-----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, JalDHOAlRtJ0Qblp3o6SZaZsU0mHHwuSbvG/thJmlVXuixIW0O6ddguRyJFqumhQ e4KOGCAKWWKC6ZbWbnodKA== 0001068800-08-000264.txt : 20080625 0001068800-08-000264.hdr.sgml : 20080625 20080625172213 ACCESSION NUMBER: 0001068800-08-000264 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 20071231 FILED AS OF DATE: 20080625 DATE AS OF CHANGE: 20080625 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: 08917338 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 dec07.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 DECEMBER 31, 2007 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, a non-accelerated filer, or a smaller reporting company (see the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act). Large accelerated filer [ X ] Accelerated filer [ ] Non-accelerated filer [ ] Smaller reporting company [ ] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [ X ] As of June 6, 2008, the registrant had outstanding 37,755,099 and 12,256,159 shares of Class A and Class B Common Stock, respectively, exclusive of treasury shares. 1 PART I. - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS K-V PHARMACEUTICAL COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Unaudited; dollars in thousands)
THREE MONTHS ENDED NINE MONTHS ENDED DECEMBER 31, DECEMBER 31, --------------------------- --------------------------- 2007 2006 2007 2006 --------- --------- --------- --------- Net revenues................................................ $ 161,623 $ 117,949 $ 448,904 $ 323,132 Cost of sales............................................... 49,996 38,439 134,697 110,764 --------- --------- --------- --------- Gross profit................................................ 111,627 79,510 314,207 212,368 --------- --------- --------- --------- Operating expenses: Research and development................................ 11,156 8,319 32,702 22,605 Purchased in-process research and development......................................... -- -- 10,000 -- Selling and administrative.............................. 50,846 41,965 147,019 124,974 Amortization of intangibles............................. 3,668 1,204 7,868 3,602 --------- --------- --------- --------- Total operating expenses.................................... 65,670 51,488 197,589 151,181 --------- --------- --------- --------- Operating income............................................ 45,957 28,022 116,618 61,187 --------- --------- --------- --------- Other expense (income): Interest expense........................................ 2,644 2,214 7,542 6,755 Interest and other income............................... (2,780) (2,240) (8,936) (6,606) --------- --------- --------- --------- Total other expense (income), net........................... (136) (26) (1,394) 149 --------- --------- --------- --------- Income before income taxes and cumulative effect of change in accounting principle....................... 46,093 28,048 118,012 61,038 Provision for income taxes.................................. 13,481 9,586 38,977 22,369 --------- --------- --------- --------- Income before cumulative effect of change in accounting principle................................. 32,612 18,462 79,035 38,669 Cumulative effect of change in accounting principle (net of $670 in taxes)........................ -- -- -- 1,976 --------- --------- --------- --------- Net income.................................................. $ 32,612 $ 18,462 $ 79,035 $ 40,645 ========= ========= ========= ========= (CONTINUED) 2 K-V PHARMACEUTICAL COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME - (CONTINUED) (Unaudited; dollars in thousands) THREE MONTHS ENDED NINE MONTHS ENDED DECEMBER 31, DECEMBER 31, ------------------------- ------------------------- 2007 2006 2007 2006 ------- ------- ------- ------- Earnings per share before effect of change in accounting principle: Basic - Class A common........................... $ 0.69 $ 0.39 $ 1.67 $ 0.82 Basic - Class B common........................... 0.57 0.33 1.39 0.68 Diluted - Class A common......................... 0.57 0.33 1.39 0.71 Diluted - Class B common......................... 0.49 0.29 1.20 0.61 Per share effect of cumulative effect of change in accounting principle: Basic - Class A common........................... $ - $ - $ - $ 0.04 Basic - Class B common........................... - - - 0.04 Diluted - Class A common......................... - - - 0.03 Diluted - Class B common......................... - - - 0.03 Earnings per share: Basic - Class A common........................... $ 0.69 $ 0.39 $ 1.67 $ 0.86 Basic - Class B common........................... 0.57 0.33 1.39 0.72 Diluted - Class A common......................... 0.57 0.33 1.39 0.74 Diluted - Class B common......................... 0.49 0.29 1.20 0.64 Shares used in per share calculation: Basic - Class A common........................... 37,193 36,926 37,094 36,757 Basic - Class B common........................... 12,179 12,336 12,231 12,422 Diluted - Class A common......................... 59,244 59,016 59,147 58,928 Diluted - Class B common......................... 12,264 12,412 12,314 12,529 SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3 K-V PHARMACEUTICAL COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Unaudited; dollars in thousands)
DECEMBER 31, MARCH 31, 2007 2007 ---- ---- ASSETS ------ CURRENT ASSETS: Cash and cash equivalents............................................................ $ 72,953 $ 82,574 Marketable securities................................................................ 123,484 157,812 Receivables, less allowance for doubtful accounts of $843 and $716 at December 31, 2007 and March 31, 2007, respectively............................. 100,986 78,634 Inventories, net..................................................................... 91,021 91,515 Prepaid and other assets............................................................. 8,269 6,571 Income taxes receivable.............................................................. 7,732 -- Deferred tax asset................................................................... 19,061 14,364 ----------- ----------- Total Current Assets.............................................................. 423,506 431,470 Property and equipment, less accumulated depreciation of $69,704 and $56,186 at December 31, 2007 and March 31, 2007, respectively............................... 187,205 186,900 Intangible assets and goodwill, net.................................................. 203,819 69,010 Other assets......................................................................... 22,957 20,403 ----------- ----------- TOTAL ASSETS......................................................................... $ 837,487 $ 707,783 =========== =========== LIABILITIES ----------- CURRENT LIABILITIES: Accounts payable..................................................................... $ 17,659 $ 18,506 Accrued liabilities.................................................................. 38,391 33,218 Income taxes payable................................................................. -- 5,558 Current maturities of long-term debt................................................. 201,984 1,897 ----------- ----------- Total Current Liabilities......................................................... 258,034 59,179 Long-term debt....................................................................... 67,956 239,451 Other long-term liabilities.......................................................... 21,958 6,319 Deferred tax liability............................................................... 40,180 38,007 ----------- ----------- TOTAL LIABILITIES.................................................................... 388,128 342,956 ----------- ----------- 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 December 31, 2007 and March 31, 2007 (convertible into Class A shares 8.4375-to-one basis)........................ -- -- Class A and Class B Common Stock, $.01 par value; 150,000,000 and 75,000,000 shares authorized, respectively; Class A - issued 40,619,336 and 40,316,426 at December 31, 2007 and March 31, 2007, respectively.............................................. 406 403 Class B - issued 12,242,114 and 12,393,982 at December 31, 2007 and March 31, 2007, respectively (convertible into Class A shares on a one-for-one basis)..... 122 124 Additional paid-in capital........................................................... 156,493 150,818 Retained earnings.................................................................... 348,413 269,430 Accumulated other comprehensive income............................................... 50 33 Less: Treasury stock, 3,287,936 shares of Class A and 92,902 shares of Class B Common Stock at December 31, 2007, respectively, and 3,237,023 shares of Class A and 92,902 shares of Class B Common Stock at March 31, 2007, respectively, at cost (56,125) (55,981) ----------- ----------- TOTAL SHAREHOLDERS' EQUITY........................................................... 449,359 364,827 ----------- ----------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY........................................... $ 837,487 $ 707,783 =========== =========== SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
4 K-V PHARMACEUTICAL COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited; dollars in thousands)
NINE MONTHS ENDED DECEMBER 31, ------------------------------ 2007 2006 ------------- ---------- OPERATING ACTIVITIES: Net income............................................................. $ 79,035 $ 40,645 Adjustments to reconcile net income to net cash provided by operating activities: Acquired in-process research and development........................ 10,000 -- Cumulative effect of change in accounting principle................. -- (1,976) Depreciation, amortization and other non-cash charges............... 22,368 16,662 Deferred income tax (benefit) provision............................. (2,532) 5,126 Deferred compensation............................................... 1,674 565 Stock-based compensation............................................ 4,089 2,948 Excess tax benefits associated with stock options................... (972) (565) Other............................................................... -- 270 Changes in operating assets and liabilities: Increase in receivables, net........................................ (22,352) (30,288) Decrease (increase) in inventories, net............................. 494 (10,854) Increase in prepaid and other assets................................ (6,675) (2,910) (Decrease) increase in income taxes payable......................... (675) 3,210 Increase in accounts payable and accrued liabilities...................................................... 4,306 1,397 ------------- ---------- Net cash provided by operating activities.............................. 90,380 24,230 ------------- ---------- INVESTING ACTIVITIES: Purchase of property and equipment, net............................. (13,090) (21,634) Purchase of marketable securities................................... (101,122) (171,014) Sale of marketable securities....................................... 135,475 122,700 Purchase of preferred stock......................................... -- (400) Product acquisition................................................. (151,500) -- ------------- ---------- Net cash used in investing activities.................................. (130,237) (70,348) ------------- ---------- FINANCING ACTIVITIES: Principal payments on long-term debt................................ (1,408) (1,185) Proceeds from borrowing on line of credit........................... 50,000 -- Repayment of borrowing on line of credit............................ (20,000) -- Dividends paid on preferred stock................................... (52) (52) Purchase of common stock for treasury............................... (144) (2,033) Excess tax benefits associated with stock options................... 972 565 Cash deposits received for stock options............................ 868 3,667 ------------- ---------- Net cash provided by financing activities.............................. 30,236 962 ------------- ---------- Decrease in cash and cash equivalents.................................. (9,621) (45,156) Cash and cash equivalents: Beginning of year................................................... 82,574 100,706 ------------- ---------- End of period....................................................... $ 72,953 $ 55,550 ============= ========== SUPPLEMENTAL INFORMATION: Interest paid....................................................... $ 7,599 $ 6,700 Income taxes paid................................................... 39,862 13,629 Stock options exercised (at expiration of two-year forfeiture period) 615 3,317 SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
5 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (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, acquisition, manufacture, marketing and sale of technologically distinguished branded and generic/non-branded prescription pharmaceutical products. The Company was incorporated in 1971 and has become a leader in the development of advanced drug delivery and formulation technologies that are designed to enhance therapeutic benefits of existing drug forms. Through internal product development and synergistic acquisitions of products, KV has grown into a fully integrated specialty pharmaceutical company. The Company also develops, manufactures and markets technologically advanced, value-added raw material products for the pharmaceutical, nutritional, food and personal care industries. 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 results of operations and cash flows for the three- and nine-month periods ended December 31, 2007 are not necessarily indicative of the results of operations and cash flows that may be expected for the fiscal year ended March 31, 2008. The interim consolidated financial statements and accompanying notes should be read in conjunction with the consolidated financial statements and footnotes thereto included in the Company's Annual Report on Form 10-K for the fiscal year ended March 31, 2007. The balance sheet information as of March 31, 2007 has been derived from the Company's audited consolidated balance sheet as of that date. 2. ACQUISITION In May 2007, the Company acquired the U.S. marketing rights to Evamist(TM), a new 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 $141,500 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 $100,000 of net sales in a fiscal year, a one-time payment of $10,000 will be made, and if net sales levels reach $200,000 in a fiscal year, a one-time payment of up to $20,000 will be made. Because the product had not obtained FDA approval when the initial payment was made at closing, the Company recorded $10,000 of in-process research and development expense during the nine months ended December 31, 2007. In July 2007, FDA approval for Evamist(TM) was received and a payment of $141,500 was made to VIVUS, Inc. The preliminary purchase price allocation, which is subject to change based on the final fair value assessment, , resulted in estimated identifiable intangible assets of $52,446 to product rights; $15,166 to trademark rights; $66,417 to rights under a sublicense agreement; and, $7,471 to a covenant not to compete. Upon FDA approval in July 2007, the Company began amortizing the product rights, trademark rights and rights under the sublicense agreement over 15 years and the covenant not to compete over nine years. 3. 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. 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. The Company also presents 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. The 6 Company presents 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 Subordinated Notes. The dilutive effects of outstanding stock options and unvested common shares subject to repurchase are reflected in diluted earnings 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 per share for Class A Common Stock assumes the conversion of the Class B Common Stock, while the diluted earnings 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 December 31, 2007 and 2006:
THREE MONTHS ENDED THREE MONTHS ENDED DECEMBER 31, 2007 DECEMBER 31, 2006 --------------------------------- --------------------------------- CLASS A CLASS B CLASS A CLASS B ---------------- ---------------- ---------------- ---------------- Basic earnings per share: Numerator: Allocation of undistributed earnings $ 25,607 $ 6,988 $ 14,428 $ 4,017 ---------------- ---------------- ---------------- ---------------- Denominator: Weighted average shares outstanding 37,620 12,282 37,288 12,372 Less - weighted average unvested common shares subject to repurchase (427) (103) (362) (36) ---------------- ---------------- ---------------- ---------------- Number of shares used in per share computations 37,193 12,179 36,926 12,336 ================ ================ ================ ================ Basic earnings per share $ 0.69 $ 0.57 $ 0.39 $ 0.33 ================ ================ ================ ================ Diluted earnings per share: Numerator: Allocation of undistributed earnings for basic computation $ 25,607 $ 6,988 $ 14,428 $ 4,017 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 6,988 - 4,017 - Reallocation of undistributed earnings to Class B shares - (947) - (480) Add - preferred stock dividends 17 - 17 - Add - interest expense convertible notes 1,199 - 1,014 - ---------------- ---------------- ---------------- ---------------- Allocation of undistributed earnings $ 33,811 $ 6,041 $ 19,476 $ 3,537 ================ ================ ================ ================ Denominator: Number of shares used in basic computation 37,193 12,179 36,926 12,336 Weighted average effect of dilutive securities: Conversion of Class B to Class A shares 12,179 - 12,336 - Employee stock options 842 85 724 76 Convertible preferred stock 338 - 338 - Convertible notes 8,692 - 8,692 - ---------------- ---------------- ---------------- ---------------- Number of shares used in per share computations 59,244 12,264 59,016 12,412 ================ ================ ================ ================ Diluted earnings per share (1) $ 0.57 $ 0.49 $ 0.33 $ 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 three months ended December 31, 2006, excluded from the computation were options to purchase 518 shares of Class A and Class B Common Stock.
