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| CHTT > SEC Filings for CHTT > Form 10-Q on 2-Jul-2004 | All Recent SEC Filings |
2-Jul-2004
Quarterly Report
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the audited consolidated financial statements and related notes thereto included in our 2003 Annual Report on Form 10-K filed with the Securities and Exchange Commission. This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. The actual results may differ materially from those anticipated in these forward-looking statements as a result of a number of factors, including, but not limited to, those described in our filings with the Securities and Exchange Commission.
OVERVIEW
We are a leading marketer and manufacturer of a broad portfolio of branded over-the-counter ("OTC") healthcare products, toiletries and dietary supplements including such categories as topical analgesics, medicated skin care products, medicated dandruff shampoos and conditioner, dietary supplements, and other OTC and toiletry products. Our portfolio of products includes well-recognized brands such as:
o Topical analgesics such as ICY HOT, ASPERCREME and FLEXALL;
o Medicated skin care products such as GOLD BOND medicated skin care powder, cream, lotion, first aid, and foot care products; and PHISODERM medicated acne treatment products and skin cleansers;
o SELSUN BLUE medicated dandruff shampoos and conditioner;
o Dietary supplements including DEXATRIM, GARLIQUE and NEW PHASE; and
o Other OTC and toiletry products such as PAMPRIN and PREMSYN PMS, menstrual analgesics; HERPECIN-L, a lip care product; BENZODENT, a dental analgesic cream; and toiletries such as BULLFROG, a line of sunblocks; ULTRASWIM, chlorine-removing shampoo; and SUN-IN, a hair lightener.
Our products typically target niche markets that are often outside the core product areas of larger companies where we believe we can achieve and sustain significant market penetration through innovation and strong advertising and promotion support. Many of our products are among the U.S. market leaders in their respective categories. For example, our portfolio of topical analgesic brands and our GOLD BOND medicated body powders have the leading U.S. market share in these categories. We support our brands through extensive and cost-effective advertising and promotion, the expenditures for which represented approximately 29% of our total revenues in the six months ended May 31, 2004. We sell our products nationally through mass merchandiser, drug and food channels principally utilizing our own sales force.
Our strategy to achieve future growth is to generate new sales through strong marketing and promotional programs, new product development, acquisitions of new brands, development of strategic marketing alliances and expansion of our international business. As previously high-growth brands mature, sales increases will become even more dependent on the development of successful line extensions, international expansion and acquisitions. During the first quarter of fiscal 2004, we introduced the DEXATRIM All in One Bar, SELSUN BLUE Conditioner, PAMPRIN All Day, BULLFROG SuperBlock Spray Lotion and PHISODERM CLEAR CONFIDENCE Self Heating Daily Scrub and Herbal Astringent. In the second quarter of fiscal 2004, we introduced the ICY HOT Medicated Sleeve. Line extensions, product introductions and acquisitions require a significant amount of introductory advertising and promotional support. For a period of time, these products do not generate a commensurate amount of sales or earnings. As a result, we may experience a short-term impact on our profitability due to line extensions and acquisitions.
In March 2002, we acquired worldwide rights (except in India) to manufacture, sell and market SELSUN BLUE, which is marketed internationally as SELSUN, plus related intellectual property and certain manufacturing equipment from Abbott Laboratories ("Abbott"). Abbott, or manufacturers under contract to Abbott, manufactured SELSUN BLUE for us domestically until June 2003 and internationally until the end of March 2004. We have entered into an amendment to the manufacturing agreement with Abbott under which Abbott will continue to manufacture SELSUN for us for the European, Middle East and several Latin American markets for an additional period ending July 2005 at agreed upon rates, which vary by market. Abbott will also continue to serve as our distributor for SELSUN in certain foreign countries under separate distribution agreements. All of our North American SELSUN BLUE product lines are presently being manufactured at our Chattanooga facilities. During a transition period which ended March 28, 2004, Abbott also marketed, sold and distributed SELSUN products for us in certain foreign countries until we could satisfy various foreign regulatory requirements, new distributors were in place and any applicable marketing permits were transferred. During the transition period, Abbott paid us an initial royalty equal to 28% of international
sales of SELSUN in these countries with the royalty reduced to 14% of international sales in certain countries if foreign regulatory requirements were satisfied prior to our assumption of sales and marketing responsibility in such countries. During the transition period, Abbott paid all costs and expenses related to the manufacture, marketing and sales of SELSUN in these countries. As we assumed responsibility for the sales and marketing effort in a country, the royalty arrangement with respect to such country terminated. We then recorded these international sales directly as well as the costs and expenses associated with these sales. Abbott has agreed to extend the transition beyond March 28, 2004 in several countries where we are still awaiting regulatory approval of the transfer. In certain international markets, we sell SELSUN through a distributor and receive a royalty based on a percentage of distributor sales.
In January 2004, our board of directors increased the total authorization to repurchase our common stock under our stock buyback program to $20.0 million. For the six months ended May 31, 2004, we repurchased 129,000 shares for $3.2 million. The remaining availability under the board authorization was $16.8 million as of May 31, 2004. We are limited in our ability to repurchase shares due to restrictions under the terms of our Senior Secured Revolving Credit Facility due February 26, 2009 (the "Revolving Credit Facility") and the indenture pursuant to which Floating Rate Senior Notes due 2010 (the "Floating Rate Notes") and 7.0 % Senior Subordinated Fixed Rate Notes due 2014 (the "7.0% Subordinated Notes") were issued.
