- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
<Table>
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
</Table>
<Table>
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2005
</Table>
COMMISSION FILE NUMBER 1-6571
SCHERING-PLOUGH CORPORATION
(Exact name of registrant as specified in its charter)
<Table>
NEW JERSEY 22-1918501
(State or other jurisdiction (I.R.S. Employer
of incorporation) Identification No.)
2000 GALLOPING HILL ROAD 07033
KENILWORTH, NJ (Zip Code)
(Address of principal executive offices)
</Table>
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
(908) 298-4000
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months, and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
COMMON SHARES OUTSTANDING AS OF SEPTEMBER 30, 2005: 1,477,895,332
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PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
STATEMENTS OF CONDENSED CONSOLIDATED OPERATIONS
<Table>
<Caption>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------- ----------------------
2005 2004 2005 2004
--------- --------- --------- ---------
(UNAUDITED)
(AMOUNTS IN MILLIONS, EXCEPT PER SHARE FIGURES)
Net sales............................................... $2,284 $1,978 $7,184 $6,088
------ ------ ------ ------
Cost of sales........................................... 775 711 2,531 2,241
Selling, general and administrative..................... 1,064 892 3,261 2,785
Research and development................................ 566 378 1,391 1,201
Other expense, net...................................... -- 34 9 112
Special charges......................................... 6 26 292 138
Equity income from cholesterol joint venture............ (215) (95) (605) (249)
------ ------ ------ ------
Income/(loss) before income taxes....................... 88 32 305 (140)
Income tax expense/(benefit)............................ 23 6 162 (28)
------ ------ ------ ------
Net income/(loss)....................................... $ 65 $ 26 $ 143 $ (112)
------ ------ ------ ------
Preferred stock dividends............................... 22 12 65 12
------ ------ ------ ------
Net income/(loss) available to common shareholders...... $ 43 $ 14 $ 78 $ (124)
------ ------ ------ ------
Diluted earnings/(loss) per common share................ $ .03 $ .01 $ .05 $ (.08)
====== ====== ====== ======
Basic earnings/(loss) per common share.................. $ .03 $ .01 $ .05 $ (.08)
====== ====== ====== ======
Dividends per common share.............................. $ .055 $ .055 $ .165 $ .165
====== ====== ====== ======
</Table>
The accompanying notes are an integral part of these Condensed Consolidated
Financial Statements.
1
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
STATEMENTS OF CONDENSED CONSOLIDATED CASH FLOWS
<Table>
<Caption>
NINE MONTHS ENDED
SEPTEMBER 30,
---------------------
2005 2004
--------- --------
(UNAUDITED)
(AMOUNTS IN MILLIONS)
Operating Activities:
Net income/(loss)......................................... $ 143 $ (112)
Adjustments to reconcile net income/(loss) to net cash
provided by operating activities:
Tax refund from U.S. loss carryback.................... -- 404
Payments to U.S. taxing authorities.................... (239) (473)
Special charges........................................ 269 (124)
Depreciation and amortization.......................... 362 325
Changes in assets and liabilities:
Accounts receivable.................................. (344) (36)
Inventories.......................................... (61) 103
Prepaid expenses and other assets.................... 233 17
Accounts payable and other liabilities............... 183 (95)
------- ------
Net cash provided by operating activities.............. 546 9
------- ------
Investing Activities:
Capital expenditures................................... (293) (299)
Proceeds from transfer of license...................... -- 118
Dispositions of property and equipment................. 41 4
Reduction/(Purchases) of investments................... 438 (294)
Other, net............................................. (48) (7)
------- ------
Net cash provided by/(used for) investing activities... 138 (478)
------- ------
Financing Activities:
Cash dividends paid to common shareholders............. (243) (243)
Cash dividends paid to preferred shareholders.......... (65) --
Proceeds from preferred stock issuance, net............ -- 1,394
Net change in short-term borrowings.................... (1,208) (173)
Other, net............................................. 51 (42)
------- ------
Net cash (used for)/provided by financing activities... (1,465) 936
------- ------
Effect of exchange rates on cash and cash equivalents....... (9) --
------- ------
Net (decrease)/increase in cash and cash equivalents........ (790) 467
Cash and cash equivalents, beginning of period.............. 4,984 4,218
------- ------
Cash and cash equivalents, end of period.................... $ 4,194 $4,685
======= ======
</Table>
The accompanying notes are an integral part of these Condensed Consolidated
Financial Statements.
2
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
<Table>
<Caption>
SEPTEMBER 30, DECEMBER 31,
2005 2004
---------------- ---------------
(UNAUDITED)
(AMOUNTS IN MILLIONS,
EXCEPT PER SHARE FIGURES)
ASSETS
Cash and cash equivalents................................... $ 4,194 $ 4,984
Short-term investments...................................... 413 851
Accounts receivable, net.................................... 1,645 1,407
Inventories................................................. 1,586 1,580
Deferred income taxes....................................... 269 309
Prepaid and other current assets............................ 680 872
------- -------
Total current assets...................................... 8,787 10,003
Property, plant and equipment............................... 7,115 7,085
Less accumulated depreciation............................... 2,654 2,492
------- -------
Property, net............................................. 4,461 4,593
Goodwill.................................................... 206 209
Other intangible assets, net................................ 383 371
Other assets................................................ 717 735
------- -------
Total assets................................................ $14,554 $15,911
======= =======
LIABILITIES AND SHAREHOLDERS' EQUITY
Accounts payable............................................ $ 1,140 $ 978
Short-term borrowings and current portion of long-term
debt...................................................... 361 1,569
Other accrued liabilities................................... 2,398 2,619
------- -------
Total current liabilities................................. 3,899 5,166
Long-term debt.............................................. 2,392 2,392
Other long-term liabilities................................. 939 797
------- -------
Total long-term liabilities............................... 3,331 3,189
Commitments and contingent liabilities (Note 16)
Shareholders' equity:
6% Mandatory convertible preferred shares -- $1 par value;
issued -- 29; $50 per share face value................. 1,438 1,438
Common shares -- $.50 per share par value; issued:
2,030.................................................. 1,015 1,015
Paid-in capital........................................... 1,282 1,234
Retained earnings......................................... 9,448 9,613
Accumulated other comprehensive loss...................... (423) (300)
------- -------
Total..................................................... 12,760 13,000
Less treasury shares: 2005 -- 552 shares; 2004 -- 555
shares, at cost........................................ (5,436) (5,444)
------- -------
Total shareholders' equity................................ 7,324 7,556
------- -------
Total liabilities and shareholders' equity................ $14,554 $15,911
======= =======
</Table>
The accompanying notes are an integral part of these Condensed Consolidated
Financial Statements.
3
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. BASIS OF PRESENTATION
These unaudited condensed consolidated financial statements of
Schering-Plough Corporation and subsidiaries (the Company), included herein have
been prepared pursuant to the rules and regulations of the Securities and
Exchange Commission (SEC) for reporting on Form 10-Q. Certain information and
disclosures normally included in financial statements prepared in accordance
with U.S. Generally Accepted Accounting Principles have been condensed or
omitted pursuant to such SEC rules and regulations. Certain prior year amounts
have been reclassified to conform to the current year presentation. These
statements should be read in conjunction with the accounting policies and notes
to consolidated financial statements included in the Company's 2004 Annual
Report on Form 10-K.
In the opinion of the Company's management, the financial statements
reflect all adjustments necessary for a fair statement of the operations, cash
flows and financial position for the interim periods presented.
2. SPECIAL CHARGES
Special charges for the three months ended September 30, 2005 totaled $6
million related primarily to the consolidation of the Company's U.S.
biotechnology organizations. Special charges for the nine months ended September
30, 2005 totaled $292 million primarily related to an increase in litigation
reserves of $250 million for the Massachusetts investigation and the previously
disclosed investigations and litigation relating to the Company's practices
regarding average wholesale price by the Department of Justice and certain
states. Additional information regarding litigation reserves is also included in
Note 16 "Legal, Environmental and Regulatory Matters."
Special charges for the three months ended September 30, 2004 were $26
million primarily relating to employee termination costs. Special charges for
the nine months ended September 30, 2004 totaled $138 million, comprised of $111
million in employee termination costs and $27 million in asset impairment
charges.
EMPLOYEE TERMINATION COSTS
In August 2003, the Company announced a global workforce reduction
initiative. The first phase of this initiative was a Voluntary Early Retirement
Program (VERP) in the U.S. Under this program, eligible employees in the U.S.
had until December 15, 2003 to elect early retirement and receive an enhanced
retirement benefit. Approximately 900 employees elected to retire under the
program, of which, approximately 850 employees retired through year-end 2004 and
approximately 50 employees have staggered retirement dates in 2005. The total
cost of this program is approximately $191 million, comprised of increased
pension costs of $108 million, increased post-retirement health care costs of
$57 million, vacation payments of $4 million and costs related to accelerated
vesting of stock grants of $22 million.
Amounts recognized relating to the VERP during the three and nine months
ended September 30, 2005 were $2 million and $5 million, respectively; and $2
million and $19 million for the three and nine months ended September 30, 2004,
respectively; with cumulative costs recognized of $189 million as of September
30, 2005.
In addition, the Company recognized $21 million of other employee severance
costs as special charges for the nine months ended September 30, 2005.
Severance costs were $23 million and $92 million for the three and nine
months ended September 30, 2004, respectively.
4
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)
The following summarizes the activity in the accounts related to employee
termination costs:
<Table>
<Caption>
EMPLOYEE TERMINATION COSTS 2005 2004
- -------------------------- ---- ----
(DOLLARS IN
MILLIONS)
Special charges liability balance at December 31, 2004 and
2003, respectively........................................ $ 18 $ 29
Special charges incurred during nine months ended September
30,....................................................... 26 111
Credit to retirement benefit plan liability during the nine
months ended September 30,................................ (5) (19)
Disbursements during the nine months ended September 30,.... (23) (78)
---- ----
Special charges liability balance at September 30,.......... $ 16 $ 43
==== ====
</Table>
ASSET IMPAIRMENT AND OTHER CHARGES
For the three months ended September 30, 2005, the Company recognized
approximately $6 million of asset impairment and other charges. For the nine
months ended September 30, 2005 and 2004, the Company recognized asset
impairment and other charges of $16 million and $27 million, respectively.
3. EQUITY INCOME FROM CHOLESTEROL JOINT VENTURE
In May 2000, the Company and Merck and Company, Inc. (Merck) entered into
separate agreements to jointly develop and market in the U.S. (1) two
cholesterol lowering drugs and (2) an allergy/asthma drug. In December 2001, the
cholesterol agreement was expanded to include all countries of the world except
Japan. In general, the companies agreed that the collaborative activities under
these agreements would operate in a virtual mode to the maximum degree possible
by relying on the respective infrastructures of the two companies. These
agreements generally provide for equal sharing of research and development costs
and for co-promotion of approved products by each company.
The cholesterol partnership agreements provide for the Company and Merck to
jointly develop ezetimibe (marketed as ZETIA in the U.S. and Asia and EZETROL in
Europe):
i. as a once-daily monotherapy;
ii. in co-administration with any statin drug; and
iii. as a once-daily fixed-combination tablet of ezetimibe and
simvastatin (Zocor), Merck's cholesterol-modifying medicine. This
combination medication (ezetimibe/simvastatin) is marketed as VYTORIN in
the U.S. and as INEGY in many international countries.
ZETIA/EZETROL (ezetimibe) and VYTORIN/INEGY (the combination of ezetimibe/
simvastatin) are approved for use in the U.S. and have been launched in many
international markets.
The Company utilizes the equity method of accounting in recording its share
of activity from the Merck/Schering-Plough Cholesterol Partnership (the
Partnership or the joint venture). The cholesterol partnership agreements
provide for the sharing of operating income generated by the Partnership based
upon percentages that vary by product, sales level and country. In the U.S.
market, Schering-Plough receives a greater share of profits on the first $300
million of annual ZETIA sales. Above $300 million of annual ZETIA sales, Merck
and Schering-Plough (the Partners) generally share profits equally. Schering-
Plough's allocation of joint venture income is increased by milestones
recognized. Further, either Partner's share of the joint venture's income from
operations is subject to a reduction if the Partner fails to perform a specified
minimum number of physician details in a particular country. The Partners agree
annually to the minimum number of physician details by country.
5
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)
The Partners bear the costs of their own general sales forces and
commercial overhead in marketing joint venture products around the world. In the
U.S., Canada and Puerto Rico, the cholesterol agreements provide for a
reimbursement to each partner for physician details that are set on an annual
basis. This reimbursed amount is equal to each Partner's physician details
multiplied by a contractual fixed fee. Schering-Plough reports this
reimbursement as part of equity income from cholesterol joint venture. This is
because under U.S. GAAP this reimbursement does not represent a reimbursement of
specific, incremental and identifiable costs for the Company's detailing of the
cholesterol products in these markets. In addition, this reimbursement amount is
not reflective of Schering-Plough's sales effort related to the joint venture as
Schering-Plough's sales force and related costs associated with the joint
venture are generally estimated to be higher.
For the nine months ended September 30, 2005, Schering-Plough recognized
milestones of $20 million. These milestones related to certain European
approvals of VYTORIN (ezetimibe/ simvastatin) in 2005.
