31, 2006, incorporate a $0.4 million reduction of net income related primarily to misstatements of net revenues and cost of sales resulting from improperly recognizing revenue prior to when title and risk of ownership of the product transferred to the customer. Please see "Review of Stock Option Grant Practices," "Review of Tax Positions (Unrelated to stock options)" and "Other Adjustments (Unrelated to stock options)" in "Management's Discussion and Analysis of Financial Condition 2 and Results of Operations" and Note 2 "Restatement of Consolidated Financial Statements" in our consolidated financial statements for a more detailed discussion related to the investigation of our former stock option grant practices, review of tax positions and other adjustments. The effect of these restatements are reflected in our Consolidated Financial Statements and other supplemental data herein and the unaudited quarterly data and selected financial data included in the 2007 Form 10-K. Financial information included in reports previously filed or furnished by K-V Pharmaceutical Company for the fiscal periods 1996 through 2006 and our assessment of internal control over financial reporting as of March 31, 2006 should not be relied upon and are superseded by the information in this Form 10-Q and the 2007 Form 10-K. 3 PART I. - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS K-V PHARMACEUTICAL COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited; dollars in thousands, except per share data)
THREE MONTHS ENDED SIX MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ---------------------------------- ---------------------------------- 2006 2005 2006 2005 ---------------- ---------------- ---------------- ---------------- (AS RESTATED) (AS RESTATED) Net revenues............................................. $ 108,983 $ 92,322 $ 205,183 $ 177,364 Cost of sales............................................ 38,879 32,640 72,325 58,675 --------- -------- --------- --------- Gross profit............................................. 70,104 59,682 132,858 118,689 --------- -------- --------- --------- Operating expenses: Research and development............................. 6,396 6,420 14,287 14,052 Purchased in-process research and development and transaction costs................ -- -- -- 30,441 Selling and administrative........................... 42,855 37,847 83,008 75,599 Amortization of intangibles.......................... 1,201 1,211 2,398 2,391 --------- -------- --------- --------- Total operating expenses................................. 50,452 45,478 99,693 122,483 --------- -------- --------- --------- Operating income (loss).................................. 19,652 14,204 33,165 (3,794) --------- -------- --------- --------- Other expense (income): Interest expense..................................... 2,305 1,467 4,541 2,844 Interest and other income............................ (2,308) (1,077) (4,366) (2,130) --------- -------- --------- --------- Total other expense (income), net........................ (3) 390 175 714 --------- -------- --------- --------- Income (loss) before income taxes and cumulative effect of change in accounting principle.................... 19,655 13,814 32,990 (4,508) Provision for income taxes............................... 7,570 5,224 12,783 9,790 --------- -------- --------- --------- Income (loss) before cumulative effect of change in accounting principle.............................. 12,085 8,590 20,207 (14,298) Cumulative effect of change in accounting principle (net of $670 in taxes)..................... -- -- 1,976 -- --------- -------- --------- --------- Net income (loss)........................................ $ 12,085 $ 8,590 $ 22,183 $ (14,298) ========= ======== ========= ========= (CONTINUED)
4 K-V PHARMACEUTICAL COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS - (CONTINUED) (Unaudited; dollars in thousands, except per share data)
THREE MONTHS ENDED SIX MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ---------------------------------- ---------------------------------- 2006 2005 2006 2005 ---------------- ---------------- ---------------- ---------------- (AS RESTATED) (AS RESTATED) Earnings (loss) per share before effect of change in accounting principle: Basic - Class A common.............................. $ 0.26 $ 0.18 $ 0.43 $ (0.29) Basic - Class B common.............................. 0.21 0.15 0.36 (0.29) Diluted - Class A common............................ 0.22 0.16 0.38 (0.29) Diluted - Class B common............................ 0.19 0.14 0.32 (0.29) Per share effect of cumulative effect of change in accounting principle: Basic - Class A common.............................. $ - $ - $ 0.04 $ - Basic - Class B common.............................. - - 0.03 - Diluted - Class A common............................ - - 0.03 - Diluted - Class B common............................ - - 0.03 - Earnings (loss) per share: Basic - Class A common.............................. $ 0.26 $ 0.18 $ 0.47 $ (0.29) Basic - Class B common.............................. 0.21 0.15 0.39 (0.29) Diluted - Class A common............................ 0.22 0.16 0.41 (0.29) Diluted - Class B common............................ 0.19 0.14 0.35 (0.29) Shares used in per share calculation: Basic - Class A common.............................. 36,744 35,687 36,671 35,566 Basic - Class B common.............................. 12,456 12,949 12,465 13,043 Diluted - Class A common............................ 58,917 58,499 58,882 48,609 Diluted - Class B common............................ 12,552 13,135 12,587 13,043 SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
5 K-V PHARMACEUTICAL COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Unaudited; dollars in thousands)
SEPTEMBER 30, MARCH 31, 2006 2006 ---- ---- (AS RESTATED) ASSETS ------ CURRENT ASSETS: Cash and cash equivalents............................................................ $ 58,705 $ 100,706 Marketable securities................................................................ 153,509 106,763 Receivables, less allowance for doubtful accounts of $474 and $397 at September 30, 2006 and March 31, 2006, respectively............................ 67,000 53,571 Inventories, net..................................................................... 76,497 71,166 Prepaid and other assets............................................................. 7,817 7,012 Deferred tax asset................................................................... 12,292 10,072 ----------- ----------- Total Current Assets.............................................................. 375,820 349,290 Property and equipment, net.......................................................... 188,452 178,042 Intangible assets and goodwill, net.................................................. 71,067 72,955 Other assets......................................................................... 19,260 19,026 ----------- ----------- TOTAL ASSETS......................................................................... $ 654,599 $ 619,313 =========== =========== LIABILITIES ----------- CURRENT LIABILITIES: Accounts payable..................................................................... $ 15,046 $ 17,975 Accrued liabilities.................................................................. 34,732 24,676 Current maturities of long-term debt................................................. 1,848 1,681 ----------- ----------- Total Current Liabilities......................................................... 51,626 44,332 Long-term debt....................................................................... 240,421 241,319 Other long-term liabilities.......................................................... 5,819 5,442 Deferred tax liability............................................................... 31,429 25,221 ----------- ----------- TOTAL LIABILITIES.................................................................... 329,295 316,314 ----------- ----------- 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 September 30, 2006 and March 31, 2006 (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 40,110,579 and 39,660,637 at September 30, 2006 and March 31, 2006, respectively.............................................. 401 397 Class B - issued 12,469,164 and 12,679,986 at September 30, 2006 and March 31, 2006, respectively (convertible into Class A shares on a one-for-one basis)... 125 127 Additional paid-in capital........................................................... 147,088 145,180 Retained earnings.................................................................... 233,558 211,410 Accumulated other comprehensive loss................................................. (170) (211) Less: Treasury stock, 3,223,298 shares of Class A and 92,902 shares of Class B Common Stock at September 30, 2006, respectively, and 3,123,975 shares of Class A and 92,902 shares of Class B Common Stock at March 31, 2006, respectively, at cost.... (55,698) (53,904) ----------- ----------- TOTAL SHAREHOLDERS' EQUITY........................................................... 325,304 302,999 ----------- ----------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY........................................... $ 654,599 $ 619,313 =========== =========== SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
6 K-V PHARMACEUTICAL COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited; dollars in thousands)
SIX MONTHS ENDED SEPTEMBER 30, 2006 2005 ------------ ---------- (AS RESTATED) OPERATING ACTIVITIES: Net income (loss)...................................................... $ 22,183 $ (14,298) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Acquired in-process research and development........................ -- 29,570 Cumulative effect of change in accounting principle................. (1,976) -- Depreciation and amortization....................................... 11,048 8,389 Deferred income tax provision....................................... 3,298 93 Deferred compensation............................................... 377 590 Stock-based compensation............................................ 1,919 453 Excess tax benefit associated with stock options.................... (306) -- Changes in operating assets and liabilities: Increase in receivables, net........................................ (13,429) (3,183) Increase in inventories, net........................................ (5,331) (5,872) (Increase) decrease in prepaid and other assets..................... (1,870) 4,132 Increase in accounts payable and accrued liabilities................ 7,344 2,964 ------------- ------------ Net cash provided by operating activities.............................. 23,257 22,838 ------------- ------------ INVESTING ACTIVITIES: Purchase of property and equipment, net............................. (18,339) (36,856) Purchase of marketable securities................................... (46,685) (49,513) Purchase of preferred stock......................................... (400) (11,300) Product acquisition................................................. -- (25,643) ------------- ------------ Net cash used in investing activities.................................. (65,424) (123,312) ------------- ------------ FINANCING ACTIVITIES: Principal payments on long-term debt................................ (731) (486) Dividends paid on preferred stock................................... (35) (35) Excess tax benefit associated with stock options.................... 306 -- Purchase of common stock for treasury............................... (1,794) (136) Cash deposits received for stock options............................ 2,420 450 ------------- ------------ Net cash provided by (used in) financing activities.................... 166 (207) ------------- ------------ Decrease in cash and cash equivalents.................................. (42,001) (100,681) Cash and cash equivalents: Beginning of year................................................... 100,706 159,825 ------------- ------------ End of period....................................................... $ 58,705 $ 59,144 ============= ============ SUPPLEMENTAL INFORMATION: Interest paid....................................................... $ 3,572 $ 2,156 Income taxes paid................................................... 5,627 3,025 Stock options exercised (at expiration of two-year forfeiture period)............................................... 2,329 2,092 SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
7 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (dollars in thousands, except per share data) 1. BASIS OF PRESENTATION K-V Pharmaceutical Company and its subsidiaries ("KV" or the "Company") are primarily engaged in the development, manufacture, acquisition, 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. The accompanying unaudited consolidated financial statements of the Company have been prepared in accordance with U.S. generally accepted accounting principles ("GAAP") for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. However, in the opinion of management, all adjustments (consisting of only normal recurring accruals) considered necessary for a fair presentation have been included. The balance sheet information as of March 31, 2006 has been derived from the Company's consolidated balance sheet as of that date, as restated (see Note 2). These consolidated financial statements and accompanying notes should be read in conjunction with the Company's consolidated financial statements and notes thereto for the fiscal year ended March 31, 2007, which are included in the Company's Annual Report on Form 10-K for the fiscal year ended March 31, 2007 to be filed with the Securities and Exchange Commission (the "2007 Form 10-K"). 2. RESTATEMENT OF CONSOLIDATED FINANCIAL STATEMENTS REVIEW OF STOCK OPTION GRANT PRACTICES BACKGROUND AND CONCLUSIONS This Form 10-Q reflects the restatement of the Company's consolidated balance sheets as of March 31, 2006 and September 30, 2005, the related consolidated statements of operations for the three and six months ended September 30, 2005 and the related consolidated statement of cash flows for the six months ended September 30, 2005. In the Company's 2007 Form 10-K, the Company is restating its consolidated balance sheet as of March 31, 2006, and the related consolidated statements of income, comprehensive income, shareholders' equity, and cash flows for the fiscal years ended March 31, 2006 and 2005. The Company has not amended, and does not intend to amend, its previously filed Annual Reports on Form 10-K or Quarterly Reports on Form 10-Q for each of the fiscal years and fiscal quarters of 1996 through 2006. The Company will be filing a Quarterly Report on Form 10-Q for the quarter ended December 31, 2006 that contains the restatement of its consolidated financial statements for certain interim periods as discussed therein. On October 31, 2006, the Company announced that it had been served with a derivative lawsuit filed in St. Louis City Circuit Court alleging that certain stock option grants to current or former officers and directors between 1995 and 2002 were dated improperly. In accordance with the Company's established corporate governance procedures, the Board of Directors referred this matter to the independent members of its Audit Committee (the "Special Committee" or "Committee"). Shortly thereafter, the Special Committee commenced an investigation of the Company's stock option grant practices, assisted by independent legal counsel and forensic accounting experts engaged by the Committee, with the objectives of evaluating the Company's accounting for stock options for compliance with GAAP and for compliance with the terms of its related stock option plans over the period January 1, 1995 through October 31, 2006 (the "relevant period"). 8 On October 11, 2007, the Company filed a Current Report on Form 8-K announcing the Special Committee had completed its investigation. The investigation concluded that there was not evidence that any employee, officer or director of the Company engaged in any intentional wrongdoing or was aware the Company's policies and procedures for granting and accounting for stock options were materially non-compliant with GAAP. The investigation also found no intentional violation of law or accounting rules with respect to the Company's historical stock option grant practices. However, the Special Committee concluded that stock-based compensation expense resulting from the stock option grant practices followed by the Company was not recorded in accordance with GAAP because the expense computed for most of the grants reflected incorrect measurement dates for financial accounting purposes. The "measurement date" under applicable accounting principles, namely APB 25 and related interpretations, is the first date on which all of the following are known and not subject to change: (a) the individual who is entitled to receive the option grant, (b) the number of options that an individual is entitled to receive, and (c) the option's exercise price. FINDINGS AND ACCOUNTING CONSIDERATIONS In general, stock options were granted to employees, executives and non-employee members of the Board of Directors over the relevant period under the terms of the Company's 1991 and 2001 Incentive Stock Option Plans (the "option plans"). In addition to options granted to the CEO under those plans, options were awarded to him under the terms of his employment agreement in lieu of, and in consideration for a reduction of, the cash bonus provided for in that agreement. The option plans required grants to be approved by the Compensation Committee of the Board of Directors. Under the option plans, options were to be granted with exercise prices set at no less than the fair market value of the underlying common stock at the date of grant. The 1991 plan provided for the exclusive grant of Incentive Stock Options ("ISOs") as defined by Internal Revenue Code Section 422, while the 2001 plan provided for the grant of ISOs and non-qualified stock options ("NSOs"). Under the plans, options granted to employees other than the CEO or directors are subject to a ten-year ratable vesting period. Options granted to the CEO and directors generally vest ratably over five years. Both option plans require that shares received upon exercise of an option cannot be sold for two years. If the employee terminates employment voluntarily or involuntarily (other than by retirement, death or disability) during the two-year forfeiture period, the option plans provide that the Company may elect to repurchase the shares at the lower of the exercise price of the option or the fair market value of the stock on the date of termination. The Company has changed its accounting for stock-based compensation to consider this provision of the option plans as a forfeiture provision to be accounted for in accordance with the guidance provided in EITF No. 00-23, "Issues Related to Accounting for Stock Based Compensation under APB 25 and FIN 44", specifically Paragraph 78 and Issue 33 (a), "Accounting for Early Exercise". In accordance with EITF No. 00-23, cash paid by an employee for the exercise price is considered a deposit or a prepayment of the exercise price that is recognized as a current liability when received by the Company at the beginning of the two-year forfeiture period. The receipt of the exercise price is recognized as a current liability because the options are deemed not exercised and the option shares are not considered issued until an employee bears the risk and rewards of ownership. The options are accounted for as exercised when the two-year forfeiture period lapses. In addition, because the options are not considered exercised for accounting purposes, the shares in the two-year forfeiture period are not considered outstanding for purposes of computing basic EPS. The Company had accounted for all option grants as fixed in accordance with the provisions of APB 25 using the date of grant as the measurement date. Because the exercise price of the option was equal to or greater than the market price of the stock at the measurement date fixed by the terms of the awards, under prior procedures the Company did not recognize any compensation expense since the option had no intrinsic value, with intrinsic value being the difference between the exercise price and the market price of the underlying stock at the measurement date. As noted above, the Special Committee determined that the Company's accounting for most of the stock option grants was not in accordance with GAAP because the date of grant, as defined by the Company, was not a proper measurement date. To correct the errors, and consistent with the accounting literature and guidance from the Securities and Exchange Commission ("SEC"), the Company organized the grants into categories based on grant type and process by which the grant was finalized. Based on the relevant facts and circumstances, the Company applied the authoritative accounting standard (APB 25 and related interpretations) to determine, for every grant within each category, the proper measurement date. If the measurement date was not the originally assigned grant date, accounting adjustments were 9 made as required, resulting in stock-based compensation expense and related tax effects. The grants were classified as follows: (1) promotion/retention grants to executives and employees and new hire grants ("employee options"); (2) grants to persons elected or appointed to the Board of Directors ("director options"); and (3) bonus option grants to the CEO in lieu of cash bonus payments under the terms of his employment agreement ("bonus options"). Employee Options. The evidence obtained through the investigation indicated - ---------------- that employee options were granted based on the lowest market price in the quarter of grant determined from an effective date (as defined below) to the end of the quarter. The exercise price and grant date of the options were determined by looking back from the end of the quarter to the effective date and choosing the lowest market price during that period. The date on which the market price was lowest became the grant date. This procedure to "look back" to the lowest market price in the preceding quarter to set the exercise price was widely known and understood within the Company. The effective date was either the date on which the option recipients and the number of shares to be granted were determined and approved by the CEO, the date of a promotion or the date of hire. For new hires and promotions of existing employees, which represents substantially all of the award recipients, the terms of the award, except for the exercise price, were communicated to the recipients prior to the end of the quarter. At the end of the quarter, when the exercise price was determined, board consents were prepared and dated as of the date on which the stock price was lowest during the quarter, to be approved by the members of the Compensation Committee. The evidence obtained through the investigation indicated the Compensation Committee never changed or denied approval of any grants submitted to them and, as such, their approval was considered a routine matter. Based on the evidence and findings of the Special Committee, the results of management's analysis, the criteria specified in APB 25 for determining measurement dates and guidance from the staff of the SEC, the Company has concluded that the measurement dates for the employee options should not have been the originally assigned grant dates, but instead, should have been the end of the quarter in which awards were granted when the exercise price and number of shares granted were fixed. Changing the measurement dates from the originally assigned grant date to the end of the quarter resulted in recognition of additional stock-based compensation expense of $150 and $293, net of tax, on 1,376 stock option grants for the three and six months ended September 30, 2005, respectively. Director Options. Director options were issued, prior to the effective date of - ---------------- the Sarbanes-Oxley Act ("Sarbanes-Oxley") in August 2002, using the same "look back" process as described above for employee options. This process was changed when the time for filing Form 4s was shortened under the provisions of Sarbanes-Oxley, to award options with exercise prices equal to the fair market value of the stock on the date of grant. Prior to this change in grant practice, the Company concluded that the measurement date for the director options should be the end of the quarter. Changing the measurement date from the originally assigned grant date to the end of the quarter resulted in recognition of additional stock-based compensation expense of $9 and $17, net of tax, on 14 stock option grants for the three and six months ended September 30, 2005, respectively. Bonus Options. Under the terms of the CEO's employment agreement, he is - ------------- permitted the alternative of electing incentive stock options, restricted stock or discounted stock options in lieu of the payment of part or all of the incentive bonus due to him in cash . In the event of an election to receive options in lieu of cash incentive, those options were to be valued using the Black-Scholes option pricing model, applying the same assumptions as those used in the Company's most recent proxy statement. The employment agreement provides that the CEO's annual bonus is based on fiscal year net income. Prior to fiscal 2005, the CEO received ten bonus option grants, consisting of 337,500 shares of Class A Common Stock and 1,743,750 shares of Class B Common Stock under this arrangement. The CEO and the Board's designated representative (the Company's Chief Financial Officer) negotiated the terms of the bonus options, including the number of shares covered, the exercise price and the grant date (the latter being selected using a "look back" process similar to that followed in granting employee and director options). The Company typically granted bonus options prior to fiscal year-end, shortly after such agreement was reached. These bonus options were fully vested at grant, had three to five year terms, were granted with a 10% or 25% premium to the market price of the stock on the selected grant date and were subject to the approval of the Compensation Committee. The CEO's cash bonus payable at the end of the fiscal year in which the options were granted was reduced by the Black-Scholes value of the options according to their terms. Based on the facts and circumstances relative to the process for granting the bonus options, the Special Committee determined, and the Company has agreed, that the measurement dates for these options should be the end of the fiscal 10 year in which they were granted. The end of the fiscal year was used as the measurement date because that is the date on which the amount of the annual bonus could be determined and therefore the terms of the option could be fixed under APB 25. This conclusion is predicated on the assumption that the terms of the option were linked to the amount of the bonus earned. While it was permissible to agree upon the number of shares that were to be issued prior to the end of the year and would not be forfeitable, under GAAP the exercise price is considered variable until the amount of the bonus could be determined with finality. The variability in the exercise price results from the premise that the CEO would have been required to repay any shortfall in the bonus earned from the value assigned to the option by the Black-Scholes model. Any amount repaid to cure the bonus shortfall would in substance be an increase in the exercise price of the option. Since the exercise price could not be determined with certainty until the amount of the bonus was known, the Company has applied variable accounting to the bonus options from the date of grant to the final fiscal year-end measurement date. Variable accounting requires that compensation expense is to be determined by comparing the quoted market value of the shares covered by the option grant to the exercise price at each intervening balance sheet date until the terms of the option become fixed. The compensation expense associated with the CEO's estimated bonus was accrued throughout the fiscal year. When the value of a bonus option was determined using the Black-Scholes model, previously recorded compensation expense associated with the accrual of the estimated bonus was reversed in the amount of the value assigned to the bonus option. The previously recorded compensation expense should not have been reversed. The Company developed a methodology in the restatement process that considers both the intrinsic value of the option under APB 25 and the Black-Scholes value assigned to the bonus option in determining the amount of compensation expense to recognize once the exercise price of the option becomes fixed and variable accounting ends. Under this methodology, the intrinsic value of the option is determined at the fiscal year-end measurement date under the principles of APB 25. The intrinsic value is then compared to the Black-Scholes value assigned to the option for compensation purposes (the bonus value). The bonus value is the amount that would have been accrued during the fiscal year through the grant date as part of the total liability for the CEO's bonus. The greater of the intrinsic value or bonus value is recorded as compensation expense. Using this methodology and fiscal year-end for the measurement dates resulted in an increase in stock-based compensation expense of $6,944 over the period from fiscal 1996 through fiscal 2004. There was no tax benefit associated with this expense due to the tax years being closed. OTHER MODIFICATIONS OF OPTION TERMS As described above, under the terms of the option plans, shares received on exercise of an option are to be held for the employee for two years during which time the shares cannot be sold. If the employee terminated employment voluntarily or involuntarily (other than by retirement, death or disability) during the two-year forfeiture period the option plans provided the Company with the option of repurchasing the shares at the lower of the exercise price or the fair market value of the stock on the date of termination. In some circumstances the Company elected not to repurchase the shares upon termination of employment while the shares were in the two-year forfeiture period, essentially waiving the remaining forfeiture period requirement. The Company did not previously recognize this waiver as requiring a new measurement date. Based on management's analysis, the Company has concluded that a new measurement date should have been recognized in two situations: (1) the employee terminated and the Company did not exercise its right under the option plans to buy back the shares in the two-year forfeiture period, and (2) the forfeiture provision was waived and the employee subsequently terminated within two years of the exercise date. The Company now considers both of these waivers to be an acceleration of the vesting period because the forfeiture provision was waived. The employee is no longer subject to a service condition to earn the right to the shares and will benefit from the modification. As such, a new measurement date is required. In this case the new measurement date is the date the forfeiture provision was waived with additional stock-based compensation expense being recognized at the date of termination. Since the shares were fully vested, the intrinsic value of the option at the new measurement date in excess of the intrinsic value at the original measurement date should be expensed immediately. The new measurement dates resulted in an increase in stock-based compensation expense of $2 and $4, net of tax, on two stock option grants for the three and six months ended September 30, 2005, respectively. STOCK OPTION ADJUSTMENTS A discussion of the stock option restatement adjustments follows and a table reflecting the impact of these adjustments is presented below on page 13. 11 Stock-based Compensation Expense. Although the period for the Special - -------------------------------- Committee's investigation was January 1, 1995 to October 31, 2006, the Company extended the period of review back to 1986 in its analysis of the aggregate impact of the measurement date changes because the incorrect accounting for stock options extended that far back in time. The Company has concluded that the measurement date changes identified by the Special Committee's investigation and management's analysis resulted in an understatement of stock-based compensation expense arising from stock option grants since 1986, affecting the Company's consolidated financial statements for each year beginning with the fiscal year ended March 31, 1986. The impact of the misstatements on the consolidated financial statements for the fiscal years from 1986 to 1995 was not considered material, individually or in the aggregate. As previously discussed, the Company now considers the two-year repurchase option specified in the option plans to be a forfeiture provision that goes into effect when stock options are exercised. Therefore, the service period necessary for an employee to earn an award varies based on the timing of stock option exercises. The Company initially expenses each award (i.e., all tranches of an option award) on a straight-line basis over ten years, which is the period that stock options become exercisable. The Company also ensures the cumulative compensation expense for an award as of any date is at least equal to the measurement-date intrinsic value of those options that have vested (i.e., when the two-year forfeiture period has ended). If stock options expire unexercised or an employee terminates employment after options become exercisable, no compensation expense associated with the exercisable, but unexercised options, is reversed. In those instances where an employee terminates employment before options become exercisable or the Company repurchased the shares during the two-year forfeiture period, compensation expense for those options is reversed as a forfeiture. Payroll Taxes, Interest and Penalties. In connection with the stock-based - ------------------------------------- compensation adjustments, the Company determined that certain options previously classified as ISO grants were determined to have been granted with an exercise price below the fair market value of the Company's stock on the revised measurement dates. Under Internal Revenue Code Section 422, ISOs may not be granted with an exercise price less than the fair market value on the date of grant, and therefore these grants would not likely qualify for ISO tax treatment. The disqualification of ISO classification exposes the Company and the affected employees to payroll related withholding taxes once the underlying shares are released from the post exercise two-year forfeiture period and the substantial risk of forfeiture has lapsed (the "taxable event"). The Company and the affected employees may also be subject to interest and penalties for failing to properly withhold taxes and report this taxable event on their respective tax returns. The Company is currently reviewing the potential disqualification of ISO grants and the related withholding tax implications with the Internal Revenue Service ("IRS") for calendar years 2004, 2005 and 2006 in an effort to reach agreement on the resulting tax liability. In the meantime, the Company has recorded expenses related to the withholding taxes, interest and penalties associated with options which would have created a taxable event in calendar years 2004, 2005 and 2006. The estimated payroll tax liability at March 31, 2006 for the disqualification of tax treatment associated with ISO awards totaled $3,278. In addition, the Company recorded an income tax benefit of $909 related to this liability. Income Tax Benefit. The Company reviewed the income tax effect of the - ------------------ stock-based compensation charges, and it believes that the proper income tax accounting for stock options under GAAP depends, in part, on the tax distinction of the stock options as either ISOs or NSOs. Because of the potential impact of the measurement date changes on the qualified status of the options, the Company has determined that substantially all of the options originally intended to be ISOs might not be qualified under the tax regulations, and therefore should be accounted for as if they were NSOs for financial accounting purposes. An income tax benefit has resulted from the determination that certain NSOs for which stock-based compensation expense was recorded will create an income tax deduction. The income tax benefit has resulted in an increase to the Company's deferred tax assets for stock options prior to the occurrence of a taxable event or the forfeiture of the related options. Upon the occurrence of a taxable event or forfeiture of the underlying options, the corresponding deferred tax asset is reversed and the excess or deficiency in the deferred tax assets is recorded to paid-in capital in the period in which the taxable event or forfeiture occurs. The Company has recorded a deferred tax asset of $1,320 as of March 31, 2006 related to stock options. REVIEW OF TAX POSITIONS (UNRELATED TO STOCK OPTIONS) In addition, the Company's restated consolidated financial statements include an adjustment to increase the provision for income taxes and taxes payable to reflect additional liabilities associated with tax positions claimed on filed tax returns for fiscal years 2004, 2005 and 2006 that should have been recorded in accordance with GAAP, partially offset 12 by certain expected tax refunds. As of March 31, 2006, the Company's liability for taxes payable increased $5,407 as a result of these adjustments. OTHER ADJUSTMENTS (UNRELATED TO STOCK OPTIONS) In addition to the restatement adjustments associated with stock options and income taxes discussed above, the Company's restated consolidated financial statements include an adjustment for fiscal years 2002 through 2006 to reflect the correction of errors related to the recognition of revenue associated with shipments to customers under FOB destination terms and an adjustment to reduce the estimated liability for employee medical claims incurred but not reported at March 31, 2006. The Company improperly recognized revenue for certain customers prior to when title and risk of ownership transferred to the customer. The aggregate impact of these adjustments over the periods affected was a decrease in net revenue of $1,175 and a decrease in net income of $385. The aggregate impact on net income reflects a $498 decrease associated with the net revenue errors and a $113 increase related to the adjustment of the liability for medical claims. The table below reflects the impacts of the restatement adjustments discussed above on the Company's consolidated statements of operations for the periods presented below (in thousands):
CUMULATIVE APRIL 1, 1995 THREE MONTHS ENDED SIX MONTHS ENDED THROUGH CATEGORY OF ADJUSTMENTS: SEPTEMBER 30, 2005 SEPTEMBER 30, 2005 MARCH 31, 2004 - ------------------------ ------------------------ ------------------------ ----------------------- (a) Pretax income impact: Stock-based compensation expense related to measurement date changes (b) $ 232 $ 453 $ 13,626 Payroll tax expense and penalties (b) 675 847 439 Other adjustments 2,595 2,860 1,666 ------------------------ ------------------------ ----------------------- Decrease in pretax income 3,502 4,160 15,731 ------------------------ ------------------------ ----------------------- Income tax impact: Measurement date changes (71) (139) (1,050) Payroll taxes (187) (234) (123) Other income tax adjustments (c) 550 1,040 1,689 Other adjustments (869) (958) (584) ------------------------ ------------------------ ----------------------- Decrease in income tax expense (577) (291) (68) ------------------------ ------------------------ ----------------------- Decrease in net income $ 2,925 $ 3,869 $ 15,663 ======================== ======================== ======================= - --------------------- (a) The cumulative effect of the restatement adjustments from fiscal 1996 through fiscal 2004 is summarized below: STOCK OPTION ADJUSTMENTS OTHER ADJUSTMENTS DECREASE YEARS ENDED ----------------------------- OTHER INCOME ------------------------ (INCREASE) TO MARCH 31, PRETAX INCOME TAX TAX ADJUSTMENTS PRETAX INCOME TAX NET INCOME - ----------- ------------- ------------- ---------------- ---------- ------------- -------------- 1996 $ 829 (d) $ - $ - $ - $ - $ 829 1997 657 (1) - - - 656 1998 2,391 (19) - - - 2,372 1999 535 (27) - - - 508 2000 1,998 (62) - - - 1,936 2001 1,722 (141) - - - 1,581 2002 2,317 (219) - 2,534 (918) 3,714 2003 1,187 (248) - (1,610) 590 (81) 2004 2,429 (456) 1,689 742 (256) 4,148 ------------- ------------- ---------------- ---------- ------------- -------------- Cumulative effect $ 14,065 $ (1,173) $ 1,689 $ 1,666 $ (584) $ 15,663 ============= ============= ================ ========== ============= ============== 13 (b) Stock-based compensation expenses, including related payroll taxes, interest and penalties have been recorded as adjustments to the selling and administrative expenses line item in the Company's consolidated statements of income for each period. (c) This represents liabilities associated with tax positions taken in these periods, partially offset by certain expected tax refunds and is not related to accounting for stock options. (d) Includes additional expense totaling $636, the affect of which on the consolidated financial statements for 1996 and for each year 1986 to 1995 was not material.