Our net income margin (net income/total revenues) was 10.3% and 11.8% for the second quarter of fiscal 2004 and 2003, respectively, and 5.0% and 9.9% for the six months ended May 31, 2004 and 2003, respectively. Our net income (excluding debt extinguishment charges and settlement and administrative costs of PPA litigation) margin (net income (excluding debt extinguishment charges and settlement and administrative costs of PPA litigation)/total revenues) was 15.1% and 13.2% for the three and six months ended May 31, 2004, respectively. We believe that disclosure of net income (excluding debt extinguishment charges and settlement and administrative costs of PPA litigation) margin provides investors with useful information regarding the Company's financial performance and allows for easier comparison with net income margin without the effect of these charges in prior periods. A reconciliation of net income (excluding debt extinguishment charges and settlement and administrative costs of PPA litigation) to net income for the three and six months ended May 31, 2004 is presented in the following table:
For the For the
Three Months Six Months
Ended Ended
May 31, May 31,
2004 2004
---------- ----------
(dollars in thousands)
Net income $ 7,247 $ 6,535
Add:
Loss on early extinguishment of debt 1,649 12,958
Settlement and administrative costs of PPA litigation 3,463 3,657
Benefit from income taxes (1,789) (5,815)
---------- ----------
Net income (excluding debt extinguishment charges and
settlement and administrative costs of PPA litigation) $ 10,570 $ 17,335
========== ==========
Net income (excluding debt extinguishment charges and settlement and administrative costs of PPA litigation)
margin 15.1% 13.2%
========== ==========
EBITDA, earnings before interest, taxes, depreciation and amortization, is a key non-GAAP financial measure used by us to measure operating performance but may not be comparable to a similarly titled measure reported by other companies. The most directly comparable GAAP financial measure is net income. EBITDA is used to supplement net income as an indicator of operating performance and not as an alternative to measures defined and required by accounting principles generally accepted in the United States. We consider EBITDA an important indicator of our operational strength and performance, including our ability to pay interest, service debt and fund capital expenditures. EBITDA is also one measure used in the calculation of certain ratios to determine our compliance with the terms of our Revolving Credit Facility.
A reconciliation of EBITDA and EBITDA (excluding settlement and administrative costs of PPA litigation) to net income is presented in the following table:
For the Three Months Ended
---------------------------------------------------
Dollar Percentage
May 31, May 31, Increase Increase
2004 2003 (Decrease) (Decrease)
-------- -------- -------- --------
(dollars in thousands)
Net income $ 7,247 $ 7,521 $ (274) (3.6%)
Add:
Provision for income taxes 3,902 4,299 (397) (9.2)
Interest expense, net (includes loss on
early extinguishment of debt in 2004) 5,173 5,174 (1) --
Depreciation and amortization less
amounts included in interest 1,349 1,018 331 32.5
-------- -------- --------
EBITDA $ 17,671 $ 18,012 $ (341) (1.9)
======== ======== ========
Settlement and administrative costs of
PPA litigation 3,463 -- 3,463 nm
-------- -------- --------
EBITDA (excluding settlement and
administrative costs of PPA litigation) $ 21,134 $ 18,012 $ 3,122 17.3
======== ======== ========
EBITDA margin (EBITDA/total revenues) 25.2% 28.3%
======== ========
EBITDA (excluding settlement and
administrative costs of PPA litigation)
margin (EBITDA (excluding settlement
and administrative costs of PPA
litigation)/total revenues) 30.2% 28.3%
======== ========
For the Three Months Ended
---------------------------------------------------
Dollar Percentage
May 31, May 31, Increase Increase
2004 2003 (Decrease) (Decrease)
-------- -------- -------- --------
(dollars in thousands)
Net income $ 6,535 $ 12,110 $ (5,575) (46.0%)
Add:
Provision for income taxes 3,519 7,112 (3,593) (50.5)
Interest expense, net (includes loss on
early extinguishment of debt in 2004) 21,192 10,287 10,905 106.0
Depreciation and amortization less
amounts included in interest 2,617 2,152 465 21.6
-------- -------- --------
EBITDA $ 33,863 $ 31,661 $ 2,202 7.0
======== ======== ========
Settlement and administrative costs of
PPA litigation 3,657 -- 3,657 nm
-------- -------- --------
EBITDA (excluding settlement and
administrative costs of PPA litigation) $ 37,520 $ 31,661 $ 5,859 18.5
======== ======== ========
EBITDA margin (EBITDA/total revenues) 25.8% 25.9%
======== ========
EBITDA (excluding settlement and
administrative costs of PPA
litigation) margin (EBITDA
(excluding settlement and
administrative costs of PPA
litigation)/total revenues) 28.6% 25.9%
======== ========
27
On December 19, 2003, we entered into a memorandum of understanding with
the Plaintiffs' Steering Committee ("PSC") in IN RE PHENYLPROPANOLAMINE ("PPA")
PRODUCTS LIABILITY LITIGATION, MDL 1407, pending before the United States
District Court for the Western District of Washingtion (the "Memorandum of
Understanding"). The Memorandum of Understanding memorialized certain settlement
terms concerning lawsuits relating to DEXATRIM products containing PPA.
On April 13, 2004, we entered into a class action settlement agreement with representatives of the plaintiffs' settlement class. The court granted preliminary approval of the class action settlement on April 23, 2004. The class action settlement agreement is generally consistent with the terms of and supercedes the Memorandum of Understanding and provides for a national class action settlement of all DEXATRIM PPA claims. The class action settlement is subject to final approval by the court at a fairness hearing currently scheduled for August 26, 2004.
In accordance with the terms of the DEXATRIM class action settlement agreement, $60.9 million has been funded into an initial settlement trust from our first three layers of insurance coverage, as described below. We have published notice of the final settlement and details as to the manner in which claims can be submitted. The deadline for submission of all claims is July 7, 2004. If the final settlement is approved by the court, claims submitted in the class settlement would be valued pursuant to an agreed upon settlement matrix that is designed to evaluate and determine the settlement value of each claim. To the extent the amount in the initial settlement trust is ultimately insufficient to fully fund the settlement, we will be required to make additional contributions to the settlement trust in the future.
We cannot assure you that the terms of the class action settlement agreement will be approved by the court. If the settlement is not approved, we will continue to defend individual cases in a number of different state and federal jurisdictions. If the final settlement is approved, we believe that the settlement will include a substantial majority of the claims by users of DEXATRIM products containing PPA, but that some claims may elect to "opt out" of any class settlement and will continue to pursue claims for damages against us in separate lawsuits. We cannot estimate at this time how many claims may opt out or whether such claims will result in significant additional liability for us. To the extent the number or settlement value of opt out claims exceeds certain levels as specified in the class action settlement agreement, we reserve the right to terminate the settlement.