During the first quarter of 2004, Schering-Plough recognized a milestone of
$7 million related to the approval of ezetimibe/simvastatin in Mexico.
Under certain other conditions, as specified in the partnership agreements
with Merck, the Company could earn additional milestones totaling $105 million.
Costs of the joint venture that the Partners contractually share are a
portion of manufacturing costs, specifically identified promotion costs
(including direct-to-consumer advertising and direct and identifiable
out-of-pocket promotion) and other agreed upon costs for specific services such
as market support, market research, market expansion, a specialty sales force
and physician education programs.
Certain specified research and development expenses are generally shared
equally by the Partners.
The unaudited financial information below presents summarized combined
financial information for the Merck/Schering-Plough Cholesterol Partnership for
the three and nine months ended September 30, 2005:
<Table>
<Caption>
THREE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30, 2005 SEPTEMBER 30, 2005
------------------ ------------------
(DOLLARS IN MILLIONS)
Net sales........................................... $630 $1,679
Cost of sales....................................... 32 99
Income from operations.............................. 340 814
</Table>
Amounts related to physician details, among other expenses, that are
invoiced by Schering-Plough and Merck in the U.S., Canada and Puerto Rico are
deducted from income from operations of the Partnership.
Schering-Plough's share of the Partnership's income from operations for the
three and nine months ended September 30, 2005 were $169 million and $465
million, respectively. In the U.S. market, Schering-Plough receives a greater
share of income from operations on the first $300 million of annual ZETIA sales.
As a result, Schering-Plough's share of the Partnership's income from operations
is generally higher in the first quarter than in subsequent quarters. In
addition, for the nine months ended September 30, 2005, the Company's share of
the Partnership's income from operations includes milestones of $20 million.
6
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)
The following information provides a summary of the components of the
Company's equity income from the cholesterol joint venture for the three and
nine months ended September 30, 2005:
<Table>
<Caption>
THREE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30, 2005 SEPTEMBER 30, 2005
------------------ ------------------
(DOLLARS IN MILLIONS)
Schering-Plough's share of income from operations... $169 $465
Reimbursement to Schering-Plough for physician
details........................................... 52 141
Elimination of intercompany profit and other, net... (6) (1)
---- ----
Total Equity income from cholesterol joint
venture........................................ $215 $605
---- ----
</Table>
Equity income excludes any profit arising from transactions between the
Company and the joint venture until such time as there is an underlying profit
realized by the joint venture in a transaction with a party other than the
Company or Merck.
Due to the virtual nature of the cholesterol joint venture, the Company
incurs substantial costs, such as selling, general and administrative costs,
that are not reflected in equity income and are borne by the overall cost
structure of the Company. These costs are reported on their respective line
items in the Statements of Condensed Consolidated Operations. The cholesterol
agreements do not provide for any jointly owned facilities and, as such,
products resulting from the joint venture are manufactured in facilities owned
by either Merck or the Company.
The allergy/asthma agreement provides for the development and marketing of
a once-daily, fixed-combination tablet containing CLARITIN and Singulair.
Singulair is Merck's once-daily leukotriene receptor antagonist for the
treatment of asthma and seasonal allergic rhinitis. In January 2002, the Merck/
Schering-Plough respiratory joint venture reported on results of Phase III
clinical trials of a fixed-combination tablet containing CLARITIN and Singulair.
This Phase III study did not demonstrate sufficient added benefits in the
treatment of seasonal allergic rhinitis. The CLARITIN and Singulair combination
tablet does not have approval in any country and remains in clinical
development.
4. ACCOUNTING FOR STOCK-BASED COMPENSATION
Currently, the Company accounts for its stock-based compensation
arrangements using the intrinsic value method. No stock-based employee
compensation cost is reflected in net income/(loss), other than for the
Company's deferred stock units and performance plans, as stock options granted
under all other plans had an exercise price equal to the market value of the
underlying common stock on the date of grant.
In December 2004, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standard (SFAS) 123R (Revised 2004),
"Share-Based Payment." SFAS 123R requires companies to recognize compensation
expense in an amount equal to the fair value of all share-based payments granted
to employees. The Company is required to implement this SFAS in the first
quarter of 2006 by recognizing compensation expense on all share-based grants
made on or after January 1, 2006, and for the unvested portion of share-based
grants made prior to January 1, 2006. The Company continues to evaluate the
impact of SFAS 123R on all of its share-based payment plans. This evaluation
includes the valuation of stock options and all other stock-based performance
plans, which are subject to a number of assumptions and changes in future market
conditions, including the Company's stock price.
7
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)
The following table reconciles net income/(loss) available to common
shareholders and basic/diluted earnings/(loss) per common share, as reported, to
pro forma net income/(loss) available to common shareholders and basic/diluted
earnings/(loss) per common share, as if the Company had expensed the grant-date
fair value of both stock options and deferred stock units as permitted by SFAS
123, "Accounting for Stock-Based Compensation."
<Table>
<Caption>
THREE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------- -------------
2005 2004 2005 2004
----- ----- ----- -----
(DOLLARS IN MILLIONS)
Net income/(loss) available to common shareholders, as
reported............................................ $ 43 $ 14 $ 78 $(124)
Add back: Expense included in reported net
income/(loss) for stock-based compensation, net of
tax in 2004......................................... 25 8 66 28
Deduct: Pro forma expense as if both stock options and
stock-based compensation were charged against net
income/(loss), net of tax in 2004................... (55) (24) (139) (77)
----- ----- ----- -----
Pro forma net income/(loss) available to common
shareholders using the fair value method............ $ 13 $ (2) $ 5 $(173)
===== ===== ===== =====
Diluted earnings/(loss) per common share:
Diluted earnings/(loss) per common share, as
reported......................................... $ .03 $ .01 $ .05 $(.08)
----- ----- ----- -----
Pro forma diluted earnings/(loss) per common share
using the fair value method...................... .01 -- -- (.12)
----- ----- ----- -----
Basic earnings/(loss) per common share:
Basic earnings/(loss) per common share, as
reported......................................... $ .03 $ .01 $ .05 $(.08)
----- ----- ----- -----
Pro forma basic earnings/(loss) per common share
using the fair value method...................... .01 -- -- (.12)
----- ----- ----- -----
</Table>
Basic and diluted earnings/(loss) per common share are calculated based on
net income/(loss) available to common shareholders.
5. OTHER EXPENSE, NET
The components of other expense, net are as follows:
<Table>
<Caption>
THREE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------- --------------
2005 2004 2005 2004
----- ----- ------ -----
(DOLLARS IN MILLIONS)
Interest cost incurred.................................. $ 41 $ 44 $ 133 $144
Less: amount capitalized on construction................ (5) (5) (11) (14)
---- ---- ----- ----
Interest expense........................................ 36 39 122 130
Interest income......................................... (45) (20) (118) (50)
Foreign exchange losses................................. 2 -- 6 5
Other, net.............................................. 7 15 (1) 27
---- ---- ----- ----
Total other expense, net................................ $ -- $ 34 $ 9 $112
==== ==== ===== ====
</Table>
8
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)
6. INCOME TAXES
At December 31, 2004, the Company had approximately $1.0 billion of U.S.
Net Operating Losses (U.S. NOLs) for tax purposes available to offset future
U.S. taxable income through 2024. The Company generated additional U.S. NOLs
during the nine months ended September 30, 2005.
The Company's tax provision for the nine months ended September 30, 2005
includes a benefit of approximately $42 million related to tax expense recorded
in 2004 related to planned earnings repatriations under the American Jobs
Creation Act (AJCA). This revision of the costs associated with repatriation
under the AJCA is the result of guidance issued by the U.S. Treasury in August
2005.
Overall income tax expense, net of the benefit described above, primarily
relates to foreign taxes and does not include any benefit related to U.S. NOLs.
The Company has established a valuation allowance on net U.S. deferred tax
assets, including the benefit of U.S. NOLs, as management cannot conclude that
it is more likely than not the benefit of U.S. net deferred tax assets can be
realized.
During the third quarter of 2005, the Company made a cash payment (tax
deposit) of approximately $239 million in anticipation of the settlement of
certain tax contingencies for tax years 1993 through 1996. The Company believes
that existing tax reserves are adequate to cover these matters.
7. RETIREMENT PLANS AND OTHER POST-RETIREMENT BENEFITS
The Company has defined benefit pension plans covering eligible employees
in the U.S. and certain foreign countries, and the Company provides
post-retirement health care benefits to its eligible U.S. retirees and their
dependents.
The components of net pension expense were as follows:
<Table>
<Caption>
THREE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------- --------------
2005 2004 2005 2004
----- ----- ----- ------
(DOLLARS IN MILLIONS)
Service cost............................................ $ 26 $ 25 $ 80 $ 74
Interest cost........................................... 28 33 93 99
Expected return on plan assets.......................... (29) (37) (97) (113)
Amortization, net....................................... 8 9 29 25
Termination benefits.................................... 2 1 5 12
Settlement.............................................. -- 1 -- 5
---- ---- ---- -----
Net pension expense..................................... $ 35 $ 32 $110 $ 102
==== ==== ==== =====
</Table>
9
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)
The components of other post-retirement benefits expense were as follows:
<Table>
<Caption>
THREE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------- --------------
2005 2004 2005 2004
----- ----- ----- -----
(DOLLARS IN MILLIONS)
Service cost............................................. $ 4 $ 1 $ 11 $ 8
Interest cost............................................ 7 2 18 15
Expected return on plan assets........................... (4) (1) (11) (9)
Amortization, net........................................ -- -- 1 2
Termination benefits..................................... -- -- -- 2
--- --- ---- ---
Net other post-retirement benefits expense............... $ 7 $ 2 $ 19 $18
=== === ==== ===
</Table>
8. EARNINGS PER COMMON SHARE
The following table reconciles the components of the basic and diluted
earnings/(loss) per share computations:
<Table>
<Caption>
THREE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------- ---------------
2005 2004 2005 2004
------ ------ ------ ------
(DOLLARS AND SHARES IN MILLIONS)
EPS Numerator:
Net income/(loss).................................. $ 65 $ 26 $ 143 $ (112)
Less: Preferred stock dividends.................... 22 12 65 12
------ ------ ------ ------
Net income/(loss) available to common
shareholders..................................... $ 43 $ 14 $ 78 $ (124)
------ ------ ------ ------
EPS Denominator:
Average shares outstanding for basic EPS........... 1,477 1,472 1,476 1,472
Dilutive effect of options and deferred stock
units............................................ 10 3 7 --
------ ------ ------ ------
Average shares outstanding for diluted EPS......... 1,487 1,475 1,483 1,472
------ ------ ------ ------
</Table>
The equivalent common shares issuable under the Company's stock incentive
plans which were excluded from the computation of diluted EPS because their
effect would have been antidilutive were 33 million and 38 million,
respectively, for the three and nine months ended September 30, 2005, and 38
million and 88 million, respectively, for the three and nine months ended
September 30, 2004. Also, at September 30, 2005, 68 million common shares
obtainable upon conversion of the Company's 6% Mandatory Convertible Preferred
Stock were excluded from the computation of diluted earnings per share because
their effect would have been antidilutive.
10
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)
9. COMPREHENSIVE INCOME/(LOSS)
Comprehensive income/(loss) is comprised of the following:
<Table>
<Caption>
THREE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------- -------------
2005 2004 2005 2004
----- ----- ----- -----
(DOLLARS IN MILLIONS)
Net income/(loss)...................................... $65 $26 $ 143 $(112)
Foreign currency translation adjustment.............. 1 18 (123) (43)
Net unrealized gain on investments................... 1 1 -- --
--- --- ----- -----
Total comprehensive income/(loss)...................... $67 $45 $ 20 $(155)
=== === ===== =====
</Table>
10. INVENTORIES
Inventories consisted of the following:
<Table>
<Caption>
SEPTEMBER 30, DECEMBER 31,
2005 2004
---------------- ---------------
(DOLLARS IN MILLIONS)
Finished products........................................... $ 855 $ 648
Goods in process............................................ 341 602
Raw materials and supplies.................................. 390 330
------ ------
Total inventories......................................... $1,586 $1,580
====== ======
</Table>
11. OTHER INTANGIBLE ASSETS
The components of other intangible assets, net are as follows:
<Table>
<Caption>
SEPTEMBER 30, 2005 DECEMBER 31, 2004
------------------------------ ------------------------------
GROSS GROSS
CARRYING ACCUMULATED CARRYING ACCUMULATED
AMOUNT AMORTIZATION NET AMOUNT AMORTIZATION NET
-------- ------------ ---- -------- ------------ ----
(DOLLARS IN MILLIONS)
Patents and licenses......... $597 $318 $279 $558 $287 $271
Trademarks and other......... 154 50 104 144 44 100
---- ---- ---- ---- ---- ----
Total other intangible
assets..................... $751 $368 $383 $702 $331 $371
==== ==== ==== ==== ==== ====
</Table>
These intangible assets are amortized on the straight-line method over
their respective useful lives. The residual value of intangible assets is
estimated to be zero.
During the first nine months of 2005, the Company recorded intangible
assets of $9 million for base technology acquired from NeoGenesis and $36
million for the acquisition of U.S. development and commercialization rights to
INTEGRILIN.