Consolidated Statements of Operations Impact The following table reconciles the Company's previously reported results to the restated consolidated statements of operations for the three and six months ended September 30, 2005:
THREE MONTHS ENDED SIX MONTHS ENDED SEPTEMBER 30, 2005 SEPTEMBER 30, 2005 ----------------------------------------- -------------------------------------------- AS AS PREVIOUSLY AS PREVIOUSLY AS REPORTED ADJUSTMENTS RESTATED REPORTED ADJUSTMENTS RESTATED -------- ----------- -------- -------- ----------- -------- Net revenues $ 96,321 $ (3,999) $ 92,322 $ 181,795 $ (4,431) $ 177,364 Cost of sales 34,044 (1,404) 32,640 60,246 (1,571) 58,675 ----------------------------------------- -------------------------------------------- Gross profit 62,277 (2,595) 59,682 121,549 (2,860) 118,689 ----------------------------------------- -------------------------------------------- Operating expenses: Research and development 6,420 - 6,420 14,052 - 14,052 Purchased in-process research and development and transaction costs - - - 30,441 - 30,441 Selling and administrative 36,940 907 37,847 74,299 1,300 75,599 Amortization of intangibles 1,211 - 1,211 2,391 - 2,391 ----------------------------------------- -------------------------------------------- Total operating expenses 44,571 907 45,478 121,183 1,300 122,483 ----------------------------------------- -------------------------------------------- Operating income (loss) 17,706 (3,502) 14,204 366 (4,160) (3,794) ----------------------------------------- -------------------------------------------- Other expense (income): Interest expense 1,467 - 1,467 2,844 - 2,844 Interest and other income (1,077) - (1,077) (2,130) - (2,130) ----------------------------------------- -------------------------------------------- Total other expense 390 - 390 714 - 714 ----------------------------------------- -------------------------------------------- Income (loss) before income taxes 17,316 (3,502) 13,814 (348) (4,160) (4,508) Provision for income taxes 5,801 (577) 5,224 10,081 (291) 9,790 ----------------------------------------- -------------------------------------------- Net income (loss) $ 11,515 $ (2,925) $ 8,590 $ (10,429) $ (3,869) $ (14,298) ========================================= ============================================ Earnings per share: Basic - Class A common $ 0.24 $ (0.06) $ 0.18 $ (0.21) $ (0.08) $ (0.29) Basic - Class B common 0.20 (0.05) 0.15 (0.21) (0.08) (0.29) Diluted - Class A common (a) 0.21 (0.05) 0.16 (0.21) (0.08) (0.29) Diluted - Class B common (a) 0.14 (0.29) Shares used in per share calculation: Basic - Class A common 36,184 (497) (b) 35,687 36,076 (510) (b) 35,566 Basic - Class B common 13,127 (178) (b) 12,949 13,222 (179) (b) 13,043 Diluted - Class A common (a) 59,158 (659) (b) 58,499 49,298 (689) (b) 48,609 Diluted - Class B common (a) 13,135 13,043 (a) In fiscal 2007, the Company began reporting diluted earnings per share for Class B Common Stock under the two-class method which does not assume the conversion of Class B Common Stock into Class A Common Stock. Previously, the Company did not present diluted earnings per share for Class B Common Stock. (b) Adjustment to reflect impact of unrecognized stock-based compensation and excess tax benefits in applying the treasury stock method and unvested stock options in the two-year forfeiture period.
14 Consolidated Balance Sheets Impact The following table reconciles the consolidated balance sheets previously reported as of March 31, 2006 and September 30, 2005 to the restated amounts:
MARCH 31, 2006 ---------------------------------------------------------------- AS PREVIOUSLY AS REPORTED ADJUSTMENTS RESTATED -------- ----------- -------- Current assets: Cash and cash equivalents $ 100,706 $ - $ 100,706 Marketable securities 106,763 - 106,763 Receivables, net 54,746 (1,175) (f) 53,571 Inventories, net 70,778 388 (f) 71,166 Prepaid and other assets 6,963 49 (a) 7,012 Deferred tax asset 8,034 2,038 (b)(c)(f)(g) 10,072 ---------------------------------------------------------------- Total current assets 347,990 1,300 349,290 Property and equipment, net 178,042 - 178,042 Intangible assets and goodwill, net 72,955 - 72,955 Other assets 19,026 - 19,026 ---------------------------------------------------------------- Total assets $ 618,013 $ 1,300 $ 619,313 ================================================================ Current liabilities: Accounts payable $ 17,975 $ - $ 17,975 Accrued liabilities 17,100 7,576 (b)(c)(d)(e)(f)(g) 24,676 Current maturities of long-term debt 1,681 - 1,681 ---------------------------------------------------------------- Total current liabilities 36,756 7,576 44,332 Long-term debt 241,319 - 241,319 Other long-term liabilities 5,442 - 5,442 Deferred tax liability 25,221 - 25,221 ---------------------------------------------------------------- Total liabilities 308,738 7,576 316,314 ---------------------------------------------------------------- Commitments and contingencies - - - Shareholders' equity: Preferred stock - - - Class A Common Stock 400 (3) (d) 397 Class B Common Stock 127 - 127 Additional paid-in capital 129,367 15,813 (b)(d) 145,180 Retained earnings 233,496 (22,086) (a)(b)(c)(e)(f)(g) 211,410 Accumulated other comprehensive income (211) - (211) Less: Treasury stock (53,904) - (53,904) ---------------------------------------------------------------- Total shareholders' equity 309,275 (6,276) 302,999 ---------------------------------------------------------------- Total liabilities and shareholders' equity $ 618,013 $ 1,300 $ 619,313 ================================================================ SEPTEMBER 30, 2005 ---------------------------------------------------------------- AS PREVIOUSLY AS REPORTED ADJUSTMENTS RESTATED -------- ----------- -------- Current assets: Cash and cash equivalents $ 59,144 $ - $ 59,144 Marketable securities 95,185 - 95,185 Receivables, net 69,975 (5,628) (f) 64,347 Inventories, net 58,247 1,999 (f) 60,246 Prepaid and other assets 5,614 34 (a) 5,648 Deferred tax asset 8,891 1,356 (b)(c)(f) 10,247 ---------------------------------------------------------------- Total current assets 297,056 (2,239) 294,817 Property and equipment, net 163,103 - 163,103 Intangible assets and goodwill, net 74,946 - 74,946 Other assets 18,931 - 18,931 ---------------------------------------------------------------- Total assets $ 554,036 $ (2,239) $ 551,797 ================================================================ Current liabilities: Accounts payable $ 12,343 $ - $ 12,343 Accrued liabilities 23,823 5,212 (b)(c)(d)(e)(f) 29,035 Current maturities of long-term debt 973 - 973 ---------------------------------------------------------------- Total current liabilities 37,139 5,212 42,351 Long-term debt 209,281 - 209,281 Other long-term liabilities 5,067 - 5,067 Deferred tax liability 20,011 - 20,011 ---------------------------------------------------------------- Total liabilities 271,498 5,212 276,710 ---------------------------------------------------------------- Commitments and contingencies - - - Shareholders' equity: Preferred stock - - - Class A Common Stock 393 (4) (d) 389 Class B Common Stock 132 - 132 Additional paid-in capital 128,632 14,137 (b)(d) 142,769 Retained earnings 207,315 (21,584) (a)(b)(c)(e)(f) 185,731 Accumulated other comprehensive income (147) - (147) Less: Treasury stock (53,787) - (53,787) ---------------------------------------------------------------- Total shareholders' equity 282,538 (7,451) 275,087 ---------------------------------------------------------------- Total liabilities and shareholders' equity $ 554,036 $ (2,239) $ 551,797 ================================================================ (a) Adjustment for accrued interest associated with certain expected tax refunds. (b) Adjustment for stock-based compensation expense pursuant to APB 25 ($15,632 at March 31, 2006 and $15,158 at September 30, 2005) and related income tax impact ($1,658 at March 31, 2006 and $1,512 at September 30, 2005), partially offset by the net effect of tax benefits realized in accrued taxes ($2,432 at March 31, 2006 and $1,333 at September 30, 2005) and excess tax benefits reflected in paid-in capital ($2,094 at March 31, 2006 and $1,202 at September 30, 2005). (c) Adjustment for payroll taxes, interest and penalties associated with stock-based compensation expense ($3,278 at March 31, 2006 and $1,832 at September 30, 2005) and the related income tax impact ($909 at March 31, 2006 and $508 at September 30, 2005). (d) Adjustment for exercise deposits received by the Company for stock options in the two-year forfeiture period ($1,916 at March 31, 2006 and $2,227 at September 30, 2005). (e) Adjustment for additional liabilities associated with tax positions taken, partially offset by certain expected tax refunds ($5,407 at March 31, 2006 and $4,261 at September 30, 2005). (f) Adjustment to record net revenue and cost of sales when product is received by the customer instead of shipping date for certain customers (decrease in receivables of $1,175 at March 31, 2006 and $5,628 at September 30, 2005; increase in 15 inventories of $388 at March 31, 2006 and $1,999 at September 30, 2005; decrease in deferred tax assets of $125 at March 31, 2006 and $533 at September 30, 2005; decrease in accrued liabilities of $414 at March 31, 2006 and $1,775 at September 30, 2005; and decrease in retained earnings of $498 at March 31, 2006 and $2,387 at September 30, 2005). (g) Adjustment for reduction in estimated liability associated with employee medical claims incurred but not reported (decrease in deferred tax assets of $66; decrease in accrued liabilities of $179; and increase in retained earnings of $113).
Consolidated Statements of Cash Flows Impact The following table reconciles the consolidated statement of cash flows previously reported for the six months ended September 30, 2005 to the restated amounts:
SIX MONTHS ENDED SEPTEMBER 30, 2005 --------------------------------------------------------------------- AS PREVIOUSLY AS REPORTED ADJUSTMENTS RESTATED -------- ----------- -------- Operating Activities: Net loss $ (10,429) $ (3,869) (a)(b)(c)(d)(e) $ (14,298) Adjustments to reconcile net loss to net cash provided by operating activities: Acquired in-process research and development 29,570 - 29,570 Depreciation, amortization and other non-cash charges 8,389 - 8,389 Deferred income tax provision 56 37 (a)(b)(d)(e) 93 Deferred compensation 590 - 590 Stock-based compensation - 453 (a) 453 Changes in operating assets and liabilities: Decrease (increase) in receivables, net (7,614) 4,431 (d) (3,183) Increase in inventories (4,302) (1,570) (d) (5,872) Decrease (increase) in prepaid and other assets 4,156 (24) (c) 4,132 Increase in accounts payable and accrued liabilities 2,422 542 (b)(c)(d)(e) 2,964 --------------------------------------------------------------------- Net cash provided by operating activities 22,838 - 22,838 --------------------------------------------------------------------- Investing Activities: Purchase of property and equipment (36,856) - (36,856) Purchase of marketable securities (49,513) - (49,513) Purchase of preferred stock (11,300) - (11,300) Product acquisition (25,643) - (25,643) --------------------------------------------------------------------- Net cash used in investing activities (123,312) - (123,312) --------------------------------------------------------------------- Financing Activities: Principal payments on long-term debt (486) - (486) Dividends paid on preferred stock (35) - (35) Purchase of common stock for treasury (136) - (136) Cash deposits received for stock options 450 - 450 --------------------------------------------------------------------- Net cash used in financing activities (207) - (207) --------------------------------------------------------------------- Decrease in cash and cash equivalents (100,681) - (100,681) Cash and cash equivalents: Beginning of year 159,825 - 159,825 --------------------------------------------------------------------- End of period $ 59,144 $ - $ 59,144 ===================================================================== - --------------------- (a) Adjustment for stock-based compensation expense pursuant to APB 25 and the related income tax impact. (b) Adjustment for payroll taxes, interest and penalties associated with stock-based compensation expense and the related income tax impact. (c) Adjustment for additional liabilities associated with tax positions taken, partially offset by certain expected tax refunds. (d) Adjustment for revenue recognition errors related to shipments made to certain customers. (e) Adjustment for reduction in estimated liability associated with employee medical claims incurred but not reported.
16 3. ACQUISITION AND LICENSE AGREEMENTS In May 2005, the Company and FemmePharma, Inc. ("FemmePharma") mutually agreed to terminate the license agreement between them entered into in April 2002. 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. Under a separate agreement, the Company had previously invested $5,000 in FemmePharma's convertible preferred stock. 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 acquired worldwide licensing rights of the endometriosis product, no longer is responsible for milestone payments and royalties specified in the original licensing agreement, and secured exclusive worldwide rights for use of the FemmePharma technology for vaginal anti-infective products. During the six months ended September 30, 2005, the Company recorded expense of $30,441 in connection with the FemmePharma acquisition that consisted of $29,570 for acquired in-process research and development and $871 in direct expenses related to the transaction. The acquired in-process research and development charge represented the estimated fair value of the endometriosis product being developed that, at the time of the acquisition, had no alternative future use and for which technological feasibility had not been established. The FemmePharma acquisition expense was determined by the Company to not be deductible for tax purposes. The Company also allocated $375 of the purchase price for a non-compete agreement and $300 of the purchase price for the royalty-free worldwide license to use FemmePharma's technology for vaginal anti-infective products acquired in the transaction. In May 2005, the Company entered into a long-term product development and marketing license agreement with Strides Arcolab Limited ("Strides"), an Indian generic pharmaceutical developer and manufacturer, for exclusive marketing rights in the United States and Canada for ten new generic drugs. Under the agreement, Strides will be responsible for developing, submitting for regulatory approval and manufacturing the ten 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. This investment is denominated in the Indian rupee and is subject to foreign currency transaction gains or losses resulting from exchange rate changes. As a result of changes in the exchange rate, the carrying value of this investment was $10,698 at September 30, 2006. This investment has been accounted for using the cost method and is included in "Other assets" in the accompanying consolidated balance sheet at September 30, 2006. 4. EARNINGS PER SHARE The Company has two classes of common stock: Class A Common Stock and Class B Common Stock that is convertible into Class A Common Stock. With respect to dividend rights, holders of Class A Common Stock are entitled to receive cash dividends per share equal to 120% of the dividends per share paid on the Class B Common Stock. In June 2004, the Company adopted the guidance in Emerging Issues Task Force ("EITF") Issue No. 03-06, "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. 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. Beginning in fiscal 2007, the Company presented diluted earnings per share for Class B Common Stock for all periods using the two-class method which does not assume the conversion of Class B Common Stock into Class A Common Stock. Previously, diluted earnings per share for Class B Common Stock was not presented. The Company continues to present diluted earnings per share for Class A Common Stock using the if-converted method which assumes the conversion of Class B Common Stock into Class A Common Stock, if dilutive. Basic earnings per share is computed using the weighted average number of common shares outstanding during the period except that it does not include unvested common shares subject to repurchase. Diluted earnings per share is computed using the weighted average number of common shares and, if dilutive, potential common shares outstanding during the period. Potential common shares consist of the incremental common shares issuable upon the exercise of stock options, unvested common shares subject to repurchase, convertible preferred stock and the Convertible 17 Subordinated Notes. The dilutive effects of outstanding stock options and unvested common shares subject to repurchase are reflected in diluted earnings (loss) per share by application of the treasury stock method. Convertible preferred stock and the Convertible Subordinated Notes are reflected on an if-converted basis. The computation of diluted earnings (loss) per share for Class A Common Stock assumes the conversion of the Class B Common Stock, while the diluted earnings (loss) per share for Class B Common Stock does not assume the conversion of those shares. The following table sets forth the computation of basic and diluted earnings per share for the three months ended September 30, 2006 and 2005:
THREE MONTHS ENDED THREE MONTHS ENDED SEPTEMBER 30, 2006 SEPTEMBER 30, 2005 --------------------------------- --------------------------------- CLASS A CLASS B CLASS A CLASS B ---------------- ---------------- ---------------- ---------------- (AS RESTATED) Basic earnings per share: Numerator: Allocation of undistributed earnings $ 9,410 $ 2,658 $ 6,583 $ 1,990 ---------------- ---------------- ---------------- ---------------- Denominator: Weighted average shares outstanding 37,066 12,503 36,184 13,127 Less - weighted average unvested common shares subject to repurchase (322) (47) (497) (178) ---------------- ---------------- ---------------- ---------------- Number of shares used in per share computations 36,744 12,456 35,687 12,949 ================ ================ ================ ================ Basic earnings per share $ 0.26 $ 0.21 $ 0.18 $ 0.15 ================ ================ ================ ================ Diluted earnings per share: Numerator: Allocation of undistributed earnings for basic computation $ 9,410 $ 2,658 $ 6,583 $ 1,990 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 2,658 - 1,990 - Reallocation of undistributed earnings to Class B shares - (259) - (134) Add - preferred stock dividends 17 - 17 - Add - interest expense convertible notes 948 - 958 - ---------------- ---------------- ---------------- ---------------- Allocation of undistributed earnings $ 13,033 $ 2,399 $ 9,548 $ 1,856 ================ ================ ================ ================ Denominator: Number of shares used in basic computation 36,744 12,456 35,687 12,949 Weighted average effect of dilutive securities: Conversion of Class B to Class A shares 12,456 - 12,949 - Employee stock options (2) 687 96 833 186 Convertible preferred stock 338 - 338 - Convertible notes 8,692 - 8,692 - ---------------- ---------------- ---------------- ---------------- Number of shares used in per share computations 58,917 12,552 58,499 13,135 ================ ================ ================ ================ Diluted earnings per share (1) $ 0.22 $ 0.19 $ 0.16 $ 0.14 ================ ================ ================ ================ - --------------------- (1) Excluded from the computation of diluted earnings per share were outstanding stock options whose exercise prices were greater than the average market price of the common shares for the period reported. For the three months ended September 30, 2006 and 2005, excluded from the computation were options to purchase 889 and 1,360 shares of Class A and Class B Common Stock, respectively. (2) Includes adjustment to reflect impact of unrecognized stock-based compensation and excess tax benefits in applying the treasury stock method and unvested stock options in the two-year forfeiture period.