7 The following table sets forth the computation of basic and diluted earnings per share for the nine months ended December 31, 2007 and 2006:
NINE MONTHS ENDED DECEMBER 31, ------------------------------------------------------------------------- 2007 2006 ------------------------------------ ------------------------------------ CLASS A CLASS B CLASS A CLASS B ----------------- ----------------- ------------------ ----------------- Basic earnings per share: Numerator: Allocation of undistributed earnings before cumulative effect of change in accounting principle $ 61,958 $ 17,025 $ 30,131 $ 8,486 Allocation of cumulative effect of change in accounting principle - - 1,542 434 ----------------- ----------------- ------------------ ----------------- Allocation of undistributed earnings $ 61,958 $ 17,025 $ 31,673 $ 8,920 ================= ================= ================== ================= Denominator: Weighted average shares outstanding 37,531 12,332 37,100 12,475 Less - weighted average unvested common shares subject to repurchase (437) (101) (343) (53) ----------------- ----------------- ------------------ ----------------- Number of shares used in per share computations 37,094 12,231 36,757 12,422 ================= ================= ================== ================= Basic earnings per share before cumulative effect of change in accounting principle $ 1.67 $ 1.39 $ 0.82 $ $ 0.68 Per share effect of cumulative effect of change in accounting principle - - 0.04 0.04 ----------------- ----------------- ------------------ ----------------- Basic earnings per share $ 1.67 $ 1.39 $ 0.86 $ 0.72 ================= ================= ================== ================= Diluted earnings per share: Numerator: Allocation of undistributed earnings for basic computation before cumulative effect of change in accounting principle $ 61,958 $ 17,025 $ 30,131 $ 8,486 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 17,025 - 8,486 - Reallocation of undistributed earnings to Class B shares - (2,245) - (845) Add - preferred stock dividends 52 - 52 - Add - interest expense convertible notes 3,198 - 2,929 - ----------------- ----------------- ------------------ ----------------- Allocation of undistributed earnings for diluted computation before cumulative effect of change in accounting principle 82,233 14,780 41,598 7,641 Allocation of cumulative effect of change in accounting principle - - 1,976 363 ----------------- ----------------- ------------------ ----------------- Allocation of undistributed earnings $ 82,233 $ 14,780 $ 43,574 $ 8,004 ================= ================= ================== ================= (CONTINUED) 8 NINE MONTHS ENDED DECEMBER 31, -------------------------------------------------------------------------- 2007 2006 ------------------------------------ ------------------------------------ CLASS A CLASS B CLASS A CLASS B ----------------- ----------------- ----------------- ----------------- Diluted earnings per share (continued): Denominator: Number of shares used in basic computation 37,094 12,231 36,757 12,422 Weighted average effect of dilutive securities: Conversion of Class B to Class A shares 12,231 - 12,422 - Employee stock options 792 83 719 107 Convertible preferred stock 338 - 338 - Convertible notes 8,692 - 8,692 - ----------------- ----------------- ----------------- ----------------- Number of shares used in per share computations 59,147 12,314 58,928 12,529 ================= ================= ================= ================= Diluted earnings per share before cumulative effect of change in accounting principle $ 1.39 $ 1.20 $ 0.71 $ 0.61 Per share effect of cumulative effect of change in accounting principle - - 0.03 0.03 ----------------- ----------------- ----------------- ----------------- Diluted earnings per share (1) $ 1.39 $ 1.20 $ 0.74 $ 0.64 ================= ================= ================= ================= - ------------------------- (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 nine months ended December 31, 2007 and 2006, excluded from the computation were options to purchase 36 and 778 shares of Class A and Class B Common Stock, respectively.
4. 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 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. 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 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. 9 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 cannot 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) 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. The shares issuable upon exercise of these options are accounted for as issued when the two-year forfeiture period lapses. Until the two-year forfeiture requirement is met, the underlying shares are not considered outstanding and not included in calculating basic earnings 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 were not expected to vest as of the adoption date. The cumulative adjustment increased net income for the nine months ended December 31, 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 $1,332 and $4,089, respectively, and related tax benefits of $302 and $1,043, respectively, for the three and nine months ended December 31, 2007 and stock-based compensation of $1,029 and $2,948, respectively, and related tax benefits of $289 and $859, respectively, for the three and nine months ended December 31, 2006. There was no stock-based employee compensation cost capitalized as of December 31, 2007. Cash received from stock option deposits was $195 and $1,247 for the three months ended December 31, 2007 and 2006, respectively, and $868 and $3,667 for the nine months ended December 31, 2007 and 2006, respectively. The actual tax benefit realized from tax deductions associated with stock option exercises (at expiration of two-year forfeiture period) was $526 and $339 for the three months ended December 31, 2007 and 2006, respectively, and $1,055 and $762 for the nine months ended December 31, 2007 and 2006, respectively. The following weighted average assumptions were used for stock options granted during the three and nine months ended December 31, 2007 and 2006:
THREE MONTHS ENDED NINE MONTHS ENDED DECEMBER 31, DECEMBER 31, ------------------------ ------------------------ 2007 2006 2007 2006 ---- ---- ---- ---- Dividend yield............................... None None None None Expected volatility.......................... 41% 45% 43% 45% Risk-free interest rate...................... 4.16% 4.93% 4.79% 4.93% Expected term ............................... 9.0 years 8.9 years 9.0 years 8.9 years Weighted average fair value per share at grant date.............................. $ 15.91 $ 14.14 $ 15.94 $ 12.98
10 A summary of the changes in the Company's stock option plans during the nine months ended December 31, 2007 is presented below:
WEIGHTED WEIGHTED AVERAGE AVERAGE REMAINING AGGREGATE EXERCISE CONTRACTUAL INTRINSIC SHARES PRICE TERM VALUE ------ ----- ---- ----- Balance, March 31, 2007.................... 3,666 $ 16.11 Options granted............................ 753 27.60 Options exercised.......................... (116) 4.94 $ 2,745 Options canceled........................... (417) 19.06 ----------- Balance, December 31, 2007................. 3,886 18.34 5.7 $ 39,687 =========== Expected to vest at December 31, 2007..................... 3,012 $ 18.34 5.7 $ 30,757 Options exercisable at December 31, 2007 (excluding shares in the two-year forfeiture period)..................... 1,230 $ 16.25 5.2 $ 15,122
As of December 31, 2007, the Company had $41,611 of total unrecognized compensation expense, related to stock option grants, which will be recognized over the remaining weighted average period of 4.9 years. 5. 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 and actual 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. Accruals for sales provisions are presented in the consolidated financial statements as reductions to net revenues and accounts receivable. Sales provisions totaled $57,201 and $42,617 for the three months ended December 31, 2007 and 2006, respectively, and $164,629 and $114,811 for the nine months ended December 31, 2007 and 2006, respectively. The reserve balances related to the sales provisions totaled $47,369 and $31,281 at December 31, 2007 and March 31, 2007, respectively, and are included in "Receivables, less allowance for doubtful accounts" in the accompanying consolidated balance sheets. 11 6. INVENTORIES Inventories consist of the following:
DECEMBER 31, 2007 MARCH 31, 2007 ----------------- -------------- Finished goods..................... $ 31,423 $ 35,420 Work-in-process.................... 13,820 13,294 Raw materials...................... 45,778 42,801 ----------- ----------- $ 91,021 $ 91,515 =========== ===========
Management establishes reserves for potentially obsolete or slow-moving inventory based on an evaluation of inventory levels, forecasted demand, and market conditions. 7. INTANGIBLE ASSETS AND GOODWILL Intangible assets and goodwill consist of the following:
DECEMBER 31, 2007 MARCH 31, 2007 ------------------------------ ----------------------------- GROSS GROSS CARRYING ACCUMULATED CARRYING ACCUMULATED AMOUNT AMORTIZATION AMOUNT AMORTIZATION ------ ------------ ------ ------------ Product rights - Micro-K(R).................. $ 36,140 $ (15,867) $ 36,140 $ (14,513) Product rights - PreCare(R).................. 8,433 (3,549) 8,433 (3,233) Product rights - Evamist(TM)................. 52,446 (1,504) -- -- Trademarks acquired: Niferex(R).............................. 14,834 (3,523) 14,834 (2,967) Chromagen(R)/StrongStart(R)............. 27,642 (6,565) 27,642 (5,528) Evamist(TM)............................. 15,166 (435) -- -- License agreements - Evamist(TM)............. 66,417 (1,904) -- -- License agreements - other................... 4,400 (615) 4,400 (480) Covenant not to compete - Evamist(TM)........ 7,471 (357) -- -- Covenant not to compete - other ............. 375 (100) 375 (72) Trademarks and patents....................... 5,368 (1,011) 4,196 (774) ------------- ---------- ----------- ---------- Total intangible assets.................... 238,692 (35,430) 96,020 (27,567) Goodwill..................................... 557 -- 557 -- ------------- ---------- ----------- ---------- $ 239,249 $ (35,430) $ 96,577 $ (27,567) ============= ========== =========== ==========
As of December 31, 2007, the Company's intangible assets have a weighted average useful life of approximately 16 years. Amortization expense for intangible assets was $3,668 and $1,204 for the three months ended December 31, 2007 and 2006, respectively, and $7,868 and $3,602 for the nine months ended December 31, 2007 and 2006, 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 $3,680 for the remainder of fiscal 2008 and approximately $14,700 in each of the four succeeding fiscal years. 8. REVOLVING CREDIT AGREEMENT The Company has a credit agreement with ten banks that provides for a revolving line of credit for borrowing up to $320,000. This credit facility also includes a provision for increasing the revolving commitment, at the lenders' sole discretion, by up to an additional $50,000. The credit agreement 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 credit facility at the lower of the prime rate or LIBOR plus 62.5 12 to 150 basis points depending on the ratio of senior debt to EBITDA. The credit facility has a five-year term expiring in June 2011. The 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. As of September 30, 2007, the Company was in compliance with all of its financial covenants. In addition, the agreement requires that the Company submit 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 quarterly financial statements for this quarter to June 30, 2008. At December 31, 2007, the Company had $30,000 of borrowings outstanding under the credit facility (see Note 9). 9. LONG-TERM DEBT Long-term debt consists of the following:
DECEMBER 31, 2007 MARCH 31, 2007 ----------------- -------------- Building mortgages.......................... $ 39,940 $ 41,348 Line of credit.............................. 30,000 -- Convertible notes........................... 200,000 200,000 ----------- ---------- 269,940 241,348 Less current portion........................ (201,984) (1,897) ----------- ---------- $ 67,956 $ 239,451 =========== ==========