If the settlement is approved based on the proposed terms and information currently known to us about the pending cases, we estimate that we may record, during fiscal 2004, a charge, net of insurance recovery, of approximately $20.0-25.0 million, or an after tax charge of $13.0-16.3 million (approximately $.65-.82 per share), for settlement costs, administrative expenses and costs of defense related to resolving the PPA litigation. In the second fiscal quarter ended May 31, 2004, we paid or accrued the first portion of this charge, $3.5 million, or $2.3 million after tax ($.11 per share). Although we believe an additional liability existed as of May 31, 2004 related to our PPA litigation, because the final terms of the settlement are still uncertain and have not been approved, we are not able to reasonably estimate the amount of such liability at May 31, 2004 and have made no provision for this liability in our condensed consolidated financial statements.
As indicated above, $60.9 million from our first three layers of our product liability insurance coverage available for the PPA litigation has been funded into an initial settlement trust. To the extent the amount in the initial settlement trust is insufficient to fully fund the settlement, we will be required to make additional contributions to the settlement trust in the future. We currently expect to use certain of our cash on hand to fund any required additional contributions to the settlement trust. If we are required to fund significant other liabilities related to the PPA litigation beyond the initial settlement trust, either pursuant to the terms of the settlement, as a result of litigation or otherwise, we will have significantly fewer sources of funds with which to satisfy such liabilities, and we may be unable to do so. Moreover, if the settlement is not approved, we may not have sufficient funds to satisfy all claims against us.
We have reached an agreement with Kemper Indemnity Insurance Company ("Kemper") to settle Kemper's lawsuit that sought to rescind our policy for $50.0 million of excess coverage for product liability claims. After giving effect to the settlement with Kemper, we have available for the claims against us related to the PPA litigation, through our first three layers of insurance coverage, approximately $60.9 million of the $77.0 million of product liability coverage provided by these insurance policies. The $60.9 million of available coverage consists of $37.5 million of insurance under the Kemper policy and approximately $23.4 million under policies with two other insurance companies. As indicated above, this $60.9 million of coverage has been funded into an initial settlement trust in accordance with the terms of the class action settlement agreement.
We continue to aggressively defend an action brought by Interstate Fire & Casualty Company ("Interstate") to rescind its $25.0 million of excess coverage for product liability and pursue our available remedies at law against Interstate. We cannot assure you that we will be successful in retaining such excess coverage. The Interstate policy is in excess of the product liability insurance available from Kemper and the two other insurance companies referred to above. In the event the $60.9 million of insurance funds available in the initial settlement trust are exhausted under the PPA settlement or otherwise, coverage under the Interstate policy would not be available until we have paid $12.6 million toward the settlement of PPA claims to reach the $73.5 million coverage point for the Interstate policy.
On December 30, 2003, the United States Food and Drug Administration ("FDA") issued a consumer alert on the safety of dietary supplements containing ephedrine alkaloids and on February 6, 2004 published a final rule with respect to these products. The final rule prohibits the sale of dietary supplements containing ephedrine alkaloids because such supplements present an unreasonable risk of illness or injury. The final rule became effective on April 11, 2004. Although we discontinued the manufacturing and shipment of DEXATRIM containing ephedrine in September 2002, the FDA's final rule may result in additional lawsuits being filed against us alleging damages related to the use or purchase of DEXATRIM containing ephedrine.
RESULTS OF OPERATIONS
-
The following table sets forth, net income and for the periods indicated, certain items from our Condensed Consolidated Statements of Income expressed as a percentage of total revenues:
For the Three Months Ended For the Six Months Ended
--------------------------- ---------------------------
May 31, 2004 May 31, 2003 May 31, 2004 May 31, 2003
------------ ------------ ------------ ------------
TOTAL REVENUES 100.0% 100.0% 100.0% 100.0%
------ ------ ----- -----
COSTS AND EXPENSES:
Cost of sales 29.3 27.9 28.6 29.0
Advertising and promotion 27.2 29.1 28.6 30.3
Selling, general and administrative 15.2 16.3 16.2 16.5
Settlement and administrative costs of
PPA litigation 5.0 -- 2.8 --
------ ------ ----- -----
Total costs and expenses 76.7 73.3 76.2 75.8
------ ------ ----- -----
INCOME FROM OPERATIONS 23.3 26.7 23.8 24.2
------ ------ ----- -----
OTHER INCOME (EXPENSE):
Interest expense (5.2) (8.2) (6.4) (8.5)
Investment and other income, net 0.2 0.1 0.1 0.1
Loss on early extinguishment of debt (2.4) -- (9.8) --
------ ------ ----- -----
Total other income (expense) (7.4) (8.1) (16.1) (8.4)
------ ------ ----- -----
INCOME BEFORE INCOME TAXES 15.9 18.6 7.7 15.8
PROVISION FOR INCOME TAXES 5.6 6.8 2.7 5.9
------ ------ ----- -----
NET INCOME (1) 10.3% 11.8% 5.0% 9.9%
====== ====== ===== =====
------------
(1) For the net income (excluding debt extinguishment charges and settlement and
administrative costs of PPA litigation) margin, see the "Overview" in this
Management's Discussion and Analysis.
The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires management to use estimates. Several different estimates or methods can be used by management that might yield different results. The following are the significant estimates used by management in the preparation of the May 31, 2004 condensed consolidated financial statements:
ALLOWANCE FOR DOUBTFUL ACCOUNTS
As of May 31, 2004, an estimate was made of the collectibility of the outstanding accounts receivable balances. This estimate requires the utilization of outside credit services, knowledge about the customer and the customer's industry, new developments in the customer's industry and operating results of the customer as well as general economic conditions and historical trends. When all these facts are compiled, a judgment as to the collectibility of the individual account is made. Many factors can impact this estimate, including those noted in this paragraph. The adequacy of the estimated allowance may be impacted by the deterioration in the financial condition of a large customer, weakness in the economic environment resulting in a higher level of customer bankruptcy filings or delinquencies and the competitive environment in which the customer operates.
REVENUE RECOGNITION
Revenue is recognized when our products are shipped to our customers. It is generally our policy across all classes of customers that all sales are final. As is common in the consumer products industry, customers return products for a variety of reasons including products damaged in transit, discontinuance of a particular size or form of product and shipping errors. As sales are recorded, we accrue an estimated amount for product returns as a reduction of these sales based upon our historical experience and any known specific events that affect the accrual. We charge the allowance account resulting from this accrual with any authorized deduction from remittance by the customer or product returns upon receipt of the product.