18 The following table sets forth the computation of basic and diluted earnings (loss) per share for the six months ended September 30, 2006 and 2005:
SIX MONTHS ENDED SEPTEMBER 30, ----------------------------------------------------------------------- 2006 2005 ------------------------------------ ---------------------------------- CLASS A CLASS B CLASS A CLASS B ----------------- ----------------- ----------------- ---------------- (AS RESTATED) Basic earnings (loss) per share: Numerator: Allocation of undistributed earnings (loss) before cumulative effect of change in accounting principle $ 15,719 $ 4,453 $ (10,487) $ (3,846) Allocation of cumulative effect of change in accounting principle 1,540 436 - - ----------------- ----------------- ----------------- ---------------- Allocation of undistributed earnings (loss) $ 17,259 $ 4,889 $ (10,487) $ (3,846) ================= ================= ================= ================ Denominator: Weighted average shares outstanding 37,005 12,527 36,076 13,221 Less - weighted average unvested common shares subject to repurchase (334) (62) (510) (178) ----------------- ----------------- ----------------- ---------------- Number of shares used in per share computations 36,671 12,465 35,566 13,043 ================= ================= ================= ================ Basic earnings (loss) per share before cumulative effect of change in accounting principle $ 0.43 $ 0.36 $ (0.29) $ (0.29) Per share effect of cumulative effect of change in accounting principle 0.04 0.03 - - ----------------- ----------------- ----------------- ---------------- Basic earnings (loss) per share $ 0.47 $ 0.39 $ (0.29) $ (0.29) ================= ================= ================= ================ Diluted earnings (loss) per share: Numerator: Allocation of undistributed earnings (loss) for basic computation before cumulative effect of change in accounting principle $ 15,719 $ 4,453 $ (10,487) $ (3,846) Reallocation of undistributed earnings (loss) as a result of conversion of Class B to Class A shares 4,453 - (3,846) - Reallocation of undistributed earnings to Class B shares - (372) - - Add - preferred stock dividends 35 - - - Add - interest expense convertible notes 1,888 - - - ----------------- ----------------- ----------------- ---------------- Allocation of undistributed earnings (loss) for diluted computation before cumulative effect of change in accounting principle 22,095 4,081 (14,333) (3,846) Allocation of cumulative effect of change in accounting principle 1,976 365 - - ----------------- ----------------- ----------------- ---------------- Allocation of undistributed earnings (loss) $ 24,071 $ 4,446 $ (14,333) $ (3,846) ================= ================= ================= ================ (CONTINUED) 19 SIX MONTHS ENDED SEPTEMBER 30, ---------------------------------------------------------------------- 2006 2005 ---------------------------------- ---------------------------------- CLASS A CLASS B CLASS A CLASS B ----------------- --------------- ---------------- ---------------- (AS RESTATED) Diluted earnings (loss) per share (continued): Denominator: Number of shares used in basic computation 36,671 12,465 35,566 13,043 Weighted average effect of dilutive securities: Conversion of Class B to Class A shares 12,465 - 13,043 - Employee stock options (2) 716 122 - - Convertible preferred stock 338 - - - Convertible notes 8,692 - - - ----------------- --------------- ---------------- ---------------- Number of shares used in per share computations 58,882 12,587 48,609 13,043 ================= =============== ================ ================ Diluted earnings (loss) per share before cumulative effect of change in accounting principle $ 0.38 $ 0.32 $ (0.29) $ (0.29) Per share effect of cumulative effect of change in accounting principle 0.03 0.03 - - ----------------- --------------- ---------------- ---------------- Diluted earnings (loss) per share (1) $ 0.41 $ 0.35 $ (0.29) $ (0.29) ================= =============== ================ ================ - --------------------- (1) Excluded from the computation of diluted earnings per share were outstanding stock options whose exercise prices were greater than the average market price of the common shares for the period reported. For the six-months ended September 30, 2006, excluded from the computation were options to purchase 908 shares of Class A and Class B Common Stock. For the six months ended September 30, 2005, there were stock options to purchase 3,856 shares of Class A and Class B Common Stock, preferred shares convertible into 338 shares of Class A Common Stock and $200,000 principal amount of Convertible Subordinated Notes convertible into 8,692 shares of Class A Common Stock that were excluded from the computation of diluted loss per share because their effect would have been anti-dilutive. (2) Includes adjustment to reflect impact of unrecognized stock-based compensation and excess tax benefits in applying the treasury stock method and unvested stock options in the two-year forfeiture period.
5. STOCK-BASED COMPENSATION Effective April 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), "Share-Based Payment" ("SFAS 123R"), which requires the measurement and recognition of compensation expense, based on estimated fair values, for all share-based compensation awards made to employees and directors over the vesting period of the awards. The Company adopted SFAS 123R using the modified prospective method and, as a result, did not retroactively adjust results from prior periods. Under the modified prospective method, stock-based compensation was recognized (1) for the unvested portion of previously issued awards that were outstanding at the initial date of adoption based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123, "Accounting for Stock-Based Compensation," and (2) for any awards granted or modified on or subsequent to the effective date of SFAS 123R based on the grant date fair value estimated in accordance with the provisions of this statement. Prior to the adoption of SFAS 123R, the Company measured compensation expense for its employee stock-based compensation plans using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25 ("APB 25"). The Company also applied the disclosure provisions of SFAS 123, as amended by SFAS 148, as if the fair-value-based method had been applied in measuring compensation expense. Under APB 25, compensation cost for stock options was recognized based on the excess, if any, of the quoted market price of the stock at the grant date of the award or other measurement date over the amount an employee must pay to acquire the stock. Determining the fair value of share-based awards at the grant date requires judgment to identify the appropriate valuation model and estimate the assumptions, including the expected term of the stock options and expected stock-price volatility, to be used in the calculation. Judgment is also required in estimating the percentage of share-based awards that are expected to be forfeited. The Company estimated the fair value of stock options granted using the Black-Scholes option pricing model with assumptions based primarily on historical data. If actual results differ significantly from these estimates, stock-based compensation expense and the Company's results of operations could be materially impacted. 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 4,500 shares of common stock. Under the Company's stock option plan, options 20 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 ten years and the options vest at the rate of 10% per year from the date of grant. The Company estimates the fair value of stock options granted using the Black-Scholes option pricing model (the "Option Model"). The Option Model requires the use of subjective and complex assumptions, including the option's expected term and the estimated future price volatility of the underlying stock, which determine the fair value of the share-based awards. The Company's estimate of expected term was determined based on the average period of time that options granted are expected to be outstanding considering current vesting schedules and the historical exercise patterns of existing option plans and the two-year forfeiture period. The expected volatility assumption used in the Option Model is based on historical volatility over a period commensurate with the expected term of the related options. The risk-free interest rate used in the Option Model is based on the yield of U.S. Treasuries with a maturity closest to the expected term of the Company's stock options. The Company's stock option agreements include a post-exercise service condition which provides that exercised options are to be held by the Company for a two-year period during which time the shares can not be sold by the employee. If the employee terminates employment voluntarily or involuntarily (other than by retirement, death or disability) during the two-year period the stock option agreements provide the Company with the option of repurchasing the shares at the lower of the exercise price or the fair market value of the stock on the date of termination. This repurchase option is considered a forfeiture provision and the two-year period is included in determining the requisite service period over which stock-based compensation expense is recognized. The requisite service period initially is equal to the expected term (as discussed above) plus two years and is revised when an option exercise occurs. If stock options expire unexercised or an employee terminates employment after options become exercisable, no compensation expense associated with the exercisable, but unexercised options, is reversed. In those instances where an employee terminates employment before options become exercisable or the Company repurchases the shares during the two-year forfeiture period, compensation expense for these options is reversed as a forfeiture. When an employee exercises stock options, the exercise proceeds received by the Company are recorded as a deposit and classified as a current liability for the two-year forfeiture period. These options are accounted for as issued shares when the two-year forfeiture period lapses. Until the two-year forfeiture requirement is met, the underlying shares are not considered outstanding and not included in calculating basic earnings (loss) per share. In accordance with the provisions of SFAS 123R, share-based compensation expense recognized during a period is based on the value of the portion of share-based awards that are expected to vest with employees. Accordingly, the recognition of share-based compensation expense beginning April 1, 2006 has been reduced for estimated future forfeitures. SFAS 123R requires forfeitures to be estimated at the time of grant with adjustments recorded in subsequent period compensation expense if actual forfeitures differ from those estimates. Prior to implementing SFAS 123R, the Company accounted for forfeitures as they occurred for the disclosure of pro forma information presented in the Notes to Consolidated Financial Statements for prior periods. Upon adoption of SFAS 123R on April 1, 2006, the Company recognized the cumulative effect of a change in accounting principle to reflect the effect of estimated forfeitures related to outstanding awards that are not expected to vest as of the adoption date. The cumulative adjustment increased net income for the six months ended September 30, 2006 by $1,976, net of tax, and increased diluted earnings per share for Class A and Class B shares by $0.03 and $0.03, respectively. The Company recognized, in accordance with SFAS 123R, stock-based compensation of $983 and $1,919, respectively, and related tax benefits of $294 and $570, respectively, for the three and six months ended September 30, 2006. As a result of the restatement discussed in Note 2, stock-based compensation totaling $232 and $453 and related tax benefits of $71 and $139 were recognized during the three and six months ended September 30, 2005, respectively. There was no stock-based employee compensation cost capitalized as of September 30, 2006. Cash received from stock option deposits was $1,988 and $351 for the three months ended September 30, 2006 and 2005, respectively, and $2,420 and $450 for the six months ended September 30, 2006 and 2005, respectively. The actual tax benefit realized from tax deductions associated with stock option exercises (at expiration of two-year forfeiture period) was $145 and $492 for the three months ended September 30, 2006 and 2005, respectively, and $423 and $610 for the six months ended September 30, 2006 and 2005, respectively. 21 The following weighted average assumptions were used for stock options granted during the three and six months ended September 30, 2006 and 2005:
THREE MONTHS ENDED SIX MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------ ---------------- 2006 2005 2006 2005 ---- ---- ---- ---- (AS RESTATED) (AS RESTATED) Dividend yield............................... None None None None Expected volatility.......................... -- 48% 46% 48% Risk-free interest rate...................... -- 4.93% 4.93% 4.93% Expected term ............................... -- 9.0 years 9.0 years 9.0 years Weighted average fair value per share at grant date.............................. -- $ 11.37 $ 11.34 $ 10.60
A summary of the changes in the Company's stock option plan during the six months ended September 30, 2006 is presented below (in thousands, except per share amounts):
WEIGHTED WEIGHTED AVERAGE AVERAGE REMAINING AGGREGATE EXERCISE CONTRACTUAL INTRINSIC SHARES PRICE TERM VALUE ------ ----- ---- ----- Balance, March 31, 2006 (as restated)...... 3,926 $ 14.71 Options granted............................ 229 18.66 Options exercised.......................... (302) 9.33 $ 3,666 Options canceled........................... (195) 15.57 ----------- Balance, September 30, 2006................ 3,658 15.36 5.3 $ 20,516 =========== Vested and expected to vest at September 30, 2006.................... 2,834 $ 15.36 5.3 $ 15,900 Options exercisable at September 30, 2006 (excluding shares in the two-year forfeiture period).... 1,491 $ 14.31 4.0 $ 14,320
As of September 30, 2006, the Company had $34,119 of total unrecognized compensation expense related to stock option grants, which will be recognized over the remaining weighted average period of 5.2 years. 22 Prior to April 1, 2006, the Company determined stock-based compensation expense using the intrinsic value method of APB 25 and provided the disclosures required by SFAS 123, as amended by SFAS 148. The following table illustrates the effect of the restatement adjustments on the Company's pro forma net income and pro forma earnings per share as if the Company had applied the fair value recognition provisions of SFAS 123 to options granted under the Company's stock option plans:
THREE MONTHS ENDED SIX MONTHS ENDED SEPTEMBER 30, 2005 SEPTEMBER 30, 2005 ------------------------------------- -------------------------------------- AS AS PREVIOUSLY AS PREVIOUSLY AS REPORTED ADJUSTMENTS RESTATED REPORTED ADJUSTMENTS RESTATED -------- ----------- -------- -------- ----------- -------- Net income (loss) $ 11,515 $ (2,925) $ 8,590 $ (10,429) $ (3,869) $ (14,298) Add: Stock-based compensation expense included in reported net income, net of tax - 161 161 - 314 314 Deduct: Stock-based compensation using the fair value based method for all awards (132) (490) (622) (262) (1,013) (1,275) ------------------------------------- -------------------------------------- Pro forma net income (loss) $ 11,383 $ (3,254) $ 8,129 $ (10,691) $ (4,568) $ (15,259) ===================================== ====================================== Earnings (loss) per share: Basic - Class A common $ 0.24 $ (0.06) $ 0.18 $ (0.21) $ (0.08) $ (0.29) Basic - Class B common 0.20 (0.05) 0.15 (0.21) (0.08) (0.29) Diluted - Class A common 0.21 (0.05) 0.16 (0.21) (0.08) (0.29) Diluted - Class B common 0.14 (0.29) Earnings (loss) per share - pro forma: Basic - Class A common $ 0.24 $ (0.07) $ 0.17 $ (0.22) $ (0.09) $ (0.31) Basic - Class B common 0.20 (0.05) 0.15 (0.22) (0.09) (0.31) Diluted - Class A common 0.21 (0.05) 0.16 (0.22) (0.09) (0.31) Diluted - Class B common 0.13 (0.31)
6. 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. 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. 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. 23 Accruals for sales provisions are presented in the consolidated financial statements as reductions to net revenues and accounts receivable. Sales provisions totaled $36,224 and $40,184 (as restated) for the three months ended September 30, 2006 and 2005, respectively, and $72,194 and $77,230 (as restated) for the six months ended September 30, 2006 and 2005, respectively. The reserve balances related to the sales provisions totaled $31,476 and $28,697 (as restated) at September 30, 2006 and March 31, 2006, respectively, and are included in "Receivables, less allowance for doubtful accounts" in the accompanying consolidated balance sheets. 7. INVENTORIES Inventories consist of the following:
SEPTEMBER 30, 2006 MARCH 31, 2006 ------------------ -------------- (AS RESTATED) Finished goods..................... $ 30,606 $ 29,365 Work-in-process.................... 10,268 7,969 Raw materials...................... 35,623 33,832 ----------- ----------- $ 76,497 $ 71,166 =========== ===========
Management establishes reserves for potentially obsolete or slow-moving inventory based on an evaluation of inventory levels, forecasted demand and market conditions. 8. INTANGIBLE ASSETS AND GOODWILL Intangible assets and goodwill consist of the following:
SEPTEMBER 30, 2006 MARCH 31, 2006 ---------------------------- ----------------------------- GROSS GROSS CARRYING ACCUMULATED CARRYING ACCUMULATED AMOUNT AMORTIZATION AMOUNT AMORTIZATION -------- ------------ -------- ------------ Product rights - Micro-K(R)................ $ 36,140 $ (13,611) $ 36,140 $ (12,708) Product rights - PreCare(R)................ 8,433 (3,022) 8,433 (2,811) Trademarks acquired: Niferex(R)............................ 14,834 (2,596) 14,834 (2,225) Chromagen(R)/StrongStart(R)........... 27,642 (4,837) 27,642 (4,147) License agreements......................... 4,400 (390) 4,400 (300) Covenant not to compete.................... 375 (53) 375 (34) Trademarks and patents..................... 3,913 (718) 3,403 (604) ----------- --------- ----------- --------- Total intangible assets.................. 95,737 (25,227) 95,227 (22,829) Goodwill................................... 557 - 557 - ----------- --------- ----------- --------- $ 96,294 $ (25,227) $ 95,784 $ (22,829) =========== ========= =========== =========
As of September 30, 2006, the Company's intangible assets have a weighted average useful life of approximately 19 years. Amortization expense for intangible assets was $1,201 and $1,211 for the three months ended September 30, 2006 and 2005, respectively, and $2,398 and $2,391 for the six months ended September 30, 2006 and 2005, respectively. Assuming no additions, disposals or adjustments are made to the carrying values and/or useful lives of the intangible assets, annual amortization expense on product rights, trademarks acquired and other intangible assets is estimated to be approximately $2,400 for the remainder of fiscal 2007 and approximately $4,800 in each of the four succeeding fiscal years. 24 9. REVOLVING CREDIT AGREEMENT On June 9, 2006, the Company replaced its $140,000 credit line by entering into a new syndicated credit agreement with ten banks that provides for a revolving line of credit for borrowing up to $320,000. The new credit agreement also includes a provision for increasing the revolving commitment, at the lenders' sole discretion, by up to an additional $50,000. The new credit facility is unsecured unless the Company, under certain specified circumstances, utilizes the facility to redeem part or all of its outstanding Convertible Subordinated Notes. Interest is charged under the facility at the lower of the prime rate or LIBOR plus 62.5 to 150 basis points depending on the ratio of senior debt to EBITDA. The new credit agreement contains financial covenants that impose limits on dividend payments, require minimum equity, a maximum senior leverage ratio and minimum fixed charge coverage ratio. The new credit facility has a five-year term expiring in June 2011. As of September 30, 2006, there were no borrowings outstanding under the new credit facility. 10. LONG-TERM DEBT Long-term debt consists of the following:
SEPTEMBER 30, 2006 MARCH 31, 2006 ------------------ -------------- Building mortgages.......................... $ 42,269 $ 43,000 Convertible notes........................... 200,000 200,000 ----------- ---------- 242,269 243,000 Less current portion........................ (1,848) (1,681) ----------- ---------- $ 240,421 $ 241,319 =========== ==========
In March 2006, the Company entered into a $43,000 mortgage loan agreement with one of its primary lenders, in part, to refinance $9,859 of existing mortgages. The $32,764 of net proceeds the Company received from this mortgage loan was used for working capital and general corporate purposes. The mortgage loan, which is secured by three of the Company's buildings, bears interest at a rate of 5.91% and matures on April 1, 2021. 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 of May 15, 2006, the average trading price of the Notes had not reached the price that would result in the payment of contingent interest. 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 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: 25 * 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; * if the Company has called the Notes for redemption; * 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 * upon the occurrence of specified corporate transactions. The Company has reserved 8,692 shares of Class A Common Stock for issuance in the event the Notes are converted into the Company's common shares. Certain conversion features of the Notes and the contingent interest feature meet the criteria of and qualify as embedded derivatives. Although these features represent embedded derivative financial instruments, based on the de minimis value of them at the time of issuance and at September 30, 2006, no value has been assigned to these embedded derivatives. 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. 11. TAXABLE INDUSTRIAL REVENUE BONDS In December 2005, the Company entered into a financing arrangement with St. Louis County, Missouri related to expansion of its operations in St. Louis County. Up to $135,500 of industrial revenue bonds may be issued to the Company by St. Louis County relative to capital improvements made through December 31, 2009. This agreement provides that 50% of the real and personal property taxes on up to $135,500 of capital improvements will be abated for a period of ten years subsequent to the property being placed in service. Industrial revenue bonds totaling $73,000 were outstanding at September 30, 2006. The industrial revenue bonds are issued by St. Louis County to the Company upon its payment of qualifying costs of capital improvements, which are then leased by the Company for a period ending December 1, 2019, unless earlier terminated. The Company has the option at any time to discontinue the arrangement and regain full title to the abated property. The industrial revenue bonds bear interest at 4.25% per annum and are payable as to principal and interest concurrently with payments due under the terms of the lease. The Company has classified the leased assets as property and equipment and has established a capital lease obligation equal to the outstanding principal balance of the industrial revenue bonds. Lease payments may be made by tendering an equivalent portion of the industrial revenue bonds. As the capital lease payments to St. Louis County may be satisfied by tendering industrial revenue bonds (which is the Company's intention), the capital lease obligation, industrial revenue bonds and related interest expense and interest income, respectively, have been offset for presentation purposes in the Consolidated Financial Statements. 12. COMPREHENSIVE INCOME (LOSS) Comprehensive income (loss) includes all changes in equity during a period except those that resulted from investments by or distributions to the Company's shareholders. Other comprehensive income refers to revenues, expenses, gains and losses that, under generally accepted accounting principles, are included in comprehensive income, but excluded from net income (loss) as these amounts are recorded directly as an adjustment to shareholders' equity. For the Company, comprehensive income (loss) is comprised of net income (loss) and the net changes in unrealized gains and losses on available for sale marketable securities, net of applicable income taxes. Total comprehensive income (loss) totaled $12,158 and $8,576 (as restated) for the three months ended September 30, 2006 and 2005, respectively, and $22,224 and $(14,312) (as restated) for the six months ended September 30, 2006 and 2005, respectively. 26 13. SEGMENT REPORTING The reportable operating segments of the Company are branded products, specialty generics and specialty materials. The branded products segment includes patent-protected products and certain trademarked off-patent products that the Company sells and markets as branded pharmaceutical products. The specialty generics segment includes off-patent pharmaceutical products that are therapeutically equivalent to proprietary products. The Company sells its branded 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 facilities including manufacturing and distribution property and equipment, intangible and other assets and all income tax related assets. The following presents information for the Company's reportable operating segments for the three and six months ended September 30, 2006 and 2005.