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 the loan was used for working capital and general corporate purposes. This mortgage loan, which is secured by three of the Company's buildings, bears interest at a rate of 5.91% and matures on April 1, 2021. 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. In November 2007, the average trading price of the Notes reached the threshold for the five-day trading period that results in the payment of contingent interest and beginning November 16, 2007 the Notes began to bear interest at a rate of 3.00% per annum. 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 Company has classified the Notes as a current liability as of December 31, 2007 due to the right the holders have to require the Company to repurchase the Notes on May 16, 2008. Since the holders did not elect to cause the Company to repurchase any of the Notes, the Notes will be reclassified as long-term beginning with the Company's consolidated balance sheet as of June 30, 2008. The Notes are subordinate to all of the Company's existing and future senior obligations. 13 The Notes are convertible, at the holders' option, into shares of the Company's Class A Common Stock prior to the maturity date under the following circumstances: o during any quarter commencing after June 30, 2003, if the closing sale price of the Company's Class A Common Stock over a specified number of trading days during the previous quarter is more than 120% of the conversion price of the Notes on the last trading day of the previous quarter. The Notes are initially convertible at a conversion price of $23.01 per share, which is equal to a conversion rate of approximately 43.4594 shares per $1,000 principal amount of Notes; o if the Company has called the Notes for redemption; o during the five trading day period immediately following any nine consecutive trading day period in which the trading price of the Notes per $1,000 principal amount for each day of such period was less than 95% of the product of the closing sale price of our Class A Common Stock on that day multiplied by the number of shares of our Class A Common Stock issuable upon conversion of $1,000 principal amount of the Notes; or o 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. 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 December 31, 2007, 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. 10. 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 $109,397 were outstanding at December 31, 2007. 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. 11. COMPREHENSIVE INCOME Comprehensive income includes all changes in equity during a period except those that resulted from investments by or distributions to the Company's shareholders. Other comprehensive income refers to revenues, expenses, gains and losses that, under generally accepted accounting principles, are included in comprehensive income, but excluded from net income as these amounts are recorded directly as an adjustment to shareholders' equity. For the Company, comprehensive income is comprised of net income and the net changes in unrealized gains and losses on available for sale marketable securities, net of applicable income taxes. Total comprehensive income totaled $32,666 and $18,632 for the three months ended December 31, 2007 and 2006, respectively, and $79,052 and $40,856 for the nine months ended December 31, 2007 and 2006, respectively. 14 12. SEGMENT REPORTING The reportable operating segments of the Company are branded products, specialty generic/non-branded and specialty materials. The branded products segment includes patent-protected products and certain trademarked off-patent products that the Company sells and markets as brand pharmaceutical products. The specialty generics segment includes off-patent pharmaceutical products that are therapeutically equivalent to proprietary products. The Company sells its branded and generic/non-branded products primarily to pharmaceutical wholesalers, drug distributors and chain drug stores. The specialty materials segment is distinguished as a single segment because of differences in products, marketing and regulatory approval when compared to the other segments. Accounting policies of the segments are the same as the Company's consolidated accounting policies. Segment profits are measured based on income before taxes and are determined based on each segment's direct revenues and expenses. The majority of research and development expense, corporate general and administrative expenses, amortization and interest expense, as well as interest and other income, are not allocated to segments, but included in the "all other" classification. Identifiable assets for the three reportable operating segments primarily include receivables, inventory, and property and equipment. For the "all other" classification, identifiable assets consist of cash and cash equivalents, corporate property and equipment, intangible and other assets and all income tax related assets. The following tables present information for the Company's reportable operating segments for the three and nine months ended December 31, 2007 and 2006.
THREE MONTHS ENDED BRANDED SPECIALTY SPECIALTY ALL DECEMBER 31, PRODUCTS GENERICS MATERIALS OTHER ELIMINATIONS CONSOLIDATED ------------ -------- -------- --------- ----- ------------ ------------ Net revenues 2007 $ 54,526 $ 101,911 $ 4,700 $ 486 $ - $ 161,623 2006 48,311 64,745 4,545 348 - 117,949 Segment profit (loss) 2007 25,119 64,699 1,799 (45,524) - 46,093 2006 22,102 35,956 725 (30,735) - 28,048 Identifiable assets 2007 29,178 108,693 7,475 693,299 (1,158) 837,487 2006 28,858 87,736 7,967 552,380 (1,158) 675,783 Property and 2007 - - 15 6,154 - 6,169 equipment additions 2006 3 - - 3,292 - 3,295 Depreciation and 2007 198 80 45 8,334 - 8,657 amortization 2006 178 84 40 5,312 - 5,614 NINE MONTHS ENDED BRANDED SPECIALTY SPECIALTY ALL DECEMBER 31, PRODUCTS GENERICS MATERIALS OTHER ELIMINATIONS CONSOLIDATED ------------ -------- -------- --------- ----- ------------ ------------ Net revenues 2007 $ 157,764 $ 277,275 $ 12,719 $ 1,146 $ - $ 448,904 2006 138,453 170,072 13,206 1,401 - 323,132 Segment profit (loss) 2007 73,068 171,538 3,985 (130,579) - 118,012 2006 62,317 88,341 2,047 (91,667) - 61,038 Property and 2007 257 - 91 12,742 - 13,090 equipment additions 2006 96 - - 21,538 - 21,634 Depreciation and 2007 559 239 133 21,437 - 22,368 amortization 2006 533 253 121 15,755 - 16,662
15 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. 13. CONTINGENCIES - LITIGATION The Company and its subsidiaries Drugtech Corporation and Ther-Rx Corporation were named as defendants in a declaratory judgment case filed in the U.S. District Court for the District of Delaware by Lannett Company, Inc. ("Lannett") on June 6, 2008 and styled Lannett Company Inc. v. KV Pharmaceuticals et. al. Lannett has subsequently amended its complaint. The action seeks a declaratory judgment of patent invalidity, patent non-infringement, and patent unenforceability for inequitable conduct with respect to five patents owned by, and two patents licensed to, the Company or its subsidiaries and pertaining to the PrimaCare ONE(R) product marketed by Ther-Rx Corporation; unfair competition; deceptive trade practices; and antitrust violations. No specific amount of damages was stated in the complaint or amended complaint. The Company has not yet been served with either the complaint or the amended complaint. However, on June 17 2008, the Company filed a counterclaim against Lannett in that action asserting patent infringement; federal and common law trademark infringement, false advertising, and unfair competition; federal false designation of origin, false description and false representation; and common law misappropriation. The Company has requested a temporary restraining order and preliminary injunction against Lannett's continued sale of its product and continued infringement of the Company's trademarks and patents, unfair competition or misappropriation, and to require Lannett to recall all of its shipped product. A briefing schedule has been set by the court on the Company's motion and a hearing has been scheduled before the court on the Company's motion on June 25, 2008. No discovery has yet commenced nor a trial date been set. The Company is named as a defendant in a patent infringement case filed in the U.S. District Court for the District of Delaware by UCB, Inc. and Celltech Manufacturing CA, Inc. (collectively, "UCB") on April 21, 2008 and styled UCB, Inc. et al. v. KV Pharmaceutical Company. After the Company filed an ANDA with the FDA seeking permission to market a generic version of the 40 mg, 50 mg and 60 mg strengths of Metadate CD(R) methylphenidate hydrochloride extended-release capsules, UCB filed this lawsuit under a patent owned by Celltech. In a Paragraph IV certification accompanying the ANDA, KV contended that its proposed 40mg generic formulation would not infringe Celltech's patent. Because the patent was not listed in the Orange Book for the 50mg and 60mg dosages, a Paragraph I certification was filed with respect to them. Pursuant to the Hatch-Waxman Act, the filing of the suit against the Company instituted an automatic stay of FDA approval of the Company's ANDA with respect to the 40 mg strength of this product until the earlier of a judgment in the Company's favor, or 30 months from the date of suit. Inasmuch as the Celltech patent was not listed in the Orange Book with respect to the 50 mg and 60 mg strengths, it is the Company's belief that the automatic stay does not apply to the Company's 50 mg and 60 mg strengths of this product. UCB may, however, seek to keep these strengths tied up in the litigation. The Company has filed an answer, asserted certain affirmative defenses (including that Plaintiffs are estopped to assert infringement of the 50 mg and 60 mg dosages due to their not listing the Celltech patent in the Orange Book for these dosages), and has asserted a counterclaim in which it seeks a declaratory judgment of invalidity and non-infringement of the claims in the Celltech patent, and an award of attorneys fees and costs. The case has recently commenced 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 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 this lawsuit 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. Discovery is on-going, but no trial date has yet been set. Following the Company's filing of an ANDA pertaining to a generic version of the 24 mg strength of Razadyne(R) ER (formerly Reminyl(R)) galantamine hydrobromide extended-release capsules and the Company's giving of notice of this filing to Janssen, Janssen has filed in June 2008 a second complaint in the same federal court, naming the Company as a defendant in a related patent infringement case 16 under the same Janssen patent with respect to such 24 mg generic version. The time to answer the new complaint has not yet run. The Company anticipates that both cases will be coordinated before the court. 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. 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. Celgene has moved to disqualify the Company's counsel in the case, asserting a conflict of interest despite its signing of an advance waiver with such counsel, and this motion is pending before the court. Should this motion be granted, the Company will need to retain new counsel. The Company does not believe that this would materially delay the progress of the lawsuit. The Company has filed a motion for sanctions against plaintiffs pursuant to Rule 11 of the Federal Rules of Civil Procedure for bringing an action without proper basis and is seeking an order dismissing the patent infringement complaint filed by plaintiffs, and awarding the Company its costs and attorneys' fees. Celgene has asked the court to dismiss the Company's Rule 11 motion, and the matter is pending before the court. 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 lawsuit against KV for patent infringement under the provisions of the Hatch-Waxman Act with respect to three Purdue patents. In the Company's Paragraph IV certification, KV contended that Purdue's patents are invalid, unenforceable, or will not be infringed by KV's proposed generic versions. 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 similar lawsuits pending against additional unrelated companies in federal court in New York. 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 17 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. The Company, among others, has asked the court to lift the stay so that the remainder of the case may resume but the stay has not yet been lifted. Discovery in the suit has not yet commenced but is expected to commence shortly after the stay is lifted on the case. 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 for the District of Minnesota. CIMA alleged that the Company and ETHEX infringed on a CIMA patent in connection with the manufacture and sale of Hyoscyamine Sulfate Orally Dissolvable Tablets, 0.125 mg. The court 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. The product involved in this lawsuit is currently subject to a hold on the Company's inventory of certain unapproved products notified to the Company in March 2008 by representatives of the Missouri Department of Health and Senior Services and the FDA. In the event that such hold is lifted, ETHEX intends to resume marketing the product during the stay in the lawsuit with CIMA. The Company intends to vigorously defend its interests when or if the stay is lifted; however, it cannot give any assurance it will prevail or that the stay will be lifted. 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 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. Plaintiffs have recently filed a motion to amend their complaint to seek declaratory judgments that Axcan does not have "unclean hands" nor violated any antitrust or unfair competition laws. This motion is pending before the court. 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. 18 The Company was named as a defendant in a case filed in U.S. District Court in Missouri by AstraZeneca AB, Aktiebolaget Hassle and AstraZeneca LP (collectively, "AstraZeneca") and styled AstraZeneca AB et. al. v. KV Pharmaceutical Company. 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 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 continued to proceed 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. In May 2008, the Company entered into a settlement agreement with AstraZeneca and settled its remaining counterclaims against AstraZeneca in exchange for a payment of $2,700. 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 pharmaceutical products valued at $150, both of which are to be paid or delivered 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 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 court 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 19 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, as well as a motion to dismiss the lawsuit based on expiration of the statute of limitations. This motion is pending before the court, with a hearing scheduled by the court on July 7, 2008. A trial date has been set for November 2008. 