In accordance with industry practice, we allow our customers to return unsold sun care products (i.e. BULLFROG line of products) at the end of the sun care season. We record the sales at the time the products are shipped and title transfers. At the time of shipment, we also record a reduction in sales and an allowance on our consolidated balance sheet for anticipated returns based upon an estimated return level. The level of returns may fluctuate from our estimates due to several factors including weather conditions, customer inventory levels and competitive conditions. Each percentage point change in our return rate would impact our net sales by approximately $0.1 million. For the three and six months ended May 31, 2004, we revised our estimate of returns related to our BULLFROG line of products by approximately $0.3 million and $0.6 million, respectively, which were included as increases to net sales in the 2004 condensed consolidated financial statements.
We routinely enter into agreements with our customers to participate in promotional programs. These programs generally take the form of coupons, temporary price reductions, scan downs, display activity and participations in advertising vehicles provided uniquely by the customer. The ultimate cost of these programs is often variable based on the number of units actually sold. Estimated unit sales of a product under a promotional program are used to estimate the total cost of the program, which is recorded as a reduction of sales. Actual results can differ from the original estimate. We also consider customer delays in requesting promotional program payments when evaluating the required accrual. Many customers audit programs significantly after the date of performance to determine the actual amount due and make a claim for reimbursement at that time. As a result, changes in the unit sales trends under promotional programs as well as the timing of payments could result in changes in the accrual. During the second quarter of fiscal 2004, we revised our estimate by approximately $0.5 million, which was included as an increase to net sales in the 2004 condensed consolidated financial statements.
INCOME TAXES
We account for income taxes using the asset and liability approach as prescribed by Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes". This approach requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the consolidated financial statements or tax returns. Using the enacted tax rates in effect for the year in which the differences are expected to reverse, deferred tax assets and liabilities are determined based on the differences between the financial reporting and the tax basis of an asset or liability. We record income tax expense in our consolidated financial statements based on an estimated annual effective income tax rate. Our tax rate for the three and six months ended May 31, 2004 was 35%, respectively, as compared to 36% in the corresponding quarter of fiscal 2003 and 37% for the six months ended May 31, 2003. The lower rate in fiscal 2004 reflects the implementation of a number of foreign and state tax planning initiatives.
For a summary of our significant accounting policies, see Note 2 of Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended November 30, 2003 filed with the Securities and Exchange Commission.
COMPARISON OF THREE MONTHS ENDED MAY 31, 2004 AND 2003
To facilitate discussion of our operating results for the three months ended May 31, 2004 and 2003, we have included the following selected data from our Condensed Consolidated Statements of Income:
Increase (Decrease)
------------------------
2004 2003 Amount Percentage
-------- -------- -------- ----------
(dollars in thousands)
Domestic net sales $ 63,684 $ 56,181 $ 7,503 13.4%
International revenues (including royalties) 6,408 7,452 (1,044) (14.0)
Total revenues 70,092 63,633 6,459 10.2
Cost of sales 20,556 17,713 2,843 16.1
Advertising and promotion expense 19,080 18,529 551 3.0
Selling, general and administrative expense 10,671 10,397 274 2.6
Settlement and administrative costs of PPA litigation 3,463 -- 3,463 nm
Interest expense 3,639 5,227 (1,588) (30.4)
Loss on early extinguishment of debt 1,649 -- 1,649 nm
Net income 7,247 7,521 (274) (3.6)
Domestic net sales for the three months ended May 31, 2004 increased $7.5 million or 13.4% as compared to the corresponding period of 2003. A comparison of domestic net sales for the categories of products included in our portfolio of OTC healthcare products is as follows:
Increase (Decrease)
------------------------
2004 2003 Amount Percentage
-------- -------- -------- ----------
(dollars in thousands)
Topical analgesics $ 18,134 $ 14,626 $ 3,508 24.0%
Medicated skin care products 17,330 14,912 2,418 16.2
Dietary supplements 10,369 10,963 (594) (5.4)
Medicated dandruff shampoos and conditioner 7,406 6,641 765 11.5
Other OTC and toiletry products 10,445 9,039 1,406 15.6
-------- -------- --------
Total $ 63,684 $ 56,181 $ 7,503 13.4
======== ======== ========
Domestic net sales increased in all product categories except for the
dietary supplements category. Net sales growth in the topical analgesics
category was led by a 67% increase in sales of ICY HOT, which was driven by the
continued strength of the ICY HOT Back Patch and better than expected initial
shipments of the ICY HOT Medicated Sleeve. Net sales growth in this category
also resulted from a 9% sales increase in CAPZASIN. The overall sales growth in
this category was partially offset by a decline in sales for the balance of the
topical analgesic brands as competition from inside and outside the category
increased. Net sales growth in the medicated skin care products category
resulted from a 32% increase in the GOLD BOND franchise. GOLD BOND sales growth
was attributable to 142%, 54% and 26% increases from the lotion, cream and foot
care lines, respectively, and was partially offset by declines in the first aid
portion of the business. The increase in the GOLD BOND lotion line of products
was attributable to the successful launch of GOLD BOND ULTIMATE Healing Skin
Therapy Lotion in the third quarter of fiscal 2003. Sales growth in the
medicated skin care products category was also offset by a 27% decrease in
PHISODERM sales. Domestic net sales of SELSUN BLUE medicated dandruff shampoo
increased due to an effective advertising campaign and initial shipments of
SELSUN BLUE conditioner, which was launched in the first quarter of fiscal 2004.
The increase in net sales for the other OTC and toiletry products category was
due primarily to sales increases of PAMPRIN, attributable to the introduction of
PAMPRIN All Day in the first quarter of fiscal 2004, and BULLFROG. The increase
in sales of BULLFROG was primarily attributable to expanded distribution and
increased sales of pre-pack displays. HERPECIN-L, SUN-IN and ULTRASWIM also
experienced net sales growth in the second fiscal quarter of 2004.