THREE MONTHS ENDED BRANDED SPECIALTY SPECIALTY ALL SEPTEMBER 30, PRODUCTS GENERICS MATERIALS OTHER ELIMINATIONS CONSOLIDATED ------------- -------- -------- --------- ----- ------------ ------------ Net revenues 2006 $47,828 $56,926 $3,780 $ 449 $ - $ 108,983 2005 (as restated) 32,563 55,398 4,101 260 - 92,322 Segment profit (loss) 2006 22,212 28,523 277 (31,357) - 19,655 2005 (as restated) 9,094 27,225 803 (23,308) - 13,814 Identifiable assets - at period-end 2006 28,244 72,528 8,182 546,803 (1,158) 654,599 2005 (as restated) 25,003 71,256 8,835 447,861 (1,158) 551,797 Property and equipment additions 2006 - - - 3,139 - 3,139 2005 3 43 25 14,393 - 14,464 Depreciation and amortization 2006 178 85 40 5,377 - 5,680 2005 147 80 42 4,229 - 4,498
27
SIX MONTHS ENDED BRANDED SPECIALTY SPECIALTY ALL SEPTEMBER 30, PRODUCTS GENERICS MATERIALS OTHER ELIMINATIONS CONSOLIDATED ------------- -------- -------- --------- ----- ------------ ------------ Net revenues 2006 $90,142 $105,327 $8,661 $ 1,053 $ - $ 205,183 2005 (as restated) 64,754 102,768 8,953 889 - 177,364 Segment profit (loss) 2006 40,214 52,386 1,322 (60,932) - 32,990 2005 (as restated) 21,256 51,681 1,984 (79,429) - (4,508) Property and equipment additions 2006 93 - - 18,246 - 18,339 2005 124 43 216 36,473 - 36,856 Depreciation and amortization 2006 355 169 81 10,443 - 11,048 2005 286 151 82 7,870 - 8,389
Consolidated revenues are principally derived from customers in North America and substantially all property and equipment is located in the St. Louis, Missouri metropolitan area. 14. CONTINGENCIES - LITIGATION The Company is named as a defendant a patent infringement case filed in the U.S. District Court for the District of New Jersey by Janssen, L.P., Janssen Pharmaceutica N.V. and Ortho-McNeil Neurologics, Inc. (collectively, "Janssen") on December 14, 2007 and styled Janssen, L.P. et al. v. KV Pharmaceutical Company. After the Company filed an ANDA with the FDA seeking permission to market a generic version of the 8 mg and 16 mg strengths of Razadyne(R) ER (formerly Reminyl(R)) galantamine hydrobromide extended-release capsules, Janssen filed these lawsuits for patent infringement under a patent owned by Janssen. In the Company's Paragraph IV certification, KV contended that its proposed generic versions do not infringe Janssen's patent. 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 an answer and counterclaim for declaratory judgment of non-infringement and patent invalidity. The case is just commencing and no trial date has yet been set. The Company intends to vigorously defend its interests; however, it cannot give any assurance that it will prevail. The Company is named as a defendant in a patent infringement case filed in the U.S. District Court for the District of New Jersey by Celgene Corporation ("Celgene") and Novartis Pharmaceuticals Corporation and Novartis Pharma AG (collectively, "Novartis") on October 4, 2007 and styled Celgene Corporation et al. v. KV Pharmaceutical Company. After the Company filed an ANDA with the FDA seeking permission to market a generic version of the 10 mg, 20 mg, 30 mg, and 40 mg strengths of Ritalin LA(R) methylphenidate hydrochloride extended-release capsules, Celgene and Novartis filed this lawsuit for patent infringement under the provisions of the Hatch-Waxman Act with respect to two patents owned by Celgene and licensed to Novartis. In the Company's Paragraph IV certification, KV contended that its proposed generic versions do not infringe Celgene's patents. We believe we were the first company to file with the FDA for generic approval of the 10mg dosage strength of Ritalin LA(R), a position that may, upon approval, afford as the opportunity for a six-month exclusivity period for marketing this generic version. 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 been served with this complaint and has filed its answer and a counterclaim in the case, seeking a declaratory judgment of non-infringement, patent invalidity, and inequitable conduct in obtaining the patents. The case is just commencing and no trial date has yet been set. The Company intends to vigorously defend its interests; however, it cannot give any assurance that it will prevail. The Company is named as a defendant in a patent infringement case brought by Purdue Pharma L.P., The P.F. Laboratories, Inc., and Purdue Pharmaceuticals L.P. ("Purdue") on January 17, 2007 against it and an unrelated third party and styled Purdue Pharma L.P. et al. v. KV Pharmaceutical Company et al. filed in the U.S. District Court for the District of Delaware. After the Company filed an ANDA with the FDA seeking permission to market a generic version of the 10 mg, 20 mg, 40 mg, and 80 mg strengths of OxyContin(R) in extended-release tablet form, Purdue filed a 28 lawsuit against KV for patent infringement under the provisions of the Hatch-Waxman Act with respect to three Purdue patents. We belive we were the first company to file with the FDA for generic approval of the 30 mg and 60 mg dosage strengths of OxyContin(R), a position that may, upon approval, afford us the opportunity for a six-month exclusivity period for marketing these generic versions. In the Company's Paragraph IV certification, KV contended that its proposed generic versions do not infringe Purdue's patents. On February 12, 2007, a second patent infringement lawsuit was filed in the same court against the Company by Purdue, asserting patent infringement under the same three patents with respect to the Company's filing of an amendment to its ANDA with FDA to sell a generic equivalent of Purdue's OxyContin(R), 30 mg and 60 mg strengths, products. On June 6, 2007, a third patent infringement lawsuit was filed against the Company by Purdue in the U.S. District Court for the Southern District of New York, asserting patent infringement under the same three patents with respect to the Company's filing of an amendment to its ANDA with FDA to sell a generic equivalent of Purdue's OxyContin(R), 15 mg strength, product. The two lawsuits filed in federal court in Delaware have been transferred to the federal court in New York for multi-district litigation purposes together with an additional lawsuit by Purdue against another unrelated company, also in federal court in New York. Purdue currently has a similar lawsuit pending against an additional unrelated company in federal court in Delaware. The Company filed answers and counterclaims against Purdue in all three lawsuits, asserting various defenses to Purdue's claims; seeking declaratory relief of the invalidity, unenforceability and non-infringement of the Purdue patents; and asserting counterclaims against Purdue for violations of federal antitrust law, including Sherman Act Section 1 and Section 2 for monopolization, attempt to monopolize, and conspiracy to monopolize with respect to the U.S. market for controlled-release oxycodone, and agreements in unreasonable restraint of competition, and for intentional interference with valid business expectancy. Purdue has filed replies to the Company's counterclaims. 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 court initially stayed all proceedings pending determining whether Purdue committed inequitable conduct in its dealings with the U.S. Patent and Trademark Office with respect to the issuance of its patents, which would render such patents unenforceable, and the court's subsequent decision on the issue. On January 7, 2008, the court issued its decision finding that Purdue had not committed inequitable conduct with respect to the patents in suit. Discovery in the suit has not yet commenced but is expected to commence shortly. No trial date has yet been set. The Company intends to vigorously defend its interests; however, it cannot give any assurance that it will prevail. 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 U.S. District Court in Minnesota. CIMA alleged that the Company and ETHEX infringed on a CIMA patent in connection with the manufacture and sale of Hyoscyamine Sulfate Orally Dissolvable Tablets, 0.125 mg. The court has entered a stay pending the outcome of the U.S. Patent and Trademark Office's reexamination of a patent at issue in the suit. The Patent and Trademark Office has, to date, issued a final office action rejecting all existing and proposed new claims by CIMA with respect to this patent. CIMA has certain rights of appeal of this rejection of its claims and has exercised those rights. ETHEX will continue to market the product during the stay. The Company intends to vigorously defend its interests if and when the stay is lifted; however, it cannot give any assurance it will prevail. The Company and ETHEX were named as defendants in a case brought by Solvay Pharmaceuticals, Inc. and styled Solvay Pharmaceuticals, Inc. v. ETHEX Corporation, filed in U.S. District Court in Minnesota. In general, Solvay alleged 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. The court has previously entered an order granting in part, and denying in part, the Company's motion for partial summary judgment on certain of plaintiff's allegations of violations of the Lanham Act, and an order denying a second motion by the Company for partial summary judgment on plaintiff's remaining allegations under the Lanham Act and state law. Settlement discussions required by federal court processes were not fruitful. Trial took place in federal court in Minneapolis and on March 6, 2007, the jury held for the Company and ETHEX on all counts and the complaint has been dismissed. The time for appeal by Solvay has now passed. The Company and ETHEX are named as defendants in a case brought by Axcan ScandiPharm Inc. and styled Axcan ScandiPharm Inc. v. ETHEX Corporation et. al., filed in U.S. District Court in Minnesota on June 1, 2007. In general, Axcan alleges that ETHEX's comparative promotion of its Pangestyme(TM) UL12 and Pangestyme(TM) UL18 products to Axcan's Ultrase(R) MT12 and Ultrase(R) MT18 products resulted in false advertising and misleading statements under various federal and state laws, and constituted unfair and deceptive trade practices. The Company filed a motion for 29 judgment on the pleadings in its favor on several grounds. The motion has been granted in part and denied in part by the court on October 19, 2007, with the court applying the statute of limitations to cut off Axcan's claims concerning conduct prior to June 2001, determining that it was too early to determine whether laches or res judicata barred the suit, and rejecting the remaining bases for dismissal. Discovery has since commenced and a trial date has been set for January 2010. The Company intends to vigorously defend its interests; however, it cannot give any assurance that it will prevail. The Company has 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 phenylpropanolamine, or 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 again in 2004, 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. 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 in the event of such future litigation; 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 25 mg, 50 mg, 100 mg, and 200 mg strengths of Toprol-XL(R) 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 filed motions for summary judgment with the United States District Court in Missouri alleging, among other things, that AstraZeneca's patent is invalid and unenforceable. These motions were granted and AstraZeneca appealed. On July 23, 2007, the Court of Appeals for the Federal Circuit affirmed the decision of the District Court below with respect to the invalidity of AstraZeneca's patent but reversed and remanded with respect to inequitable conduct by AstraZeneca. AstraZeneca filed for rehearing by the Federal Circuit, which was denied and the time has now run with respect to any petition for certiorari to the United States Supreme Court. As a result, the Company no longer faces the prospect of any liability to AstraZeneca in connection with this lawsuit. KV is, however, proceeding with its counterclaim against AstraZeneca for inequitable conduct in obtaining the patents that have been ruled invalid, in order to recover the Company's defense costs, including legal fees; 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 States of Massachusetts, Alabama, Mississippi, Utah and Iowa, New York City, and approximately 45 counties in New York State. The State of Mississippi effectively voluntarily dismissed the Company and ETHEX without prejudice on October 5, 2006 by virtue of the State's filing an Amended Complaint on such date that does not name either the Company or ETHEX as a defendant. In the remaining cases, only ETHEX is a named defendant. On August 13, 2007, ETHEX settled the Massachusetts lawsuit for $575 in cash and $150 in free pharmaceuticals over the next two years and received a general release; no admission of liability was made. The New York City case and all New York county cases (other than the Erie, Oswego and Schenectady County cases) have been transferred to the U.S. District Court for the District of Massachusetts for coordinated or consolidated pretrial proceedings under the Average Wholesale Price Multidistrict 30 Litigation (MDL No. 1456). The cases pertaining to the State of Alabama, Erie County, Oswego County, and Schenectady County were removed to federal court by a co-defendant in October 2006, but all of these cases have since been remanded to the state courts in which they originally were filed. A motion is pending in New York state courts to coordinate the Oswego, Erie and Schenectady Counties cases. Each of these actions is in the early stages, with fact discovery commencing or ongoing in the Alabama case and the federal cases involving New York City and 42 New York counties. On October 24, 2007, ETHEX was served with a complaint filed in Utah state court by the State of Utah naming it and nine other pharmaceutical companies as defendants in a pricing suit. On November 19, 2007, the State of Utah filed an amended complaint. The Utah suit has been removed to federal court and a motion has been filed to transfer the case to the MDL litigation for pretrial coordination. The State is seeking to remand the case to state court, and the decision is pending before the court. The time for ETHEX to answer or respond to the Utah complaint has not yet run. On October 9, 2007, the State of Iowa filed a complaint in federal court in Iowa naming ETHEX and 77 other pharmaceutical companies as defendants in a pricing suit. ETHEX and the other defendants have filed a motion to dismiss the Iowa complaint. 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 assurance that it would prevail if legal actions are instituted by these governmental entities. The Company and ETHEX were named as co-defendants in a suit in the U.S. District Court for the Southern District of Florida filed by the personal representative of the estate of Joyce Hoyle and her children in connection with Ms. Hoyle's death in 2003, allegedly from oxycodone toxicity styled Thomas Hoyle v. Purdue Pharma et al. The suit alleged that between June 2001 and May 2003 Ms. Hoyle was prescribed and took three different opiate pain medications manufactured and sold by the defendants, including one product, oxycodone, that was manufactured by the Company and marketed by ETHEX, and that such medications were promoted without sufficient warnings about the side effect of addiction. The causes of action were strict liability for an inherently dangerous product, negligence, breach of express and implied warranty and breach of implied warranty of fitness for a particular purpose. The discovery process had not yet begun, and the court had set the trial to commence in July 2007. The plaintiff and the Company agreed, however, to a tolling agreement, under which the plaintiff dismissed the case without prejudice in return for the Company's agreement to toll the statute of limitations in the event the plaintiff refiled its case in the future. The case was dismissed without prejudice. On January 18, 2008, the Company and ETHEX were served with a new complaint, substantially similar to the earlier law suit. KV and ETHEX have filed an answer to the new complaint. The Company intends to vigorously defend its interests; however, it cannot give any assurance that it will prevail. On September 15, 2006, a shareholder derivative suit, captioned Fuhrman v. Hermelin et al., was filed in state court in St. Louis, Missouri against the Company, as nominal defendant, and seven present or former officers and directors, alleging that defendants had breached their fiduciary duties and engaged in unjust enrichment in connection with the granting, dating, expensing and accounting treatment of past grants of stock options between 1995 and 2002 to six current or former directors or officers. Relief sought included damages, disgorgement of backdated stock options and their proceeds, attorneys' fees, and equitable relief. On February 26, 2007, the Fuhrman lawsuit was dismissed without prejudice by the plaintiff in state court, and a lawsuit, captioned Krasick v. Hermelin et al., was filed in the U.S. District Court for the Eastern District of Missouri by the same law firms as in the Fuhrman lawsuit, with a different plaintiff. The Krasick lawsuit was also a shareholder derivative suit filed against the Company, as nominal defendant, and 19 present or former officers and directors. The complaint asserted within its fiduciary duties claims allegations that the officers and/or directors of KV improperly (including through collusion and aiding and abetting) backdated stock option grants in violation of shareholder-approved plans, improperly recorded and accounted for the allegedly backdated options in violation of GAAP, improperly took tax deductions under the Internal Revenue Code, disseminated and filed false financials and false SEC filings in violation of federal securities laws and rules thereunder, and engaged in insider trading and misappropriation of information. Relief sought included damages, a demand for accounting and recovery of the benefits allegedly improperly received, rescission of the allegedly backdated stock options and disgorgement of their proceeds, and reasonable attorney's fees, in addition to equitable relief, including an injunction to require the Company to change certain of its corporate governance and internal control procedures. On May 11, 2007, the Company learned of the filing of another lawsuit, captioned Gradwell v. Hermelin et al., also in the U.S. District Court for the Eastern District of Missouri. The complaint was brought by the same law firms that brought 31 the Krasick litigation and was substantively the same as in the Krasick litigation, other than being brought on behalf of a different plaintiff and eliminating one individual defendant from the suit. On July 18, 2007, the Krasick and Gradwell suits were refiled as a consolidated action in U.S. District Court for the Eastern District of Missouri, styled in re K-V Pharmaceutical Company Derivative Litigation, which was substantively the same as the Krasick and Gradwell suits. The Company has moved to terminate the litigation based on a determination by members of a Special Committee of the Board of Directors, as described more fully in Note 2, that continuation of the litigation was not in the best interest of KV and its shareholders. All individual officer and director defendants have joined in that motion. Plantiffs filed a motion for rule to show cause why the defendants' motion to terminate the lawsuit should not be stricken and dismissed. The Company has filed an opposition and the matter is pending before the court. On February 15, 2008, the court stayed proceedings in the case until April 9, 2008, to permit mediation pursuant to the parties' stipulation. Mediation is scheduled to occur April 2, 2008. No formal discovery has yet commenced, and no trial date has been set. In the course of the Special Committee's investigation, by letter dated December 18, 2006, the Company was notified by the SEC staff that it had commenced an investigation with respect to the Company's stock option plans, grants, exercises, and accounting treatment. The Company has cooperated with the SEC staff in its investigation and, among other things, has provided them with copies of the Special Committee's report and all documents collected by the Special Committee in the course of its review. Recently, the SEC staff, pursuant to a formal order of investigation, has issued subpoenas for testimony of certain employees and for documents, most of which have already been produced to the SEC staff. The Company expects that the production of any additional documents called for by the subpoena and the testimony of the employees will be completed by April 2008. Resolution of any of the matters discussed above could have a material adverse effect on the Company's results of operations or financial condition. From time to time, the Company is involved in various other legal proceedings in the ordinary course of its business. While it is not feasible to predict the ultimate outcome of such other proceedings, the Company believes that the ultimate outcome of such other proceedings will not have a material adverse effect on its results of operations or financial condition. There are uncertainties and risks associated with all litigation and there can be no assurance that the Company will prevail in any particular litigation. 15. RECENTLY ISSUED ACCOUNTING STANDARDS In June 2006, the FASB issued FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109" ("FIN 48"), which prescribes accounting for and disclosure of uncertainty in tax positions. This interpretation addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements. Under FIN 48, the Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement. FIN 48 also provides guidance on derecognition of tax positions, financial statement classification, recognition of interest and penalties, accounting in interim periods, and disclosure and transition requirements. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company adopted FIN 48 on April 1, 2007. In September 2006, FASB issued SFAS 157, "Fair Value Measurements" ("SFAS 157") which provides enhanced guidance for using fair value to measure assets and liabilities. SFAS 157 clarifies the principle that fair value should be based on the assumptions that market participants would use when pricing an asset or liability, provides a framework for measuring fair value under GAAP and expands disclosures requirements about fair value measurements. SFAS 157 is effective for financial statements issued in fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company plans to adopt SFAS 157 at the beginning of fiscal 2009 and is evaluating the impact, if any, the adoption of SFAS 157 will have on its financial condition and results of operations. In March 2007, the FASB ratified the consensus reached by the Emerging Issues Task Force ("EITF") in Issue No. 32 06-10, "Accounting for Collateral Assignment Split-Dollar Life Insurance Arrangements" ("Issue 06-10"). Issue 06-10 requires companies with collateral assignment split-dollar life insurance policies that provide a benefit to an employee that extends to postretirement periods to recognize a liability for future benefits based on the substantive agreement with the employee. Recognition should be in accordance with FASB Statement No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," or APB Opinion No. 12, "Omnibus Opinion - 1967," depending on whether a substantive plan is deemed to exist. Companies are permitted to recognize the effects of applying the consensus through either (1) a change in accounting principle through a cumulative-effect adjustment to retained earnings or to other components of equity or net assets as of the beginning of the year of adoption or (2) a change in accounting principle through retrospective application to all prior periods. Issue 06-10 is effective for fiscal years beginning after December 15, 2007, with early adoption permitted. The Company plans to adopt Issue 06-10 at the beginning of fiscal 2009 and is evaluating the impact of the adoption of Issue 06-10 on its financial condition and results of operations. In June 2007, the FASB ratified the consensus reached by the EITF on Issue No. 07-3, Accounting for Advance Payments for Goods or Services Received for Use in Future Research and Development Activities ("Issue 07-3"), which is effective December 15, 2007 and is applied prospectively for new contracts entered into on or after the effective date. Issue 07-3 addresses nonrefundable advance payments for goods or services for use in future research and development activities. Issue 07-3 will require that these payments that will be used or rendered for future research and development activities be deferred and capitalized and recognized as an expense as the related goods are delivered or the related services are performed. If an entity does not expect the goods to be delivered or the services to be rendered, the capitalized advance payments should be expensed. The Company is assessing the effects of adoption of Issue 07-3 on its financial condition and results of operations. In September 2007, the EITF reached a consensus on Issue No. 07-1 ("Issue 07-1"), "Accounting for Collaborative Arrangements." The scope of Issue 07-1 is limited to collaborative arrangements where no separate legal entity exists and in which the parties are active participants and are exposed to significant risks and rewards that depend on the success of the activity. The EITF concluded that revenue transactions with third parties and associated costs incurred should be reported in the appropriate line item in each company's financial statements pursuant to the guidance in Issue 99-19, "Reporting Revenue Gross as a Principal versus Net as an Agent." The EITF also concluded that the equity method of accounting under Accounting Principles Board Opinion 18, "The Equity Method of Accounting for Investments in Common Stock," should not be applied to arrangements that are not conducted through a separate legal entity. The EITF also concluded that the income statement classification of payments made between the parties in an arrangement should be based on a consideration of the following factors: the nature and terms of the arrangement; the nature of the entities' operations; and whether the partners' payments are within the scope of existing GAAP. To the extent such costs are not within the scope of other authoritative accounting literature, the income statement characterization for the payments should be based on an analogy to authoritative accounting literature or a reasonable, rational, and consistently applied accounting policy election. The provisions of Issue 07-1 are effective for fiscal years beginning on or after December 15, 2007, and companies will be required to apply the provisions through retrospective application. The Company plans to adopt Issue 07-1 at the beginning of fiscal 2009 and is currently evaluating the impact of the adoption of Issue 07-1 on its financial condition and results of operations. In December 2007, the FASB issued SFAS 141 (revised 2007), "Business Combinations" ("SFAS 141(R)"), which replaces SFAS 141 but retains the fundamental concept of purchase method of accounting in a business combination and improves reporting by creating greater consistency in the accounting and financial reporting of business combinations, resulting in more complete, comparable, and relevant information for investors and other users of financial statements. To achieve this goal, the new standard requires the acquiring entity in a business combination to recognize all the assets acquired and liabilities assumed in the transaction and any non-controlling interest at the acquisition date measured at their fair value as of that date. This statement requires measuring a non-controlling interest in the acquiree at fair value which will result in recognizing the goodwill attributable to the non-controlling interest in addition to that attributable to the acquirer. This statement also requires the recognition of assets acquired and liabilities assumed arising from contractual contingencies as of the acquisition date, measured at their acquisition fair values. SFAS 141(R) is effective for fiscal years beginning after December 15, 2008. The Company plans to adopt SFAS 141(R) at the beginning of fiscal 2010 and is evaluating the impact of SFAS 141(R) on its financial condition and results of operations. In December 2007, the FASB issued SFAS 160, "Non-controlling Interests in Consolidated Financial Statements" 33 ("SFAS 160") an amendment of ARB No. 51, which will affect only those entities that have an outstanding non-controlling interest in one or more subsidiaries or that deconsolidate a subsidiary by requiring all entities to report non-controlling (minority) interests in subsidiaries in the same way as equity in the consolidated financial statements. In addition, SFAS 160 eliminates the diversity that currently exists in accounting for transactions between an entity and non-controlling interests by requiring they be treated as equity transactions. SFAS 160 is effective for fiscal years beginning after December 15, 2008. The Company plans to adopt SFAS 160 at the beginning of fiscal 2010 and is evaluating the impact of SFAS 160 on its financial condition and results of operations. 16. SUBSEQUENT EVENTS In May 2007, the Company acquired the U.S. marketing rights to EvaMist(TM), a new low-dose estrogen replacement therapy product delivered with a patented metered-dose transdermal spray system, from VIVUS, Inc. Under terms of the Asset Purchase Agreement, the Company paid $10,000 in cash at closing and agreed to make an additional cash payment of $140,000 upon final approval of the product by the U.S. Food and Drug Administration ("FDA"). The agreement also provides for two future payments upon achievement of certain net sales milestones. If EvaMist(TM) achieves at least $100,000 of net sales in a fiscal year, a one-time payment of $10,000 will be made, and if net sales levels reach $200,000 in a fiscal year, a one-time payment of up to $20,000 will be made. In July 2007, FDA approval for EvaMist(TM) was received and a payment of $140,000 was subsequently made to VIVUS, Inc. The Company is in the process of determining the appropriate allocation of the $140,000 payment. Since the product had not yet obtained FDA approval when the initial payment was made at closing, the Company recorded $10,000 of in-process research and development expense during the three months ended June 30, 2007. In May 2007, the Company received FDA approval to market the 100 mg and 200 mg strengths of metoprolol succinate extended-release tablets, the generic version of Toprol-XL(R) (marketed by AstraZeneca). In fiscal 2006, the Company received a favorable court ruling in a Paragraph IV patent infringement action filed against the Company by AstraZeneca based on our ANDA submissions to market these generic formulations. Since KV was the first company to file with the FDA for generic approval of the 100 mg and 200 mg dosage strengths, the Company was accorded the opportunity for a 180-day exclusivity period for marketing these two dosage strengths. In January 2008, the Company entered into a definitive asset purchase agreement with CYTYC Prenatal Products and Hologic, Inc. ("CYTYC") to acquire the U.S. and worldwide rights to Gestiva(TM) (17-alpha hydroxyprogesterone caproate). Gestiva(TM) is used in the prevention of preterm birth in certain categories of pregnant women. The proposed indication is for women with a history of at least one spontaneous preterm delivery (i.e., less than 37 weeks), who are pregnant with a single fetus. Under the terms of the asset purchase agreement, the Company agreed to pay a total of $82,000 for Gestiva(TM), $7,500 of which was paid at closing. The remainder is payable on the completion of two milestones: (1) $2,000 on CYTYC's receipt of acknowledgement from the FDA that their response to the FDA's October 20, 2006 Approval letter is sufficient for the FDA to proceed with their review of the NDA and (2) $72,500 on FDA approval of a Gestiva(TM) NDA and receipt by the Company of 15,000 units of finished Gestiva(TM) suitable for commercial sale. Because the product is not expected to have received FDA approval by the closing of the transaction, the Company expects to record $7,500 when the initial payment is made and $2,000 when the subsequent milestone payment is made of in-process research and development expenses. On January 9, 2008 the Company has received a subpoena from the Office of Inspector General of HHS, seeking documents with respect to two of ETHEX's nitroglycerin products. The subpoena states that it is in connection with an investigation into potential false claims under Title 42 of the U.S. Code, and the inquiry appears to pertain to whether these nitroglycerin products are eligible for reimbursement under federal health care programs, such as Medicaid and VA programs. The Company is in the process of gathering the relevant documents in response to the subpoena. On January 23, 2008, the 133 employees represented by the Teamsters Union voted to decertify union representation effective February 7, 2008. As a result of the decertification, the Company incurred a withdrawal liability for the portion of the unfunded benefit obligation associated with the multi-employer pension plan administered by the union applicable to its employees covered by the plan. The withdrawal liability of $923 will be recorded as an expense in fiscal year 2008. As of February 24, 2008, the Company held auction rate debt securities in the aggregate principal amount of $83,900. The auction rate securities are AAA rated, long-term debt obligations secured by student loans, which are guaranteed by the U.S. Government. Liquidity for these securities has been provided by an auction process that resets the applicable interest rate at pre-determined intervals, up to 35 days. In the past, the auction process has allowed investors to obtain immediate liquidity by selling the securities at their face amounts. The value of these securities was not impaired as of March 31, 2007. Disruptions in credit markets, subsequent to March 31, 2007, however, have adversely affected the auction market for these types of securities. During the period from February 11, 2008 to March 6, 2008 auctions for all of the auction rate securities held by the Company failed to produce sufficient bidders to allow 34 for successful auctions. The Company cannot predict how long the current imbalance in the auction market will continue. As a result, for a period of time, the Company may or may not be able to liquidate any of its auction-rate securities prior to their maturities at prices approximating their face amounts. The Company is currently evaluating the market for these securities to determine if impairment of the carrying value of the securities has occurred due to the loss of liquidity. If such impairment has occurred and is not temporary, the Company would recognize an impairment loss in the statement of income for fiscal year 2008. 