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 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 moved to terminate the litigation based on a determination by members of a Special Committee of the Board of Directors that continuation of the litigation was not in the best interest of KV and its shareholders. All individual officer and director defendants joined in that motion. Plaintiffs filed a motion for rule to show cause why the defendants' motion to terminate the lawsuit should not be stricken and dismissed. On February 15, 2008, the court stayed proceedings in the case until April 9, 2008, to permit mediation pursuant to the parties' stipulation. Mediation occurred on April 2, 2008. On May 23, 2008, all remaining parties to the litigation filed a proposed settlement with the court which, if approved by the court, would resolve all claims asserted in the Action. The proposed settlement provides for a payment of fees and expenses to plaintiffs' counsel not to exceed $1,650, which amount is expected to be covered by insurance. The proposed settlement received preliminary approval by the court on June 3, 2008. Notice of the terms of the settlement has been mailed to all shareholders of record as of May 23, 2008 and a final fairness hearing has been scheduled by the court to be conducted on August 26, 2008. 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, 20 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. In December 2007, the SEC staff, pursuant to a formal order of investigation, issued subpoenas for additional documents and testimony by certain employees. The production of additional documents called for by the subpoena and the testimony of the employees was completed in May 2008. The Company has received a subpoena from the Office of Inspector General of the Department of Health and Human Services, seeking documents with respect to two of ETHEX's nitroglycerin products. Both are unapproved products, that is, they have not received FDA approval. (FDA approval is not necessarily required for all drugs to be sold in the marketplace, such as pre-1938 "grandfathered" products or certain drugs reviewed under the so-called DESI process. The Company believes that its two products come within these exceptions.) The subpoena states that it is in connection with an investigation into potential false claims under Title 42 of the U.S. Code, and appears to pertain to whether these products are eligible for reimbursement under federal health care programs, such as Medicaid and VA programs. 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 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 the Company will prevail in any particular litigation. 14. INCOME TAXES The Company adopted FASB Interpretation 48, "Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109" ("FIN 48") effective April 1, 2007. FIN 48 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 50% 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. The Company's adoption of FIN 48 was not material to its consolidated financial position; however, certain reclassifications of various income tax-related balance sheet amounts were required. At April 1, 2007, upon adoption of FIN 48, the Company had $12,980 of gross unrecognized tax benefits, which if recognized would favorably affect the effective income tax rate in future periods. As of December 31, the consolidated balance sheet reflects a liability for unrecognized tax benefits of $11,884, excluding liabilities for interest and penalties. Accrued interest and penalties included in the consolidated balance sheet were $2,082 as of December 31, 2007. The Company recognizes interest and penalties associated with uncertain tax positions as a component of income tax expense in the consolidated statement of income. It is anticipated the Company will recognize approximately $1,300 of unrecognized tax benefits within the next 12 months as a result of the expected expiration of the relevant statute of limitations. 21 The Company is subject to taxation in the U.S. and various states and is subject to examinations by those authorities. The Company's federal statute of limitations has expired for fiscal years prior to 2005 and the relevant state statutes vary. The Company currently is being audited by the IRS for its March 31, 2006 and 2007 tax years. The IRS is also currently auditing the employment tax returns of the Company for calendar years 2004, 2005, 2006 and 2007. Various information requests with respect to the periods under audit have been received and responded to. We expect the IRS to issue additional information requests. The Company does not have any state examinations in progress at this time. An income tax benefit has resulted from the determination that certain non-qualified stock options for which stock-based compensation expense was recorded will create an income tax deduction. This 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 asset is recorded to paid-in capital in the period in which the taxable event or forfeiture occurs. The Company determined that certain options previously classified as Incentive Stock Option ("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, which creates a taxable event. The Company and the affected employees may also be subject to interest and penalties for failing to properly withhold taxes and report the 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 IRS in an effort to reach agreement on the resulting tax liability. The Company recorded liabilities related to this matter of $8,806 as of December 31, 2007, in accrued liabilities on the consolidated balance sheet. Management regularly reevaluates the Company's tax positions taken on filed tax returns using information about recent court decisions and legislative activities. Many factors are considered in making these evaluations, including past history, recent interpretations of tax law, and the specific facts and circumstances of each matter. Because tax law and regulations are subject to interpretation and tax litigation is inherently uncertain, these evaluations can involve a series of complex judgments about future events and can rely heavily on estimates and assumptions. The recorded tax liabilities are based on estimates and assumptions that have been deemed reasonable by management. However, if our estimates are not representative of actual outcomes, recorded tax liabilities could be materially impacted. 15. RECENTLY ISSUED ACCOUNTING STANDARDS In September 2006, the Financial Accounting Standards Board ("FASB") issued SFAS No. 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 disclosure 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 February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities" ("SFAS 159"), which permits companies to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing companies with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS 159 is effective for fiscal years beginning after November 15, 2007. Companies are not allowed to adopt SFAS 159 on a retrospective basis unless they choose early adoption. The Company plans to adopt SFAS 159 at the beginning of fiscal 2009 and is evaluating the impact, if any, the adoption of SFAS 159 will have on its financial condition and results of operations. 22 In March 2007, the FASB ratified the consensus reached by the Emerging Issues Task Force ("EITF") in Issue No. 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 for fiscal years beginning after 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 plans to adopt Issue 07-3 at the beginning of fiscal 2009 and is evaluating the impact of the adoption of this issue 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, 2008, 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 2010 and is 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 No. 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 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 141R is effective for business combinations for which the 23 acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008 and early adoption is prohibited. The Company plans to adopt SFAS 141R at the beginning of fiscal 2010 and is evaluating the impact of SFAS 141R on its financial condition and results of operations. In December 2007, the FASB issued SFAS No. 160, "Non-controlling Interests in Consolidated Financial Statements" ("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. In May 2008, the FASB issued FASB Staff Position No. APB 14-a, "Accounting for Convertible Debt Instruments That May Be Settled in Cash Upon Conversion (Including Partial Cash Settlement)." Under the new rules for convertible debt instruments that may be settled entirely or partially in cash upon conversion, an entity should separately account for the liability and equity components of the instrument in a manner that reflects the issuer's economic interest cost. The effect of the proposed new rules for the debentures is that the equity component would be included in the paid-in-capital section of shareholders' equity on an entity's consolidated balance sheet and the value of the equity component would be treated as original issue discount for purposes of accounting for the debt component of convertible debt. The FSP will be effective for fiscal years beginning after December 15, 2008, and for interim periods within those fiscal years, with retrospective application required. Early adoption is not permitted. The Company is currently evaluating the proposed new rules and the impact on its financial condition and results of operations. 16. SUBSEQUENT EVENTS 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). The NDA for Gestiva(TM) is currently before the FDA, pending approval for use 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 $82,000 for Gestiva(TM), $7,500 of which was paid at closing and recorded as in-process research and development expense. The remainder is payable on the completion of two milestones: (1) $2,000 on the earlier to occur of CYTYC's receipt of acknowledgement from the FDA that their response to the FDA's October 20, 2006 "approvable" letter is sufficient for the FDA to proceed with their review of the NDA or the receipt of FDA's approval of the Gestiva(TM) NDA and (2) $72,500 on FDA approval of a Gestiva(TM) NDA, transfer of all rights in the NDA to the Company and receipt by the Company of defined launch quantities of finished Gestiva(TM) suitable for commercial sale. In January 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 was recorded as an expense in the fourth quarter of fiscal year 2008. At March 31, 2008, the Company had invested $83,900 in the principal amount of auction rate securities ("ARS"). The Company's investments in ARS represent interests in securities that have student loans as collateral that are guaranteed by the U.S. Government. Accordingly, ARS that are backed by student loans are viewed as having low default risk and very low risk of downgrade. 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. The auctions have historically provided a liquid market for these securities. The ARS investments held by the Company all had AAA credit ratings at the time of purchase and at the end of the Company's fiscal 2008 year end. With the liquidity issues experienced in global credit and capital markets, the ARS held by the Company at March 31, 2008 experienced failed auctions beginning in February 2008 as the amount of securities submitted for sale exceeded the 24 amount of purchase orders. Given the failed auctions, the Company's ARS will continue to be illiquid until there is a successful auction for them. The Company cannot predict how long the current imbalance in the auction rate market will continue. The estimated fair value of the Company's ARS holdings at March 31, 2008 was 81,516, which reflected a $2,384 difference from the principal amount of $83,900. The estimated fair value of the ARS was based on a discounted cash flow model that considered, among other factors, the time to work out the market disruption in the traditional trading mechanism, the stream of cash flows (coupons) earned until maturity, the prevailing risk free yield curve, credit spreads applicable to a portfolio of student loans with various tenures and ratings and an illiquidity premium. These factors were used in a Monte Carlo simulation based methodology to derive the estimated fair value of the ARS. Although the ARS continue to pay interest according to their stated terms, the Company recorded during the fourth quarter of fiscal 2008 an unrealized loss of $1,550, net of tax, as a reduction to shareholders' equity in accumulated other comprehensive loss, reflecting adjustments to the ARS holdings that the Company has concluded have a temporary decline in value. ARS have historically been classified as short-term marketable securities in the Company's consolidated balance sheet. Given the failed auctions, the Company has reclassified the $81,516 of ARS as of March 31, 2008 from current assets to non-current assets. The Company believes that as of March 31, 2008, based on its current cash, cash equivalents and marketable securities balances of $126,893 and its current borrowing capacity under its credit facility of $290,000, the current lack of liquidity in the auction rate market will not have a material impact on the Company's ability to fund its operations or interfere with its external growth plans, although the Company cannot assure you that this will continue to be the case. In March 2008, representatives of the Missouri Department of Health and Senior Services, accompanied by representatives of the FDA, notified the Company of a hold on its inventory of certain unapproved drug products, restricting the Company's ability to remove or dispose of those inventories without permission. The hold relates to a misinterpretation about the intended scope of recent FDA notices setting limits on the marketing of unapproved guaifenesin products. In response to notices issued by the 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, the Company timely discontinued a number of its guaifenesin products and believed that, by doing so, had complied with those notices. The recent action to place a hold on certain of the Company's products indicates that additional guaifenesin products should also have been discontinued. In addition, the FDA expanded the hold to include other products that did not contain guaifenesin but were being marketed by the Company without FDA approval under certain "grandfather clauses" and statutory and regulatory exceptions to the pre-market approval requirement for "new drugs" under the FDCA. FDA policies permit the agency to initiate broad action against the marketing of additional categories of the Company's unapproved products, if the FDA deems approval necessary, even if the agency has not instituted similar actions against the marketing of such products by other parties. Pursuant to discussions with the Missouri Department of Health and Senior Services and with the FDA, the affected Morphine and Oxycodone products have been released from the hold. The Company will discontinue manufacturing and marketing substantially all unapproved products subject to the hold. The FDA has not proposed, nor does the Company expect them to propose, that the products subject to the hold be recalled from the distribution channel. As such, the Company has written-off the value of the products subject to the hold in its inventory as of March 31, 2008. The Company also evaluated the active pharmaceutical ingredients and excipients used in the manufacture of the hold products and determined that they should also be written-off since the Company will be discontinuing further manufacturing and many of them cannot be returned or sold to other manufacturers. The write-off included in the results of operations for the fourth quarter of fiscal 2008 totaled $5,500. During most of fiscal 2008, the Company marketed approximately 30 products in its generic/non-branded respiratory line, which consisted primarily of cough/cold products. The cough/cold line accounted for $38,536 , or 10.5%, of the Company's specialty generic net revenues in fiscal 2008. As a result of the FDA hold discussed above, the Company is currently marketing one generic cough/cold product with four strengths that has been approved by the FDA. Since its launch in December 2007, this approved product generated sales of $884 during fiscal 2008. 