Net sales for the dietary supplements category declined primarily due to a 55% decrease in DEXATRIM diet pill sales and a 12% decline in GARLIQUE sales from the corresponding year-ago quarter. Sales of DEXATRIM were impacted by the overall decline in the diet pill market resulting from negative ephedrine publicity and the emergence of low carbohydrate diet products. The decline in net sales of DEXATRIM diet pills and GARLIQUE was partially offset by better than expected sales of the DEXATRIM All in One Bar, which was introduced in the first quarter of fiscal 2004, as well as increased sales of NEW PHASE. The increase in net sales of NEW PHASE was primarily attributable to effective media campaigns and increased distribution. With the exception of PAMPRIN, PREMSYN PMS, PHISODERM, FLEXALL, ASPERCREME, CAPZASIN and SPORTSCREME, domestic sales variances were principally the result of changes in unit sales volumes. PAMPRIN, PREMSYN PMS, PHISODERM, FLEXALL, ASPERCREME, CAPZASIN and SPORTSCREME experienced a unit sales price increase.
INTERNATIONAL REVENUES
For the second quarter of fiscal 2004, international revenues decreased $1.0 million or 14.0% as compared to the second quarter of fiscal 2003 due principally to a 8.9% sales decrease in Canada and a 24.6% sales decrease in the United Kingdom ("U.K."). Weaker sales in Canada are attributable to increased competition, primarily in the medicated lotion category. The sales decrease in the U.K. resulted primarily from the termination of certain European distributor relationships. Other international revenues, including royalties from the sales of SELSUN, increased 4.7% primarily as a result of increased SELSUN sales. Sales variances for international operations were principally the result of changes in unit sales volumes.
COST OF SALES
Cost of sales as a percentage of total revenues was 29.3% for the second quarter of fiscal 2004 as compared to 27.9% for the second quarter of fiscal 2003. Cost of sales in the second quarter of fiscal 2004 increased $2.8 million due primarily to initial sales of the DEXATRIM All in One Bar and the ICY HOT Medicated Sleeve, both of which have lower profit margins than most of our other products.
ADVERTISING AND PROMOTION EXPENSE
Advertising and promotion expenses in the second quarter of fiscal 2004 increased $0.6 million or 3.0% as compared to the same quarter of fiscal 2003 and were 27.2% of total revenues for the three months ended May 31, 2004 compared to 29.1% for the comparable period of fiscal 2003. Support for new product introductions drove an increase in advertising and promotion expenditures in the current period for ICY HOT, PAMPRIN, DEXATRIM All in One Bar, BULLFROG, SELSUN BLUE and the GOLD BOND cream, lotion and foot care lines.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSE
Selling, general and administrative expenses increased $0.3 million or 2.6% as compared to the same quarter of fiscal 2003. Selling, general and administrative expenses were 15.2% and 16.3% of total revenues for the second quarter of fiscal 2004 and 2003, respectively. An increase in sales was primarily responsible for the increase in selling expense, which was offset by a decrease in general and administrative expenses primarily attributable to a decrease in compensation and benefit costs.
SETTLEMENT AND ADMINISTRATIVE COSTS OF PPA LITIGATION
Settlement and administrative costs of PPA litigation were $3.5 million in the second quarter of fiscal 2004. This expense was attributable to administrative costs of PPA litigation, advertising costs related to the PPA settlement and reimbursement of legal and administrative costs in accordance with a settlement with one of our insurance providers. No corresponding expenses were recorded in the three months ended May 31, 2003.
INTEREST EXPENSE
Interest expense decreased $1.6 million or 30.4% in the second quarter of fiscal 2004 as compared to the same quarter of fiscal 2003. The decrease was largely the result of our debt refinancing completed during the first quarter of fiscal 2004. Until our indebtedness is reduced substantially, interest expense will continue to represent a significant percentage of our total revenues.
LOSS ON EARLY EXTINGUISHMENT OF DEBT
In the second quarter of fiscal 2004, we recorded a loss on early extinguishment of debt of approximately $1.7 million and a related tax benefit of $0.6 million related to the redemption of the remaining $30.0 million of our 8.875% Senior Subordinated Notes due 2009 ("8.875% Subordinated Notes").
COMPARISON OF SIX MONTHS ENDED MAY 31, 2004 AND 2003
To facilitate discussion of our operating results for the six months ended May 31, 2004 and 2003, we have included the following selected data from our Condensed Consolidated Statements of Income:
Increase (Decrease)
------------------------
2004 2003 Amount Percentage
-------- -------- -------- ----------
(dollars in thousands)
Domestic net sales $119,291 $108,861 $ 10,430 9.6%
International revenues (including royalties) 12,038 13,197 (1,159) (8.8)
Total revenues 131,329 122,058 9,271 7.6
Cost of sales 37,508 35,404 2,104 5.9
Advertising and promotion expense 37,612 36,934 678 1.8
Selling, general and administrative expense 21,306 20,211 1,095 5.4
Settlement and administrative costs of PPA litigation 3,657 -- 3,657 nm
Interest expense 8,394 10,374 (1,980) (19.1)
Loss on early extinguishment of debt 12,958 -- 12,958 nm
Net income 6,535 12,110 (5,575) (46.0)
Domestic net sales for the six months ended May 31, 2004 increased $10.4 million or 9.6% as compared to the corresponding period of 2003. A comparison of domestic net sales for the categories of products included in our portfolio of OTC healthcare products is as follows:
Increase (Decrease)
------------------------
2004 2003 Amount Percentage
-------- -------- -------- ----------
(dollars in thousands)
Topical analgesics $ 33,846 $ 28,198 $ 5,648 20.0%
Medicated skin care products 30,663 28,062 2,601 9.3
Dietary supplements 18,880 20,568 (1,688) (8.2)
Medicated dandruff shampoos and conditioner 16,627 14,812 1,815 12.3
Other OTC and toiletry products 19,275 17,221 2,054 11.9
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Total $119,291 $108,861 $ 10,430 9.6
======== ======== ========
Domestic net sales increased in all product categories except for the
dietary supplements category. Net sales growth in the topical analgesics
category was led by a 51% increase in sales of ICY HOT, which was driven by the
continued strength of the ICY HOT Back Patch and better than expected initial
shipments of the ICY HOT Medicated Sleeve. Net sales growth in this category
also resulted from a 20% sales increase in CAPZASIN. The overall sales growth in
this category was partially offset by a decline in sales for the balance of the
topical analgesic brands as competition from inside and outside the category
increased. Net sales growth in the medicated skin care products category
resulted from an 18% increase in the GOLD BOND franchise. GOLD BOND sales growth
was attributable to 50%, 48% and 27% increases from the lotion, cream and foot
care lines, respectively, and was partially offset by declines in the first aid
portion of the business. The increase in the GOLD BOND lotion line of products
was attributable to the successful launch of GOLD BOND ULTIMATE Healing Skin
Therapy Lotion in the third quarter of fiscal 2003. Sales growth in this
category was further offset by a 16% decrease in PHISODERM sales. Domestic net
sales of SELSUN BLUE medicated dandruff shampoo increased due to an effective
advertising campaign and initial shipments of SELSUN BLUE conditioner. The
increase in net sales for the other OTC and toiletry products category was due
primarily to sales increases of PAMPRIN, attributable to the introduction of
PAMPRIN All Day in the first quarter of fiscal 2004, and BULLFROG. The increase
in sales of BULLFROG was primarily attributable to expanded distribution and
increased sales of pre-pack displays. HERPECIN-L also experienced net sales
growth in the six months ended May 31, 2004.