12. PRODUCT LICENSES AND ACQUISITIONS
In August 2005, the Company announced that it has exercised its right to
develop and commercialize with Centocor, Inc. ("Centocor"), CNTO 148
(golimumab), a fully human monoclonal antibody being developed as a therapy for
the treatment of rheumatoid arthritis and other immune-mediated inflammatory
diseases. Pursuant to the exercise, the Company receives exclusive worldwide
marketing rights to
11
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)
golimumab, excluding the U.S., Japan, China (including Hong Kong), Taiwan, and
Indonesia. In exchange for its rights under this agreement, the Company made an
upfront payment in the amount of $124 million to Centocor before a tax benefit
of $6 million. This payment has been expensed and reported in Research and
Development in the third quarter 2005. The Company will share future development
costs with Centocor.
Effective September 1, 2005, the Company restructured its INTEGRILIN
co-promotion agreement with Millennium Pharmaceuticals, Inc. ("Millennium").
Under the terms of the restructured agreement, the Company acquired exclusive
U.S. development and commercialization rights to INTEGRILIN in exchange for an
upfront payment of $36 million and royalties on INTEGRILIN sales. The Company
has agreed to pay minimum royalties of $85 million per year to Millennium for
2006 and 2007. The Company also purchased existing INTEGRILIN inventory from
Millennium. The $36 million upfront payment has been capitalized and included in
"Other Intangible Assets."
13. SHORT AND LONG-TERM BORROWINGS AND OTHER COMMITMENTS
SHORT AND LONG-TERM BORROWINGS
At September 30, 2005 and December 31, 2004, short-term borrowings totaled
$361 million and $1.6 billion, respectively.
On November 26, 2003, the Company issued $1.25 billion aggregate principal
amount of 5.3 percent senior unsecured Notes due 2013 and $1.15 billion
aggregate principal amount of 6.5 percent senior unsecured Notes due 2033
(collectively the Notes). Interest is payable semi-annually. The net proceeds
from this offering were $2.37 billion. Upon issuance, the Notes were rated A3 by
Moody's Investors Service, Inc. (Moody's), and A+ by Standard & Poor's Rating
Services (S&P). The interest rates payable on the Notes are subject to
adjustment as follows: if the rating assigned to a particular series of Notes by
either Moody's or S&P changes to a rating set forth below, the interest rate
payable on that series of Notes will be the initial interest rate (5.3 percent
for the Notes due 2013 and 6.5 percent for the Notes due 2033) plus the
additional interest rate set forth below for each rating assigned by Moody's and
S&P.
<Table>
<Caption>
ADDITIONAL ADDITIONAL
MOODY'S RATING INTEREST RATE SP RATING INTEREST RATE
- -------------- ------------- --------- -------------
Baa1.......................................... 0.25% BBB+ 0.25%
Baa2.......................................... 0.50% BBB 0.50%
Baa3.......................................... 0.75% BBB- 0.75%
Ba1 or below.................................. 1.00% BB+ or below 1.00%
</Table>
In no event will the interest rate for any of the Notes increase by more
than 2 percent above the initial coupon rates of 5.3 percent and 6.5 percent,
respectively. If either Moody's or S&P subsequently upgrades its ratings, the
interest rates will be correspondingly reduced, but not below 5.3 percent or 6.5
percent, respectively. Furthermore, the interest rate payable on a particular
series of Notes will return to 5.3 percent and 6.5 percent, respectively, and
the rate adjustment provisions will permanently cease to apply if, following a
downgrade by either Moody's or S&P below A3 or A-, respectively, the Notes are
subsequently rated above Baal by Moody's and BBB+ by S&P.
On July 14, 2004, Moody's lowered its rating of the Notes to Baa1 and,
accordingly, the interest payable on each note increased by 25 basis points,
effective December 1, 2004. Therefore, on December 1, 2004, the interest rate
payable on the Notes due 2013 increased from 5.3% to 5.55%, and the interest
rate payable on the Notes due 2033 increased from 6.5% to 6.75%. At September
30, 2005, the Notes were rated Baa1 by Moody's and A- by S&P.
12
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)
The Notes are redeemable in whole or in part, at the Company's option at
any time, at a redemption price equal to the greater of (1) 100 percent of the
principal amount of such Notes or (2) the sum of the present values of the
remaining scheduled payments of principal and interest discounted using the rate
of treasury Notes with comparable remaining terms plus 25 basis points for the
2013 Notes or 35 basis points for the 2033 Notes.
CREDIT FACILITIES
The Company has a revolving credit facility from a syndicate of major
financial institutions. During March 2005, the Company negotiated an increase in
the commitments under this credit facility from $1.25 billion to $1.5 billion
with no changes in the basic terms of the pre-existing credit facility.
Concurrently with the increase in commitments under this facility, the Company
terminated early a separate $250 million line of credit which would have matured
in May 2006. There was no outstanding balance under this facility at the time it
was terminated.
The existing $1.5 billion credit facility matures in May 2009 and requires
the Company to maintain a total debt to capital ratio of no more than 60
percent. This credit line is available for general corporate purposes and is
considered as support to the Company's commercial paper borrowings. Borrowings
under the credit facility may be drawn by the U.S. parent company or by its
wholly-owned foreign subsidiaries when accompanied by a parent guarantee. This
facility does not require compensating balances; however, a nominal commitment
fee is paid. As of September 30, 2005, no funds have been drawn down under this
facility.
6% MANDATORY CONVERTIBLE PREFERRED STOCK AND SHELF REGISTRATION
In August 2004, the Company issued 28,750,000 shares of 6% Mandatory
Convertible Preferred stock (the Preferred Stock) with a face value of $1.44
billion. Net proceeds to the Company were $1.4 billion after deducting
commissions, discounts and other underwriting expenses. The Preferred Stock will
automatically convert into between 2.2451 and 2.7840 common shares of the
Company depending on the average closing price of the Company's common shares
over a period immediately preceding the mandatory conversion date of September
14, 2007, as defined in the prospectus. The preferred shareholders may elect to
convert at any time prior to September 14, 2007, at the minimum conversion ratio
of 2.2451 common shares per share of the Preferred Stock. Additionally, if at
any time prior to the mandatory conversion date, the closing price of the
Company's common shares exceeds $33.41 (for at least 20 trading days within a
period of 30 consecutive trading days), the Company may elect to cause the
conversion of all, but not less than all, of the Preferred Stock then
outstanding at the same minimum conversion ratio of 2.2451 common shares for
each preferred share.
The Preferred Stock accrues dividends at an annual rate of 6 percent on
shares outstanding. The dividends are cumulative from the date of issuance and,
to the extent the Company is legally permitted to pay dividends and the Board of
Directors declares a dividend payable, the Company will pay dividends on each
dividend payment date. The dividend payment dates are March 15, June 15,
September 15 and December 15.
As of September 30, 2005, the Company has the ability to issue $563 million
(principal amount) of securities under a currently effective SEC shelf
registration.
INTEREST RATE SWAP CONTRACT
The Company previously disclosed an interest rate swap arrangement with a
counterparty bank. The arrangement utilized two long-term interest rate swap
contracts, one between a foreign-based subsidiary of
13
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)
the Company and a bank and the other between a U.S. subsidiary of the Company
and the same bank. The two contracts had equal and offsetting terms and were
covered by a master netting arrangement. The contract involving the
foreign-based subsidiary permitted the subsidiary to prepay a portion of its
future obligation to the bank, and the contract involving the U.S. subsidiary
permitted the bank to prepay a portion of its future obligation to the U.S.
subsidiary. Interest was paid on the prepaid balances by both parties at market
rates. Prepayments totaling $1.9 billion were made under both contracts as of
December 31, 2004.
The terms of the swap contracts, as amended, called for a phased
termination of the swaps based on an agreed repayment schedule that was to begin
no later than March 31, 2005. Termination would require the Company and the
counterparty each to repay all prepayments pursuant to the agreed repayment
schedule. The terms also allowed the Company, at its option, to accelerate the
termination of the arrangement and associated scheduled repayments for a nominal
fee.
On February 28, 2005, the Company's foreign-based subsidiary and U.S.
subsidiary each gave notice to the counterparty of their intent to terminate the
arrangement. On March 21, 2005, the Company terminated these swap agreements and
all associated repayments were made by the respective obligors with no material
impact on the Company's Statement of Condensed Consolidated Operations.
14. SEGMENT DATA
The Company has three reportable segments: Prescription Pharmaceuticals,
Consumer Health Care and Animal Health. The segment sales and profit data that
follow are consistent with the Company's current management reporting structure.
The Prescription Pharmaceuticals segment discovers, develops, manufactures and
markets human pharmaceutical products. The Consumer Health Care segment
develops, manufactures and markets over-the-counter, foot care and sun care
products, primarily in the U.S. The Animal Health segment discovers, develops,
manufactures and markets animal health products.
Net sales by segment:
<Table>
<Caption>
THREE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------- ---------------
2005 2004 2005 2004
------ ------ ------ ------
(DOLLARS IN MILLIONS)
Prescription Pharmaceuticals....................... $1,840 $1,556 $5,660 $4,681
Consumer Health Care............................... 235 239 895 868
Animal Health...................................... 209 183 629 539
------ ------ ------ ------
Consolidated net sales............................. $2,284 $1,978 $7,184 $6,088
====== ====== ====== ======
</Table>
14
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)
Profit by segment:
<Table>
<Caption>
THREE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------- -------------
2005 2004 2005 2004
----- ------ ----- -----
(DOLLARS IN MILLIONS)
Prescription Pharmaceuticals.......................... $ 93 $ 83 $ 507 $ 43
Consumer Health Care.................................. 55 35 225 180
Animal Health......................................... 33 20 89 41
Corporate and other, including net interest
(income)/expense of $(9) and $4 in 2005 and $19 and
$80 in 2004......................................... (93) (106) (516) (404)
---- ----- ----- -----
Consolidated profit/(loss) before tax................. $ 88 $ 32 $ 305 $(140)
==== ===== ===== =====
</Table>
"Corporate and other" includes interest income and expense, foreign
exchange gains and losses, headquarters expenses, special charges and other
miscellaneous items. The accounting policies used for segment reporting are the
same as those described in Note 1 "Summary of Significant Accounting Policies"
in the Company's 2004 10-K.
For the three and nine months ended September 30, 2005, "Corporate and
other" included special charges of $6 million and $292 million, respectively,
related to certain litigation charges, VERP, other employee severance costs, and
asset impairment charges (see Note 2 "Special Charges" footnote for additional
information). Special charges for the three months ended September 30, 2005 is
estimated to be as follows: Prescription Pharmaceuticals -- $5 million and
Corporate and other -- $1 million. Special charges for the nine months ended
September 30, 2005 is estimated to be as follows: Prescription
Pharmaceuticals -- $288 million, Consumer Health Care -- $1 million, Animal
Health -- $1 million and Corporate and other -- $2 million.
For the three and nine months ended September 30, 2004, "Corporate and
other" included special charges of $26 million and $138 million, respectively,
related to VERP, other employee severance costs and asset impairment charges
(see Note 2 "Special Charges" for additional information). It is estimated that
special charges for the three months ended September 30, 2004 related to the
reportable segments as follows: Prescription Pharmaceuticals -- $23 million,
Consumer Health Care -- $1 million and Corporate and other -- $2 million.
Special charges for the nine months ended September 30, 2004 is estimated to be
as follows: Prescription Pharmaceuticals -- $119 million, Consumer Health
Care -- $3 million, Animal Health -- $2 million and Corporate and other -- $14
million.
Net sales of products comprising 10% or more of the Company's U.S. or
international net sales in the three and nine months ended September 30, 2005
were as follows:
<Table>
<Caption>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, 2005 SEPTEMBER 30, 2005
-------------------- --------------------
U.S. INTERNATIONAL U.S. INTERNATIONAL
---- ------------- ---- -------------
(DOLLARS IN MILLIONS)
NASONEX........................................ $109 $ 61 $332 $220
CLARINEX/AERIUS................................ 93 64 249 258
OTC CLARITIN................................... 88 4 323 17
REMICADE....................................... -- 237 -- 691
PEG-INTRON..................................... 42 143 132 405
</Table>
15
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)
15. CONSENT DECREE
On May 17, 2002, the Company announced that it had reached an agreement
with the FDA for a consent decree to resolve issues involving the Company's
compliance with current Good Manufacturing Practices (cGMP) at certain
manufacturing facilities in New Jersey and Puerto Rico. The U.S. District Court
for the District of New Jersey approved and entered the consent decree on May
20, 2002.
Under terms of the consent decree, the Company agreed to pay a total of
$500 million to the U.S. government in two equal installments of $250 million;
the first installment was paid in May 2002, and the second installment was paid
in May 2003.
The consent decree requires the Company to complete a number of actions,
including a comprehensive cGMP Workplan for the Company's manufacturing
facilities in New Jersey and Puerto Rico and revalidation of the finished drug
products and bulk active pharmaceutical ingredients manufactured at those
facilities.
Under the decree, the scheduled completion dates are December 31, 2005 for
the cGMP Workplan; September 30, 2005, for revalidation programs for bulk active
pharmaceutical ingredients; and December 31, 2005 for revalidation programs for
finished drugs. The Company continues to make steady progress in fulfilling
consent decree obligations with the FDA. The Company completed the revalidation
programs for bulk active pharmaceutical ingredients by September 30, 2005, as
required, and is working toward its goal of completing the cGMP Workplan and
revalidation of finished drugs by December 31, 2005 in order to be in a position
to request by May of 2007 to have the decree lifted.