25 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, 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," "expects," "aims," "believes," "projects," "anticipates," "commits," "intends," "estimate," "will," "should," "could," and other expressions that indicate future events and trends. All statements that address expectations or projections about the future, including without limitation, statements about our strategy for growth, product development, product launches, regulatory approvals, market position, market share increases, 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 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 us 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 operating results; (10) the difficulty of predicting international regulatory approval, including 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) actions by the Securities and Exchange Commission and the Internal Revenue Service with respect to our stock option grants and accounting practices; (15) the impact of credit market disruptions on the fair value of auction rate securities that we have acquired as short-term investments and have now become illiquid; (16) whether any recalled products will have any material financial impact or result in litigation, agency actions or material damages; and (17) the risks detailed from time to time in our filings with the Securities and Exchange Commission. This discussion is by no means exhaustive, but is designed to highlight important factors that may impact the Company's outlook. We undertake no obligation to update any of the forward-looking statements after the date of this report. 26 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Except for the historical information contained herein, the following discussion contains forward-looking statements that are subject to known and unknown risks, uncertainties, and other factors that may cause our actual results to differ materially from those expressed or implied by those forward-looking statements. These risks, uncertainties and other factors are discussed above under the caption "Cautionary Statement Regarding Forward-Looking Information." In addition, the following discussion and analysis of financial condition and results of operations should be read in conjunction with the consolidated financial statements, the related notes to consolidated financial statements and "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, and the unaudited interim consolidated financial statements and related notes to unaudited interim consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q. 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 broad portfolio of drug delivery technologies which we leverage to create technologically-distinguished brand name and specialty generic products. We have developed and patented 15 drug delivery and formulation technologies primarily in four principal areas: SITE RELEASE(R) bioadhesives, oral controlled release, tastemasking and oral quick dissolving tablets. We incorporate these technologies in the products we market to control and improve the absorption and utilization of active pharmaceutical compounds. These technologies provide a number of benefits, including reduced frequency of administration, reduced side effects, improved drug efficacy, enhanced patient compliance and improved taste. Our drug delivery technologies allow us to differentiate our products in the marketplace, both in the branded and generic pharmaceutical areas. We believe that this differentiation provides substantial competitive advantages for our products, allowing us to establish a strong record of growth and profitability and a leadership position in certain segments of our industry. RESULTS OF OPERATIONS Net revenues for the three months ended December 31, 2007 increased $43.7 million, or 37.0%, from the prior year quarter as we experienced sales growth of 57.4% in our specialty generics/non-branded products segment. The increase in specialty generic net revenues resulted primarily from the launch in July 2007 of the 100 mg and 200 mg strengths of metoprolol succinate extended-release tablets, the generic version of Toprol-XL(R) (marketed by AstraZeneca). The resulting $32.1 million increase in consolidated gross profit was offset in part by a $14.2 million increase in operating expenses. The increase in operating expenses was primarily due to increases in personnel costs, legal fees, research and development expense, and amortization of intangibles. As a result, net income for the third quarter increased $14.2 million, or 76.6%, to $32.6 million. Net revenues for the nine months ended December 31, 2007 increased $125.8 million, or 38.9%, as we experienced sales growth of 63.0% in our specialty generics/non-branded products segment. The increase in specialty generic net revenues resulted primarily from the launch in July 2007 of the 100 mg and 200 mg strengths of metoprolol succinate extended-release tablets, the generic version of Toprol-XL(R) (marketed by AstraZeneca). The resulting $101.8 million increase in consolidated gross profit was offset in part by a $46.4 million increase in operating expenses. The increase in operating expenses was primarily due to increases in personnel costs, branded marketing 27 and promotions expense, legal fees, research and development expense, and amortization of intangibles. Operating expenses for the nine-month period also included $10.0 million recorded in connection with the EvaMist(TM) acquisition as acquired in-process research and development (see Note 2 of the Notes to Consolidated Financial Statements). As a result, net income for the nine-month period increased $38.4 million, or 94.5%, to $79.0 million.
NET REVENUES BY SEGMENT - ----------------------- ($ IN THOUSANDS) - ----------------------- THREE MONTHS ENDED NINE MONTHS ENDED DECEMBER 31, DECEMBER 31, ----------------------------------------- -------------------------------------- % % 2007 2006 CHANGE 2007 2006 CHANGE ------------ ------------ ------ ------------ ------------ ------ Branded products $ 54,526 $ 48,311 12.9% $ 157,764 $ 138,453 13.9% as % of total net revenues 33.7% 41.0% 35.1% 42.8% Specialty generics/non-branded 101,911 64,745 57.4% 277,275 170,072 63.0% as % of total net revenues 63.1% 54.9% 61.8% 52.6% Specialty materials 4,700 4,545 3.4% 12,719 13,206 (3.7)% as % of total net revenues 2.9% 3.9% 2.8% 4.1% Other 486 348 39.7% 1,146 1,401 (18.2)% Total net revenues $ 161,623 $ 117,949 37.0% $ 448,904 $ 323,132 38.9%
The increases in branded product sales of $6.2 million and $19.3 million for the three- and nine-month periods, respectively, were due primarily to sales growth of our anti-infective brand, Clindesse(TM), and increased sales of our hematinic products. The increase in sales for the nine-month period was also positively affected by sustained sales growth of our prescription prenatal product, PrimaCare(R) ONE. Clindesse(TM) experienced increased sales of 81.8% and 45.0% for the three- and nine-month periods as our share of the intravaginal bacterial vaginosis market improved to 27.9% at the end of the fiscal 2008 third quarter. The sales increase in Clindesse(TM) was also impacted by larger-than-normal customer purchases during the second and third quarters in anticipation of September 2007 and December 2007 price increases. Sales of our hematinic products increased 43.2% to $13.7 million and 24.4% to $37.7 million during the three- and nine-month periods, respectively. These increases primarily reflected the sales growth of Repliva 21/7(TM), our newest hematinic product, and an increase in sales from our Niferex(R) product line. These increases primarily resulted from larger-than-normal customer purchases during the third quarter in anticipation of a December 2007 price increase. Sales of Repliva 21/7(TM) were also positively impacted by the introduction of a reformulated version of Repliva 21/7(TM) in August 2007. Sales of PrimaCare(R) ONE were flat during the quarter and increased 19.1% to $43.6 million during the nine-month period. The flat sales level of PrimaCare(R) ONE for the quarter resulted from larger-than-normal customer purchases made during the prior year quarter in anticipation of a December 2006 price increase. For the nine-month period, the increase in sales of PrimaCare(R) ONE reflected the impact of price increases that have occurred over the past 12 months coupled with an increase in our share of the branded prenatal vitamin market to 26.2% at the end of the fiscal 2008 third quarter. Sales of Gynazole-1(R), our vaginal antifungal cream product, decreased 23.7% and 9.6% for the three- and nine-month periods, respectively. The decline in sales for the quarter resulted from larger-than-normal customer purchases made during the comparative prior quarter in anticipation of a December 2006 price increase. The growth in specialty generic net sales of $37.2 million and $107.2 million for the three- and nine-month periods, respectively, resulted primarily from the launch in July 2007 of 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, we received a favorable court ruling in a Paragraph IV patent infringement action filed against us by AstraZeneca based on our ANDA submissions to market these generic formulations. Since we were the first company to file with the FDA for generic approval of the 100 mg and 200 mg dosage strengths, we were accorded the opportunity for a 180-day exclusivity period for marketing these two dosage strengths. We began shipping these two products in July 2007 and they generated net revenues of $35.6 million and $85.3 million during the three- and nine-month periods, respectively. Our specialty generic sales for the nine-month period were also favorably impacted by sales of six strengths of Diltiazem HCI ER Capsules (AB rated to Tiazac(R)) which we launched in September 2006. These products generated incremental revenues of $8.9 million for the nine-month period. 28 GROSS PROFIT BY SEGMENT - ----------------------- ($ IN THOUSANDS) - -----------------------
THREE MONTHS ENDED NINE MONTHS ENDED DECEMBER 31, DECEMBER 31, ------------------------------------------ ----------------------------------------- % % 2007 2006 CHANGE 2007 2006 CHANGE ------------ ------------ ------------ ------------ ------------- ------------ Branded products $ 49,019 $ 42,532 15.3% $ 141,149 $ 122,297 15.4% as % of net revenues 89.9% 88.0% 89.5% 88.3% Specialty generics/non-branded 67,491 38,148 76.9% 181,368 97,824 85.4% as % of net revenues 66.2% 58.9% 65.4% 57.5% Specialty materials 1,922 1,404 36.9% 4,962 4,467 11.1% as % of net revenues 40.9% 30.9% 39.0% 33.8% Other (6,805) (2,574) (164.4)% (13,272) (12,220) (8.6)% Total gross profit $ 111,627 $ 79,510 40.4% $ 314,207 $ 212,368 48.0% as % of total net revenues 69.1% 67.4% 70.0% 65.7%
The increases in gross profit of $32.1 million and $101.8 million for the three- and nine-month periods, respectively, were primarily due to the sales growth experienced by our specialty generics and branded products segments. The increases in the specialty generic gross profit amounts and percentages for the three- and nine-month periods resulted from sales of the 100 mg and 200 mg strengths of metoprolol succinate extended-release tablets. We began shipping these two products in July 2007 and they generated net revenues of $35.6 million and $85.3 million during the three- and nine-month periods, respectively. Since we were the first company to file with the FDA for generic approval of the 100 mg and 200 mg dosage strengths, we were accorded the opportunity for a 180-day exclusivity period for marketing these two dosage strengths. The 180-day exclusivity period has allowed us to offer these products at relatively higher prices than our other generic/non-branded products. The higher branded product gross profit percentages for the quarter and nine-month period reflected the impact of price increases made over the past 12 months. Impacting the Other category were contract manufacturing revenues, pricing and production variances, and changes to inventory reserves associated with production. Any inventory reserve changes associated with finished goods were reflected in the applicable segment. The fluctuations in the Other category were primarily due to the impact of higher production costs in the quarter that resulted from lower than expected production volume, coupled with an increase in the provisions for obsolete inventory. RESEARCH AND DEVELOPMENT - ------------------------ ($ IN THOUSANDS) - ------------------------