Net sales for the dietary supplements category declined primarily due to a 52% decrease in DEXATRIM diet pill sales from the corresponding year-ago period. Sales of DEXATRIM were impacted by the overall decline in the diet pill market resulting from negative ephedrine publicity and the emergence of low carbohydrate diet products. The decline in net sales of DEXATRIM diet pills was partially offset by better than expected sales of the DEXATRIM All in One Bar, which was introduced in the first quarter of fiscal 2004, as well as increased sales of NEW PHASE. The increase in net sales of NEW PHASE was primarily attributable to effective media campaigns and increased distribution. With the exception of PAMPRIN, PREMSYN PMS, PHISODERM, FLEXALL, ASPERCREME, CAPZASIN and SPORTSCREME, domestic sales variances were principally the result of changes in unit sales volumes. PAMPRIN, PREMSYN PMS, PHISODERM, FLEXALL, ASPERCREME, CAPZASIN and SPORTSCREME experienced a unit sales price increase.
INTERNATIONAL REVENUES
For the six months ended May 31, 2004, international revenues decreased $1.2 million or 8.8% as compared to the same period in fiscal 2003 due principally to a 3.3% sales decrease in Canada and a 22.6% sales decrease in the U.K. The sales decrease in the U.K. primarily resulted from the termination of certain European distributor relationships. Other international revenues, including royalties from the sales of SELSUN, increased 15.0% primarily as a result of SELSUN sales. Sales variances for international operations were principally the result of changes in unit sales volumes.
COST OF SALES
Cost of sales as a percentage of total revenues was 28.6% for the six months ended May 31, 2004 as compared to 29.0% for the comparable period of fiscal 2003. Cost of sales in the six months ended May 31, 2004 increased $2.1 million due primarily to initial sales of the DEXATRIM All in One Bar and the ICY HOT Medicated Sleeve, which are both lower margin products. The increase was partially offset by a fiscal 2003 charge of approximately $0.7 million related to DEXATRIM charges for product returns containing ephedrine.
ADVERTISING AND PROMOTION EXPENSE
Advertising and promotion expenses in the six months ended May 31, 2004 increased $0.7 million or 1.8% as compared to the same period in fiscal 2003 and were 28.6% of total revenues for the six months ended May 31, 2004 compared to 30.3% for the comparable period of fiscal 2003. Support for new product introductions drove an increase in advertising and promotion expenditures in the current period for ICY HOT, PAMPRIN, DEXATRIM All in One Bar, BULLFROG, SELSUN BLUE and the GOLD BOND cream, lotion and foot care lines.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSE
Selling, general and administrative expenses increased $1.1 million or 5.4% as compared to the same period of fiscal 2003. Selling, general and administrative expenses were 16.2% and 16.5% of total revenues for the six months ended May 31, 2004 and 2003, respectively. An increase in sales was primarily responsible for the increase in selling expense. General and administrative expenses remained flat compared to the corresponding period of fiscal 2003.
SETTLEMENT AND ADMINISTRATIVE COSTS OF PPA LITIGATION
Settlement and administrative costs of PPA litigation were $3.7 million for the six months ended May 31, 2004. This expense was attributable to administrative costs of PPA litigation, advertising costs related to the PPA settlement and reimbursement of legal and administrative costs in accordance with a settlement with one of our insurance providers. No corresponding expenses were recorded in the six months ended May 31, 2003.
INTEREST EXPENSE
Interest expense decreased $2.0 million or 19.1% in the six months ended May 31, 2004 as compared to the same period in fiscal 2003. The decrease was largely the result of our debt refinancing completed during the first quarter of fiscal 2004. Until our indebtedness is reduced substantially, interest expense will continue to represent a significant percentage of our total revenues.
LOSS ON EARLY EXTINGUISHMENT OF DEBT
During the six months ended May 31, 2004, we retired $204.5 million principal amount of our 8.875% Subordinated Notes and the remaining outstanding balance of our $60,000 senior secured credit facility from a syndicate of commercial banks led by Bank of America, N.A., as agent ("Credit Facility"), which resulted in a loss on early extinguishment of debt of $13.0 million and a related tax benefit of $4.5 million.
LIQUIDITY AND CAPITAL RESOURCES
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We have historically financed our operations with a combination of internally generated funds and borrowings. Our principal uses of cash are for operating expenses, servicing long-term debt, acquisitions, working capital, repurchases of our common stock, payment of income taxes and capital expenditures.
Cash of $13.5 million and $12.4 million was provided by operations for the six months ended May 31, 2004 and 2003, respectively. Cash flows from operations were impacted by an increase in working capital primarily attributable to an increase in accounts receivable resulting from an increase in sales of seasonal products, which have longer dated terms, as compared to the
corresponding period of fiscal 2003. In addition, a loss on early extinguishment of debt of $13.0 million and a tax benefit of $4.5 million was recorded in the six months ended May 31, 2004.