The cGMP Workplan contains a number of Significant Steps whose timely and
satisfactory completion are subject to payments of $15 thousand per business day
for each deadline missed. These payments may not exceed $25 million for 2002,
and $50 million for each of the years 2003, 2004 and 2005. These payments are
subject to an overall cap of $175 million.
In general, the timely and satisfactory completion of the revalidations are
subject to payments of $15 thousand per business day for each deadline missed,
subject to the caps described above. However, if a product scheduled for
revalidation has not been certified as having been validated by the last date on
the validation schedule, the FDA may assess a payment of 24.6 percent of the net
domestic sales of the uncertified product until the validation is certified.
Further, in general, if a product scheduled for revalidation under the consent
decree is not certified within nine months of its scheduled date, the Company
must cease production of that product until certification is obtained.
The completion of the Significant Steps in the Workplan and the completion
of the revalidation programs are subject to third-party expert certification, as
well as the FDA's acceptance of such certification.
The consent decree provides that if the Company believes that it may not be
able to meet a deadline, the Company has the right, upon the showing of good
cause, to request extensions of deadlines in connection with the cGMP Workplan
and revalidation programs. However, there is no guarantee that the FDA will
grant any such requests.
Although the Company believes it has made significant progress in meeting
its obligations under the consent decree, it is possible that (1) the Company
may fail to complete a Significant Step or a revalidation by the prescribed
deadline; (2) the third-party expert may not certify the completion of the
Significant Step or revalidation; or (3) the FDA may disagree with an expert's
certification of a Significant Step or revalidation. In such a case, it is
possible that the FDA may assess payments as described above.
16
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)
The Company would expense any payments assessed under the decree if and
when incurred.
16. LEGAL, ENVIRONMENTAL AND REGULATORY MATTERS
BACKGROUND
The Company is involved in various claims, investigations and legal
proceedings.
The Company records a liability for contingencies when it is probable that
a liability has been incurred and the amount can be reasonably estimated. The
Company adjusts its liabilities for contingencies to reflect the current best
estimate of probable loss or minimum liability as the case may be. Where no best
estimate is determinable, the Company records the minimum amount within the most
probable range of its liability. Expected insurance recoveries have not been
considered in determining the amounts of recorded liabilities for
environmental-related matters.
If the Company believes that a loss contingency is reasonably possible,
rather than probable, or the amount of loss cannot be estimated, no liability is
recorded. However, where a liability is reasonably possible, disclosure of the
loss contingency is made.
The Company reviews the status of the matters discussed in the remainder of
this Note on an ongoing basis. From time to time, the Company may settle or
otherwise resolve these matters on terms and conditions management believes are
in the best interests of the Company. Resolution of any or all of the items
discussed in the remainder of this Note, individually or in the aggregate, could
have a material adverse effect on the Company's results of operations, cash
flows or financial condition. Resolution (including settlements) of matters of
the types set forth in the remainder of this Note, and in particular under
Investigations, frequently involve fines and penalties of an amount that would
be material to the Company's results of operations, cash flows or financial
condition. Resolution of such matters may also involve injunctive or
administrative remedies that would adversely impact the business such as
exclusion from government reimbursement programs, which in turn would have a
material adverse impact on the business, future financial condition, cash flows
or the results of operations. There are no assurances that the Company will
prevail in any of the matters discussed in the remainder of this Note, that
settlements can be reached on acceptable terms (including the scope of the
release provided and the absence of injunctive or administrative remedies that
would adversely impact the business such as exclusion from government
reimbursement programs) or in amounts that do not exceed the amounts reserved.
Even if an acceptable settlement were to be reached, there can be no assurance
that further investigations or litigations will not be commenced raising similar
issues, potentially exposing the Company to additional material liabilities. The
outcome of the matters discussed below under "Investigations" could include the
commencement of civil and/or criminal proceedings involving the imposition of
substantial fines, penalties and injunctive or administrative remedies,
including exclusion from government reimbursement programs. Total liabilities
reserved reflect an estimate, and any final settlement or adjudication of any of
these matters could possibly be less than, or could materially exceed the
liabilities recorded in the financial statements and could have a material
adverse impact on the Company's results of operations, cash flows or financial
condition. Further, the Company cannot predict the timing of the resolution of
these matters or their outcomes.
Except for the matters discussed in the remainder of this Note, the
recorded liabilities for contingencies at September 30, 2005, and the related
expenses incurred during the three and nine-month periods ended September 30,
2005, were not material. In the opinion of the Company, based on the advice of
legal counsel, the ultimate outcome of these matters, except matters discussed
in the remainder of this Note, will not have a material impact on the Company's
results of operations, cash flows or financial condition.
17
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)
Prior to the quarter ended June 30, 2005, the Company had recorded a
liability of approximately $250 million related to the Massachusetts
investigation. During the 2005 second quarter, the Company increased this
reserve by $250 million, to a total of $500 million. This increase relates to
the investigation by the U.S. Attorney's Office for the District of
Massachusetts into the Company's marketing, sales, pricing and clinical trial
practices, as well as previously disclosed investigations and litigation
relating to the Company's practices regarding average wholesale price by the
Department of Justice and certain states. See "Pricing matters, AWP
investigation" later in this Note. While no agreement has been reached, the
increase in litigation reserves reflects the Company's current estimate to
resolve these matters. If the Company is not able to reach a settlement at the
current estimate, the resolution of this matter could have a material adverse
impact on the Company's results of operations (beyond what has been reflected to
date if the Company is not able to reach a settlement at the current estimate),
cash flows, financial condition and/or its business.
PATENT MATTERS
DR. SCHOLL'S FREEZE AWAY Patent. On July 26, 2004, OraSure Technologies
filed an action in the U.S. District Court for the Eastern District of
Pennsylvania alleging patent infringement by Schering-Plough HealthCare Products
by its sale of DR. SCHOLL'S FREEZE AWAY wart removal product. The complaint
seeks a permanent injunction and unspecified damages, including treble damages.
The FREEZE AWAY product was launched in March 2004. Net sales of this product
totaled approximately $20 million for the year-ended December 31, 2004 and $14
million for the nine months ended September 30, 2005.
INVESTIGATIONS
Pennsylvania Investigation. On July 30, 2004, Schering-Plough Corporation,
the U.S. Department of Justice and the U.S. Attorney's Office for the Eastern
District of Pennsylvania announced settlement of the previously disclosed
investigation by that Office. Under the settlement, Schering Sales Corporation,
an indirect wholly-owned subsidiary of Schering-Plough Corporation, pled guilty
to a single federal criminal charge concerning a payment to a managed care
customer. In connection with the settlement:
- The aggregate settlement amount was $345.5 million in fines and damages.
Schering-Plough Corporation was credited with $53.6 million that was
previously paid in additional Medicaid rebates, leaving a net settlement
amount of $291.9 million. An amount of $294 million including interest
was paid during 2004.
- Schering Sales Corporation will be excluded from participating in federal
health care programs. The settlement will not affect the ability of
Schering-Plough Corporation to participate in those programs.
- Schering-Plough Corporation entered into a five-year corporate integrity
agreement with the Office of the Inspector General of the Department of
Health and Human Services, under which Schering-Plough Corporation agreed
to implement specific measures to promote compliance with regulations on
issues such as marketing. Failure to comply can result in financial
penalties.
Massachusetts Investigation. The U.S. Attorney's Office for the District
of Massachusetts is investigating a broad range of the Company's sales,
marketing and clinical trial practices and programs along with those of Warrick
Pharmaceuticals (Warrick), the Company's generic subsidiary.
Schering-Plough has disclosed that, in connection with this investigation,
on May 28, 2003, Schering Corporation, a wholly owned and significant operating
subsidiary of Schering-Plough, received a letter (the
18
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)
Boston Target Letter) from that Office advising that Schering Corporation
(including its subsidiaries and divisions) is a target of a federal criminal
investigation with respect to four areas:
1. Providing remuneration, such as drug samples, clinical trial grants
and other items or services of value, to managed care
organizations, physicians and others to induce the purchase of
Schering pharmaceutical products;
2. Sale of misbranded or unapproved drugs, which the Company
understands to mean drugs promoted for indications for which
approval by the U.S. FDA had not been obtained (so-called off-label
uses);
3. Submitting false pharmaceutical pricing information to the
government for purposes of calculating rebates required to be paid
to the Medicaid program, by failing to include prices of a product
manufactured and sold under a private label arrangement with a
managed care customer as well as the prices of free and nominally
priced goods provided to that customer to induce the purchase of
Schering products; and
4. Document destruction and obstruction of justice relating to the
government's investigation.
A target is defined in Department of Justice guidelines as a person as to
whom the prosecutor or the grand jury has substantial evidence linking him or
her to the commission of a crime and who, in the judgment of the prosecutor, is
a putative defendant (U.S. Attorney's Manual, Section 9-11.151).
The Company has implemented certain changes to its sales, marketing and
clinical trial practices and is continuing to review those practices to foster
compliance with relevant laws and regulations. The Company is cooperating with
this investigation.
See information about prior increases to the liabilities reserved in the
financial statements, including in relation to this investigation, and the other
potential impacts of the outcome of this investigation in the Background section
of this Note.
Prior to the quarter ended June 30, 2005, the Company had recorded a
liability of approximately $250 million related to this investigation. During
the 2005 second quarter, the Company increased this reserve by $250 million, to
a total of $500 million. This increase relates to the investigation by the U.S.
Attorney's Office for the District of Massachusetts into the Company's
marketing, sales, pricing and clinical trial practices, as well as previously
disclosed investigations and litigation relating to the Company's practices
regarding average wholesale price by the Department of Justice and certain
states. While no agreement has been reached, the increase in litigation reserves
reflects the Company's current estimate to resolve these matters. If the Company
is not able to reach a settlement at the current estimate, the resolution of
this matter could have a material adverse impact on the Company's results of
operations (beyond what has been reflected to date if the Company is not able to
reach a settlement at the current estimate), cash flows, financial condition
and/or its business.
NITRO-DUR Investigation. In August 2003, the Company received a civil
investigative subpoena issued by the Office of Inspector General of the U.S.
Department of Health and Human Services seeking documents concerning the
Company's classification of NITRO-DUR for Medicaid rebate purposes, and the
Company's use of nominal pricing and bundling of product sales. The Company is
cooperating with the investigation. It appears that the subpoena is one of a
number addressed to pharmaceutical companies concerning an inquiry into issues
relating to the payment of government rebates.
19
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)
PRICING MATTERS
AWP Investigations. The Company continues to respond to existing and new
investigations by, among others, the U.S. Department of Health and Human
Services, the U.S. Department of Justice and certain states into industry and
Company practices regarding average wholesale price (AWP). These investigations
include a Department of Justice review of the merits of a federal action filed
by a private entity on behalf of the U.S. in the U.S. District Court for the
Southern District of Florida, as well as an investigation by the U.S. Attorney's
Office for the District of Massachusetts, regarding, inter alia, whether the AWP
set by pharmaceutical companies for certain drugs improperly exceeds the average
prices paid by dispensers and, as a consequence, results in unlawful inflation
of certain government drug reimbursements that are based on AWP. The Company is
cooperating with these investigations. The outcome of these investigations could
include the imposition of substantial fines, penalties and injunctive or
administrative remedies.
Prescription Access Litigation. In December 2001, the Prescription Access
Litigation project (PAL), a Boston-based group formed in 2001 to litigate
against drug companies, filed a class action suit in Federal Court in
Massachusetts against the Company. In September 2002, a consolidated complaint
was filed in this court as a result of the coordination by the Multi-District
Litigation Panel of all federal court AWP cases from throughout the country (the
MDL Proceeding). The consolidated complaint alleges that the Company and Warrick
Pharmaceuticals, the Company's generic subsidiary, conspired with providers to
defraud consumers by reporting fraudulently high AWPs for prescription
medications reimbursed by Medicare or third-party payers. The complaint seeks a
declaratory judgment and unspecified damages, including treble damages.
Included in the litigation described in the prior paragraph are lawsuits
that allege that the Company and Warrick reported inflated AWPs for prescription
pharmaceuticals and thereby caused state and federal entities and third-party
payers to make excess reimbursements to providers. Some of these actions also
allege that the Company and Warrick failed to report accurate prices under the
Medicaid Rebate Program and thereby underpaid rebates to some states. Some cases
filed by State Attorneys General also seek to recover on behalf of citizens of
the State and entities located in the State for excess payments as a result of
inflated AWPs. These actions, which began in October 2001, have been brought by
State Attorneys General, private plaintiffs, nonprofit organizations and
employee benefit funds. They allege violations of federal and state law,
including fraud, antitrust, Racketeer Influenced Corrupt Organizations Act
(RICO) and other claims. During the first quarter of 2004, the Company and
Warrick were among five groups of companies put on an accelerated discovery
track in the MDL Proceeding.
In addition, Warrick and the Company are defendants in a number of similar
lawsuits in state courts, including West Virginia. Trial in the West Virginia
action is currently scheduled for November 28, 2005.