THREE MONTHS ENDED NINE MONTHS ENDED DECEMBER 31, DECEMBER 31, ------------------------------------------- ------------------------------------------ % % 2007 2006 CHANGE 2007 2006 CHANGE ------------- ------------- -------------- ------------- -------------- ------------- Research and development $ 11,156 $ 8,319 34.1% $ 32,702 $ 22,605 44.7% as % of total net revenues 6.9% 7.1% 7.3% 7.0%
The increases in research and development expense of $2.8 million and $10.1 million for the three- and nine-month periods, respectively, were primarily due to a growing product development pipeline, continued active development of various branded and generic/non-brand products in our internal and external pipelines, and increased personnel expenses related to the growth of our research and development staff. PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT - --------------------------------------------- ($ IN THOUSANDS) - ---------------------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED DECEMBER 31, DECEMBER 31, ------------------------------------------- ------------------------------------------ % % 2007 2006 CHANGE 2007 2006 CHANGE ------------- ------------- -------------- ------------- -------------- ------------- Purchased in-process research and development $ - $ - - % $ 10,000 $ - NM as % of total net revenues - % - % 2.2% - %
29 In May 2007, we completed the acquisition of the U.S. marketing rights to Evamist(TM), a new estrogen replacement therapy product delivered with a patented metered-dose transdermal spray system, from VIVUS, Inc (see Note 2 of the Notes to Consolidated Financial Statements). Under terms of the Agreement, the Company paid $10.0 million in cash at closing and made an additional cash payment of $141.5 million in July 2007 when final approval of the product was received from the FDA. Since the product had not yet obtained FDA approval when the initial payment was made at closing, we recorded a $10.0 million purchased in-process research and development charge during the nine months ended December 31, 2007. SELLING AND ADMINISTRATIVE - -------------------------- ($ IN THOUSANDS) - --------------------------
THREE MONTHS ENDED NINE MONTHS ENDED DECEMBER 31, DECEMBER 31, ------------------------------------------- ------------------------------------------ % % 2007 2006 CHANGE 2007 2006 CHANGE ------------- ------------- -------------- ------------- -------------- ------------- Selling and administrative $ 50,846 $ 41,965 21.2% $ 147,019 $ 124,974 17.6% as % of total net revenues 31.5% 35.6% 32.8% 38.7%
The increases in selling and administrative expense of $8.9 million and $22.0 million for the three- and nine-month periods, respectively, were primarily due to greater personnel costs associated with increases in management, sales and other personnel, an increase in legal fees, and costs incurred during the three- and nine-month periods associated with distribution agreements entered into by our branded products segment during the year with two of our large wholesale customers. The increase in legal costs was commensurate with an increase in litigation activity and evaluation of potential acquisition opportunities. The increase in litigation activity also included ongoing costs associated with certain patent infringement actions brought against us on products we market or propose to market. For the nine-month period, the increase in selling and administrative expense was also due to an increase in branded marketing and promotions expense and a $0.8 million reimbursement of legal fees we received during the comparative prior year nine-month period. AMORTIZATION OF INTANGIBLE ASSETS - --------------------------------- ($ IN THOUSANDS) - ---------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED DECEMBER 31, DECEMBER 31, ------------------------------------------- ------------------------------------------ % % 2007 2006 CHANGE 2007 2006 CHANGE ------------- ------------- -------------- ------------- -------------- ------------- Amortization of intangible assets $ 3,668 $ 1,204 204.7% $ 7,868 $ 3,602 118.4%
The increases in amortization of intangible assets of $2.5 million and $4.3 million for the three- and nine-month periods, respectively, were due to amortization of intangible assets associated with the May 2007 purchase of Evamist(TM), a new estrogen replacement therapy product delivered with a patented metered-dose transdermal spray system, from VIVUS, Inc (see Note 2 of the Notes to Consolidated Financial Statements). Under terms of the Agreement, we made two cash payments: $10.0 million was paid in May 2007 and expensed as in-process research and development and $141.5 million was paid in July 2007 when final approval of the product was received from the FDA. The preliminary purchase price allocation, which is subject to change based on the final fair value assessment, resulted in estimated identifiable intangible assets of $52.4 million to product rights; $15.2 million to trademark rights; $66.4 million to rights under a sublicense agreement; and, $7.5 million to a covenant not to compete. Upon FDA approval in July 2007, we began amortizing the product rights, trademark rights and rights under the sublicense agreement over 15 years and the covenant not to compete over nine years. INTEREST EXPENSE - ---------------- ($ IN THOUSANDS) - ----------------
THREE MONTHS ENDED NINE MONTHS ENDED DECEMBER 31, DECEMBER 31, ------------------------------------------- ------------------------------------------ % % 2007 2006 CHANGE 2007 2006 CHANGE ------------- ------------- -------------- ------------- -------------- ------------- Interest expense $ 2,644 $ 2,214 19.4% $ 7,542 $ 6,755 11.7% as % of total net revenues 1.6% 1.9% 1.7% 2.1%
30 The increases in interest expense for the three- and nine-month periods resulted from interest incurred on the $50.0 million of borrowings made under our credit facility in August 2007. The advance against our credit facility was used, along with cash on hand, to fund the $141.5 million payment for the purchase of Evamist(TM) (see Note 2 of the Notes to Consolidated Financial Statements). We repaid $20.0 million of the borrowing against our credit facility during the quarter. INTEREST AND OTHER INCOME - ------------------------- ($ IN THOUSANDS) - -------------------------
THREE MONTHS ENDED NINE MONTHS ENDED DECEMBER 31, DECEMBER 31, ------------------------------------------- ------------------------------------------ % % 2007 2006 CHANGE 2007 2006 CHANGE ------------- ------------- -------------- ------------- -------------- ------------- Interest and other income $ 2,780 $ 2,240 24.1% $ 8,936 $ 6,606 35.3% as % of total net revenues 1.7% 1.9% 2.0% 2.0%
The increases in interest and other income were primarily due to an increase in the weighted average interest rate earned on short-term investments. The increase in the weighted average interest rate resulted principally from a restructuring of the investment portfolio from short-term tax-exempt securities to short-term taxable securities. PROVISION FOR INCOME TAXES - -------------------------- ($ IN THOUSANDS) - --------------------------
THREE MONTHS ENDED NINE MONTHS ENDED DECEMBER 31, DECEMBER 31, ------------------------------------------- ------------------------------------------ % % 2007 2006 CHANGE 2007 2006 CHANGE ------------- ------------- -------------- ------------- -------------- ------------- Provision for income taxes $ 13,481 $ 9,586 40.6% $ 38,977 $ 22,369 74.3% Effective tax rate 29.2% 34.2% 33.0% 36.6%
The lower effective tax rates for the three- and nine-month periods resulted primarily from the reversal of certain tax liabilities associated with tax positions from previous years that were determined to no longer be necessary as the statute of limitations had expired. The effective tax rates for all periods were favorably impacted by the domestic manufacturer's deduction. The prior year tax rate was adversely affected by the recording of additional tax liabilities associated with tax positions claimed on filed tax returns. NET INCOME AND DILUTED EARNINGS PER SHARE - ----------------------------------------- ($ IN THOUSANDS EXCEPT PER SHARE AMOUNTS) - ------------------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED DECEMBER 31, DECEMBER 31, ------------------------------------------- ------------------------------------------ % % 2007 2006 CHANGE 2007 2006 CHANGE ------------- ------------- -------------- ------------- -------------- ------------- Net income $ 32,612 $ 18,462 76.6% $ 79,035 $ 40,645 94.5% Diluted earnings per Class A share 0.57 0.33 72.7% 1.39 0.74 87.8% Diluted earnings per Class B share 0.49 0.29 69.0% 1.20 0.64 87.5%
The increases in net income of $14.2 million and $38.4 million for the three- and nine-month periods, respectively, resulted primarily from the launch in July 2007 of the 100 mg and 200 mg strengths of metoprolol succinate extended-release tablets. Since we were the first company to file with the FDA for generic approval of the 100 mg and 200 mg dosage strengths, we were accorded the opportunity for a 180-day exclusivity period for marketing these two dosage strengths. The 180-day exclusivity period has allowed us to offer these products at relatively higher prices than our other generic/non-branded products. We began shipping these two products in July 2007 and they generated net revenues of $35.6 million and $85.3 million during the three- and nine-month periods, respectively. 31 LIQUIDITY AND CAPITAL RESOURCES Cash and cash equivalents and working capital were $73.0 million and $165.5 million, respectively, at December 31, 2007, compared to $82.6 million and $372.3 million, respectively, at March 31, 2007. The decrease in working capital resulted primarily from the $200.0 million principal amount of Convertible Subordinated Notes that were classified as a current liability as of December 31, 2007 due to the holders having the right to require us to repurchase all or a portion of their Notes on May 16, 2008. 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 nine months ended December 31, 2007, our net cash flow from operations of $90.4 million resulted primarily from net income adjusted for non-cash items. Net cash flow used in investing activities included capital expenditures of $13.1 million for the nine months ended December 31, 2007 compared to $21.6 million for the corresponding prior year period. The decrease in capital expenditures was primarily due to the comparative prior year amount including the cost of a building purchased in June 2006, additional costs associated with the development of a new lab facility and equipment purchases for Metoprolol production. Other investing activities during the nine-month period consisted of two cash payments made in conjunction with the terms of the Evamist(TM) purchase agreement: $10.0 million was paid in May 2007 and expensed as in-process research and development and $141.5 million was paid in July 2007 when final approval of the product was received from the FDA. The preliminary purchase price allocation, which is subject to change based on the final fair value assessment, resulted in estimated identifiable intangible assets of $52.4 million to product rights; $15.2 million to trademark rights; $66.4 million to rights under a sublicense agreement; and, $7.5 million to a covenant not to compete. Upon FDA approval in July 2007, we began amortizing the product rights, trademark rights and rights under the sublicense agreement over 15 years and the covenant not to compete over nine years. Other investing activities also included $101.1 million and $135.5 million of purchases and sales, respectively, of short-term marketable securities classified as available for sale. The net proceeds received from the purchase and sales activity associated with marketable securities was used in the funding of the Evamist(TM) acquisition. Our debt balance, including current maturities, was $269.9 million at December 31, 2007 compared to $241.3 million at March 31, 2007. In August 2007, we borrowed $50.0 million under our credit facility, the proceeds of which were used in the funding of the Evamist(TM) purchase. We repaid $20.0 million of the borrowing under our credit facility in November 2007. In May 2003, we issued $200.0 million principal amount of Convertible Subordinated Notes (the "Notes") that are convertible, under certain circumstances, into shares of our Class A Common Stock at an initial conversion price of $23.01 per share. The Notes bear interest at a rate of 2.50% and mature on May 16, 2033. We are also obligated to pay contingent interest at a rate equal to 0.5% per annum during any six-month period commencing May 16, 2006, if the average trading price of the Notes per $1,000 principal amount for the five-trading day period ending on the third trading day immediately preceding the first day of the applicable six-month period equals $1,200 or more. In November 2007, the average trading price of the Notes reached the threshold for the five-day trading period that results in the payment of contingent interest and beginning November 16, 2007 the Notes began to bear interest at a rate of 3.00% per annum. We may redeem some or all of the Notes at any time on or after May 21, 2006, at a redemption price, payable in cash, of 100% of the principal amount of the Notes, plus accrued and unpaid interest (including contingent interest, if any) to the date of redemption. Holders may require us to repurchase all or a portion of their Notes on May 16, 2008, 2013, 2018, 2023 and 2028, or upon a change in control, as defined in the indenture governing the Notes, at 100% of the principal amount of the Notes, plus accrued and unpaid interest (including contingent interest, if any) to the date of repurchase, payable in cash. As a result, we have classified the Notes as a current liability as of December 31, 2007 due to the right the holders have to require us to repurchase the Notes on May 16, 2008. Since the holders did not elect to cause us to repurchase any of the Notes, the Notes will be reclassified as long-term beginning with our consolidated balance sheet as of June 30, 2008. The Notes are subordinate to all of our existing and future senior obligations. We have a credit agreement with ten banks that provides for a revolving line of credit for borrowing up to $320.0 million. The credit agreement also includes a provision for increasing the revolving commitment, at the lenders' sole discretion, by up to an additional $50.0 million. This credit facility is unsecured unless we, under certain specified circumstances, utilize the facility to redeem part or all of our outstanding Convertible Subordinated 32 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 senior debt to EBITDA. The 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 credit facility has a five-year term expiring in June 2011. As of December 31, 2007, we were in compliance with all of our financial covenants and there was $30.0 million of borrowings outstanding under the facility. In addition, the agreement requires that we submit quarterly financial statements with 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 quarterly statements for this quarter to June 30, 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 10 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 10 years subsequent to the property being placed in service. Industrial revenue bonds totaling $109.4 million were outstanding at December 31, 2007. 