Investing activities used cash of $2.0 million and $2.6 million in the six months ended May 31, 2004 and 2003, respectively. The decrease in usage of cash was primarily due to reduced spending on capital expenditures in the first half of fiscal 2004. Capital expenditures are anticipated to increase in the second half of fiscal 2004.
Financing activities used cash of $27.6 million and $11.9 million in the six months ended May 31, 2004 and 2003, respectively. The increase in cash used in financing activities in the current period was attributable to a net repayment of long-term debt of $12.3 million, an increase in and retirement of debt issuance costs of $13.6 million related to the refinancing transactions, a payment of $1.4 million for a premium on the interest rate cap agreement and $3.2 million of repurchased shares offset by proceeds from the exercise of stock options of $2.9 million.
As of May 31, 2004, total debt consisted of our Floating Rate Notes of $75.0 million and 7.0 % Subordinated Notes of $125.0 million. As of May 31, 2004 and June 30, 2004, we had no borrowings outstanding under our Revolving Credit Facility with available borrowings up to $50.0 million. Borrowings under our Revolving Credit Facility bear interest at LIBOR plus applicable percentages of 1.75% to 2.50% or a base rate (the higher of the federal funds rate plus 0.5% or the prime rate) plus applicable percentages of 0.25% to 1.0% ( 4.75% as of May 31, 2004). The applicable percentages are calculated based on our leverage ratio. The Floating Rate Notes bear interest at a three-month LIBOR plus 3.00% per year (4.12% as of May 31, 2004). On March 8, 2004, we entered into an interest rate cap agreement effective June 1, 2004 with decreasing notional principal amounts and cap rates ranging from 4.0% to 5.0% over the life of the agreement. We paid a $1.4 million premium to enter into the interest rate cap agreement, which will be amortized over the life of the agreement. The current portion of the premium on the interest rate cap agreement of $14,000 is included in prepaid expenses and other current assets, and the long-term portion of $1.4 million is included in other noncurrent assets. The amortized value of the premium on the interest rate cap will be compared to its fair value quarterly. If the fair value is lower than the carrying value of the premium on the interest rate cap, a charge will be recorded to other comprehensive income. The interest rate cap agreement terminates on March 1, 2010.
On December 19, 2003, we entered into a Memorandum of Understanding with the PSC, which memorialized certain settlement terms concerning lawsuits relating to DEXATRIM products containing PPA. On April 13, 2004, we entered into a class action settlement agreement with representatives of the plaintiffs' settlement class. The court granted preliminary approval of the class action settlement on April 23, 2004. The class action settlement agreement is generally consistent with the terms of and supercedes the Memorandum of Understanding and provides for a national class action settlement of all DEXATRIM PPA claims. The class action settlement is subject to final approval by the court at a fairness hearing currently scheduled for August 26, 2004.
In accordance with the terms of the DEXATRIM class action settlement agreement, $60.9 million has been funded into an initial settlement trust from our first three layers of insurance coverage, as described below. We have published notice of the final settlement and details as to the manner in which claims can be submitted. The deadline for submission of all claims is July 7, 2004. If the final settlement is approved by the court, claims submitted in the class settlement would be valued pursuant to an agreed upon settlement matrix that is designed to evaluate and determine the settlement value of each claim. To the extent the amount in the initial settlement trust is ultimately insufficient to fully fund the settlement, we will be required to make additional contributions to the settlement trust in the future.
We cannot assure you that terms of the class action settlement agreement will be approved by the court. If the settlement is not approved, we will continue to defend individual cases in a number of different state and federal jurisdictions. If the final settlement is approved, we believe that the settlement will include a substantial majority of the claims by users of DEXATRIM products containing PPA, but that some claims may elect to "opt out" of any class settlement and will continue to pursue claims for damages against us in separate lawsuits. We cannot estimate at this time how many claims may opt out or whether such claims will result in significant additional liability for us. To the extent the number or settlement value of opt out claims exceeds certain levels as specified in the class action settlement agreement, we reserve the right to terminate the settlement.
DELACO filed a Chapter 11 bankruptcy petition on February 12, 2004 in the United States Bankruptcy Court for the Southern District of New York. We understand that DELACO intends to implement its contemplated settlement with the PSC through a liquidating Chapter 11 bankruptcy plan. If DELACO pursues the settlement through its bankruptcy plan, we expect that the administrative process for DELACO's settlement will be similar to the process in our class action. We have filed a claim in DELACO's bankruptcy case in order to preserve our claims for indemnification against DELACO. As part of this Chapter 11 plan, we expect that after resolution of creditors' claims, DELACO will seek to liquidate and distribute all of its assets and will dissolve as a company.
If the settlement is approved based on the proposed terms and information currently known to us about the pending cases, we estimate that we may record, during fiscal 2004, a charge, net of insurance recovery, of approximately $20.0-25.0
million, or an after tax charge of $13.0-16.3 million (approximately $.65-.82 per share), for settlement costs, administrative expenses and costs of defense related to resolving the PPA litigation. In the second fiscal quarter ended May 31, 2004, we paid or accrued the first portion of this charge, $3.5 million, or $2.3 million after tax ($.11 per share). Although we believe an additional liability existed as of May 31, 2004 related to our PPA litigation, because the final terms of the settlement are still uncertain and have not been approved, we are not able to reasonably estimate the amount of such liability at May 31, 2004 and have made no provision for this liability in our condensed consolidated financial statements.
As indicated above, $60.9 million from our first three layers of our product liability insurance coverage available for the PPA litigation has been funded into an initial settlement trust. To the extent the amount in the initial settlement trust is insufficient to fully fund the settlement, we will be required to make additional contributions to the settlement trust in the future. We currently expect to use certain of our cash on hand to fund any required additional contributions to the settlement trust. If we are required to fund significant other liabilities related to the PPA litigation beyond the initial settlement trust, either pursuant to the terms of the settlement, as a result of litigation or otherwise, we will have significantly fewer sources of funds with which to satisfy such liabilities, and we may be unable to do so. Moreover, if the settlement is not approved, we may not have sufficient funds to satisfy all claims against us.