35 CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION This Form 10-Q, 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, and which may be based on or include assumptions concerning our operations, future results and prospects. Such statements may be identified by the use of words like "plans," "expect," "aim," "believe," "projects," "anticipates," "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 continued satisfaction of the continued listing requirements on the New York Stock Exchange and our strategy for growth, product development, regulatory approvals, market position, acquisitions, revenues, expenditures and other financial results, are forward-looking statements. All forward-looking statements are based on current expectations and are subject to risk and uncertainties. In connection with the "safe harbor" provisions, we provide the following cautionary statements identifying important economic, political and technology factors which, among others, could cause actual results or events to differ materially from those set forth or implied by the forward-looking statements and related assumptions. Such factors include (but are not limited to) the following: (1) 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, including as a result of so-called authorized-generic drugs; (5) new product development and launch, including 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 and/or products manufactured for the Company under contract manufacturing arrangements with third parties; (8) the regulatory environment, including regulatory agency and judicial actions and changes in applicable law or regulations; (9) fluctuations in revenues and 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; (14) the restatement of our financial statements for fiscal periods 1996 through 2006 and for the quarter ended June 30, 2006, as well as completion of the Company's financial statements for the second and third quarters of fiscal 2007 and for the full fiscal year ended March 31, 2007, and for the first, second and third quarters of fiscal 2008; (15) actions by the Securities and Exchange Commission and the Internal Revenue Service with respect to the Company's stock option grants and accounting practices; (16) the risks detailed from time to time in our filings with the Securities and Exchange Commission; (17) actions by the NYSE Regulation, Inc. with respect to the continued listing of the Company's stock on the New York Stock Exchange; and (18) the impact of credit market disruptions on the fair value of auction rate securities that the Company has acquired as short-term investments. This discussion is by no means exhaustive, but is designed to highlight important factors that may impact the Company's outlook. We are under no obligation to update any of the forward-looking statements after the date of this report. 36 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Except for the historical information contained herein, the following discussion contains forward-looking statements that are subject to known and unknown risks, uncertainties, and other factors that may cause our actual results to differ materially from those expressed or implied by 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 financial condition and results of operations, which gives effect to the restatement discussed in Note 2 to the Consolidated Financial Statements, should be read in conjunction with the consolidated financial statements, the related notes to consolidated financial statements and "Management's Discussion and Analysis of Results of Operations and Financial Condition" included in our Annual Report on Form 10-K for the fiscal year ended March 31, 2007 to be filed with the Securities and Exchange Commission (the "2007 Form 10-K"), and the unaudited interim consolidated financial statements and related notes to unaudited interim consolidated financial statements included in Item 1 of this Quarterly Report on Form 10-Q. REVIEW OF STOCK OPTION GRANT PRACTICES BACKGROUND AND CONCLUSIONS On October 31, 2006, we announced that we had been served with a derivative lawsuit filed in St. Louis City Circuit Court alleging that certain stock option grants to current or former officers and directors between 1995 and 2002 were dated improperly. In accordance with our established corporate governance procedures, the Board of Directors referred this matter to the independent members of its Audit Committee (the "Special Committee" or "Committee"). Shortly thereafter, the Special Committee commenced an investigation of our stock option grant practices, assisted by independent legal counsel and forensic accounting experts engaged by the Committee, with the objectives of evaluating our accounting for stock options for compliance with GAAP and for compliance with the terms of our related stock option plans over the period January 1, 1995 through October 31, 2006 (the "relevant period"). Over an approximately twelve-month period, the Committee and its advisors interviewed all available persons (45 in all) believed to be relevant to the issues being investigated, including current and former employees, current and former outside directors and our current auditors and outside legal counsel. They reviewed nearly 300,000 electronic and hard copy documents relating to our stock option grant practices. During the relevant period we awarded 2,639 option grants covering 10.6 million shares of our Class A and Class B Common Stock, which were reviewed by the Committee. On October 11, 2007, we filed a Current Report on Form 8-K announcing the Special Committee had completed its investigation. The investigation concluded that there was no evidence that any employee, officer or director of the Company engaged in any intentional wrongdoing or was aware that the Company's policies and procedures for granting and accounting for stock options were materially non-compliant with GAAP. The investigation also found no intentional violation of law or accounting rules with respect to our historical stock option grant practices. However, the Special Committee concluded that stock-based compensation expense resulting from the stock option grant practices followed by the Company prior to April 2, 2006 were not recorded in accordance with GAAP because the expense computed for most of the grants reflected incorrect measurement dates for financial accounting purposes. The "measurement date" under applicable accounting principles, namely Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," ("APB 25") and related interpretations, is the first date on which all of the following are known and not subject to change: (a) the individual who is entitled to receive the option grant, (b) the number of options that an individual is entitled to receive, and (c) the option's exercise price. FINDINGS AND ACCOUNTING CONSIDERATIONS In general, stock options were granted to employees, executives and non-employee members of the Board of Directors over the relevant period under the terms of our 1991 and 2001 Incentive Stock Option Plans (the "option plans"). The majority of our employees participate in our stock option program. Approximately 78% of our employees have been awarded grants under our option plans. In addition to options granted to the CEO under those plans, "bonus options" were awarded to him under the terms of his employment agreement in lieu of, and in consideration for a reduction of, the cash bonus provided for in that agreement. 37 The option plans required grants to be approved by the Compensation Committee of the Board of Directors. Under the option plans, options were to be granted with exercise prices set at no less than the fair market value of the underlying common stock at the date of grant. The 1991 plan provided for the exclusive grant of Incentive Stock Options ("ISOs") as defined by Internal Revenue Code Section 422, while the 2001 plan provided for the grant of both ISOs and non-qualified stock options ("NSOs"). Under the plans, options granted to employees other than the CEO or directors are subject to a ten-year ratable vesting period. Options granted to the CEO and directors generally vest ratably over five years. Both option plans require that shares received upon exercise of an option cannot be sold for two years. If the employee terminates employment voluntarily or involuntarily (other than by retirement, death or disability) during the two-year forfeiture period, the option plans provide the Company with the option of repurchasing the shares at the lower of the exercise price of the option or the fair market value of the stock on the date of termination. We have changed our accounting for stock-based compensation to consider this provision of the option plans as a forfeiture provision to be accounted for in accordance with the guidance provided in EITF No. 00-23, "Issues Related to Accounting for Stock Based Compensation under APB 25 and FIN 44", specifically Paragraph 78 and Issue 33 (a), "Accounting for Early Exercise." In accordance with EITF No. 00-23, cash paid by an employee for the exercise price is considered a deposit or a prepayment of the exercise price that is recognized as a current liability when received by the Company at the beginning of the two-year forfeiture period. The receipt of the exercise price is recognized as a current liability because the options are deemed not exercised and the option shares are not considered issued until an employee bears the risk and rewards of ownership. The options are accounted for as exercised when the two-year forfeiture period lapses. In addition, because the options are not considered exercised for accounting purposes, the shares in the two-year forfeiture period are not considered outstanding for purposes of computing basic EPS. Prior to fiscal 2007, we had accounted for all option grants as fixed in accordance with the provisions of APB 25 using the date of grant as the measurement date. Because the exercise price of the option was equal to or greater than the market price of the stock at the measurement date, under our prior procedures we did not recognize any compensation expense since the option had no intrinsic value (intrinsic value being the difference between the exercise price and the market price of the underlying stock at the measurement date). As noted above, the Special Committee determined that our accounting for most of the stock option grants was not in accordance with GAAP because the date of grant, as defined by the Company, was not a proper measurement date. To correct those errors, and consistent with the accounting literature and guidance from the Securities and Exchange Commission ("SEC"), we organized the grants into categories based on grant type and process by which the grant was finalized. Based on the relevant facts and circumstances, we applied the authoritative accounting standard (APB 25 and related interpretations) to determine, for every grant within each category, the proper measurement date. If the measurement date was not the originally assigned grant date, accounting adjustments were made as required, resulting in stock-based compensation expense and related tax effects. The grants were classified as follows: (1) promotion/retention grants to executives and employees and new hire grants ("employee options"); (2) grants to persons elected or appointed to the Board of Directors ("director options"); and (3) bonus option grants to the CEO in lieu of cash bonus payments under the terms of his employment agreement ("bonus options"). Employee Options. The evidence obtained through the Committee's investigation - ---------------- indicates that employee options were granted based on the lowest market price in the quarter of grant determined from an effective date (as defined below) to the end of the quarter. The exercise price and grant date of the options were determined by looking back from the end of the quarter to the effective date and choosing the lowest market price during that period. The date on which the market price was lowest became the grant date. This procedure to "look back" to the lowest market price in the preceding quarter to set the exercise price was widely known and understood within the Company. The effective date was either the date on which the option recipients and the number of shares to be granted were determined and approved by the CEO, the date of a promotion or the date of hire. For new hires and promotions of existing employees, which represents substantially all of the award recipients, the terms of the award, except for the exercise price, were communicated to the recipients prior to the end of the quarter. At the end of the quarter, when the exercise price was determined, written consents were prepared, dated as of the date on which the stock price was lowest during the quarter, to be approved by the members of the Compensation Committee. The evidence obtained through the investigation indicated the Compensation Committee never changed or denied approval of any grants submitted to them and, as such, their approval was considered a routine matter. Based on the evidence and findings of the Special Committee, the results of management's analysis, the criteria specified in APB 25 for determining measurement dates 38 and guidance from the staff of the SEC, we have concluded that the measurement dates for the employee options should not have been the originally assigned grant dates, but instead, should have been the end of the quarter in which awards were granted when the exercise price and number of shares granted were fixed. Changing the measurement date from the originally assigned grant date to the end of the quarter resulted in recognition of additional stock-based compensation expense of $6.0 million, net of tax, on 2,830 stock option grants over the period from fiscal 1996 through fiscal 2006. Director Options. Director options were issued, prior to the effective date of - ---------------- the Sarbanes-Oxley Act ("Sarbanes-Oxley") in August 2002, using the same "look back" process as described above for employee options. This process was changed when the time for filing Form 4's was shortened under the provisions of Sarbanes-Oxley, to award options with exercise prices equal to the fair market value of the stock on the date of grant. We concluded that the measurement date for the director options granted prior to this change in grant practice should be the end of the quarter. Changing the measurement date from the originally assigned grant date to the end of the quarter resulted in recognition of additional stock-based compensation expense of $0.7 million, net of tax, on 24 stock option grants over the period from fiscal 1996 through fiscal 2006. Bonus Options. The terms of the CEO's employment agreement permitted him the - ------------- alternative of electing incentive stock options, restricted stock or discounted stock options in lieu of the cash payment of part or all of the annual incentive bonus due to him. In the event of an election to receive options in lieu of the cash incentive due, those options were to be valued using the Black-Scholes option pricing model, applying the same assumptions as those used in the Company's most recent proxy statement. The employment agreement provides that the CEO's annual bonus, based on the fiscal year net income, is payable after the end of the year. However, based on advice provided to us by legal counsel, and longstanding interpretation, the Company believed that it was permissible to make advance payments in the form of bonus options during the year based on the anticipated annual bonus, and did so. Prior to fiscal 2005, the CEO received ten bonus option grants, consisting of options to purchase 337,500 shares of Class A Common Stock and 1,743,750 shares of Class B Common Stock under this arrangement. The CEO and the Board's designated representative (our Chief Financial Officer) agreed on the terms of the bonus options, including the number of shares covered, the exercise price and the grant date (the latter being selected using a "look back" process similar to that followed in granting employee and director options). We typically granted bonus options prior to fiscal year-end, shortly after such agreement was reached. These bonus options were fully vested at grant, had three-to-five year terms, were granted with a 10% or 25% premium to the market price of the stock on the selected grant date and were subject to the approval of the Compensation Committee. The CEO's cash bonus payable at the end of the fiscal year in which the options were granted, was reduced by the Black-Scholes value of the options according to their terms. Based on the facts and circumstances relative to the process for granting the bonus options, the Special Committee determined, and management has agreed that the measurement dates for these options should be the end of the fiscal year in which they were granted. The end of the fiscal year was used as the measurement date because that is the date on which the amount of the annual bonus could be determined and therefore the terms of the option could be fixed under APB 25. This conclusion is predicated on the assumption that the terms of the option were linked to the amount of the bonus earned. While it was permissible to agree upon the number of shares that were to be issued prior to the end of the year and would not be forfeitable, under GAAP the exercise price is considered variable until the amount of the bonus could be determined with finality. The variability in the exercise price results from the premise that the CEO would have been required to repay any shortfall in the bonus earned from the value assigned to the option by the Black-Scholes model. Although there was never an instance when the CEO's bonus did not exceed substantially the value of the options as calculated, if that were to have occurred, the amount repaid to cure the bonus shortfall would in substance be an increase in the exercise price of the option. Since the exercise price could not be determined with certainty until the amount of the bonus was known, we have applied variable accounting to the bonus options from the date of grant to the final fiscal year-end measurement date. Variable accounting requires that compensation expense is to be determined by comparing the quoted market value of the shares covered by the option grant to the exercise price at each intervening balance sheet date until the terms of the option become fixed. The compensation expense associated with the CEO's estimated bonus was accrued throughout the fiscal year. When the value of a bonus option was determined using the Black-Scholes model, previously recorded compensation expense associated with the accrual of the estimated bonus was reversed in the amount of the value assigned to the bonus option. The previously recorded compensation expense should not have been reversed. We developed a methodology in the restatement process that considers both the intrinsic value of the option under APB 25 and the Black-Scholes value 39 assigned to the bonus option in determining the amount of compensation expense to recognize once the exercise price of the option becomes fixed and variable accounting ends. Under this methodology, the intrinsic value of the option is determined at the fiscal year-end measurement date under the principles of APB 25. The intrinsic value is then compared to the Black-Scholes value assigned to the option for compensation purposes (the bonus value). The bonus value is the amount that would have been accrued during the fiscal year through the grant date as part of the total liability for the CEO's bonus. The greater of the intrinsic value or bonus value is recorded as compensation expense. Using this methodology and fiscal year-end for the measurement dates resulted in an increase in stock-based compensation expense of $6.9 million over the period from fiscal 1996 through fiscal 2004. There was no tax benefit associated with this expense due to the tax years being closed. OTHER MODIFICATIONS OF OPTION TERMS As described above, under the terms of our stock option plans shares received on exercise of an option are to be held for the employee for two years during which time the shares cannot be sold. If the employee terminates employment voluntarily or involuntarily (other than by retirement, death or disability) during the two-year forfeiture period the plans provide the Company with the option of repurchasing the shares at the lower of the exercise price or the fair market value of the stock on the date of termination. In some circumstances we elected not to repurchase the shares upon termination of employment while the shares were in the two-year forfeiture period essentially waiving the remaining forfeiture period requirement. We did not recognize this waiver as requiring a new measurement date. Based on management's analysis, we have concluded that a new measurement date should have been recognized in two situations: (1) where the employee terminated and the Company did not exercise its right under the option plans to buy back the shares in the two-year forfeiture period; and (2) where the forfeiture provision was waived and the employee subsequently terminated within two years of the exercise date. We now consider both of these waivers to be an acceleration of the vesting period because the forfeiture provision was waived (i.e., the employee is no longer subject to a service condition to earn the right to the shares and will benefit from the modification). As such, a new measurement date is required. In this case the new measurement date is the date the forfeiture provision was waived with additional stock-based compensation expense being recognized at the date of termination. Since the shares were fully vested, the intrinsic value of the option at the new measurement date in excess of the intrinsic value at the original measurement date should be expensed immediately. The new measurement dates resulted in an increase in stock-based compensation expense of $0.4 million, net of tax, on 27 stock option grants over the period from fiscal 1996 through fiscal 2006. STOCK OPTION ADJUSTMENTS Stock-based Compensation Expense. Although the period for the Special - -------------------------------- Committee's investigation was January 1, 1995 to October 31, 2006, management extended the period of review back to 1986 for purposes of analyzing the aggregate impact of the measurement date changes because the incorrect accounting for stock options extended that far back in time. We have concluded that the measurement date changes identified by the Special Committee's investigation and management's analysis resulted in an understatement of stock-based compensation expense arising from stock option grants since fiscal 1986, effecting our consolidated financial statements for each year beginning with the fiscal year ended March 31, 1986. The affect on the consolidated financial statements for the fiscal years from 1986 to 1995 was not considered material, individually or in the aggregate. Therefore, it was included as a cumulative adjustment to the stock-based compensation expense for fiscal 1996. We have determined the aggregate understatement of stock-based compensation expense for the 11-year restatement period from 1996 through 2006 was $14.0 million, net of tax, on 2,891 stock option grants. As previously discussed, we now consider the two-year repurchase option specified in the option plans to be a forfeiture provision that goes into effect when stock options are exercised. Therefore, the service period necessary for an employee to earn an award varies based on the timing of stock option exercises. We initially expense each award (i.e., all tranches of an option award) on a straight-line basis over ten years, which is the period that stock options become exercisable. We ensure the cumulative compensation expense for an award as of any date is at least equal to the measurement-date intrinsic value of those options that have vested (i.e., when the two-year forfeiture period has ended). If stock options expire unexercised or an employee terminates employment after options become exercisable, no compensation expense associated with the exercisable, but unexercised options, is reversed. In those instances where an employee terminates employment before options become exercisable or we repurchased the shares during the two-year forfeiture period, all compensation expense for those options is reversed as a forfeiture. 40 Payroll Taxes, Interest and Penalties. In connection with the stock-based - ------------------------------------- compensation adjustments, we determined that certain options previously classified as ISO grants were determined to have been granted with an exercise price below the fair market value of our stock on the revised measurement date. Under the Internal Revenue Code Section 422, ISOs may not be granted with an exercise price less than the fair market value on the date of grant and, therefore, these grants would not likely qualify for ISO tax treatment. The disqualification of ISO classification exposes the Company and the affected employees to payroll related withholding taxes once the two-year forfeiture period and the substantial risk of forfeiture has lapsed (the "taxable event"). The Company and the affected employees may also be subject to interest and penalties for failing to properly withhold taxes and report this taxable event on their respective tax returns. The Company is currently reviewing the potential disqualification of ISO grants and the related withholding tax implications with the Internal Revenue Service for calendar years 2004, 2005 and 2006 in an effort to reach agreement on the resulting tax liability. In the meantime, the Company has recorded expenses related to the withholding taxes, interest and penalties associated with options which would have created a taxable event in calendar years 2004, 2005 and 2006. The Company estimates that the payroll tax liability at March 31, 2006 for the disqualification of tax treatment associated with ISO awards totaled $3.3 million. In addition, we recorded an income tax benefit of $0.9 million related to this liability. Income Tax Benefit. We reviewed the income tax effect of the stock-based - ------------------ compensation charges, and we believe that the proper income tax accounting for stock options under GAAP depends, in part, on the tax designation of the stock options as either ISOs or NSOs. Because of the potential impact of measurement date changes on the qualified status of the options, we have determined that substantially all of the options originally intended to be ISOs might not be qualified under the tax regulations and, therefore, should be accounted for as if they were NSOs for financial accounting purposes. An income tax benefit has resulted from the determination that certain NSOs for which stock-based compensation expense was recorded will create an income tax deduction. This tax benefit has resulted in an increase to our deferred tax assets for stock options prior to the occurrence of a taxable event or the forfeiture of the related options. Upon the occurrence of a taxable event or forfeiture of the underlying options, the corresponding deferred tax asset is reversed and the excess or deficiency in the deferred tax assets is recorded to paid-in capital in the period in which the taxable event or forfeiture occurs. We have recorded a deferred tax asset of $1.3 million as of March 31, 2006 related to stock options. The stock option adjustments and related income tax impacts discussed above reduced net income by $16.3 million in aggregate for the fiscal years ended March 31, 1996 through 2006. We have restated pro forma net income and earnings per share under Statement of Financial Accounting Standards No. 123 ("SFAS 123") in Note 1 of the Notes to Consolidated Financial Statements of this Form 10-Q to reflect the impact of these adjustments for the three and six months ended September 30, 2005. The Special Committee recommended a remediation plan that included the repricing of certain stock option grants awarded to officers and directors and reimbursement by our CEO of $1.4 million. To reprice the stock option grants awarded to certain senior officers and directors, the original exercise prices have been increased to the market prices of the stock on the new measurement date for all options outstanding as of the beginning of the investigation. As described above, the Special Committee concluded that the CEO's bonus options awarded under his employment agreement should have been issued at the end of the fiscal year rather than during the year as had been our past practice. The Committee concluded that an adjustment was appropriate to reflect that the bonus options should not have been issued before fiscal year end and to remove any benefits to the CEO from our past practice of looking back to select grant dates and exercise prices. The Committee determined the adjustment by calculating the Black-Scholes values of the bonus options as if they had been issued at the end of the fiscal year and then comparing those values to the amounts reported in our proxy statements as the values of the bonus options based on the earlier grant dates. The difference in the aggregate value of the bonus options based on this methodology was $1.4 million. The Committee considered several other alternative remediation calculations but concluded, based on consideration of all of the facts and circumstances, that the recommended amount was the appropriate remediation. The CEO has made the recommended reimbursement of $1.4 million by delivery to the Company of 45,531 shares of Class A Common Stock on November 1, 2007. The Committee also recommended changes to our stock option grant practices and additional training for employees involved in the accounting for and administration of our stock option program. These recommendations were accepted by the Board of Directors by unanimous consent on October 11, 2007. 41 REVIEW OF TAX POSITIONS (UNRELATED TO STOCK OPTIONS) In addition to the restatement adjustments associated with stock options discussed above, our restated Consolidated Financial Statements include an adjustment for fiscal years 2004, 2005 and 2006 to reflect additional liabilities associated with tax positions taken on filed tax returns for those years that should have been recorded in accordance with GAAP, partially offset by certain expected tax refunds. The aggregate impact of this adjustment was a $5.4 million increase in income tax expense with a corresponding increase in taxes payable. This adjustment is not related to accounting for stock-based compensation expense discussed above. OTHER ADJUSTMENTS (UNRELATED TO STOCK OPTIONS) In addition to the restatement adjustments associated with stock options and income taxes discussed above, our restated Consolidated Financial Statements include an adjustment for fiscal years 2002 through 2006 to reflect the correction of errors related to the recognition of revenue associated with shipments to customers under FOB destination terms and an adjustment to reduce the estimated liability for employee medical claims incurred but not reported at March 31, 2006. We improperly recognized revenue from certain customers prior to when title and risk of ownership transferred to the customer. The aggregate impact of these adjustments over the periods affected was a decrease in net revenue of $1.2 million and a decrease in net income of $0.4 million. The aggregate impact on net income reflected a $0.5 million decrease associated with the net revenue errors and a $0.1 million increase related to the adjustment of the liability for medical claims. RESTATEMENT OF CONSOLIDATED FINANCIAL STATEMENTS This Form 10-Q reflects the restatement of our consolidated balance sheets as of March 31, 2006 and September 30, 2005, the related consolidated statements of operations for the three and six months ended September 30, 2005, and the related consolidated statement of cash flows for the six months ended September 30, 2005. In our Form 10-K for the fiscal year ended March 31, 2007 filed with the Securities and Exchange Commission (the "2007 Form 10-K"), we restated our consolidated balance sheet as of March 31, 2006, and the related consolidated statements of income, comprehensive income, shareholders' equity, and cash flows for the fiscal years ended March 31, 2006 and 2005. We have not amended, and we do not intend to amend, our previously filed Annual Reports on Form 10-K or Quarterly Reports on Form 10-Q for each of the fiscal years and fiscal quarters of 1996 through 2006. Our 2007 Form 10-K also reflects the restatement of Selected Financial Data in Item 6 as of March 31, 2005 and as of and for the fiscal years ended March 31, 2004 and 2003. We will also be filing a Quarterly Report on Form 10-Q for the quarter ended December 31, 2006, that contains the restatement of our consolidated statements for certain interim periods as discussed therein. 42 The table below reflects the impacts of the restatement adjustments discussed above on the Company's consolidated statements of operations for the periods presented below:
CUMULATIVE APRIL 1, 1995 THREE MONTHS ENDED SIX MONTHS ENDED THROUGH CATEGORY OF ADJUSTMENTS: SEPTEMBER 30, 2005 SEPTEMBER 30, 2005 MARCH 31, 2004 - ------------------------ ------------------------ ------------------------ ----------------------- (a) Pretax income impact: Stock-based compensation expense related to measurement date changes (b) $ 232 $ 453 $ 13,626 Payroll tax expense and penalties (b) 675 847 439 Other adjustments 2,595 2,860 1,666 ------------------------ ------------------------ ----------------------- (Increase) decrease in pretax income 3,502 4,160 15,731 ------------------------ ------------------------ ----------------------- Income tax impact: Measurement date changes (71) (139) (1,050) Payroll taxes (187) (234) (123) Other income tax adjustments (c) 550 1,040 1,689 Other adjustments (869) (958) (584) ------------------------ ------------------------ ----------------------- Increase (decrease) in income tax expense (577) (291) (68) ------------------------ ------------------------ ----------------------- Increase (decrease) in net income $ 2,925 $ 3,869 $ 15,663 ======================== ======================== ======================= - -------------- (a) The cumulative effect of the restatement adjustments from fiscal 1996 through fiscal 2004 is summarized below:
STOCK OPTION ADJUSTMENTS OTHER ADJUSTMENTS DECREASE YEARS ENDED ----------------------------- OTHER INCOME ------------------------ (INCREASE) TO MARCH 31, PRETAX INCOME TAX TAX ADJUSTMENTS PRETAX INCOME TAX NET INCOME - ----------- ------------- ------------- ---------------- ---------- ------------- -------------- 1996 $ 829 (d) $ - $ - $ - $ - $ 829 1997 657 (1) - - - 656 1998 2,391 (19) - - - 2,372 1999 535 (27) - - - 508 2000 1,998 (62) - - - 1,936 2001 1,722 (141) - - - 1,581 2002 2,317 (219) - 2,534 (918) 3,714 2003 1,187 (248) - (1,610) 590 (81) 2004 2,429 (456) 1,689 742 (256) 4,148 ------------- ------------- ---------------- ---------- ------------- -------------- Cumulative effect $ 14,065 $ (1,173) $ 1,689 $ 1,666 $ (584) $ 15,663 ============= ============= ================ ========== ============= ============== (b) Stock-based compensation expenses, including related payroll taxes, interest and penalties have been recorded as adjustments to the selling and administrative expenses line item in the Company's consolidated statements of income for each period. (c) Represents liabilities associated with tax positions taken in previous years, partially offset by certain tax refunds and is not related to accounting for stock options. (d) Includes additional expense totaling $0.6 million, the affect of which on the consolidated financial statements for 1996 and for each year 1986 to 1995 was not material.