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 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. (See Note 16 of the Notes to Consolidated Financial Statements for a discussion of our investments in auction-rate securities.)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. GOVERNMENT REGULATION In March 2008, representatives of the Missouri Department of Health and Senior Services, accompanied by representatives of the FDA, notified us of a hold on our inventory of certain unapproved drug products, restricting our ability to remove or dispose of those inventories without permission. The hold relates to a misinterpretation about the intended scope of recent FDA notices setting limits on the marketing of unapproved guaifenesin products. In response to notices issued by the 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, we timely discontinued a number of our guaifenesin products and believed that, by doing so, had complied with those notices. The recent action to place a hold on certain of our products indicates that additional guaifenesin products should also have been discontinued. In addition, the FDA expanded the hold to include other products that did not contain guaifenesin but were being marketed by us without FDA approval under certain "grandfather clauses" and statutory and regulatory exceptions to the pre-market approval requirement for "new drugs" under the FDCA. FDA policies permit the agency to initiate broad 33 action against the marketing of additional categories of our unapproved products, if the FDA deems approval necessary, even if the agency has not instituted similar actions against the marketing of such products by other parties. Pursuant to discussions with the Missouri Department of Health and Senior Services and with the FDA, the affected Morphine and Oxycodone products have been released from the hold. We will discontinue manufacturing and marketing substantially all unapproved products subject to the hold. The FDA has not proposed, nor do we expect them to propose, that the products subject to the hold be recalled from the distribution channel. As such, we have written-off the value of the products subject to the hold in our inventory as of March 31, 2008. We also evaluated the active pharmaceutical ingredients and excipients used in the manufacture of the hold products and determined that they should also be written-off since we will be discontinuing further manufacturing and many of them cannot be returned or sold to other manufacturers. The write-off included in the results of operations for the fourth quarter of fiscal 2008 totaled $5.5 million. During most of fiscal 2008, we marketed approximately 30 products in our generic/non-branded respiratory line, which consisted primarily of cough/cold products. The cough/cold line accounted for $38.5 million, or 10.5%, of our specialty generic net revenues in fiscal 2008. As a result of the FDA hold discussed above, we are currently marketing one generic cough/cold product with four strengths that has been approved by the FDA. Since its launch in December 2007, this approved product generated sales of $0.9 million during fiscal 2008. On June 6, 2008, ETHEX initiated a voluntary recall of a single lot of morphine sulfate 60mg extended-release tablets due to a report that a tablet with as much as double the appropriate thickness was identified and therefore the possibility that other oversized tablets could have been commercially released in the affected lot. On June 13, 2008, the recall was expanded to include additional specific lots of morphine sulfate 60 mg extended-release tablets and specific lots of morphine sulfate 30 mg extended release tablets. We accrued a liability of $0.9 million in the fourth quarter of fiscal 2008 for the anticipated cost of the recall. No oversized tablets have been identified in any additional distributed lot of these products and based on our investigation, there are likely to be few, if any, oversized tablets in the recalled lots. In addition, under ordinary pharmacy dispensing procedures, any significantly oversized tablets would likely be identified at the time of dispensing. However, the decision to recall the additional lots has been taken as a responsible precaution because of the possibility that there may be oversized tablets in the recalled lots. 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 ESTIMATES Our consolidated financial statements are presented on the basis of U.S. generally accepted accounting principles. Certain of our accounting policies are particularly important to the portrayal of our financial condition and results of operations and require the application of significant judgment by our management. As a result, these policies are subject to an inherent degree of uncertainty. In applying these policies, we make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures. We base our estimates and judgments on historical experience, the terms of existing contracts, observance of trends in the industry, information that is obtained from customers and outside sources, and on various other assumptions that are believed to be reasonable and appropriate under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Although we believe that our estimates and assumptions are reasonable, actual results may differ significantly from our estimates. Changes in estimates and assumptions based upon actual results may have a material impact on our results of operations and/or financial condition. Our critical accounting estimates are described below. REVENUE 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 34 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 but not limited to, historical relationship to revenues, historical payment and return experience, estimated and actual customer inventory levels, customer rebate arrangements, and current contract sales terms with wholesale and indirect customers. From time to time, we provide incentives to our wholesale customers, such as trade show allowances or stocking allowances that they in turn use to accelerate distribution to their end customers. We believe that such incentives are normal and customary in the industry. Sales allowances are accrued and revenue is recognized as sales are made pursuant to the terms of the allowances offered to the customer. Due to the nature of these allowances, we believe we are able to accurately calculate the required provisions for the allowances based on the specific terms in each agreement. Additionally, customers will normally purchase additional product ahead of regular demand to take advantage of the temporarily lower cost resulting from the sales allowances. This practice has been customary in the industry and we believe would be part of a customer's ordinary course of business inventory level. We reserve the right, with our major wholesale customers, to limit the amount of these forward buys. Sales made as a result of allowances offered on our specialty generics product line in conjunction with trade shows sponsored by our major wholesale customers and for other promotional programs accounted for 11.6% and 14.8% of total gross revenues for the nine months ended December 31, 2007 and 2006, respectively. 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 61% of our unit sales during the nine months ended December 31, 2007, through an internal analysis that considers, among other things, wholesaler purchases, wholesaler contract sales, available end consumer prescription information and inventory data received from our three largest wholesale customers. We believe that our evaluation of wholesaler inventory levels allows us to make reasonable estimates of our reserve balances. Further, our products are typically sold with adequate shelf life to permit sufficient time for our wholesaler customers to sell our products in their inventory through to the end consumer. The following table reflects the activity during the nine months ended December 31, 2007 for each accounts receivable reserve:
CURRENT PROVISION CURRENT PROVISION ACTUAL RETURNS RELATED TO SALES RELATED TO SALES OR CREDITS (IN THOUSANDS) BEGINNING MADE IN THE MADE IN IN THE ENDING BALANCE CURRENT PERIOD PRIOR PERIODS CURRENT PERIOD BALANCE ----------- ------------------ ------------------- ----------------- ------------ NINE MONTHS ENDED DECEMBER 31, 2007 Accounts Receivable Reserves: Chargebacks $ 13,005 $ 100,652 $ - $ (95,456) $ 18,201 Sales Rebates 5,386 24,643 - (18,174) 11,855 Sales Returns 2,873 11,645 - (10,256) 4,262 Cash Discounts and Other Allowances 3,511 20,034 - (18,337) 5,208 Medicaid Rebates 6,506 7,655 - (6,318) 7,843 ----------- ------------------ ------------------- ----------------- ------------ TOTAL $ 31,281 $ 164,629 $ - $ (148,541) $ 47,369 =========== ================== =================== ================= ============
The increase in the reserve for chargebacks at December 31, 2007 was primarily due to chargeback reserves established on the 100 mg and 200 mg strengths of metoprolol succinate extended-release tablets, the generic 35 version of Toprol-XL(R) (marketed by AstraZeneca). We began shipping these two products in July 2007 and they generated net revenues of $35.6 million and $85.3 million during the three- and nine-month periods, respectively. The increases at December 31, 2007 in the reserves for sales rebates, sales returns, and cash discounts and other allowances were also primarily due to the impact of sales associated with the two strengths of metoprolol succinate extended-release tablets. The increase in the reserve for Medicaid rebates at December 31, 2007 resulted primarily from the timing of when certain Medicaid rebate payments were processed. 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 nine months ended December 31, 2007 and 2006, the chargeback provision reduced the gross sales of our specialty generics segment by $98.9 million and $72.0 million, respectively. These amounts accounted for 98.5% and 99.3% of the total chargeback provisions recorded during the nine months ended December 31, 2007 and 2006, 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: o 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 nine months ended December 31, 2007, unit sales to our three major wholesale customers accounted for 82% of our total unit sales to all wholesalers, and the aggregate inventory position of the three major wholesalers at December 31, 2007 was approximately equivalent to our last eight 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 wholesale customers carry less inventory than our large wholesale customers. As of December 31, 2007, each week of inventory for those remaining wholesalers represented approximately $0.2 million, or 1.2%, of the reported reserve for chargebacks. o The percentage of sales to our wholesale 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 wholesale 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 December 31, 2007, the aggregate weighted average percentage of sales to wholesalers assumed to result in chargebacks was approximately 94%, with each 1% representing approximately $0.2 million, or 1.0%, of the reported reserve for chargebacks. o 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 wholesale customer using historical weighted average pricing, based on actual chargeback experience. Use of 36 weighted average pricing over time compensates for changes in the mix of indirect customers and products from period to period. As of December 31, 2007, 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 4.7%, 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. Sales Returns - Consistent with industry practice, we maintain a returns - ------------- policy that allows our direct and indirect customers to return product six months prior to expiration and within one year after expiration. This policy is applicable to both our branded and specialty generics business segments. Upon recognition of revenue from product sales to customers, we provide for an estimate of product to be returned. This estimate is determined by applying a historical relationship of customer returns to gross sales. We evaluate the reserve for sales returns by calculating historical return rates using data from the last 12 months on a product specific basis and by class of trade (wholesale versus retail chain). The calculated percentages are applied against estimates of inventory in the distribution channel on a product specific basis. To determine the inventory levels in the wholesale distribution channel, we utilize actual inventory information from our major wholesale customers and estimate the inventory positions of the remaining wholesalers based on historical buying patterns. For inventory held by our non-wholesale customers, we use the last two months of sales to the direct buying chains and the indirect buying retailers as an estimate. A 10% change in the product specific historical return rates used in the reserve analysis would have changed the reserve balance at December 31, 2007 by approximately $0.3 million, or 6.6%, 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 December 31, 2007 by approximately $0.5 million, or 10.8%, 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 driven 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 December 31, 2007 by $0.4 million, or 5.7% of the reported reserve for Medicaid rebates. Similarly, a 10% change in estimated patient usage would have changed the reserve at December 31, 2007 by $0.4 million, or 5.7% 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. 