SECURITIES AND CLASS ACTION LITIGATION
On February 15, 2001, the Company stated in a press release that the FDA
had been conducting inspections of the Company's manufacturing facilities in New
Jersey and Puerto Rico and had issued reports citing deficiencies concerning
compliance with current Good Manufacturing Practices, primarily relating to
production processes, controls and procedures. The next day, February 16, 2001,
a lawsuit was filed in the U.S. District Court for the District of New Jersey
against the Company and certain named officers alleging violations of Sections
10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5
promulgated thereunder. Additional lawsuits of the same tenor followed. These
complaints were consolidated into one action in the U.S. District Court for the
District of New Jersey, and a lead plaintiff, the Florida State Board of
Administration, was appointed by the Court on July 2, 2001. On October 11, 2001,
a consolidated amended complaint was filed, alleging the same violations
described in
20
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)
the second sentence of this paragraph and purporting to represent a class of
shareholders who purchased shares of Company stock from May 9, 2000, through
February 15, 2001. The complaint seeks compensatory damages on behalf of the
class. The Company's motion to dismiss the consolidated amended complaint was
denied on May 24, 2002. On October 10, 2003, the Court certified the shareholder
class. Discovery is ongoing.
In addition to the lawsuits described in the immediately preceding
paragraph, two lawsuits were filed in the U.S. District Court for the District
of New Jersey, and two lawsuits were filed in New Jersey state court against the
Company (as a nominal defendant) and certain officers, directors and a former
director seeking damages on behalf of the Company, including disgorgement of
trading profits made by defendants allegedly obtained on the basis of material
non-public information. The complaints in each of those four lawsuits relate to
the issues described in the Company's February 15, 2001 press release, and
allege a failure to disclose material information and breach of fiduciary duty
by the directors. One of the federal court lawsuits also includes allegations
related to the investigations by the U.S. Attorney's Offices for the Eastern
District of Pennsylvania and the District of Massachusetts, the FTC's
administrative proceeding against the Company, and the lawsuit by the state of
Texas against Warrick, the Company's generic subsidiary. The U.S. Attorney's
investigations and the FTC proceeding are described herein. The Texas litigation
is described in previously filed 10-Ks and 10-Qs. Each of these lawsuits is a
shareholder derivative action that purports to assert claims on behalf of the
Company, but as to which no demand was made on the Board of Directors and no
decision had been made on whether the Company can or should pursue such claims.
In August 2001, the plaintiffs in each of the New Jersey state court shareholder
derivative actions moved to dismiss voluntarily the complaints in those actions,
which motions were granted. The two shareholder derivative actions pending in
the U.S. District Court for the District of New Jersey have been consolidated
into one action, which is in its very early stages.
On January 2, 2002, the Company received a demand letter dated December 26,
2001, from a law firm not involved in the derivative actions described above, on
behalf of a shareholder who also is not involved in the derivative actions,
demanding that the Board of Directors bring claims on behalf of the Company
based on allegations substantially similar to those alleged in the derivative
actions. On January 22, 2002, the Board of Directors adopted a Board resolution
establishing an Evaluation Committee, consisting of three directors, to
investigate, review and analyze the facts and circumstances surrounding the
allegations made in the demand letter and the consolidated amended derivative
action complaint described above, but reserving to the full Board authority and
discretion to exercise its business judgment in respect of the proper
disposition of the demand. The Committee engaged independent outside counsel to
advise it and issued a report on the findings of its investigation to the
independent directors of the Board in late October 2002. That report determined
that the shareholder demand should be refused, and finding no liability on the
part of any officers or directors. In November 2002, the full Board adopted the
recommendation of the Evaluation Committee.
The Company is a defendant in a number of purported nationwide or state
class action lawsuits in which plaintiffs seek a refund of the purchase price of
laxatives or phenylpropanolamine-containing cough/cold remedies (PPA products)
they purchased. Other pharmaceutical manufacturers are co-defendants in some of
these lawsuits. In general, plaintiffs claim that they would not have purchased
or would have paid less for these products had they known of certain defects or
medical risks attendant with their use. In the litigation of the claims relating
to the Company's PPA products, courts in the national class action suit and
several state class action suits have denied certification and dismissed the
suits. A similar application to deny class certification in New Jersey, the only
remaining statewide class action suit involving the Company, was granted on
September 30, 2004. Approximately 96 individual lawsuits relating to the
laxative products, PPA products and recalled albuterol/VANCERIL/VANCENASE
inhalers are
21
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)
also pending against the Company seeking recovery for personal injuries or
death. In a number of these lawsuits, punitive damages are claimed.
Litigation filed in 2003 in the U.S. District Court in New Jersey alleging
that the Company, Richard Jay Kogan, the Company's Employee Savings Plan (Plan)
administrator, several current and former directors, and certain corporate
officers breached their fiduciary obligations to certain participants in the
Plan. The complaint seeks damages in the amount of losses allegedly suffered by
the Plan. The complaint was dismissed on June 29, 2004. The plaintiffs appealed.
On August 19, 2005, the U.S. Court of Appeals for the Third Circuit reversed the
decision of the District Court and the matter has been remanded to the District
Court for further proceedings.
ANTITRUST AND FTC MATTERS
K-DUR. K-DUR is Schering-Plough's long-acting potassium chloride product
supplement used by cardiac patients. Schering-Plough had settled patent
litigation with Upsher-Smith, Inc. (Upsher-Smith) and ESI Lederle, Inc.
(Lederle), which had related to generic versions of K-DUR for which Lederle and
Upsher Smith had filed Abbreviated New Drug Applications (ANDAs). On April 2,
2001, the FTC started an administrative proceeding against Schering-Plough,
Upsher-Smith and Lederle. The complaint alleged anti-competitive effects from
those settlements. In June 2002, the administrative law judge overseeing the
case issued a decision that the patent litigation settlements complied with the
law in all respects and dismissed all claims against the Company. The FTC Staff
appealed that decision to the full Commission. On December 18, 2003, the full
Commission issued an opinion that reversed the 2002 decision and ruled that the
settlements did violate the antitrust laws. The full Commission issued a cease
and desist order imposing various injunctive restraints. By opinion filed March
8, 2005, the federal Court of Appeals set aside that 2003 Commission ruling and
vacated the cease and desist order. The FTC filed a petition with the Court of
Appeals seeking to have the Court vacate its March 8, 2005 decision, which was
denied on May 31, 2005. On August 29, 2005, the FTC filed a petition seeking a
hearing by the U.S. Supreme Court.
Following the commencement of the FTC administrative proceeding, alleged
class action suits were filed in federal and state courts on behalf of direct
and indirect purchasers of K-DUR against Schering-Plough, Upsher-Smith and
Lederle. These suits all allege essentially the same facts and claim violations
of federal and state antitrust laws, as well as other state statutory and/or
common law causes of action. These suits seek unspecified damages. Discovery is
ongoing.
SEC INQUIRIES AND RELATED LITIGATION
On September 9, 2003, the SEC and the Company announced settlement of the
SEC enforcement proceeding against the Company and Richard Jay Kogan, former
chairman and chief executive officer, regarding meetings held with investors the
week of September 30, 2002, and other communications. Without admitting or
denying the allegations, the Company agreed not to commit future violations of
Regulation FD and related securities laws and paid a civil penalty of $1
million. Mr. Kogan paid a civil penalty of $50 thousand.
On September 25, 2003, a lawsuit was filed in New Jersey Superior Court,
Union County, against Richard Jay Kogan and the Company's outside Directors
alleging breach of fiduciary duty, fraud and deceit and negligent
misrepresentation, all relating to the alleged disclosures made during the
meetings mentioned above. The Company removed this case to federal court. The
case was remanded to state court. The Company filed a motion to dismiss all
claims, which was granted on June 23, 2005.
22
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)
OTHER MATTERS
EMEA Pharmacovigilance Matter. During 2003 pharmacovigilance inspections
by officials of the British and French medicines agencies conducted at the
request of the European Agency for the Evaluation of Medicinal Products (EMEA),
serious deficiencies in reporting processes were identified. Schering-Plough
continues to work on its action plan to rectify the deficiencies and provides
regular updates to EMEA. The Company does not know what action, if any, the EMEA
or national authorities will take in response to these findings. Possible
actions include further inspections, demands for improvements in reporting
systems, criminal sanctions against the Company and/or responsible individuals
and changes in the conditions of marketing authorizations for the Company's
products.
Biopharma Contract Dispute. Biopharma S.r.l. filed a claim in the Civil
Court of Rome on July 21, 2004 (docket No. 57397/2004, 9th Chamber) against
certain Schering-Plough subsidiaries. The matter relates to certain contracts
dated November 15, 1999, (distribution and supply agreements between Biopharma
and a Schering-Plough subsidiary) for distribution by Schering-Plough of generic
products manufactured by Biopharma to hospitals and to pharmacists in France;
and July 26, 2002 (letter agreement among Biopharma, a Schering-Plough
subsidiary and Medipha Sante, S.A., appointing Medipha to distribute products in
France). Biopharma alleges that Schering-Plough did not fulfill its duties under
the contracts.
TAX MATTERS
In October 2001, IRS auditors asserted, in reports, that the Company is
liable for additional tax for the 1990 through 1992 tax years. The reports
allege that two interest rate swaps that the Company entered into with an
unrelated party should be re-characterized as loans from affiliated companies.
In April 2004, the Company received a formal Notice of Deficiency (Statutory
Notice) from the IRS asserting additional federal income tax due. The Company
received bills related to this matter from the IRS on September 7, 2004. Payment
in the amount of $194 million for income tax and $279 million for interest was
made on September 13, 2004. The Company filed refund claims for the tax and
interest with the IRS on December 23, 2004. The Company was notified on February
16, 2005, that its refund claims were denied by the IRS. The Company has filed a
suit for refund for the full amount of the tax and interest. The Company's tax
reserves were adequate to cover the above-mentioned payments.
ENVIRONMENTAL
The Company has responsibilities for environmental cleanup under various
state, local and federal laws, including the Comprehensive Environmental
Response, Compensation and Liability Act, commonly known as Superfund. At
several Superfund sites (or equivalent sites under state law), the Company is
alleged to be a potentially responsible party (PRP). Except where a site is
separately disclosed, the Company believes that it is remote at this time that
there is any material liability in relation to such sites. The Company estimates
its obligations for cleanup costs for Superfund sites based on information
obtained from the federal Environmental Protection Agency (EPA), an equivalent
state agency and/or studies prepared by independent engineers, and on the
probable costs to be paid by other PRPs. The Company records a liability for
environmental assessments and/or cleanup when it is probable a loss has been
incurred and the amount can be reasonably estimated.
23
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Shareholders and Board of Directors of Schering-Plough Corporation:
We have reviewed the accompanying condensed consolidated balance sheet of
Schering-Plough Corporation and subsidiaries (the "Corporation") as of September
30, 2005, and the related statements of condensed consolidated operations for
the three and nine-month periods ended September 30, 2005 and 2004, and the
statements of condensed consolidated cash flows for the nine-month periods ended
September 30, 2005 and 2004. These interim financial statements are the
responsibility of the Corporation's management.
We conducted our reviews in accordance with the standards of the Public
Company Accounting Oversight Board (United States). A review of interim
financial information consists principally of applying analytical procedures and
making inquiries of persons responsible for financial and accounting matters. It
is substantially less in scope than an audit conducted in accordance with
standards of the Public Company Accounting Oversight Board (United States), the
objective of which is the expression of an opinion regarding the financial
statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our reviews, we are not aware of any material modifications that
should be made to such condensed consolidated interim financial statements for
them to be in conformity with accounting principles generally accepted in the
United States of America.
We have previously audited, in accordance with the standards of the Public
Company Accounting Oversight Board (United States), the consolidated balance
sheet of Schering-Plough Corporation and subsidiaries as of December 31, 2004,
and the related statements of consolidated operations, shareholders' equity, and
cash flows for the year then ended (not presented herein); and in our report
dated March 8, 2005, we expressed an unqualified opinion on those consolidated
financial statements. In our opinion, the information set forth in the
accompanying condensed consolidated balance sheet as of December 31, 2004 is
fairly stated, in all material respects, in relation to the consolidated balance
sheet from which it has been derived.
/s/ Deloitte & Touche LLP
Parsippany, New Jersey
October 28, 2005
24
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
EXECUTIVE OVERVIEW
OVERVIEW OF THE COMPANY
Schering-Plough Corporation (the Company) discovers, develops, manufactures
and markets medical therapies and treatments to enhance human health. The
Company also markets leading consumer brands in the over-the-counter (OTC), foot
care and sun care markets and operates a global animal health business. Further,
the Company licenses products for these businesses.
As a research-based pharmaceutical company, a core strategy of
Schering-Plough is to invest substantial funds in scientific research with the
goal of creating therapies and treatments with important medical and commercial
value. Consistent with this core strategy, the Company has been increasing its
investment in research and development, and this trend is expected to continue
at historic levels or greater. Research and development activities focus on
mechanisms to treat serious diseases. There is a high rate of failure inherent
in such research and, as a result, there is a high risk that the funds invested
in research programs will not generate financial returns. This risk profile is
compounded by the fact that this research has a long investment cycle. To bring
a pharmaceutical compound from the discovery phase to the commercial phase may
take a decade or more. Because of the high-risk nature of research investments,
financial resources typically must come from internal sources (operations and
cash reserves) or from equity-type capital.