43 GOVERNMENT REGULATION In June 2006, May 2007 and September 2007, the FDA issued Notices to the pharmaceutical industry stating that manufacture of all unapproved drug products containing carbinoxamine, carbinoxamine labeled for children under two, timed-released guaifenesin, hydrocodone labeled for children under six and all other unapproved products containing hydrocodone, respectively, cease by September 6, 2006, July 9, 2006, August 26, 2007, October 31, 2007, and December 31, 2007, respectively. These Notices affect the continued manufacture and sale of ETHEX's Hydro-Tussin(TM) CBX Syrup, Tri-Vent(TM) HC Liquid, Guaifenex(R) DM ER Tablets, Guaifenex(R) PSE 60 ER Tablets, PhenaVent(TM) D Capsules, Guaifenex(R) PSE 80 ER Tablets, Pseudovent(TM) DM Tablets, Histinex(R) PV Syrup, Hydrocodone Bitartrate & Guaifenesin Liquid, Hydro-Tussin(TM) HC Syrup, Histinex(R) HC Syrup and Hydro-Tussin(TM) Syrup. On March 13, 2008, representatives of the Missouri Department of Health and Senior Services, accompanied by representatives of the FDA, notified the Company of a hold on the Company's inventory of certain unapproved drug products, restricting the Company's ability to remove or dispose of those inventories without permission. KV believes that the hold relates to a potential misunderstanding by KV about the intended scope of recent FDA notices setting limits on the marketing of unapproved guaifenesin products. In response to notices issued by FDA in 2002 and 2003 with respect to single-entity timed-release guaifenesin products, and a further notice issued in 2007 with respect to combination timed-released guaifenesin products, KV timely discontinued a number of its guaifenesin products and believed that, by doing so, it had complied with those notices. The recent action to place a hold on certain KV products may indicate, however, that additional guaifenesin products may have to be discontinued. Pursuant to discussions with the Missouri Department, and with the FDA, seeking to clarify the status of products that were initially placed on hold, certain categories of those products were released from the hold later in the day on March 13, 2008. These discussions are continuing with respect to the status of the remaining products subject to the hold. In fiscal 2007, ETHEX reported net sales of $39.2 million from the products remaining subject to the hold. Of this amount, approximately 84%, or $33.0 million, are cough/cold and allergy products sold by ETHEX as part of its respiratory product line, 90% of which contain guaifenesin. We believe this hold will not materially affect our results of operations for fiscal 2008. If the hold continues for an extended period or if it becomes permanent, it would substantially eliminate ETHEX's respiratory product line. The Company believes that the potential loss of these revenues will be more than offset by increases in revenues expected in our existing branded and generic product lines and by anticipated new product approvals. 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/non-branded 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 diverse 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 non-branded/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 Net revenues for the three months ended September 30, 2006 increased $16.7 million, or 18.0%, from the prior year quarter as we experienced sales growth of 46.9% in our branded products segments. The resultant $10.4 million increase in gross profit was offset in part by a $5.0 million increase in operating expenses. The increase in operating expenses was primarily due to an increase in personnel costs, expansion of our facilities and the impact of stock-based compensation expense recorded in conjunction with the adoption of SFAS 123R (see Note 5 to the Consolidated Financial Statements). As a result, net income for the second quarter increased $3.5 million, or 40.7%, to $12.1 million compared to the prior year quarter. Net revenues for the six months ended September 30, 2006 increased $27.8 million, or 15.7%, as we experienced sales growth of 39.2% in our branded products segment. The resulting $14.2 million increase in gross profit was offset in part by a $7.7 million increase in operating expenses before taking into account the $30.4 million of expense associated with the prior year acquisition of FemmePharma. The increase in operating expenses was primarily due to an increase in personnel costs, expansion of our facilities and the impact of stock-based compensation expense recorded in conjunction with the adoption of SFAS 123R. For the six months ended September 30, 2006, we reported net income of $22.2 million compared to a net loss of $14.3 million for the six months ended September 30, 2005. During the prior year six-month period, we recorded expense of $30.4 million in connection with the FemmePharma acquisition (see Note 3 to the Consolidated Financial Statements) that consisted of $29.6 million for acquired in-process research and development and $0.9 million in direct expenses related to the transaction. As a result of this, we incurred a net loss of $14.3 million, or $0.29 per Class A and Class B diluted share for the six months ended September 30, 2005. Excluding the $30.4 million of expense associated with the prior year acquisition of FemmePharma, net income for the six months ended September 30, 2006 would have increased $6.0 million, or 37.4%. 44 NET REVENUES BY SEGMENT - ----------------------- ($ IN THOUSANDS) - -----------------------
THREE MONTHS ENDED SIX MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ---------------------------------- ---------------------------------- % % 2006 2005 CHANGE 2006 2005 CHANGE --------- --------- -------- --------- ---------- --------- (AS RESTATED) (AS RESTATED) Branded products $ 47,828 $32,563 46.9% $ 90,142 $ 64,754 39.2% as % of total net revenues 43.9% 35.3% 43.9% 36.5% Specialty generics/non-branded 56,926 55,398 2.8% 105,327 102,768 2.5% as % of total net revenues 52.2% 60.0% 51.3% 57.9% Specialty materials 3,780 4,101 (7.8)% 8,661 8,953 (3.3)% as % of total net revenues 3.5% 4.4% 4.2% 5.0% Other 449 260 72.7% 1,053 889 18.4% Total net revenues $108,983 $92,322 18.0% $205,183 $177,364 15.7%
The growth in branded product sales of $15.3 million and $25.4 million for the three- and six-month periods, respectively, was due primarily to: increased sales volume from our two anti-infective brands, Clindesse(TM) and Gynazole-1(R); continued sales growth from our hematinic and prescription prenatal product lines; and various branded product price increases that have occurred over the proceeding 12 months. Clindesse(TM) continued to experience sales growth as our share of the prescription intravaginal bacterial vaginosis market increased to 21.3% at the end of the fiscal 2006 second quarter. The sales increase in Clindesse(TM) was also impacted by larger-than-normal customer purchases during the quarter in anticipation of a September price increase. Sales of Gynazole-1(R), our vaginal antifungal cream product, increased 69.7% to $6.3 million for the quarter and increased $1.6 million, or 13.8%, to $13.4 million for the six-month period. The change in Gynazole-1(R) sales was partially the result of $3.0 million of customer purchases made during the three months ended June 30, 2005 in anticipation of a July 2005 price increase. Sales from our PreCare(R) product line increased 56.0% to $16.9 million and 93.8% to $37.0 million during the three- and six-month periods, respectively. These increases were primarily due to sales growth experienced by PrimaCare(R) ONE, the introduction of PreCare Premier(TM) and product line price increases that have occurred over the past 12 months. Specifically, sales of PrimaCare(R) ONE increased $7.0 million, or 183.5%, for the quarter and $14.6 million, or 235.6%, for the six-month period due to $5.4 million and $10.4 million of sales volume growth, respectively, coupled with $1.6 million and $4.2 million, respectively, of higher sales associated with price increases over the past year. The sales volume growth experienced by PrimaCare(R) ONE was primarily due to continued market share gains since the fourth quarter of fiscal 2005 when a temporary supply disruption of PrimaCare(R) ONE occurred. Sales from our hematinic products increased 48.1% to $12.4 million and 23.0% to $20.7 million during the three- and six-month periods, respectively. For the quarter, the increase in hematinic product sales was primarily due to higher sales from our reformulated Chromagen(R) product line coupled with the impact of larger-than-normal customer purchases during the fiscal 2006 quarter in anticipation of a September price increase. For the six-month period, the increase in hematinic sales also reflected the impact of Repliva 21/7(TM), a new product introduced in the second quarter of fiscal 2005, and an increase in sales from our Niferex(R) product line. The increases in specialty generic sales of $1.5 million and $2.6 million for the three- and six-month periods, respectively, resulted primarily from sales volume growth in our pain management and cough/cold product lines and price increases on certain cardiovascular and cough/cold products, offset in part by a decline in sales volume from certain products in our cardiovascular and prenatal vitamin product lines. The pain management product line contributed $2.2 million and $4.7 million in increased revenue for the three- and six-month periods, respectively, due primarily to incremental sales from three product approvals which were received late in fiscal 2006. In September 2006, we expanded our cardiovascular product line when we received approval to market six strengths of Diltiazem HCI ER Capsules (AB rated to Tiazac(R)). Although we launched the six strengths of Diltiazem HCI ER Capsules late in September 2006, we were able to generate incremental revenues for the second quarter of $1.3 million. 45 GROSS PROFIT BY SEGMENT - ----------------------- ($ IN THOUSANDS) - -----------------------
THREE MONTHS ENDED SIX MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ---------------------------------- ---------------------------------- % % 2006 2005 CHANGE 2006 2005 CHANGE --------- --------- -------- --------- ---------- --------- (AS RESTATED) (AS RESTATED) Branded products $42,464 $28,153 50.8% $79,765 $57,733 38.2% as % of net revenues 88.8% 86.5% 88.5% 89.2% Specialty generics/non-branded 32,047 30,009 6.8% 59,424 57,233 3.8% as % of net revenues 56.3% 54.2% 56.4% 55.7% Specialty materials 1,066 1,547 (31.1)% 3,063 3,572 (14.3)% as % of net revenues 28.2% 37.7% 35.4% 39.9% Other (5,473) (27) NM (9,394) 151 NM Total gross profit $70,104 $59,682 17.5% $132,858 $118,689 11.9% as % of total net revenues 64.3% 64.6% 64.8% 66.9%
The increases in gross profit of $10.4 million and $14.2 million for the three- and six-month periods, respectively, were primarily due to the sales growth experienced by our branded products segment. The higher branded product gross profit percentage for the quarter reflected a favorable shift in the mix of product sales toward higher margin anti- infective products. For the six-month period, the gross profit percentage decrease experienced by branded products was partially due to the impact of rebates associated with branded product sales to managed care organizations that began in fiscal 2006. The increases in the specialty generic gross profit percentages for the three- and six-month periods were primarily attributable to the impact of price increases on certain cardiovascular and cough/cold products. Impacting the Other category were contract manufacturing revenues, pricing and production variances, and changes to inventory reserves associated with production. Any inventory reserve changes associated with finished goods were reflected in the applicable segment. The fluctuation in the Other category was primarily due to the impact of higher production costs that resulted from lower than expected production volume, coupled with an increase in the provisions for obsolete inventory on certain existing products in various stages of production. During the second quarter of fiscal 2007, we also recorded provisions associated with certain new products where production occurred prior to receiving FDA approval and the upcoming expiration dates made them unsaleable. The provision for obsolete inventory for the six months ended September 30, 2006 and 2005 was $6.3 million and $1.7 million, respectively. RESEARCH AND DEVELOPMENT - ------------------------ ($ IN THOUSANDS) - -----------------------
THREE MONTHS ENDED SIX MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ---------------------------------- ---------------------------------- % % 2006 2005 CHANGE 2006 2005 CHANGE --------- --------- -------- --------- ---------- --------- Research and development $6,396 $6,420 (0.4)% $ 14,287 $14,052 1.7% as % of total net revenues 5.9% 7.0% 7.0% 7.9%
Research and development expense for the first six months of fiscal 2007 grew at a slower rate than management anticipated due to the timing of certain clinical studies that have been re-scheduled. Although the level of research and development expense for the first six months was below management's expectation, we continue to project that future research and development costs will increase based on our growing product development pipeline. 46 PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT - --------------------------------------------- ($ IN THOUSANDS) - --------------------------------
THREE MONTHS ENDED SIX MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ---------------------------------- ---------------------------------- % % 2006 2005 CHANGE 2006 2005 CHANGE --------- --------- -------- --------- ---------- --------- Purchased in-process research and development $ - $ - - % $ - $30,441 NM as % of total net revenues - % - % - % 17.2%
During the six months ended September 30, 2005, we recorded expense of $30.4 million in connection with the FemmePharma acquisition (see Note 3 to the Consolidated Financial Statements) that consisted of $29.6 million for acquired in-process research and development and $0.9 million in direct expenses related to the transaction. The valuation of acquired in-process research and development represented the estimated fair value of the worldwide marketing rights to an endometriosis product we acquired as part of the FemmePharma, Inc. acquisition that, at the time of the acquisition, had no alternative future use and for which technological feasibility had not been established. SELLING AND ADMINISTRATIVE - -------------------------- ($ IN THOUSANDS) - --------------------------
THREE MONTHS ENDED SIX MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ---------------------------------- ---------------------------------- % % 2006 2005 CHANGE 2006 2005 CHANGE --------- --------- -------- --------- ---------- --------- (AS RESTATED) (AS RESTATED) Selling and administrative $42,855 $37,847 13.2% $83,008 $75,599 9.8% as % of total net revenues 39.3% 41.0% 40.5% 42.6%
The increases in selling and administrative expense of $5.0 million and $7.4 million for the three- and six-month periods were primarily due to greater personnel costs associated with increases in management and other personnel and increases in expense resulting from facility expansion. The increases in personnel costs were also impacted by the adoption of SFAS 123R, "Share Based Payment," using the modified prospective method which resulted in the recognition of incremental stock-based compensation expense during the three- and six-month periods of $0.8 million and $1.5 million, respectively. We adopted SFAS 123R using the modified prospective method and, as a result, did not retroactively adjust results from prior periods. Prior to the adoption of SFAS 123R, we accounted for stock-based compensation using the intrinsic value method prescribed in APB 25, (see the "Explanatory Note" immediately preceding Part I, Item 1, "Management's Discussion and Analysis of Financial Condition and Results of Operation", and Note 2 "Restatement of Consolidated Financial Statements" in the Notes to Consolidated Financial Statements of this Form 10-Q). For the six-month period, the increase in selling and administrative expense was offset in part by a $0.8 million reimbursement of legal fees received during the first quarter. OPERATING INCOME (LOSS) - -------------------------- ($ IN THOUSANDS) - --------------------------
THREE MONTHS ENDED SIX MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ---------------------------------- ---------------------------------- % % 2006 2005 CHANGE 2006 2005 CHANGE --------- --------- -------- --------- ---------- --------- (AS RESTATED) (AS RESTATED) Operating income (loss) $19,652 $14,204 38.4% $33,165 $(3,794) NM
For the six-month period, the improvement in operating income (loss) was primarily due to the $30.4 million of expense we recorded during the six months ended September 30, 2005 in connection with the FemmePharma acquisition. Excluding the effect of this $30.4 million of expense, operating income for the six months ended September 30, 2006 would have increased $6.5 million, or 24.5%. 47 INTEREST EXPENSE - ---------------- ($ IN THOUSANDS) - --------------------------
THREE MONTHS ENDED SIX MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ---------------------------------- ---------------------------------- % % 2006 2005 CHANGE 2006 2005 CHANGE --------- --------- -------- --------- ---------- --------- Interest expense $2,305 $1,467 57.1% $4,541 $2,844 60.0% as % of total net revenues 2.1% 1.6% 2.2% 1.6%
The increases in interest expense for the three- and six-month periods resulted from interest incurred on the $43.0 million mortgage loan agreement we entered into in March 2006 coupled with the completion of a number of capital projects during fiscal 2006 and the related reduced level of capitalized interest thereon. INTEREST AND OTHER INCOME - -------------------------- ($ IN THOUSANDS) - --------------------------
THREE MONTHS ENDED SIX MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ---------------------------------- ---------------------------------- % % 2006 2005 CHANGE 2006 2005 CHANGE --------- --------- -------- --------- ---------- --------- Interest and other income $2,308 $1,077 114.3% $4,366 $2,130 105.0% as % of total net revenues 2.1% 1.2% 2.1% 1.2%
The increases in interest and other income for the three- and six-month periods were primarily due to an increase in interest income on short- term investments and dividends earned on the Strides redeemable preferred stock investment. The increases in interest income on short- term investments resulted from an increase in the average balance of invested cash and an increase in short-term interest rates. PROVISION FOR INCOME TAXES - -------------------------- ($ IN THOUSANDS) - --------------------------
THREE MONTHS ENDED SIX MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ---------------------------------- ---------------------------------- % % 2006 2005 CHANGE 2006 2005 CHANGE --------- --------- -------- --------- ---------- --------- (AS RESTATED) (AS RESTATED) Provision for income taxes $7,570 $5,224 44.9% $12,783 $9,790 30.6% Effective tax rate 38.5% 37.8% 38.7% 37.8%
The effective tax rates for the three- and six-month periods were adversely affected by the expiration of Federal research and experimentation tax credits on December 31, 2005. Additional credits could not be recognized until passed by Congress and signed into law. The effective tax rates for all periods were also adversely affected by the non-deductibility of stock-based compensation on certain of our outstanding stock options that were issued as incentive stock options (see Note 2 to the Consolidated Financial Statements). For the six months ended September 30, 2005, we recorded a provision for income taxes as the $30.4 million of expense we recognized for the FemmePharma acquisition was determined to not be deductible for tax purposes. The effective tax rate of 37.8% for that period was applied to a pre-tax income amount for the six months ended September 30, 2005 that excluded the FemmePharma acquisition expense of $30.4 million. 48 NET INCOME (LOSS) AND DILUTED EARNINGS (LOSS) PER SHARE - ------------------------------------------------------- ($ IN THOUSANDS) - --------------------------
THREE MONTHS ENDED SIX MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ---------------------------------- ---------------------------------- % % 2006 2005 CHANGE 2006 2005 CHANGE --------- --------- -------- --------- ---------- --------- (AS RESTATED) (AS RESTATED) Net income (loss) $12,085 $8,590 40.7% $22,183 $(14,298) NM Diluted earnings (loss) per Class A share 0.22 0.16 37.5% 0.41 (0.29) NM Diluted earnings (loss) per Class B share 0.19 0.14 35.7% 0.35 (0.29) NM
For the fiscal 2007 six-month period, the improvement in net income per share was primarily due to the $30.4 million of expense we recorded during the six months ended September 30, 2005 in connection with the FemmePharma acquisition. Excluding the effect of the $30.4 million of expense associated with the prior year acquisition of FemmePharma, net income for the six months ended September 30, 2006 would have increased $6.0 million, or 37.4%. LIQUIDITY AND CAPITAL RESOURCES Cash and cash equivalents and working capital were $58.7 million and $324.2 million, respectively, at September 30, 2006, compared to $100.7 million and $305.0 million, respectively, at March 31, 2006. The decrease in cash and cash equivalents resulted primarily from the $46.7 million of additional short-term marketable securities that were purchased and classified as available for sale during the six months ended September 30, 2006. The primary source of operating cash flow used in the funding of our businesses continues to be internally generated funds from product sales. For the six months ended September 30, 2006, our net cash flow from operations of $23.3 million resulted primarily from net income. In addition, we had $115.8 million invested in auction rate securities ("ARS") at September 30, 2006. The ARS held by the Company are AAA rated securities with long-term maturities secured by student loans which are guaranteed by the U.S. Government. The interest rates on these securities are reset through an auction process that resets the applicable interest rate at pre-determined intervals, up to 35 days. Subsequent to September 30, 2006 the ARS market has experienced liquidity issues due to emerging instability in the broader credit and capital markets. As a result, all of the ARS held by the Company have recently experienced failed auctions as the amount of securities submitted for sale has exceeded the amount of purchase orders. Given the failed auctions, the Company's ARS are illiquid until there is a successful auction for them. We cannot predict how long the current imbalance in the auction rate market will continue. We are currently evaluating the market for these securities to determine if impairment of the carrying value of the securities has occurred due to the loss of liquidity. However, the Company believes that as of December 31, 2007, based on its current cash, cash equivalents and marketable securities balances of $112 million (exclusive of ARS) and its current borrowing capacity under its credit facility of $290 million, the current lack of liquidity in the auction rate market will not have a material impact on its ability to fund its operations or interfere with the Company's external growth plans. (See Note 16 to the Notes to Consolidated Financial Statements). Net cash flow used in investing activities included capital expenditures of $18.3 million for the six months ended September 30, 2006 compared to $36.9 million for the corresponding prior year period. In June 2006, the Company completed the purchase of a 126,000 square foot building in the St. Louis metropolitan area for $4.9 million. The property had been leased by the Company since June 2001 and is used as a manufacturing facility and office space. The purchase price was paid in cash. The remaining capital expenditures during the six-month period were primarily for purchasing machinery and equipment to upgrade and expand our pharmaceutical manufacturing and distribution capabilities, and for other building renovation projects. Other investing activities during the six-month period consisted of $46.7 million in purchases of short- term marketable securities that were classified as available for sale and a $0.4 million payment for preferred stock. For the prior year six- month period, other investing activities included the acquisition of FemmePharma for a $25.6 million cash payment and the purchase of Strides redeemable preferred stock for $11.3 million (see Note 3 to the Consolidated Financial Statements). Our debt balance including current maturities, was $242.3 million at September 30, 2006 compared to $243.0 million 49 at March 31, 2006. In March 2006, we entered into a $43.0 million mortgage loan agreement with one of our primary lenders, in part, to refinance $9.9 million of existing mortgages. The $32.8 million of net proceeds we received from this mortgage loan was used for working capital and general corporate purposes. The mortgage loan bears interest at a rate of 5.91% and matures on April 1, 2021. In May 2003, we issued $200.0 million principal amount of Convertible Subordinated Notes that are convertible, under certain circumstances, into shares of our Class A Common Stock at a conversion price of $23.01 per share subject to possible adjustment. 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 June 9, 2006, we replaced our $140.0 million credit line by entering into a new syndicated credit agreement with ten banks that provides for a revolving line of credit for borrowing up to $320.0 million. The new credit agreement also includes a provision for increasing the revolving commitment, at the lenders' sole discretion, by up to an additional $50.0 million. The new credit facility is unsecured unless we, under certain specified circumstances, utilize the facility to redeem part or all of our outstanding Convertible Subordinated Notes. Interest is charged under the facility at the lower of the prime rate or one-month LIBOR plus 62.5 to 150 basis points depending on the ratio of our senior debt to EBITDA. The new credit agreement contains financial covenants that impose limits on dividend payments, require minimum equity, a maximum senior leverage ratio and minimum fixed charge coverage ratio. The new credit facility has a five-year term expiring in June 2011. As of September 30, 2006, we were in compliance with all of our financial covenants and there were no borrowings outstanding under the facility. In addition, the agreement requires that we submit annual audited financial statements to the lenders within 90 days of the close of the fiscal year and quarterly financial statements within 45 days of the close of each fiscal quarter. The Company has obtained the consent of the lenders to extend the period for submission of the audited financial statements for the year ended March 31, 2007 to March 31, 2008 and for the submission of the quarterly financial statements for the quarters ended June 30, 2007, September 30, 2007 and December 31, 2007 to May 31, 2008. In December 2005, we entered into a financing arrangement with St. Louis County, Missouri related to expansion of our operations in St. Louis County (see Note 11 of the Notes to Consolidated Financial Statements). Up to $135.5 million of industrial revenue bonds may be issued to us by St. Louis County relative to capital improvements made through December 31, 2009. This agreement provides that 50% of the real and personal property taxes on up to $135.5 million of capital improvements will be abated for a period of ten years subsequent to the property being placed in service. Industrial revenue bonds totaling $73.0 million were outstanding at September 30, 2006. The industrial revenue bonds are issued by St. Louis County to us upon our payment of qualifying costs of capital improvements, which are then leased by us for a period ending December 1, 2019, unless earlier terminated. We have the option at any time to discontinue the arrangement and regain full title to the abated property. The industrial revenue bonds bear interest at 4.25% per annum and are payable as to principal and interest concurrently with payments due under the terms of the lease. We have classified the leased assets as property and equipment and have established a capital lease obligation equal to the outstanding principal balance of the industrial revenue bonds. Lease payments may be made by tendering an equivalent portion of the industrial revenue bonds. As the capital lease payments to St. Louis County may be satisfied by tendering industrial revenue bonds (which is our intention), the capital lease obligation, industrial revenue bonds and related interest expense and interest income, respectively, have been offset for presentation purposes in the Consolidated Financial Statements. 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 50 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 facilities, 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 years. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Our Consolidated Financial Statements are presented on the basis of GAAP. Certain of our accounting policies are particularly important to the presentation of our financial condition and results of operations and require the application of significant judgment by our management. As a result, amounts determined under these policies are subject to an inherent degree of uncertainty. In applying these policies, we make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures. We base our estimates and judgments on historical experience, the terms of existing contracts, observance of trends in the industry, information that is obtained from customers and outside sources, and on various other assumptions that we believe to be reasonable and appropriate under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Although we believe that our estimates and assumptions are reasonable, actual results may differ significantly from our estimates. Changes in estimates and assumptions based upon actual results may have a material impact on our results of operations and/or financial condition. Our critical accounting estimates are described below. REVENUE RECOGNITION AND PROVISIONS FOR ESTIMATED REDUCTIONS TO GROSS - -------------------------------------------------------------------- REVENUES. Revenue is generally realized or realizable and earned when - --------- persuasive evidence of an arrangement exists, the seller's price to the buyer is fixed or determinable, the customer's payment ability has been reasonably assured and title and risk of ownership have been transferred to the customer. Simultaneously with the recognition of revenue, we reduce the amount of gross revenues by recording estimated sales provisions for chargebacks, sales rebates, sales returns, cash discounts and other allowances, and Medicaid rebates. These sales provisions are established based upon consideration of a variety of factors, including among other factors, historical relationship to revenues, historical payment and return experience, estimated and actual customer inventory levels, customer rebate arrangements, and current contract sales terms with wholesale and indirect customers. From time to time, we provide incentives to our wholesale customers, such as trade show allowances or stocking allowances that they in turn use to accelerate distribution to their end customers. We believe that these incentives are normal and customary in the industry. Sales allowances are accrued and revenue is recognized as sales are made in accordance with the terms of the allowances offered to the customer. Due to the nature of these allowances, we are able to accurately calculate the required provisions for the allowances based on the specific terms in each agreement. Additionally, customers will normally purchase additional product ahead of regular demand to take advantage of the temporarily lower cost resulting from the sales allowances. This practice has been customary in the industry and we believe would be part of a customer's ordinary course of business inventory level. We reserve the right, with our major wholesale customers, to limit the amount of these forward buys. Sales made as a result of allowances offered on our specialty generics product line in conjunction with trade shows sponsored by our major wholesale customers and for other promotional programs accounted for 16.0% and 13.5% of total gross revenues for the six months ended September 30, 2006 and 2005, respectively. 51 In addition, we understand that certain of our wholesale customers have anticipated the timing of price increases and have made, and may continue to make, business decisions to buy additional product in anticipation of future price increases. This practice has been customary in the industry and we believe would be part of a customer's ordinary course of business inventory level. We evaluate inventory levels at our wholesale customers, which accounted for approximately 60% of our unit sales during the six months ended September 30, 2006, through an internal analysis that considers, among other things, wholesaler purchases, wholesaler contract sales, available end consumer prescription information and inventory data received from our three largest wholesaler customers. We believe that our evaluation of wholesaler inventory levels allows us to make reasonable estimates of our reserve balances. Further, our products are typically sold with adequate shelf life to permit sufficient time for our wholesaler customers to sell our products in their inventory through to the end consumer. The following table reflects the activity during the six months ended September 30, 2006 for each accounts receivable reserve:
CURRENT CURRENT ACTUAL PROVISION PROVISION RETURNS RELATED TO RELATED TO OR CREDITS SALES MADE IN SALES MADE IN IN THE (in thousands) BEGINNING THE CURRENT THE PRIOR CURRENT ENDING BALANCE PERIOD PERIODS PERIOD BALANCE --------- ------------- ------------ --------- ------- SIX MONTHS ENDED SEPTEMBER 30, 2006 (as restated) Accounts Receivable Reserves: Chargebacks $14,312 $46,111 $ - $(45,639) $14,784 Sales Rebates 2,214 6,877 - (5,670) 3,421 Sales Returns 2,127 5,952 - (5,516) 2,563 Cash Discounts and Other Allowances 4,226 8,562 - (8,329) 4,459 Medicaid Rebates 5,818 4,692 - (4,261) 6,249 ------- ------- --------- -------- ------- TOTAL $28,697 $72,194 $ - $(69,415) $31,476 ======= ======= ========= ======== =======
The increase in the reserve for chargebacks at September 30, 2006 was primarily due to chargeback reserves established on certain specialty generic products introduced in fiscal 2007. The higher reserve for sales rebates at September 30, 2006 resulted from increased reserves on rebates associated with branded product sales to managed care organizations that began late in fiscal 2006. The increase in the reserve for sales returns at September 30, 2006 was primarily due to an increase in the estimated level of inventory in the distribution channel at the end of the quarter. The impact of increased utilization of our branded products by state Medicaid programs during the past two years resulted in a larger reserve for Medicaid rebates at September 30, 2006. The reserves for sales rebates and cash discounts and other allowances require a lower degree of subjectivity, are less complex in nature and are more readily ascertainable due to specific contract terms, rates and consistent historical performance. The reserves for chargebacks, sales returns and Medicaid rebates, however, are more complex and require management to make more subjective judgments. These reserves and their respective provisions are discussed in further detail below. Chargebacks - We market and sell products directly to wholesalers, - ----------- distributors, warehousing pharmacy chains, mail order pharmacies and other direct purchasing groups. We also market products indirectly to independent pharmacies, non-warehousing chains, managed care organizations, and group purchasing organizations, collectively referred to as "indirect customers." We enter into agreements with some indirect customers to establish contract pricing for certain products. These indirect customers then independently select a wholesaler from which to purchase the products at these contracted prices. Alternatively, we may pre-authorize wholesalers to offer specified contract pricing to other indirect customers. Under either arrangement, we provide credit to the wholesaler for any difference between the contracted price with the indirect customer and the wholesaler's invoice price. This credit is called a chargeback. Chargeback transactions are almost exclusively related to our specialty generics business segment. During the six months ended September 30, 2006 and 2005, the chargeback provision reduced the gross sales of our specialty generics 52 segment by $45.7 million and $48.7 million, respectively. These amounts accounted for 99.2% and 99.3% of the total chargeback provisions recorded during the six months ended September 30, 2006 and 2005, respectively. The provision for chargebacks is the most significant and complex estimate used in the recognition of revenue. The primary factors we consider in developing and evaluating the reserve for chargebacks include: * The amount of inventory in the wholesale distribution channel. We receive actual inventory information from our three major wholesale customers and estimate the inventory position of the remaining wholesalers based on historical buying patterns. During the six months ended September 30, 2006, unit sales to our three major wholesaler customers accounted for 81% of our total unit sales to all wholesalers, and the aggregate inventory position of the three major wholesalers at September 30, 2006 was approximately equivalent to our last ten weeks of shipments during the fiscal year. We currently use the last six weeks of our shipments as an estimate of the inventory held by the remaining wholesalers where we do not receive actual inventory data, as our experience and buying patterns indicate that our smaller wholesaler customers carry less inventory than our large wholesaler customers. As of September 30, 2006, each week of inventory for those remaining wholesalers represented approximately $0.2 million, or 1.3%, of the reported reserve for chargebacks. * The percentage of sales to our wholesaler customers that will result in chargebacks. Using our automated chargeback system we track, at the product level, the percentage of sales units shipped to our wholesaler customers that eventually result in chargebacks to us. The percentage for each product, which is based on actual historical experience, is applied to the respective inventory units in the wholesale distribution channel. As of September 30, 2006, the aggregate weighted average percentage of sales to wholesalers assumed to result in chargebacks was approximately 95%, with each 1% representing approximately $0.2 million, or 1.1%, of the reported reserve for chargebacks. * Contract pricing and the resulting chargeback per unit. The chargeback provision is based on the difference between our invoice price to the wholesaler, or "WAC," and the contract price negotiated with either our indirect customer or with the wholesaler for sales by the wholesaler to the indirect customers. We calculate the price difference, or chargeback per unit, for each product and for each major wholesaler customer using historical weighted average pricing, based on actual chargeback experience. Use of weighted average pricing over time compensates for changes in the mix of indirect customers and products from period to period. As of September 30, 2006, a 5% shift in the calculated chargeback per unit in the same direction across all products and customers would result in a $0.8 million, or 5.2%, impact on the reported reserve for chargebacks. Shelf-Stock Adjustments - These adjustments represent credits issued to - ----------------------- our wholesale customers that result from a decrease in our WAC. Decreases in our invoice prices are discretionary decisions we make to reflect market conditions. These credits are customary in the industry and are intended to reduce a wholesale customer's inventory cost to better reflect current market prices. Generally, we provide credits to customers at the time the price reduction occurs based on the inventory that is owned by them on the effective date of the price reduction. Since a reduction in WAC reduces the chargeback per unit, or the difference between WAC and the contract price, shelf-stock adjustments are typically included as part of the reserve for chargebacks because the price reduction credits act essentially as accelerated chargebacks. Although we have contractually agreed to provide price adjustment credits to our major wholesale customers at the time they occur, the impact of any such price reductions not included in the reserve for chargebacks is immaterial to the amount of revenue recognized in any given period. In the first quarter, our specialty generics segment reduced the invoice price to our wholesale customers (referred to as wholesale acquisition cost, or "WAC") on a number of generic products. As a result of a WAC decrease to certain generic products, we paid shelf-stock adjustments of $1.4 million and $5.9 million to our wholesale customers during the three and six months ended September 30, 2006, respectively. The $1.4 million of shelf-stock adjustments that we paid during the second quarter were included in the June 30, 2006 reserve for chargebacks. Sales Returns - Consistent with industry practice, we maintain a returns - ------------- policy that allows our direct and indirect customers to return product six months prior to expiration and within one year after expiration. This policy is applicable to both our branded and specialty generics business segments. Upon recognition of revenue from product sales to customers, we provide for an estimate of product to be returned. This estimate is determined by applying a historical relationship of customer returns to gross sales. We evaluate the reserve for sales returns by calculating historical return rates using data from the last 12 months on a product specific basis and by class of trade (wholesale 53 versus retail chain). The calculated percentages are applied against estimates of inventory in the distribution channel on a product specific basis. To determine the inventory levels in the wholesale distribution channel, we utilize actual inventory information from our major wholesale customers and estimate the inventory positions of the remaining wholesalers based on historical buying patterns. For inventory held by our non-wholesale customers, we use the last two months of sales to the direct buying chains and the indirect buying retailers as an estimate. A 10% change in the product specific historical return rates used in the reserve analysis would have changed the reserve balance at September 30, 2006 by approximately $0.2 million, or 7.6%, of the reported reserve for sales returns. A 10% change in the amount of estimated inventory in the distribution channel would have changed the reserve balance at September 30, 2006 by approximately $0.2 million, or 8.5%, of the reported reserve for sales returns. Medicaid Rebates - Established in 1990, the Medicaid Drug Rebate Program - ---------------- requires a drug manufacturer to provide to each state a rebate every calendar quarter for covered outpatient drugs dispensed to Medicaid patients. Medicaid rebates apply to both our branded and specialty generic segments. Individual states invoice us for Medicaid rebates on a quarterly basis using statutorily determined rates for generic (11%) and branded (15%) products, which are applied to the Average Manufacturer's Price, or "AMP," for a particular product to arrive at a Unit Rebate Amount, or "URA." The amount owed is based on the number of units dispensed by the pharmacy to Medicaid patients extended by the URA. The reserve for Medicaid rebates is based on expected payments, which are affected by patient usage and estimated inventory in the distribution channel. We estimate patient usage by calculating a payment rate as a percentage of net sales lagged six months, which is then applied to an estimate of customer inventory. We currently use the last two months of our shipments to wholesalers and direct buying chains as an estimate of inventory in the wholesale and chain channels and an additional month of wholesale sales as an estimate of inventory held by the indirect buying retailer. A 10% change in the amount of customer inventory subject to Medicaid rebates would have changed the reserve at September 30, 2006 by $0.7 million, or 11.0% of the reported reserve for Medicaid rebates. Similarly, a 10% change in estimated patient usage would have changed the reserve at September 30, 2006 by $0.7 million, or 11.0% of the reported reserve for Medicaid rebates. INVENTORY VALUATION. Inventories consist of finished goods held for - ------------------- distribution, raw materials and work in process. Our inventories are stated at the lower of cost or market, with cost determined on the first-in, first-out basis. In evaluating whether inventory should be stated at the lower of cost or market, we consider such factors as the amount of inventory on hand and in the distribution channel, estimated time required to sell existing inventory, remaining shelf life and current and expected market conditions, including levels of competition. We establish reserves, when necessary, for slow-moving and obsolete inventories based upon our historical experience and management's assessment of current product demand. INTANGIBLE ASSETS. Our intangible assets principally consist of product - ----------------- rights, license agreements and trademarks resulting from product acquisitions and legal fees and similar costs relating to the development of patents and trademarks. Intangible assets that are acquired are stated at cost, less accumulated amortization, and are amortized on a straight-line basis over their estimated useful lives. 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. 54 STOCK-BASED COMPENSATION. As discussed in Note 3 of the Notes to - ------------------------ Consolidated Financial Statements, effective April 1, 2006, we adopted SFAS 123R, which requires the measurement and recognition of compensation expense, based on estimated fair values, for all share- based compensation awards made to employees and directors over the vesting period of the awards. The Company adopted SFAS 123R using the modified prospective method and, as a result, did not retroactively adjust results from prior periods. Under the modified prospective method, stock-based compensation was recognized (1) for the unvested portion of previously issued awards that were outstanding at the initial date of adoption based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123 and (2) for any awards granted on or subsequent to the effective date of SFAS 123R based on the grant date fair value estimated in accordance with the provisions of this statement. Prior to the adoption of SFAS 123R, the Company measured compensation expense for its employee stock-based compensation plans using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25 ("APB 25"). The Company also applied the disclosure provisions of SFAS 123, as amended by SFAS 148, as if the fair-value-based method had been applied in measuring compensation expense. Determining the fair value of share-based awards at the grant date requires judgment to identify the appropriate valuation model and estimate the assumptions, including the expected term of the stock options and expected stock-price volatility, to be used in the calculation. Judgment is also required in estimating the percentage of share-based awards that are expected to be forfeited. We estimated the fair value of stock options granted using the Black-Scholes option- pricing model with assumptions based primarily on historical data. If actual results differ significantly from these estimates, stock-based compensation expense and our results of operations could be materially impacted. INCOME TAXES. Our deferred tax assets and liabilities are determined - ------------ based on temporary differences between financial reporting and tax bases of assets and liabilities. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets are expected to be realized or settled. We record a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. Management believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with the tax effects of the deferred tax liabilities, will be sufficient to fully recover the remaining deferred tax assets. If all or part of the net deferred tax assets are determined not to be realizable in the future, an adjustment to the valuation allowance would be charged to earnings in the period such determination is made. Similarly, if we subsequently realize deferred tax assets that were previously determined to be unrealizable, the respective valuation allowance would be reversed, resulting in a positive adjustment to earnings in the period such determination is made. Management regularly reevaluates the Company's tax positions taken on filed tax returns using information about recent tax court decisions and legislative activities. Many factors are considered in making these evaluations, including past history, recent interpretations of tax law, and the specific facts and circumstances of each matter. Because tax regulations are subject to interpretation and tax litigation is inherently uncertain, these evaluations can involve a series of complex judgments about future events and can rely heavily on estimates and assumptions. The recorded tax liabilities are based on estimates and assumptions that have been deemed reasonable by management. However, if our estimates are not representative of actual outcomes, recorded tax liabilities could be materially impacted. Our accounting for income taxes in fiscal 2008 will be affected by the adoption of FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109." See Note 15 of the Notes to Consolidated Financial Statements. CONTINGENCIES. We are involved in various legal proceedings, some of - ------------- which involve claims for substantial amounts. An estimate is made to accrue for a loss contingency relating to any of these legal proceedings if 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 condition or results of operations, such estimates are considered to be critical accounting estimates. After review, it was determined at September 30, 2006 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. 55 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Our exposure to market risk is limited to fluctuating interest rates associated with variable rate indebtedness and marketable securities that are subject to interest rate changes. 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 September 30, 2006. The majority of our investments in marketable securities are tax exempt auction rate securities. The rates on these securities reset at pre- determined interval up to 35 days. As of September 30, 2006 we had invested $115.8 million in auction rate securities, primarily in high quality (AAA rated) bonds secured by student loans which are guaranteed by the U.S. Government. Recent developments in the capital and credit markets subsequent to September 30, 2006 have adversely affected the market for auction rate securities, which has resulted in a loss of liquidity for these investments. We are currently evaluating these securities to determine if impairment of the carrying value of the securities has occurred due to the loss of liquidity. (See Note 16 to the Consolidated Financial Statements for further discussion of our investment in auction rate securities). However, the Company believes that as of December 31, 2007, based on its current cash, cash equivalents and marketable securities balances of $112 million (exclusive of auction rate securities) and its current borrowing capacity of $290 million under its credit facility, the current lack of liquidity in the auction rate market will not have a material impact on its ability to fund its operations or interfere with the Company's external growth plans. 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% and therefore not subject to interest rate changes. Beginning May 16, 2006, we are 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. As of May 15, 2006, the average trading price of the Convertible Subordinated Notes had not reached the price that would result in the payment of contingent interest. In March 2006, we entered into a $43.0 million mortgage loan secured by three of our buildings that matures in April 2021. The interest rate on this loan is fixed at 5.91% per annum and not subject to market interest rate changes. ITEM 4. CONTROLS AND PROCEDURES Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, as of the end of the period of this report, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) and determined that, as a result of material weaknesses in internal control over financial reporting described below, as of December 31, 2006 our disclosure controls and procedures were not effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms. The Public Company Accounting Oversight Board's Auditing Standard No. 2 defines a material weakness as a significant deficiency, or a combination of significant deficiencies, that results in there being a more than remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The Company identified a material weakness in its internal control over financial reporting as of March 31, 2007 related to the determination of appropriate measurement dates and forfeiture provisions for stock option grants to employees; accordingly, the measurement dates used for certain option grants were not appropriate, and the accounting for those grants was not in accordance with Accounting Principles Board Opinion 25, Accounting for Stock Issued to Employees ("APB 25"). The material weakness resulted from the combined effect of the following control deficiencies: The design of the Company's policies, procedures and control activities did not adequately address the financial reporting risks associated with stock options. Specifically, these deficiencies in the design of the Company's controls resulted in a more than remote likelihood of a material misstatement in the Company's financial statements in each of 56 the following areas: * Determining measurement dates, * Determining forfeiture provisions, and * Determining the tax treatment of stock option awards. The Company's policies and procedures to ensure that the necessary information was captured and communicated to those responsible for stock option accounting were inadequate. This resulted in a more than remote likelihood of a material misstatement in the Company's financial statements. The Company's finance and accounting personnel and personnel involved in the stock option granting and administration process were inadequately trained. This resulted in a more than remote likelihood of a material misstatement in the Company's financial statements. In addition, and unrelated to accounting for stock-based compensation, in August, 2006 our management identified additional liabilities associated with tax positions taken on filed tax returns that should have been recorded in accordance with GAAP, partially offset by certain expected tax refunds for the years ended March 31, 2004 through 2006. We have determined that these errors in our accounting for income taxes resulted from a material weakness in our internal control over financial reporting. Specifically, the design of the Company's policies, procedures and control activities did not adequately address the financial reporting risks associated with uncertain tax positions and were inadequate in ensuring that the necessary information was captured and communicated to those responsible for accounting for uncertain tax positions. This resulted in a more than remote likelihood of a material misstatement in the Company's financial statements. In addition, management identified a material weakness in our internal control over financial reporting as of March 31, 2007 related to revenue recognition. Specifically, the design of the Company's policies, procedures, and control activities did not adequately address the financial reporting risks associated with customer shipping terms. This resulted in a more than remote likelihood of a material misstatement in the Company's financial statements. As a result of financial statement errors attributable to the material weaknesses described above, we will file a comprehensive Form 10-K for the fiscal year ended March 31, 2007 in which we will restate our consolidated statements of earnings, of shareholders' equity and comprehensive income and of cash flows for the years ended March 31, 2006 and 2005, our consolidated balance sheet as of March 31, 2006 and selected consolidated financial data for the years ended March 31, 2006, 2005, 2004, and 2003, and for each of the quarters in the year ended March 31, 2006. PART II. - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The information set forth under Note 14 - CONTINGENCIES - LITIGATION of the Notes to Consolidated Financial Statements included in Part I of this report is incorporated in this Part II, Item I by reference. ITEM 1A. 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. 57 RISKS RELATED TO OUR BUSINESS THE MATTERS RELATING TO THE INVESTIGATION BY THE SPECIAL COMMITTEE AND THE RESTATEMENT OF THE COMPANY'S CONSOLIDATED FINANCIAL STATEMENTS MAY RESULT IN ADDITIONAL LITIGATION AND GOVERNMENTAL ENFORCEMENT ACTIONS. We announced at an earlier date that our Board of Directors had formed a Special Committee of outside directors to conduct an investigation, with the assistance of independent legal counsel and forensic accounting experts, of our past stock option grant practices over the period January 1, 1995 through October 31, 2006. The investigation concluded that no employee, officer or director of the Company engaged in any intentional wrongdoing or was aware that the Company's policies and procedures for granting and accounting for stock options were materially noncompliant with GAAP. The investigation also found no intentional violation of law or accounting rules with respect to the Company's historical stock option grant practices. However, as a result of the independent investigation, the Special Committee concluded, and based on its internal review, management agrees, that incorrect measurement dates were used for financial accounting purposes for stock option grants made in certain prior periods. Therefore, we have recorded additional non-cash stock-based compensation expense, and related tax effects, with regard to certain past stock option grants, and we have restated certain previously filed financial statements included in this Form 10-Q, as more fully described in the Explanatory Note immediately preceding Part I, Item 1, in "Management's Discussion and Analysis of Financial Condition and Results of Operation" in Item 7, and in Note 2 "Restatement of Consolidated Financial Statements" of the Notes to Consolidated Financial Statements in this Form 10-Q. The independent investigation, management's internal review and related activities have required us to incur substantial expenses for legal, accounting, tax and other professional services, have diverted some of our management's attention from the Company's business, and could have a material adverse effect on our business, financial condition, results of operations and cash flows. While we believe we have made appropriate judgments in determining the correct measurement dates for our stock option grants, based upon the Special Committee's findings and in consultation with outside experts and our independent registered public accounting firm, the SEC may disagree with the manner in which we have accounted for and reported, the financial impact in our consolidated financial statements. Accordingly, there is a risk we may have to further restate our prior financial statements, amend prior filings with the SEC, or take other actions not currently contemplated by us. Our past stock option grant practices and the restatement of prior financial statements have exposed the Company to risks associated with litigation, regulatory proceedings and government enforcement actions. As described in Note 14 to our Consolidated Financial Statements, "Contingencies - Litigation," several derivative lawsuits have been filed in state and federal courts against certain current and former directors and executive officers pertaining to allegations relating to stock option grants. Also, the Company was notified by the SEC in December 2006 that it had initiated a confidential, informal inquiry with respect to the Company's stock option plans, grants, exercises and accounting practices. Outcomes of litigation or regulatory proceedings relating to the Company's past stock option practices may have a material adverse effect on our financial condition, results of operations or cash flows. The resolution of these matters will continue to be time-consuming, expensive, and a distraction of management from the conduct of the Company's business. Furthermore, if we are subject to adverse findings in litigation or regulatory proceedings we could be required to pay damages or penalties or have other remedies imposed. WE HAVE MATERIAL WEAKNESSES IN INTERNAL CONTROL OVER FINANCIAL REPORTING AND CANNOT ASSURE YOU THAT ADDITIONAL MATERIAL WEAKNESSES WILL NOT BE IDENTIFIED IN THE FUTURE. Section 404 of the Sarbanes-Oxley Act of 2002 requires us to evaluate the effectiveness of our internal control over financial reporting as of the end of each year, and to include a management report assessing the effectiveness of our internal control over financial reporting in each Annual Report on Form 10-K. Section 404 also requires our independent registered public accounting firm to attest to, and report on, management's assessment of the Company's internal control over financial reporting. In assessing the findings of the investigation as well as the restatement, management concluded that there were material 58 weaknesses, as defined in the Public Company Accounting Oversight Board's Auditing Standard No. 2, in our internal control over financial reporting as of September 30, 2006. Management is implementing steps to remediate these material weaknesses by March 31, 2008, however, we cannot assure you that such remediation will be effective. See the discussion included in Item 4 of this report for additional information regarding our internal control over financial reporting. Our internal control over financial reporting may not prevent all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system's objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. Over time, controls may become inadequate because changes in conditions or deterioration in the degree of compliance with policies or procedures may occur. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. As a result, significant deficiencies or material weaknesses in our internal control over financial reporting may be identified in the future. Any failure to maintain or implement required new or improved controls, or any difficulties we encounter in their implementation, could result in significant deficiencies or material weaknesses, cause us to fail to timely meet our periodic reporting obligations, or result in material misstatements in our financial statements. Any such failure could also adversely affect the results of periodic management evaluations and annual auditor attestation reports regarding disclosure controls and the effectiveness of our internal control over financial reporting required under Section 404 of the Sarbanes-Oxley Act of 2002 and the rules promulgated there under. If our internal control over financial reporting or disclosure controls and procedures are not effective, there may be errors in our financial statements that could require a restatement or our filings may not be timely and investors may lose confidence in our reported financial information, which could lead to a decline in our stock price. OUR FUTURE GROWTH WILL LARGELY DEPEND UPON OUR ABILITY TO DEVELOP NEW PRODUCTS. We need to continue to develop and commercialize new branded products and generic/non-branded products utilizing our proprietary drug delivery systems to maintain the growth of our business. 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/non-branded 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/non-branded products, assuming they would be available for licensing, which could decrease our profitability. We may not be successful in pursuing this strategy. IF WE ARE UNABLE TO COMMERCIALIZE PRODUCTS UNDER DEVELOPMENT OR THAT WE ACQUIRE, OUR FUTURE OPERATING RESULTS MAY SUFFER. Certain products we develop or acquire 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 or at all. OUR ACQUISITION STRATEGY MAY NOT BE SUCCESSFUL. We intend to continue to pursue our efforts 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 and other types of pharmaceutical companies for products and product line acquisitions. Many of these competitors have substantially greater financial and managerial resources than we have. 59 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, our pending or future patent applications may not 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. 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. 60 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. They could have a material adverse effect on our future financial position, results of operations or cash flows. 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, sales, customer support and financial control systems and (2) hire, train and retain qualified personnel. If we are unable to manage our growth effectively, our financial position, results of operations or cash flows could be materially adversely affected. 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, 2006, our three largest customers, which are wholesale distributors, accounted for 27%, 16% and 13% of our gross sales. The loss of any of these customers could materially and adversely affect our financial position, results of operations or cash flows. THE REGULATORY STATUS OF CERTAIN OF OUR GENERIC PRODUCTS MAY MAKE THEM SUBJECT TO INCREASED COMPETITION OR TO REGULATORY DECISIONS TO REQUIRE MARKET WITHDRAWAL OF ONE OR MORE OF OUR UNAPPROVED PRODUCTS. 