37 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, which range from nine to 20 years. We determine amortization periods for intangible assets that are acquired based on our assessment of various factors impacting estimated useful lives and cash flows of the acquired products. Such factors include the product's position in its life cycle, the existence or absence of like products in the market, various other competitive and regulatory issues, and contractual terms. Significant changes to any of these factors may result in a reduction in the intangible asset's useful life and an acceleration of related amortization expense. We assess the impairment of intangible 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. STOCK-BASED COMPENSATION. 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. 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 38 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 was affected by the adoption of FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109" on April 1, 2007. (See Note 14 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 December 31, 2007 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. 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. The majority of our investments in marketable securities are taxable auction rate securities. The rates on these securities reset at a pre-determined interval up to 35 days. As of December 31, 2007 and March 31, 2007, we had invested $83.3 million and $119.2 million, respectively, 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 December 31, 2007 have adversely affected the market for auction rate securities, which has resulted in a loss of liquidity for these investments. We have evaluated these securities to determine if other-than-temporary impairment of the carrying value of the securities has occurred due to the loss of liquidity. At March 31, 2008, the fair value of auction rate securities was $81.5 million and the resultant difference of $2.4 million was recorded in accumulated other comprehensive loss as the unrealized losses were considered to be temporary (See Note 16 of the Notes to the Consolidated Financial Statements for further discussion of our investment in auction rate securities). We believe that as of March 31, 2008, based on our cash, cash equivalents and short-term marketable securities balances of $126.9 million and our current borrowing capacity of $290.0 million under our credit facility, the current lack of liquidity in the auction rate market will not have a material impact on our ability to fund our operations or interfere with our external growth plans, although we cannot assure you that this will continue to be the case. The annual favorable impact on our net income as a result of a 25, 50 or 100 basis point (where 100 basis points equals 1%) increase in short-term interest rates would be approximately $0.5 million, $1.1 million or $2.1 million, respectively, based on our average cash, cash equivalents and short-term marketable investment balances during the nine months ended December 31, 2007 compared to an increase of $0.6 million, $1.1 million or $2.2 million, respectively, during the fiscal year ended March 31, 2007. Advances to us under our credit facility 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. At December 31, 2007, we had $30.0 million of borrowings outstanding under our credit facility. At March 31, 2007, we had no borrowings outstanding under our credit facility. 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 became obligated to pay contingent interest at a rate equal to 0.5% per annum during any six-month period, if the average trading price of the 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 39 six-month period equals $1,200 or more. In November 2007, the average trading price of the Notes reached the threshold for the five-day trading period that results in the payment of contingent interest and beginning November 16, 2007 the Notes began to bear interest at a rate of 3.00% per annum. 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. As a result, we have classified the Convertible Subordinated Notes as a current liability as of December 31, 2007 due to the right the holders have to require us to repurchase the Convertible Subordinated Notes on May 16, 2008. Since the holders did not elect to cause us to repurchase any of the Notes, the Notes will be reclassified as long-term beginning with our consolidated balance sheet as of June 30, 2008. 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 (a) EVALUATION OF DISCLOSURE 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, 2007 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. Exchange Act Rule 12b-2 defines a material weakness as a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company's annual or interim financial statements will not be prevented or detected on a timely basis. During the completion of its fiscal 2008 financial statements, the Company determined that a material weakness in its internal control over financial reporting existed as of June 30, 2007 related to revenue recognition. Specifically, the design of the Company's policies and procedures did not adequately address the financial reporting risk associated with customer rebate agreements and were inadequate in ensuring that the necessary information for new or modified rebate agreements was communicated to those responsible for evaluating the accounting implications of the agreements. This resulted in a reasonable possibility that a material misstatement of the Company's annual or interim financial statements will not be prevented or detected on a timely basis. 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 the following areas: o Determining measurement dates, o Determining forfeiture provisions, and o Determining the tax treatment of stock option awards. 40 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 for the years ended March 31, 2004 through 2006 that should have been recorded in accordance with GAAP, partially offset by certain expected tax refunds. 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 identified as of August 2006 and March 31, 2007 described above, we have filed a comprehensive Form 10-K for the fiscal year ended March 31, 2007 in which we restated our consolidated statements of income, comprehensive income, shareholders' equity and cash flows for the fiscal years ended March 31, 2006 and 2005, our consolidated balance sheet as of March 31, 2006 and selected consolidated financial data for the fiscal years ended March 31, 2006, 2005, 2004, and 2003, and for each of the quarters in the fiscal year ended March 31, 2006. (b) CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING SEC regulations require that Company management evaluate any change in our internal controls over financial reporting that occurred during each of our fiscal quarters that has materially affected, or is reasonably likely to materially affect the Company's internal control over financial reporting. There were no changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended December 31, 2007 that have materially affected, or are reasonably likely to materially affect the Company's internal control over financial reporting. 41 (c) INHERENT LIMITATIONS OF DISCLOSURE CONTROLS AND PROCEDURES Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to risks that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies and procedures may deteriorate. (d) REMEDIATION ACTIVITIES Subsequent to March 31, 2008, the Company is taking steps to remediate the material weakness related to rebate agreements by designing policies and procedures that require all new or modified customer agreements to be reviewed by accounting personnel with relevant GAAP knowledge to determine the appropriate accounting treatment. Subsequent to December 31, 2007, we are still in the process of remediating the material weaknesses related to accounting for stock-based compensation, income taxes and revenue recognition described in (a) above as follows: Stock-Based Compensation o Expanded the General Counsel's role to include oversight of the process of documenting stock option grants in order to assure that grants are properly awarded under the approved plan document and proper grant dates are associated with awards. o Engaged an outside professional services firm to advise us on improving the design of the internal controls over our stock option processes and controls over the preparation and review of stock-based compensation information in the Company's financial reports. o Established an Employee Compensation Reporting Committee comprised of senior tax, legal, human resource, and accounting/finance personnel, to assure that grants are properly awarded under the plan document, proper grant dates are assigned for measurement purposes, the reasonableness of key assumptions used in the valuation of stock options are reviewed for appropriateness and any modifications to the standard terms of outstanding awards are reviewed for appropriate accounting treatment. o Established a procedure whereby senior financial management reviews employment agreements, employment offers, and other employee agreements to ensure proper accounting based upon the terms and conditions of such agreements. o Training and education to ensure that all relevant personnel involved in the administration of and accounting for stock option grants, including tax personnel, understand the terms of the Company's stock option plans and the relevant accounting guidance under U.S. generally accepted accounting principles. o Established quarterly testing by the Company's Internal Audit Department of controls relating to stock option activity and the accuracy of the model used in valuing the Company's stock options. Income Taxes o Established quarterly meetings between the tax department, operating division executives and other management personnel to facilitate communication of relevant business issues impacting accounting for income taxes, and; o Implemented procedures that require the documentation of tax liabilities and facilitate an effective review of the recognition and measurement of tax liabilities. Revenue Recognition o Implemented a procedure to verify actual customer receipt dates of shipments made during the last several days of a period end for the FOB destination customers. o Implemented a policy requiring that shipping terms for all customers are properly documented and reviewed by finance/accounting personnel to verify the appropriate timing of revenue recognition. 42 PART II. - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The information set forth under Note 13 - CONTINGENCIES - LITIGATION of the Notes to Consolidated Financial Statements included in Part I, Item I of this report is incorporated in this Part II, Item 1 by reference. ITEM 1A. RISK FACTORS There are no material changes from the risk factors set forth in Item 1A, "Risk Factors," of the Company's Annual Report on Form 10-K for the fiscal year ended March 31, 2007. Please refer to that section for disclosures regarding the risks and uncertainties related to the Company's business. 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 December 31, 2007:
TOTAL NUMBER OF SHARES MAXIMUM NUMBER OF SHARES TOTAL NUMBER OF PURCHASED AS PART OF A THAT MAY YET BE SHARES PURCHASED AVERAGE PRICE PAID PUBLICLY ANNOUNCED PURCHASED UNDER THE PERIOD (a) PER SHARE PROGRAM PROGRAM October 1-31, 2007 310 $ 30.70 -- -- November 1-30, 2007 597 $ 30.14 -- -- December 1-31, 2007 399 $ 27.78 -- -- ----- ------- Total 1,306 $ 29.55 -- -- ===== =======
Shares were purchased from employees upon their termination pursuant to the terms of the Company's stock option plan. 43 ITEM 6. EXHIBITS Exhibits. See Exhibit Index. 44 SIGNATURES ---------- Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. K-V PHARMACEUTICAL COMPANY Date: June 25, 2008 By /s/ Marc S. Hermelin ------------------------------------------ Marc S. Hermelin Chairman of the Board and Chief Executive Officer (Principal Executive Officer) Date: June 25, 2008 By /s/ Ronald J. Kanterman ------------------------------------------ Ronald J. Kanterman Vice President and Chief Financial Officer (Principal Financial Officer) Date: June 25, 2008 By /s/ Richard H. Chibnall ------------------------------------------ Richard H. Chibnall Vice President, Finance (Principal Accounting Officer) 45 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. 46 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: June 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: June 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 December 31, 2007, 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: June 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 December 31, 2007, 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: June 25, 2008 /s/ Ronald J. Kanterman -------------------------------------------- Ronald J. Kanterman Vice President and Chief Financial Officer (Principal Financial Officer) -----END PRIVACY-ENHANCED MESSAGE-----