There are two sources of new products: products acquired through
acquisition and licensing arrangements, and products in the Company's late-stage
research pipeline. With respect to acquisitions and licensing, there are limited
opportunities for obtaining or licensing critical late-stage products, and these
limited opportunities typically require substantial amounts of funding. The
Company competes for these opportunities against companies often with greater
financial resources. Accordingly, it may be challenging for the Company to
acquire or license critical late-stage products that will have a positive
material financial impact. The Company is in the process of revamping its
organizational structure for acquisition and licensing activities.
The Company supports commercialized products with manufacturing, sales and
marketing efforts. The Company is also moving forward with additional
investments to enhance its infrastructure and business, including capital
expenditures for the development process, where products are moved from the drug
discovery pipeline to markets, information technology systems, and
post-marketing studies and monitoring.
The Company's financial situation has begun to improve in 2005, as
discussed below. The Company's cholesterol franchise products, VYTORIN and
ZETIA, are the primary drivers of this improvement. ZETIA is the Company's novel
cholesterol absorption inhibitor. VYTORIN is the combination of ZETIA and Zocor,
Merck & Co., Inc.'s statin medication. These two products have been launched
through a joint venture between the Company and Merck. ZETIA (ezetimibe),
marketed in Europe as EZETROL, is marketed for use either by itself or together
with statins for the treatment of elevated cholesterol levels. ZETIA/EZETROL has
been launched in more than 60 countries. VYTORIN (ezetimibe/simvastatin),
marketed as INEGY internationally, has been launched in over 20 countries,
including the United States.
The Company currently expects its cholesterol franchise to continue to
grow. The financial commitment to compete in the cholesterol reduction market is
shared with Merck and profits from the sales of VYTORIN and ZETIA are also
shared with Merck. The operating results of the joint venture with Merck are
recorded using the equity method of accounting. Due to the virtual nature of the
cholesterol joint venture, the Company incurs substantial selling, general and
administrative and other costs, which are not reflected in the equity income and
instead are included in the overall cost structure of the Company. Outside of
the joint venture with Merck, in the Japanese market, Bayer Healthcare will co-
market the Company's cholesterol absorption inhibitor ZETIA upon approval,
currently anticipated in 2006 or later.
The cholesterol-reduction market is the single largest pharmaceutical
market in the world. VYTORIN and ZETIA are competing in this market, and on a
combined basis, these products continued to grow in terms of market share during
the third quarter 2005. As a franchise, the two products together have
25
captured more than 13 percent of new prescriptions for the U.S. cholesterol
management market. VYTORIN currently ranks as the third-leading prescription
product for treating patients with high cholesterol (based on new
prescriptions). To date, physicians have written more than 6 million total
prescriptions for VYTORIN in the U.S. ZETIA (ezetimibe) has retained its market
share even as VYTORIN's market share has grown.
During 2005, the Company's results of operations and cash flows are being
driven significantly by the performance of VYTORIN and ZETIA. As a result, the
Company's ability to generate profits is predominantly dependent upon the
performance of the VYTORIN and ZETIA cholesterol management franchise, which
dependence is expected to continue for some time. For the nine months ended
September 30, 2005, equity income was $605 million and net income was $143
million. Although operating cash flow, existing cash and investments, including
funds to be repatriated under the American Jobs Creation Act, will fund the
Company's operations in the near and intermediate term, as discussed in more
detail below, future cash flows are also dependent upon the performance of
VYTORIN and ZETIA. The Company must generate profits and cash flows to maintain
and enhance its infrastructure and business as discussed above.
The Company expects that generic forms of Pravachol and Zocor, two existing
well-established cholesterol management products, will be introduced in the U.S.
as they lose patent protection beginning in 2006 (generics have been introduced
during 2005 in some international markets). In addition, the intellectual
property for the leading cholesterol management product, Lipitor, is being
challenged by a generic manufacturer and, if successful, this could lead to
additional significant generic competition in the U.S., possibly as early as
2006. The Company cannot reasonably predict what effect the introduction of
generic forms of cholesterol management products may have on VYTORIN and ZETIA,
although the decisions of government entities, managed care groups and other
groups concerning formularies and reimbursement policies could potentially
negatively impact the dollar size and/or growth of the cholesterol management
market, including VYTORIN and ZETIA. A material change in the sales or market
share of VYTORIN and ZETIA would have a significant impact on the Company's
operations and cash flow.
REMICADE is prescribed for the treatment of rheumatoid arthritis, early
rheumatoid arthritis, psoriatic arthritis, Crohn's disease, ankylosing
spondylitis, and recently gained approval in Europe for psoriasis. REMICADE is
the Company's second largest marketed pharmaceutical product line (after the
cholesterol management franchise). This product is licensed from and
manufactured by Centocor, a Johnson & Johnson company. The Company has the
exclusive marketing rights to this product outside of the U.S., China (including
Hong Kong), Taiwan and Indonesia. During the third quarter, the Company
exercised an option under its contract with Centocor for rights to develop CNTO
148 (golimumab), a fully human monoclonal antibody. Centocor believes such
rights to golimumab expire in 2014, while the Company believes such rights
extend beyond such date. The parties are working together to move forward with
their collaboration on golimumab and steps are being taken to resolve the
difference of opinion as to the expiration date.
As is typical in the pharmaceutical industry, the Company licenses
manufacturing, marketing and/or distribution rights to certain products to
others, and also manufactures, markets and/or distributes products owned by
others pursuant to licensing and joint venture arrangements. Any time that third
parties are involved, there are additional factors, relating to the third party
and outside control of the Company that may create positive or negative impacts
on the Company. VYTORIN, ZETIA and REMICADE are subject to such arrangements,
and are key to the Company's current business and financial performance.
Additional information regarding the joint venture with Merck is also included
in Note 3 "Equity Income from Cholesterol Joint Venture" in the Notes to
Condensed Consolidated Financial Statements.
In addition, any potential strategic alternatives may be impacted by the
change of control provisions in those arrangements, which could result in
VYTORIN and ZETIA being acquired by Merck or REMICADE reverting back to
Centocor. The change in control provision relating to VYTORIN and ZETIA is
included in the contract with Merck, filed as Exhibit 10(q) to the Company's
10-K and the change of control provision relating to REMICADE is contained in
the contract with Centocor, filed as Exhibit 10(u) to the Company's 10-K.
26
During the period 2002 to 2004, the Company experienced a number of
negative events that have strained and continue to strain the Company's
financial resources. While as explained below, the Company's overall financial
situation has begun to improve in 2005, these negative events remain relevant to
understanding the Company's current challenges. These negative events included,
but were not limited to, the following matters:
- Entered into a formal consent decree with the U.S. Food and Drug
Administration (FDA) in 2002 and agreed to revalidate manufacturing
processes at certain manufacturing sites in the U.S. and Puerto Rico.
Significant increased spending associated with manufacturing compliance
efforts will continue through the completion of the FDA consent decree
obligation. In addition, the Company has found it necessary to
discontinue certain older profitable products and outsource other
products.
- Switch of CLARITIN in the U.S., beginning in December 2002, from
prescription to OTC status. This switch coupled with private label
competition has resulted in substantially lower overall sales of this
product starting in 2003 as well as lower average unit selling price for
this product and ongoing intense competition. The Company's exposure to
powerful retail purchasers has also increased.
- Market shares and sales levels of certain other Company products fell
significantly and have experienced increased competition. Many of these
products compete in declining or volatile markets.
- Investigations into certain of the Company's sales and marketing
practices by the U.S. Attorney's Offices in Massachusetts and
Pennsylvania. During 2004, the Company made payments totaling $294
million to the U.S. Attorney's Office for the Eastern District of
Pennsylvania in settlement of that investigation.
In response to these matters, beginning in April 2003, the Company
appointed a new management team that formulated and has begun a six- to
eight-year, five phase Action Agenda with the goal of stabilizing, repairing and
then turning around the Company. The Company recently announced that it has
entered the third, Turnaround, phase of the Action Agenda. The beginning of the
Turnaround phase had been defined as achieving three consecutive quarters of
sales and earnings growth, excluding special items.
CURRENT STATE OF BUSINESS
Third quarter 2005 net sales of $2.3 billion were 15 percent higher than
the 2004 period. As discussed below, the sales increase was driven primarily by
the growth of PEG-INTRON, REMICADE, TEMODAR and REBETOL. Contributing 5 percent
to the sales increase was the U.S. sales contribution from the antibiotics,
AVELOX and CIPRO, and other products under the agreement with Bayer that became
effective in October 2004, and 1 percent from the impact of foreign exchange.
Sales and marketing costs have increased due to the addition of Bayer sales
representatives and increased selling expenses in Europe to support the
continued launch of VYTORIN and ZETIA, as well as increased promotional
spending, primarily for NASONEX and ASMANEX.
The Company had net income available to common shareholders of $43 million
in the third quarter of 2005 as compared to $14 million in the third quarter of
2004. Net income available to common shareholders was $78 million for the first
nine months of 2005, compared to a loss of $124 million during the same period
of the prior year. Net income available to common shareholders for the three and
nine months ended September 30, 2005 included a research and development
expenditure of approximately $124 million (or $118 million net of tax) for the
rights develop golimumab, a fully human monoclonal antibody under the same
agreement with Centocor, which governs the Company's marketing rights to
REMICADE.
Many of the Company's manufacturing sites operate below capacity. Overall
costs of operating manufacturing sites have significantly increased due to the
consent decree and other compliance activities. The Company's manufacturing cost
base is relatively fixed. Efforts to significantly reduce the Company's
27
manufacturing infrastructure involve complex issues. In most cases, shifting
products between manufacturing plants can take many years due to construction,
revalidation and registration requirements. The costs of operating the Company's
manufacturing sites are not expected to be reduced significantly solely as a
result of the consent decree work being completed. The Company continues to
review the carrying value of these assets for indications of impairment.
Beginning in the first quarter of 2005, the Company has repatriated and
continues to repatriate previously unremitted foreign earnings at a reduced tax
rate as provided by the American Job Creation Act of 2004 (AJCA). Repatriating
funds under the AJCA is benefiting the Company in the following ways:
- The Company's U.S. operations currently incur significant negative cash
flow. Repatriations being made during 2005 under the AJCA are expected to
provide the Company with the ability to fund U.S. cash needs for the near
and intermediate term.
- The negative cash flow from U.S. operations during 2004 and 2005 produced
U.S. tax net operating losses (U.S. NOLs). Under the AJCA, qualifying
repatriations do not reduce U.S. tax losses. As such, the Company will
have both the cash necessary to fund its U.S. cash needs as well as
maintaining the potential benefit of being able to carry forward U.S.
NOLs to reduce U.S. taxable income in the future. This potential future
benefit could be significant but is dependent on the Company achieving
profitability in the U.S.
DISCUSSION OF OPERATING RESULTS
NET SALES
A significant portion of net sales is made to major pharmaceutical and
health care products distributors and major retail chains in the U.S.
Consequently, net sales and quarterly growth comparisons may be affected by
fluctuations in the buying patterns of major distributors, retail chains and
other trade buyers. These fluctuations may result from seasonality, pricing,
wholesaler buying decisions or other factors.
Consolidated net sales for the three months ended September 30, 2005
totaled $2.3 billion, an increase of $306 million or 15 percent compared with
the same period in 2004. For the nine months ended September 30, 2005,
consolidated net sales totaled $7.2 billion, an increase of $1.1 billion or 18
percent compared with the same period in 2004. Consolidated net sales for the
three and nine months ended September 30, 2005 reflected higher volumes and the
inclusion of the sales of AVELOX and CIPRO.
In addition, foreign exchange had a positive impact of 1 percent and 3
percent for the three and nine months ended September 30, 2005, respectively.
28
Net sales for the three and nine months ended September 30, 2005 and 2004
were as follows:
<Table>
<Caption>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
----------------------------- -----------------------------
% INCREASE % INCREASE
2005 2004 (DECREASE) 2005 2004 (DECREASE)
------ ------ ----------- ------- ------ ----------
(DOLLARS IN MILLIONS)
PRESCRIPTION
PHARMACEUTICALS............. $1,840 $1,556 18% $5,660 $4,681 21%
REMICADE.................... 237 188 26 691 535 29
PEG-INTRON.................. 185 132 40 537 425 26
NASONEX..................... 170 153 11 552 449 23
CLARINEX/AERIUS............. 157 175 (10) 507 530 (4)
TEMODAR..................... 152 121 25 428 309 38
INTEGRILIN.................. 86 94 (8) 244 245 0
REBETOL..................... 82 52 58 237 239 (1)
CLARITIN Rx(a).............. 76 67 13 287 240 19
INTRON A.................... 72 81 (11) 220 239 (8)
CAELYX...................... 46 39 17 135 109 24
SUBUTEX..................... 44 45 (1) 148 136 9
AVELOX...................... 41 -- N/M 159 -- N/M
CIPRO....................... 41 -- N/M 114 -- N/M
ELOCON...................... 34 42 (19) 113 127 (11)
Other Pharmaceutical........ 417 367 14 1,288 1,098 17
CONSUMER HEALTH CARE.......... 235 239 (2) 895 868 3
OTC(b)...................... 129 150 (14) 453 456 (1)
Foot Care................... 85 86 (2) 258 252 3
Sun Care.................... 21 3 N/M 184 160 15
ANIMAL HEALTH................. 209 183 14 629 539 17
------ ------ --- ------ ------ ---
CONSOLIDATED NET SALES........ $2,284 $1,978 15% $7,184 $6,088 18%
====== ====== === ====== ====== ===
</Table>
- ---------------
N/M -- Not a meaningful percentage.