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 61 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. In other cases, we sell unapproved products that may become subject to FDA orders to the pharmaceutical industry to remove one or more types of such products from the marketplace. During the past year, such FDA orders have required manufacturers and distributors of certain unapproved products containing guaifenesin and hydrocodone to cease manufacture or distribution, including certain ETHEX products. In the future, FDA may issue similar orders affecting other of our products. In addition, in the event that FDA concludes that we have failed to comply with a notice setting deadlines for discontinuation of the manufacture and sale of unapproved products, or decides to take enforcement action against us on other grounds, such as for alleged violations of current good manufacturing practice requirements or for failure to obtain product approvals that FDA deems to be necessary, FDA policies permit the agency to initiate broad action against the marketing of additional categories of our unapproved drug products, even if the agency has not instituted similar actions against the marketing of such products by other parties. 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. We may not ultimately prevail in these litigations, we may not receive final FDA approval of our ANDAs, and we may not achieve our expectation of a period of generic exclusivity for certain of these products 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 has been the subject of controversy, court decisions, changes to FDA regulations and guidelines, and other changes in FDA interpretation. In addition, in 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, have had significant effects 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 effects on particular pipeline products. In addition, continuing uncertainty over the interpretation and implementation of the original Hatch-Waxman provisions, as well as the 2003 statutory amendments, 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. COMMERCIALIZATION OF A GENERIC PRODUCT PRIOR TO THE FINAL RESOLUTION OF PATENT INFRINGEMENT LITIGATION COULD EXPOSE US TO SIGNIFICANT DAMAGES IF THE OUTCOME OF SUCH LITIGATION IS UNFAVORABLE AND COULD IMPAIR OUR REPUTATION. We could invest a significant amount of time and expense in the development of our generic products only to be subject to significant additional delay and changes in the economic prospects for our products. If we receive FDA approval for our pending ANDAs, we may consider commercializing the product prior to the final resolution of any related patent infringement litigation. The risk involved in marketing a product prior to the final resolution of the litigation may be substantial because the remedies available to the patent holder could include, among other things, damages measured by the profits lost by such patent holder and not by the profits earned by us. Patent holders may also recover damages caused by the erosion of prices for its patented drug as a result of the introduction of our generic drug in the marketplace. Further, in the case of a willful infringement, which requires a complex analysis of the totality of the circumstances, such damages may be trebled. However, in order to realize the economic benefits of some of our products, we may decide to risk an amount that may exceed the profit we anticipate making on our product. There are a number of factors we would need to consider in order to decide whether to launch our product prior to final resolution, including (1) outside legal advice, (2) the status of a pending lawsuit, (3) interim court decisions, (4) status and timing of a trial, (5) legal decisions affecting other competitors for the same product, (6) market factors, (7) liability sharing 62 agreements, (8) internal capacity issues, (9) expiration dates of patents, (10) strength of lower court decisions and (11) potential triggering or forfeiture of exclusivity. An adverse determination in the litigation relating to a product we launch at risk could have a material adverse effect on our financial condition, results of operations or cash flows. After we filed ANDAs with the FDA seeking permission to market a generic version of the 25 mg, 50 mg, 100 mg, and 200 mg strengths of Toprol- XL(R) in extended release capsule form, AstraZeneca filed lawsuits against KV for patent infringement under the provisions of the Hatch- Waxman Act. In our Paragraph IV certification, we contended that our proposed generic versions do not infringe AstraZeneca's patents. Pursuant to the Hatch-Waxman Act, the filing date of the suit against us instituted an automatic stay of FDA approval of our ANDA until the earlier of a judgment, or 30 months from the date of the suit. We filed motions for summary judgment with the Federal District Court in Missouri alleging, among other things, that AstraZeneca's patent is invalid and unenforceable. These motions have been granted. AstraZeneca has appealed. On July 23, 2007, the Court of Appeals for the Federal Circuit affirmed the decision of the District Court below with respect to the invalidity of AstraZeneca's patent but reversed and remanded with respect to inequitable conduct by AstraZeneca. AstraZeneca filed for rehearing by the Federal Circuit, which has been denied. The time has not yet run with respect to any petition for certiorari by AstraZeneca to the United States Supreme Court. We intend to vigorously defend our interests regardless of the outcome of any further appeal by AstraZeneca; however, we may not prevail. 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 financial position, results of operations or cash flows. We have 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 phenylpropanolamine, or 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 again in 2004, and we 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 may be impleaded into the action, and, if we are impleaded, we may not 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 defense costs and indemnity payments involving PPA claims on a going forward basis as incurred. 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 may not 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. 63 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. WE EXPEND A SIGNIFICANT AMOUNT OF RESOURCES ON RESEARCH AND DEVELOPMENT EFFORTS THAT MAY NOT LEAD TO SUCCESSFUL PRODUCT INTRODUCTIONS. We conduct research and development primarily to enable us to manufacture and market FDA-approved pharmaceuticals in accordance with FDA regulations. Typically, research costs related to the development of innovative compounds and the filing of NDAs are significantly greater than those expenses associated with ANDA filings. As such, our investment in research and development reflects our ongoing commitment to develop new products and/or technologies through our internal development programs, and with our external strategic partners. Because of the inherent risk associated with research and development efforts in our industry, particularly with respect to new drugs, our research and development expenditures may not result in the successful introduction of FDA approved new pharmaceutical products. Also, after we submit an ANDA, the FDA may request that we conduct additional studies and as a result, we may be unable to reasonably determine the total research and development costs to develop a particular product. Finally, we cannot be certain that any investment made in developing products will be recovered, even if we are successful in commercialization. To the extent that we expend significant resources on research and development efforts and are not able, ultimately, to introduce successful new products as a result of those efforts, our financial condition or results of operations may be materially adversely affected. ANY SIGNIFICANT INTERRUPTION IN THE SUPPLY OF RAW MATERIALS AND/OR CERTAIN FINISHED PRODUCTS COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR BUSINESS. We typically purchase the active pharmaceutical ingredient (i.e., the chemical compounds that produce the desired therapeutic effect in our products) and other materials and supplies that we use in our manufacturing operations, as well as certain finished products, from many different domestic and foreign suppliers. Additionally, we maintain safety stocks in our raw materials inventory, and in certain cases where we have listed only one supplier in our applications with the FDA, have received FDA approval to use alternative suppliers should the need arise. However, there is no guarantee that we will always have timely and sufficient access to a critical raw material or finished product. A prolonged interruption in the supply of a single- sourced raw material, including the active ingredient, or finished product could cause our financial position and results of operations to be materially adversely affected. In addition, our manufacturing capabilities could be impacted by quality deficiencies in the products which our suppliers provide, which could have a material adverse effect on our business. We utilize controlled substances in certain of our current products and products in development and therefore must meet the requirements of the Controlled Substances Act of 1970 and the related regulations administered by the Drug Enforcement Administration ("DEA"). These regulations relate to the manufacture, shipment, storage, sale and use of controlled substances. The DEA limits the availability of the active ingredients used in certain of our current products and products in development and, as a result, our procurement quota of these active ingredients may not be sufficient to meet commercial demand or complete clinical trials. We must annually apply to the DEA for procurement quota in order to obtain these substances. Any delay or refusal by the DEA in establishing our procurement quota for controlled substances could delay or stop our clinical trials or product launches, or could cause trade inventory disruptions for those products that have already been launched, which could have a material adverse effect on our financial position, results of operations or cash flows. 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 when the credits are accrued. Like our 64 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 allowances based on our prior experience and our best estimates of the impact that these policies may have in subsequent periods, our allowances may not be adequate or our actual product returns, allowances and chargebacks may 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 asserted that reporting of inflated AWP's have led to excessive payments for prescription drugs. 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 States of Massachusetts, Alabama, Mississippi, Utah and Iowa, New York City, and approximately 42 counties in New York State. The State of Mississippi effectively voluntarily dismissed the Company and ETHEX without prejudice on October 5, 2006 by virtue of the State's filing an Amended Complaint on such date that does not name either the Company or ETHEX as a defendant. On August 13, 2007, the Company settled the Massachusetts lawsuit for $575,000 in cash and agreed to supply $150,000 in free pharmaceuticals over the next two years and the Company has received a general release; no admission of liability was made. The New York City case and all New York county cases (other than the Erie, Oswego and Schenectady County cases) have been transferred to the U.S. District Court for the District of Massachusetts for coordinated or consolidated pretrial proceedings under the Average Wholesale Price Multidistrict Litigation (MDL No. 1456). The cases pertaining to the State of Alabama, Erie County, Oswego County, and Schenectady County were removed to federal court by a co-defendant in October 2006, but all of these cases have since been remanded to the state courts in which they originally were filed. Each of these actions is in the early stages, with fact discovery commencing or ongoing. The Company has been served with a complaint naming ETHEX and nine other pharmaceutical companies as defendants in a pricing suit filed in state court in Utah by the State of Utah. The time to file an answer or other response in the Utah suit has not yet run. In October 2007, the State of Iowa filed a complaint naming ETHEX and 77 other pharmaceutical companies as defendants in a pricing suit filed in federal court in the State of Iowa. ETHEX and the other defendants have moved to dismiss the Iowa complaint. The Company intends to vigorously defend its interests in the actions described above; however, the outcome may have a material adverse effect on our future business, financial condition, results of operations or cash flows. 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 may not 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 financial condition, results of operations or cash flows. OUR REVENUES, GROSS PROFIT AND OPERATING RESULTS MAY FLUCTUATE FROM PERIOD TO PERIOD DEPENDING UPON OUR PRODUCT SALES MIX, OUR PRODUCT PRICING, AND OUR COSTS TO MANUFACTURE OR PURCHASE PRODUCTS. Our future results of operations, financial condition and cash flows will depend to a significant extent upon our branded and generic/non- branded product sales mix. Our sales of branded products generate higher gross margins than our sales of generic/non-branded products. In addition, the introduction of new generic products at any given time can 65 involve significant initial quantities being purchased by our wholesaler customers, as they supply initial quantities to pharmacies and purchase product for their own wholesaler inventories. As a result, our sales mix (the proportion of total sales between branded products and generic/non-branded products) will significantly impact our gross profit from period to period. During fiscal 2006, sales of our branded products and generic/non-branded products accounted for 39.6% and 55.4%, respectively, of our net revenues. During that same year, branded products and generic/non-branded products contributed gross margins of 88.4% and 54.9%, respectively, to our consolidated gross profit margin of 66.3% in fiscal 2006. Factors that may cause our sales mix to vary include: * the amount and timing of new product introductions; * marketing exclusivity, if any, which may be obtained on certain new products; * the level of competition in the marketplace for certain products; * the availability of raw materials and finished products from our suppliers; * the buying patterns of our three largest wholesaler customers; * the scope and outcome of governmental regulatory action that may involve us; * periodic dependence on a relatively small number of products for a significant portion of net revenue or income; and * legal actions brought by our competitors. The profitability of our product sales is also dependent upon the prices we are able to charge for our products, the costs to purchase products from third parties, and our ability to manufacture our products in a cost-effective manner. If our revenues and gross profit decline or do not grow as anticipated, we may not be able to correspondingly reduce our operating expenses. WE ARE INVOLVED IN VARIOUS LEGAL PROCEEDINGS AND CERTAIN GOVERNMENT INQUIRIES AND MAY EXPERIENCE UNFAVORABLE OUTCOMES OF SUCH PROCEEDINGS OR INQUIRIES, WHICH COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR FINANCIAL CONDITION, RESULTS OF OPERATIONS OR CASH FLOWS. We are involved in various legal proceedings and certain government inquiries, including, but not limited to, patent infringement, product liability, breach of contract and claims involving Medicaid and Medicare reimbursements, some of which are described in our periodic reports and involve claims for, or the possibility of fines and penalties involving, substantial amounts of money or for other relief. If any of these legal proceedings or inquiries were to result in an adverse outcome, the impact could have a material adverse effect on our financial condition, results of operations or cash flows. With respect to product liability, we maintain commercial insurance to protect against and manage a portion of the risks involved in conducting our business. Although we carry insurance, we believe that no reasonable amount of insurance can fully protect against all such risks because of the potential liability inherent in the business of producing pharmaceuticals for human consumption. To the extent that a loss occurs, depending on the nature of the loss and the level of insurance coverage maintained, it could have a material adverse effect on our financial condition, results of operations or cash flows. INCREASED INDEBTEDNESS MAY IMPACT OUR FINANCIAL CONDITION, RESULTS OF OPERATIONS OR CASH FLOWS. At September 30, 2006, we had $242.3 million of outstanding debt, consisting of $200.0 million principal amount of 2.5% Contingent Convertible Subordinated Notes (the "Notes") and the remaining principal balance of a $43.0 million mortgage loan entered into in March 2006. In June 2006, we replaced our $140.0 million credit line by entering into a new credit agreement with ten banks that provides for a revolving line of credit for borrowing up to $320.0 million. The new credit agreement also includes a provision for increasing the revolving commitment, at the lenders' sole discretion, by up to an additional $50.0 million. The new credit facility is unsecured unless we, under certain specified circumstances, utilize the facility to redeem part or all of our outstanding Convertible Subordinated Notes. The new credit facility has a term expiring in June 2011. At September 30, 2006, we had no cash borrowings under our credit facility. Our level of indebtedness may have several important effects on our future operations, including: * 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; 66 * our outstanding indebtedness and leverage will increase the impact of negative changes in general economic and industry conditions, as well as competitive pressures and increases in interest rates; and * 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: * seek additional financing in the debt or equity markets; * refinance or restructure all or a portion of our indebtedness; * sell selected assets; * reduce or delay planned capital expenditures; or * 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 or at all. We may also consider issuing additional debt or equity securities in the future to fund potential acquisitions or investments, to refinance existing debt and/or for general corporate purposes. If a material acquisition or investment is completed, our financial position, results of operations or cash flows could change materially in future periods. However, additional funds may not be available on satisfactory terms, or at all, to fund such activities. 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. As a result of this, we classified the Convertible Subordinated Notes as a current liability as of June 30, 2007 due to the right the holders have to require us to repurchase the Convertible Subordinated Notes on May 16, 2008. 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 THAT MAY RESULT IN DILUTION. We anticipate that funds generated internally, together with funds available under our credit facility will be sufficient to implement our business plan for the foreseeable future, subject to additional needs that may arise if acquisition opportunities become available. We also may need additional capital if unexpected events occur or opportunities arise. We may raise additional capital 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. Additional funding may not be accessible or available to us on favorable terms or at all. 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. The Company has funds invested in auction rate securities ("ARS"). Consistent with the Company's investment policy guidelines, the ARS held by the Company are AAA rated securities with long-term nominal maturities secured by student loans which are guaranteed by the U.S. Government. The interest rates on these securities are reset through an auction process at pre-determined intervals, up to 35 days. There may be liquidity issues which arise in the credit and capital markets and the ARS held by the Company may experience failed auctions as the amount of securities submitted for sale may exceed the amount of purchase orders. As a result, the Company may not be able to liquidate some or all of its auction rate securities prior to their maturities at prices approximating their face amounts. During 2008, disruption in the credit and capital markets have adversely affected the auction market for the type of 67 securities held by the Company. If uncertainties in these credit and capital markets continue or these markets deteriorate further the Company may incur impairments to the carrying value of its investments in ARS, which could negatively affect the Company's financial condition, cash flow and reported earnings. (See Note 16 to the Consolidated Financial Statements for further discussion of the Company's investment in ARS). However, the Company believes that as of December 31, 2007, based on its current cash, cash equivalents and marketable securities balances of $112 million (exclusive of auction rate securities) and its current borrowing capacity of $290 million under its credit facility, the current lack of liquidity in the auction rate market will not have a material impact on its ability to fund its operations or interfere with the Company's external growth plans. 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 statements of income over the estimated economic useful life of the related asset. The factors that affect 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 and the impact of promotional efforts, among many others. We consider all of these factors in initially estimating the economic useful lives of our products, and we also continuously monitor these factors for indications of decline in carrying value. 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. Because circumstances after an acquisition can change, the value of intangible assets we record may not be realized by us. If we determine that 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. In addition, in the event of a sale of any of our assets, we might not recover our recorded value of associated intangible assets. THERE ARE INHERENT UNCERTAINTIES INVOLVED IN THE ESTIMATES, JUDGMENTS AND ASSUMPTIONS USED IN THE PREPARATION OF OUR FINANCIAL STATEMENTS, AND ANY CHANGES IN THOSE ESTIMATES, JUDGMENTS AND ASSUMPTIONS COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR FINANCIAL CONDITION, RESULTS OF OPERATIONS OR CASH FLOWS. The consolidated and condensed consolidated financial statements that we file with the SEC are prepared in accordance with GAAP. The preparation of financial statements in accordance with GAAP involves making estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and the related disclosure of contingent assets and liabilities. The most significant estimates we are required to make under GAAP include, but are not limited to, those related to revenue recognition and reductions to gross revenues, inventory valuation, intangible assets, stock-based compensation, income taxes and loss contingencies related to legal proceedings. We periodically evaluate estimates used in the preparation of the consolidated financial statements for reasonableness, including estimates provided by third parties. Appropriate adjustments to the estimates will be made prospectively, as necessary, based on such periodic evaluations. We base our estimates on, among other things, currently available information, market conditions, historical experience and various assumptions, which together form the basis of making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Although we believe that our assumptions are reasonable under the circumstances, estimates would differ if different assumptions were utilized and these estimates may prove in the future to have been inaccurate. 68 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 regularly challenge the pricing of pharmaceutical products and review 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: * the trend toward managed health care in the United States; * the growth of organizations such as HMOs and MCOs; * legislative proposals to reform health care and government insurance programs; and * 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, 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, results of operations or cash flows. 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. EXTENSIVE INDUSTRY REGULATION HAS HAD, AND WILL CONTINUE TO HAVE, A SIGNIFICANT IMPACT ON OUR INDUSTRY AND 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 or holds, recall or seizure of -------- products and total or partial suspension of production, as well as other regulatory actions against our products and us. 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 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 governmental 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 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. 69 RISKS RELATED TO OUR COMMON STOCK 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: developments regarding litigation and an investigation regarding our former stock option granting practices; announcements by us or our competitors of technological innovations or new commercial products; delays in the development or approval of products; regulatory withdrawals of our products from the market; the filing or results of litigation; 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 technologies or products; financial results which are different from securities analysts' forecasts; economic and other external factors; and 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, 2006, an aggregate of 3,162,307 shares of our Class A Common Stock and 356,849 shares of our Class B Common Stock were issuable upon exercise of outstanding stock options under our stock option plans, and an additional 611,494 shares of our Class A Common Stock and 1,230,000 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, 2006, 8,691,880 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. MANAGEMENT SHAREHOLDERS CONTROL OUR COMPANY. At March 31, 2006, our directors and executive officers beneficially own approximately 13% of our Class A Common Stock and approximately 62% of our Class B Common Stock. As a result, these persons control approximately 55% 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 shareholders, including the election of directors and any merger, sale of assets or other change in control of our Company. 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 shareholders, while each share of Class B Common Stock entitles the holder to one full vote on each matter considered by the shareholders. 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 shareholders. 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. 70 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 shareholder" (as defined in the statute) for a period of three years unless certain conditions are met. In addition, our senior management is entitled to certain payments upon a change in control and all of our stock option plans provide for the acceleration of vesting in the event of a change in control of our Company. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS. PURCHASE OF EQUITY SECURITIES BY THE COMPANY The following table provides information about purchases the Company made of its common stock during the quarter ended September 30, 2006:
TOTAL NUMBER OF SHARES PURCHASED MAXIMUM NUMBER TOTAL NUMBER AS PART OF A OF SHARES THAT MAY OF SHARES AVERAGE PRICE PUBLICLY ANNOUNCED YET BE PURCHASED PERIOD PURCHASED PAID PER SHARE PROGRAM UNDER THE PROGRAM July 1-31, 2006 96,965 $ 18.01 -- -- August 1-31, 2006 -- -- -- -- September 1-30, 2006 743 $ 22.44 -- -- ------ Total 97,708 $ 18.04 -- -- ======
Shares were purchased from employees upon their termination pursuant to the terms of the Company's stock option plan or were purchased from certain individuals who sold existing shares to the Company as a means to exercise stock options. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Our 2006 annual meeting of shareholders was held on August 4, 2006. Of 49,499,736 shares of Class A and Class B Common Stock issued, outstanding and eligible to be voted at the meeting, holders of 39,179,228 shares, constituting a quorum, were represented in person or by proxy at the meeting. Two matters were submitted to a vote of security holders at the meeting, the election of three Class B director nominees to our board of directors, each to continue in office until the year 2009 or until their successors are elected and ratification of engagement of our independent registered accounting firm. The voting results are set forth below: Proposal 1. CLASS B DIRECTOR NOMINEES - ------------------------- 71 ABSTENTIONS AND NAME FOR WITHHOLD BROKER NON-VOTES - ---- --- -------- ---------------- David S. Hermelin 12,662,542 21,539 55,557 Jonathon E. Killmer 12,657,227 26,854 55,557 Gerald R. Mitchell(1) 12,662,508 21,573 55,557 Because we have a staggered board, the terms of office of the following named Class A and Class C directors continue after the meeting: CLASS C (TO CONTINUE IN OFFICE UNTIL 2007 OR UNTIL SUCCESSORS ELECTED) - ---------------------------------------------------------------------- Jean M. Bellin Norman D. Schellenger Terry B. Hatfield CLASS A (TO CONTINUE IN OFFICE UNTIL 2008 OR UNTIL SUCCESSORS ELECTED) - ---------------------------------------------------------------------- Kevin S. Carlie Marc S. Hermelin David A. Van Vliet(2) _____________ (1) Resigned March 23, 2008. (2) Resigned September 29, 2006. Proposal 2. To ratify the engagement of KPMG LLP to serve as the Company's independent registered public accounting firm for the year ending March 31, 2007: Votes "For" 12,735,300 Votes "Against" 2,494 Votes "Abstained" 1,844 ITEM 6. EXHIBITS Exhibits. See Exhibit Index. 72 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: March 25, 2008 By /s/ Marc S. Hermelin ------------------------------ Marc S. Hermelin Chairman of the Board and Chief Executive Officer (Principal Executive Officer) Date: March 25, 2008 By /s/ Ronald J. Kanterman ------------------------------ Ronald J. Kanterman Vice President and Chief Financial Officer (Principal Financial Officer) Date: March 25, 2008 By /s/ Richard H. Chibnall ------------------------------ Richard H. Chibnall Vice President, Finance (Principal Accounting Officer) 73 EXHIBIT INDEX Exhibit No. Description - ----------- ----------- 31.1 Certification of Chief Executive Officer. 31.2 Certification of Chief Financial Officer. 32.1 Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 74 EX-31.1 2 ex31p1.txt EXHIBIT 31.1 ------------ CERTIFICATIONS I, Marc S. Hermelin, Chairman of the Board and Chief Executive Officer, certify that: 1. I have reviewed this quarterly report on Form 10-Q of K-V Pharmaceutical Company; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, 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; (c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 25, 2008 /s/ MARC S. HERMELIN ------------------------------------ Marc S. Hermelin Chairman and Chief Executive Officer (Principal Executive Officer) EX-31.2 3 ex31p2.txt EXHIBIT 31.2 ------------ CERTIFICATIONS I, Ronald J. Kanterman, Vice President and Chief Financial Officer, certify that: 1. I have reviewed this quarterly report on Form 10-Q of K-V Pharmaceutical Company; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, 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; (c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 25, 2008 /s/ RONALD J. KANTERMAN ------------------------------------ Ronald J. Kanterman Vice President and Chief Financial Officer (Principal Financial Officer) EX-32.1 4 ex32p1.txt Exhibit 32.1 ------------ CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the quarterly report of K-V Pharmaceutical Company (the "Company") on Form 10-Q for the quarter ended September 30, 2006, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Marc S. Hermelin, Chairman and Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. Date: March 25, 2008 /s/ Marc S. Hermelin ------------------------------------ Marc S. Hermelin Chairman and Chief Executive Officer (Principal Executive Officer) EX-32.2 5 ex32p2.txt EXHIBIT 32.2 ------------ CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the quarterly report of K-V Pharmaceutical Company (the "Company") on Form 10-Q for the quarter ended September 30, 2006, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Ronald J. Kanterman, Vice President and Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. Date: March 25, 2008 /s/ Ronald J. Kanterman ------------------------------------------ Ronald J. Kanterman Vice President and Chief Financial Officer (Principal Financial Officer) -----END PRIVACY-ENHANCED MESSAGE-----