We have reached an agreement with Kemper to settle Kemper's lawsuit that sought to rescind our policy for $50.0 million of excess coverage for product liability claims. After giving effect to the settlement with Kemper, we have available for the claims against us related to the PPA litigation, through our first three layers of insurance coverage, approximately $60.9 million of the $77.0 million of product liability coverage provided by these policies. The $60.9 million of available coverage consists of $37.5 million of insurance under the Kemper policy and approximately $23.4 million under policies with two other insurance companies. As indicated above, this $60.9 million of coverage has been funded into an initial settlement trust in accordance with the terms of the class action settlement agreement
We continue to aggressively defend an action brought by Interstate to rescind its $25.0 million of excess coverage for product liability and pursue our available remedies at law against Interstate. We cannot assure you that we will be successful in retaining such excess coverage. The Interstate policy is in excess of the product liability insurance available from Kemper and the two other insurance companies referred to above. In the event the $60.9 million of insurance funds available in the initial settlement trust are exhausted under the PPA settlement or otherwise, coverage under the Interstate policy would not be available until we have paid $12.6 million toward the settlement of PPA claims to reach the $73.5 million coverage point for the Interstate policy.
In January 2004, our board of directors increased the total authorization to repurchase our common stock under our stock buyback program to $20.0 million. For the six months ended May 31, 2004, we repurchased 129,000 shares for $3.2 million. The remaining availability under the board authorization was $16.8 million as of May 31, 2004. We are limited in our ability to repurchase shares due to restrictions under the terms of our Revolving Credit Facility and the indenture pursuant to which Floating Rate Notes and 7.0% Subordinated Notes were issued.
We believe that cash provided by operating activities, our cash and cash equivalents balance and funds available under our Revolving Credit Facility will be sufficient to fund our capital expenditures, debt service and working capital requirements for the foreseeable future as our business is currently conducted. It is likely that any acquisitions we make in the future will require us to obtain additional financing.
FOREIGN OPERATIONS
Historically, our primary foreign operations have been conducted through our Canadian and U.K. subsidiaries. The functional currencies of these subsidiaries are Canadian dollars and British pounds, respectively. Fluctuations in exchange rates can impact operating results, including total revenues and expenses, when translations of the subsidiary financial statements are made in accordance with SFAS No. 52, "Foreign Currency Translation". For the six months ended May 31, 2004 and 2003, these subsidiaries accounted for 7% and 9% of total revenues, respectively, and 4% and 3% of total assets for each period, respectively. It has not been our practice to hedge our assets and liabilities in Canada and the U.K. or our intercompany transactions due to the inherent risks associated with foreign currency hedging transactions and the timing of payments between us and our foreign subsidiaries. Following our acquisition of SELSUN BLUE, which is sold in more than 75 foreign countries, our international business operations have expanded significantly, which will increase our exposure to fluctuations in foreign exchange rates. During the first six months of fiscal 2004, a portion of these foreign sales was reflected as royalties, which have been paid to us in U.S. dollars. In addition, Abbott has continued to supply a portion of our international product where appropriate and bill us in U.S. dollars. Beginning April 1, 2004, we were billed in local currencies. Historically, gains or losses from foreign currency transactions have not had a material impact on our operating results. (Losses) and gains of ($3,000) and $0.2 million for the six months ended May 31, 2004 and 2003, respectively, resulted from foreign currency transactions and are included in selling, general and administrative expenses in the Condensed Consolidated Statements of Income.
RECENT ACCOUNTING PRONOUNCEMENTS
In April 2002, the Financial Accounting Standards Board ("FASB") issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections" ("SFAS 145"). We adopted SFAS 145 on December 1, 2002. SFAS 145 requires us to classify gains and losses on extinguishments of debt as income or loss from continuing operations rather than as extraordinary items as previously required under SFAS No. 4, "Reporting Gains and Losses from Extinguishment of Debt". We are also required to reclassify any gain or loss on extinguishment of debt previously classified as an extraordinary item in prior periods presented. SFAS 145 also provides accounting standards for certain lease modifications that have economic effects similar to sale-leaseback transactions and various other technical corrections. The application of SFAS 145 resulted in recording a loss on early extinguishment of debt of $13.0 million in fiscal 2004, which was classified in the condensed consolidated financial statements in accordance with the provisions of SFAS 145.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities" ("SFAS 146"). We adopted SFAS 146 on January 1, 2003. SFAS 146 supercedes Emerging Issues Task Force ("EITF") Issue No. 94-3. SFAS 146 requires that the liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred, not at the date of an entity's commitment to an exit or disposal plan. SFAS 146 is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. The application of SFAS 146 resulted in recording $40,000 of accrued liabilities related to the restructuring of the U.K operations. We expect to record additional charges related to the restructuring of the U.K. operations in the third and fourth quarters of fiscal 2004.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"). FIN 46 requires a company to consolidate a variable interest entity ("VIE"), as defined, when the company will absorb a majority of the VIE's expected losses, receives a majority of the VIE's expected residual returns or both. FIN 46 also requires consolidation of existing, non-controlled affiliates if the VIE is unable to finance its operations without investor support, or where the other investors do not have exposure to the significant risks and rewards of ownership. FIN 46 applies immediately to a VIE created or acquired after January 31, 2003. For a VIE created before February 1, 2003, FIN 46 applies in the first fiscal year or interim period beginning after March 15, 2004, our third fiscal quarter beginning June 1, 2004. Application of FIN 46 is also required in financial statements that have interests in structures that are commonly referred to as special-purpose entities for periods ending after December 15, 2003. The adoption of FIN 46 did not have an impact on our financial position, results of operations or cash flows.
In December 2003, the FASB issued SFAS No. 132 (revised 2003), "Employers' Disclosure about Pensions and Other Postretirement Benefits" ("SFAS 132"). The revision of SFAS 132 provides for additional disclosures including the description of the types of plan assets, investment strategy, measurement date(s), plan obligations, cash flows and components of net periodic benefit cost recognized in interim periods. The revisions of SFAS 132 are effective for financial statements with fiscal years ending after December 15, 2003 and interim periods beginning after December 15, 2003. The adoption of the revised SFAS 132 did not have an impact on our financial position, results of operations or cash flows.
FORWARD LOOKING STATEMENTS
Statements in this Quarterly Report on Form 10-Q which are not historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements involve risks, uncertainties and assumptions that could cause actual outcomes and results to differ materially from those expressed or projected.
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