(a) Amounts shown for 2005 and 2004 represents international sales of CLARITIN
Rx only.
(b) Includes OTC CLARITIN of $92 million and $110 million in the third quarter
of 2005 and 2004, respectively, and $340 million and $344 million for the
first nine months of 2005 and 2004, respectively.
International net sales of REMICADE, for the treatment of immune-mediated
inflammatory disorders such as rheumatoid arthritis, early rheumatoid arthritis,
psoriatic arthritis, Crohn's disease, plaque psoriasis, and ankylosing
spondylitis, were up $49 million or 26 percent in the third quarter of 2005 to
$237 million, and $156 million or 29 percent for the first nine months of 2005
to $691 million due to greater demand, expanded indications and continued market
growth. In the near future, additional competitive products for the indications
referred to above are likely to be introduced.
Global net sales of PEG-INTRON Powder for Injection, a pegylated interferon
product for treating hepatitis C, increased 40 percent to $185 million for the
third quarter of 2005 and 26 percent to $537 million for the nine-month period.
Sale results were driven by higher sales in Japan as a result of the December
2004 launch of the PEG-INTRON and REBETOL combination therapy. Sales in Japan
benefited from the significant number of patients who were waiting for approval
of PEG-INTRON before beginning treatment ("patient warehousing"). Comparisons in
2006 will be unfavorably impacted by the
29
absence of this patient warehousing and, as a result, sales may decline
materially. Sales of PEG-INTRON in the U.S. have decreased, primarily reflecting
a decline in the overall market.
Global net sales of NASONEX Nasal Spray, a once-daily corticosteroid nasal
spray for allergies, rose 11 percent to $170 million in the third quarter of
2005 and 23 percent to $552 million for the nine-month period as the product
captured greater U.S. and international market share versus the 2004 period.
U.S. sales benefited from the nationwide availability beginning in January 2005
of a new scent-free, alcohol-free formulation of NASONEX nasal spray. In
international markets, NASONEX sales were up 26 percent to $61 million for the
third quarter and up 24 percent to $220 million for the nine month period as a
result of market share gains and a stronger allergy season.
Global net sales of CLARINEX (marketed as AERIUS in many countries outside
the U.S.) for the treatment of seasonal outdoor allergies and year-round indoor
allergies decreased 10 percent to $157 million in the third quarter of 2005,
compared to $175 million in the third quarter of last year. For the nine months
ended September 30, 2005, global net sales of CLARINEX decreased 4 percent to
$507 million. In the U.S., CLARINEX continued to experience reduced market share
in a declining market. As a result, sales in the U.S. decreased 22 percent for
the third quarter and 20 percent for the nine months ended September 30, 2005.
In September 2005, generic Allegra (fexofenadine) was introduced to the U.S.
which will affect the antihistamine market including CLARINEX. Sales outside the
U.S. increased 13 percent to $64 million for the third quarter and 18 percent to
$258 million for the nine month period due to a stronger allergy season coupled
with market share gains.
Global net sales of TEMODAR Capsules, for treating certain types of brain
tumors, increased $31 million or 25 percent to $152 million in the third quarter
of 2005 and increased $119 million or 38 percent to $428 million for the first
nine months of 2005 due to increased utilization for treating newly diagnosed
glioblastoma multiforme (GBM), which is the most prevalent form of brain cancer.
This new indication was granted U.S. FDA approval in March 2005, and has been
rapidly adopted by U.S. physicians. In June 2005, TEMODAR received approval from
the European Commission for use in combination with radiotherapy for GBM
patients in twenty-five member states as well as in Iceland and Norway.
Global net sales of INTEGRILIN Injection, a glycoprotein platelet
aggregation inhibitor for the treatment of patients with acute coronary
syndrome, which is sold primarily in the U.S. by Schering-Plough, decreased 8
percent to $86 million in the third quarter of 2005 due to unfavorable trade
inventory comparisons. Global net sales for the first nine months of 2005 were
$244 million compared to $245 million in the prior year.
Effective September 1, 2005, the Company restructured its INTEGRILIN
co-promotion agreement with Millennium Pharmaceuticals, Inc. ("Millennium").
Under the terms of the restructured agreement, the Company acquired exclusive
U.S. development and commercialization rights to INTEGRILIN in exchange for an
upfront payment of $36 million and royalties on INTEGRILIN sales. The
restructured agreement calls for minimum royalty payments of $85 million per
year to Millennium for 2006 and 2007. The Company also purchased existing
INTEGRILIN inventory from Millennium. The Company does not anticipate that this
restructured agreement will have an impact on sales or earnings, however, gross
margin is negatively impacted as the royalty payments under the restructured
agreement are reported as cost of sales. Selling, general and administrative
costs are favorably impacted due to the elimination of profit sharing payments
that had been reflected in these expenses in earlier periods.
Global net sales of REBETOL Capsules, for use in combination with INTRON A
or PEG-INTRON for treating hepatitis C, increased 58 percent to $82 million in
the third quarter of 2005 due primarily to the launch of the PEG-INTRON and
REBETOL combination therapy in Japan in December 2004. Sales in Japan benefited
from the significant number of patients who were waiting for approval of PEG-
INTRON before beginning combination treatment ("patient warehousing"). Global
sales of REBETOL decreased 1 percent to $237 million for the nine month period
due to the launch of generic versions of REBETOL in the U.S. in April 2004 and
increased price competition outside the U.S., partially offset by the favorable
impact of the aforementioned launch in Japan.
30
International net sales of prescription CLARITIN increased 13 percent to
$76 million in the third quarter of 2005 and 19 percent to $287 million for the
year-to-date period due to the launch of CLARITIN REDITABS in Japan coupled with
an unusually severe Japanese allergy season that may not recur in 2006.
Global net sales of INTRON A Injection, for chronic hepatitis B and C and
other antiviral and anticancer indications, decreased 11 percent to $72 million
in the third quarter of 2005 and 8 percent to $220 million for the first nine
months of 2005, due to the conversion to PEG-INTRON in Japan. Net sales in the
U.S. for the third quarter and the first nine months of 2005 increased $6
million and $23 million, respectively, reflecting favorable trade inventory
comparisons.
International sales of CAELYX, for the treatment of ovarian cancer,
metastatic breast cancer and Kaposi's sarcoma, increased 17 percent to $46
million in the third quarter of 2005 and 24 percent to $135 million for the
year-to-date period reflecting further adoption of the ovarian cancer and
metastatic breast cancer indications in patients who are at increased cardiac
risk.
International net sales of SUBUTEX Tablets, for the treatment of opiate
addiction, were $44 million in the third quarter of 2005 compared to $45 million
in the prior year. Net sales increased 9 percent to $148 million for the nine
month period due to increased market penetration. SUBUTEX may be vulnerable to
generic competition in the near future.
Net sales of AVELOX, a fluoroquinolone antibiotic for the treatment of
certain respiratory and skin infections, which is sold primarily in the U.S. by
Schering-Plough as a result of the Company's license agreement with Bayer, were
$41 million and $159 million for the third quarter and first nine months of
2005, respectively.
Net sales of CIPRO, a fluoroquinolone antibiotic for the treatment of
certain respiratory, skin, urinary tract and other infections, which is sold
primarily in the U.S. by Schering-Plough as a result of the Company's license
agreement with Bayer, were $41 million and $114 million for the third quarter
and first nine months of 2005, respectively.
Global net sales of ELOCON cream, a medium-potency topical steroid,
decreased 19 percent to $34 million in the third quarter of 2005 and 11 percent
to $113 million for the first nine months of 2005, reflecting generic
competition introduced in the U.S. during the first quarter of 2005. Generic
competition is expected to continue to adversely affect sales of this product.
Other pharmaceutical net sales include a large number of lower sales volume
prescription pharmaceutical products. Several of these products are sold in
limited markets outside the U.S., and many are multiple source products no
longer protected by patents. The products include treatments for respiratory,
cardiovascular, dermatological, infectious, oncological and other diseases.
Global net sales of Consumer Health Care products, which include OTC, foot
care and sun care products, decreased $4 million or 2 percent to $235 million in
the third quarter of 2005 and increased $27 million or 3 percent to $895 million
for the year-to-date period. Sales of OTC CLARITIN were $92 million in the third
quarter of 2005, a decrease of $18 million from 2004 reflecting the beginning of
the adverse impact on sales of CLARITIN-D due to recent restrictions on the
retail sale of OTC products containing pseudoephedrine (PSE). Sales of
CLARITIN-D may continue to be adversely affected by both recent and future
restrictions on the retail sale of such products. In addition, OTC CLARITIN
continues to face competition from private label and branded loratadine. Net
sales of sun care products increased $18 million in the third quarter and $24
million or 15 percent for the nine months ended September 30, 2005, primarily
due to the launch of new COPPERTONE CONTINUOUS SPRAY products coupled with a
stronger tanning season in the U.S. Third quarter net sales of foot care
products were essentially flat, and increased $6 million or 3 percent for the
nine months ended September 30, 2005 due primarily to the new MEMORY FIT and FOR
HER INSOLES and other insole products.
The Company sells numerous non-prescription upper respiratory products
which contain PSE, an FDA-approved ingredient for the relief of nasal
congestion. The Company's annual North American sales
31
of non-prescription upper respiratory products that contain PSE totaled
approximately $305 million in 2004, and $224 million and $226 million for the
nine months ended September 30, 2005 and 2004, respectively. These products
include all CLARITIN-D products as well as some DRIXORAL, CORICIDIN and
CHLOR-TRIMETON products. The Company understands that PSE has been used in the
illicit manufacture of methamphetamine, a dangerous and addictive drug. As of
October 2005, 38 states, Canada and Mexico have enacted regulations concerning
the non-prescription sale of products containing PSE, including limiting the
amount of these products that can be purchased at one time or requiring that
these products be located behind the pharmacist's counter, with the stated goal
of deterring the illicit/illegal manufacture of methamphetamine. An additional
two states have enacted limits on the quantity of PSE any person can possess.
One state has recently enacted legislation that regulates all PSE products to
prescription status. Also, the U.S. Federal government has proposed legislation
placing restrictions on the sale of products containing PSE. Further, major U.S.
retailers that are customers of the Company have announced that they may
voluntarily place non-prescription products containing PSE behind the pharmacist
counter at all of their stores, whether or not required by local law. For the
quarter ended September 30, 2005, sales of non-prescription PSE products were
down $24 million or approximately 28 percent as compared to the same period in
2004. The Company continues to monitor developments in this area that could have
a further negative impact on operations or financial results. It should be noted
that these regulations do not relate to the sale of prescription products, such
as CLARINEX-D products, that contain PSE.
Global net sales of Animal Health products increased 14 percent in the
third quarter of 2005 to $209 million and 17 percent to $629 million for the
year-to-date. The Company expects these growth rates to moderate. The increased
sales reflected higher sales of core brands across most geographic areas, led by
products serving the U.S. cattle market, and a favorable foreign exchange impact
of 1 percent for the third quarter and 3 percent for the year-to-date.
Certain situations that had a positive impact on sales and net income in
2005 may not recur in 2006. These include the positive effect of foreign
exchange, the "patient warehousing" benefit to PEG-INTRON and REBETOL related to
the launch of PEG-INTRON in Japan, and an unusually severe allergy season in
Japan that benefited the reported sales of prescription CLARITIN. Generic
Allegra (fexofenadine) was introduced in the U.S. during 2005, which will likely
have a negative impact on U.S. CLARINEX sales in 2006. In addition, growth of
REMICADE may also be affected by increased competition.
32
COSTS, EXPENSES AND EQUITY INCOME
A summary of costs, expenses and equity income for the three and nine
months ended September 30, 2005 and 2004 follows:
<Table>
<Caption>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------------- ----------------------------
% INCREASE % INCREASE
2005 2004 (DECREASE) 2005 2004 (DECREASE)
------ ----- ---------- ------ ------ ----------
(DOLLARS IN MILLIONS)
Cost of sales.................. $ 775 $ 711 9% $2,531 $2,241 13%
% of net sales................. 34.0% 35.9% 35.2% 36.8%
Selling, general and
administrative............... $1,064 $ 892 19% $3,261 $2,785 17%
% of net sales................. 46.6% 45.1% 45.4% 45.7%
Research and development....... $ 566 $ 378 50% $1,391 $1,201 16%
% of net sales................. 24.8% 19.1% 19.4% 19.7%
Other expense, net............. $ 0 $ 34 N/M $ 9 $ 112 N/M
% of net sales................. 0% 1.7% 0.1% 1.8%
Special charge................. $ 6 $ 26 N/M $ 292 $ 138 N/M
% of net sales................. 0.3% 1.3% 4.1% 2.3%
Equity income from cholesterol
joint venture................ $ (215) $ (95) N/M $ (605) $ (249) N/M
</Table>
- ---------------
N/M -- Not a meaningful percentage.
Cost of sales as a percentage of net sales decreased to 34.0 percent
compared to 35.9 percent in the third quarter of 2004, with the improvement
primarily stemming from supply chain process improvements and a positive impact
from foreign exchange, partly offset by higher royalties related to the Bayer
products and the impact of the restructured agreement for INTEGRILIN, which
became effective September 1, 2005. Cost of sales as a percentage of net sales
for the first nine months of 2005 decreased to 35.2 percent, compared to 36.8
percent for the first nine months of 2004. This improvement was due primarily to
supply chain process improvements, increased sales of higher-margin products and
a positive impact from foreign exchange, partly offset by higher royalties
related to the Bayer products. The restructuring of the INTEGRILIN agreement,
effective September 1, will have substantially offsetting effects, generally
increasing cost of sales due to increased royalties offset by reduced selling
general and administrative expenses.
Substantially all the sales of cholesterol products are not included in the
Company's net sales. The results of the operations of the joint venture are
reflected in equity income and have no impact on the Company's gross and other
operating margins.
Selling, general and administrative expenses (SG&A) increased 19 percent to
$1.1 billion in the third quarter and 17 percent to $3.3 billion year-to-date
versus $0.9 billion and $2.8 billion for the third quarter and first nine months
of 2004, respectively. These increases were primarily due to the addition in the
2004 fourth quarter of Bayer sales representatives, increased selling expenses
in Europe to support the continued launch of VYTORIN and ZETIA, and increased
promotional spending, primarily for NASONEX and ASMANEX. As a result of the
increased spending, the third quarter ratio to net sales increased to 46.6
percent compared to 45.1 percent in the third quarter of 2004. The year-to-date
2005 ratio to net sales decreased from 45.7 percent for the same period in 2004
to 45.4 percent, as a result of the higher sales levels.
The Company has had several regulatory product successes in recent months,
including the approval and launch of ASMANEX, which have resulted in new
promotional opportunities. This may increase promotional spending during the
remainder of 2005 and continuing through at least 2006.
33
Research and development (R&D) spending increased 50 percent to $566
million in the third quarter of 2005 and 16 percent to $1.4 billion
year-to-date, representing 24.8 percent and 19.4 percent of net sales,
respectively. R&D spending for the third quarter and first nine months of 2005
include a $124 million charge in conjunction with the Company's exercise of its
rights to develop and commercialize golimumab. R&D spending for the first nine
months of 2004 included an $80 million charge in conjunction with the license
from Toyama Chemical Company Ltd. for garenoxacin. Generally, changes in R&D
spending reflect the timing of the Company's funding of both internal research
efforts and research collaborations with various partners to discover and
develop a steady flow of innovative products. The Company expects R&D spending
in subsequent quarters to increase as compared to prior years, reflecting the
timing of clinical trials and the progression of the Company's early-stage
pipeline.
The decrease in other expense, net, for the three and nine months ended
September 30, 2005 reflects higher net interest income due to higher interest
rates.
SPECIAL CHARGES
The components of Special Charges for the three and nine months ended
September 30, 2005 and 2004 are as follows:
<Table>
<Caption>
THREE MONTHS
ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
----------------- -----------------
2005 2004 2005 2004
----- ---- ----- -----
(DOLLARS IN MILLIONS)
Litigation..................................... $ -- $-- $250 $ --
Employee termination costs..................... 0 25 26 111
Asset impairment and other charges............. 6 1 16 27
----- --- ---- ----
$ 6 $26 $292 $138
===== === ==== ====
</Table>
LITIGATION CHARGES
Litigation charges for the nine months ended September 30, 2005 were $250
million related to an increase in litigation reserves. This increase during the
second quarter of 2005 resulted in a total reserve of $500 million for the
Massachusetts investigation as well as the previously disclosed investigations
and litigation relating to the Company's practices regarding average wholesale
price by the Department of Justice and certain states, representing the
Company's current estimate to resolve this matter. Additional information
regarding litigation reserves is also included in Note 16 "Legal, Environmental
and Regulatory Matters" in the Notes to Condensed Consolidated Financial
Statements.
EMPLOYEE TERMINATION COSTS
In August 2003, the Company announced a global workforce reduction
initiative. The first phase of this initiative was a Voluntary Early Retirement
Program (VERP) in the U.S. Under this program, eligible employees in the U.S.
had until December 15, 2003 to elect early retirement and receive an enhanced
retirement benefit. Approximately 900 employees elected to retire under the
program, of which approximately 850 employees retired through year end 2004 and
approximately 50 employees have staggered retirement dates in 2005. The total
cost of this program is approximately $191 million, comprised of increased
pension costs of $108 million, increased post-retirement health care costs of
$57 million, vacation payments of $4 million and costs related to accelerated
vesting of stock grants of $22 million. For employees with staggered retirement
dates in 2005, these amounts will be recognized as a charge over the employees'
remaining service periods. Amounts recognized during the three and nine months
ended September 30, 2005 were $2 million and $5 million, respectively, compared
to $2 million and $19 million, respectively, during the same periods in the
prior year. The amount expected to be recognized in the remainder of 2005 is $2
million.
34
Employee termination costs not associated with the VERP totaled ($2)
million and $21 million for the three and nine months ended September 30, 2005,
compared to $23 million and $92 million, respectively, during the same periods
of 2004. The termination costs in 2005 related primarily to employee termination
costs at a manufacturing facility.
The following summarizes the activity in the accounts related to employee
termination costs:
<Table>
<Caption>
EMPLOYEE TERMINATION COSTS 2005 2004
- -------------------------- ------- -------
(DOLLARS IN MILLIONS)
Special charges liability balance at December 31, 2004 and
2003, respectively........................................ $ 18 $ 29
Special charges incurred during nine months ended September
30,....................................................... 26 111
Credit to retirement benefit plan liability during the nine
months ended September 30,................................ (5) (19)
Disbursements during the nine months ended September 30,.... (23) (78)
---- ----
Special charges liability balance at September 30,.......... $ 16 $ 43
==== ====
</Table>
ASSET IMPAIRMENT AND OTHER CHARGES
The Company recorded asset impairment and other charges of $6 million and
$16 million in the third quarter and first nine months of 2005, respectively.
The charges in 2005 related primarily to the consolidation of the Company's U.S.
biotechnology organizations. For the nine months ended September 30, 2004, the
Company recognized asset impairment charges of $27 million related primarily to
the shutdown of a small European research and development facility.
EQUITY INCOME FROM CHOLESTEROL JOINT VENTURE
Global cholesterol franchise sales, which include sales made by the Company
and the cholesterol joint venture with Merck of VYTORIN and ZETIA, totaled $622
million in the third quarter of 2005 and $1.6 billion year-to-date, compared
with sales of $344 million and $780 million in the third quarter and first nine
months of 2004, respectively. The 2005 year-to-date sales comparison benefited
from the U.S. launch of VYTORIN in the second half of 2004. In the U.S., as of
September 30, 2005, VYTORIN and ZETIA accounted for 13 percent of the
lipid-lowering prescription market. VYTORIN has been launched in more than 20
countries, including the U.S. in July 2004. ZETIA has been launched in more than
60 countries.
The Company utilizes the equity method of accounting for the joint venture.
Sharing of income from operations is based upon percentages that vary by
product, sales level and country. Schering-Plough's allocation of joint venture
income is increased by milestones earned. The partners bear the costs of their
own general sales forces and commercial overhead in marketing joint venture
products around the world. In the U.S., Canada and Puerto Rico, the joint
venture reimburses each partner for a pre-defined amount of physician details
that are set on an annual basis. Schering-Plough reports this reimbursement as
part of equity income from the cholesterol joint venture. This is because under
U.S. GAAP this reimbursement does not represent a reimbursement of specific,
incremental and identifiable costs for the Company's detailing of the
cholesterol products in these markets. In addition, this reimbursement amount is
not reflective of Schering-Plough's sales effort related to the joint venture as
Schering-Plough's sales force and related costs associated with the joint
venture are generally estimated to be higher.
Costs of the joint venture that the partners contractually share are a
portion of manufacturing costs, specifically identified promotion costs
(including direct-to-consumer advertising and direct and identifiable
out-of-pocket promotion) and other agreed upon costs for specific services such
as market support, market research, market expansion, a specialty sales force
and physician education programs.
Certain specified research and development expenses are generally shared
equally by the partners.
Equity income from the cholesterol joint venture, totaled $215 million and
$605 million in the third quarter and year-to-date 2005, respectively. For the
third quarter and year-to-date 2004, equity income
35
from the cholesterol joint venture totaled $95 million and $249 million,
respectively. 2005 year-to-date equity income comparison benefited from the U.S.
launch of VYTORIN in the second half of 2004.
During the first nine months of 2005, the Company earned a milestone of $20
million. This milestone related to certain European approvals of VYTORIN
(ezetimibe/simvastatin) in the first quarter of 2005.
During the first nine months of 2004, the Company earned and recognized a
milestone of $7 million related to the approval of ezetimibe/simvastatin in
Mexico in 2004.
Under certain other conditions, as specified in the partnership agreements
with Merck, the Company could earn additional milestones totaling $105 million.
In addition to the milestone recognized in the first nine months of 2005,
the Company's equity income in the first nine months of 2005 was favorably
impacted by the proportionally greater share of income allocated from the joint
venture for the first $300 million of annual ZETIA sales.
It should be noted that the Company incurs substantial selling, general and
administrative and other costs, which are not reflected in equity income from
the cholesterol joint venture and instead are included in the overall cost
structure of the Company.
In the second quarter of 2005, the Merck/Schering-Plough Cholesterol
Partnership entered into inventory management agreements with the major U.S.
pharmaceutical wholesalers for VYTORIN and ZETIA.
PROVISION FOR INCOME TAXES
At December 31, 2004, the Company had approximately $1 billion of U.S. Net
Operating Losses (U.S. NOLs) for tax purposes available to offset future U.S.
taxable income through 2024. The Company generated additional U.S. NOLs during
the nine months ended September 30, 2005.
The Company's tax provision for the nine month period ended September 30,
2005 includes a benefit of approximately $42 million related to tax expense
recorded in 2004 related to planned earnings repatriations under the AJCA. This
revision of the costs associated with repatriation under the AJCA is the result
of guidance issued by the U.S. Treasury in August 2005.
Overall income tax expense, net of the benefit described above, primarily
relates to foreign taxes and does not include any benefit related to U.S. NOLs.
The Company has established a valuation allowance on net U.S. deferred tax
assets, including the benefit of U.S. NOLs, as management cannot conclude that
it is more likely than not that the benefit of U.S. net deferred tax assets can
be realized.
During the third quarter of 2005, the Company made a cash payment (tax
deposit) of approximately $239 million in anticipation of the settlement of
certain tax contingencies for tax years 1993 through 1996. The Company believes
that existing tax reserves are adequate to cover these matters.
NET INCOME/(LOSS) AVAILABLE TO COMMON SHAREHOLDERS
Net income available to common shareholders for the third quarter and
year-to-date 2005 includes the deduction of preferred stock dividends of $22
million and $65 million, respectively, related to the issuance of the 6%
Mandatory Convertible Preferred Stock in August 2004. Net income available to
common shareholders for the third quarter and year-to-date 2004 includes the
deduction of preferred stock dividends of $12 million.
36
LIQUIDITY AND FINANCIAL RESOURCES
DISCUSSION OF CASH FLOW
<Table>
<Caption>
NINE MONTHS ENDED
SEPTEMBER 30,
----------------------
2005 2004
---------- --------
(DOLLARS IN MILLIONS)
Cash flow from operating activities......................... $ 546 $ 9
Cash flow from investing activities......................... 138 (478)
Cash flow from financing activities......................... (1,465) 936
</Table>
During the period from 2003 through 2005, the Company's cash flow declined
significantly. The overriding cause of this was the loss of marketing
exclusivity for two of the Company's major pharmaceutical products, CLARITIN and
REBETOL, as well as increased competition in the hepatitis C market.
In the first nine months of 2005, operating activities generated $546
million of cash, compared with $9 million in the first nine months of 2004. The
increase was primarily due to higher net income and timing of payments of
special charges partially offset by an increase in accounts receivable due to
sales growth, payments to taxing authorities for tax liabilities related to the
repatriation of foreign earnings under the AJCA of approximately $230 million
and tax deposits in the amount of $239 million for the anticipated settlement of
certain tax contingencies for the tax years 1993 through 1996. Additional
payments for tax liabilities related to the AJCA repatriations will be required
in the fourth quarter of 2005. Tax charges related to the AJCA were expensed in
2004. A U.S. tax refund of $404 million as a result of loss carryback benefits
favorably impacted operating cash flow in 2004. In addition, a $473 million
payment to the U.S. government for a tax deficiency related to certain
transactions in tax years 1991 to 1992 unfavorably impacted cash flow in 2004.
Net cash provided by investing activities during the first nine months of
2005 was $138 million primarily related to the reduction in short-term
investments of $438 million and proceeds from sales of property and equipment of
$41 million offset by $293 million of capital expenditures and purchase of
intangible assets of $48 million. Net cash used for investing activities for the
first nine months of 2004 was $478 million and included purchases of investments
of $294 million and capital expenditures of $299 million, partially offset by
cash proceeds of $118 million from the transfer of license rights.
Net cash used for financing activities was $1.5 billion for the first nine
months of 2005, compared to net cash provided by financing activities of $936
million for the same period in the prior year. Uses of cash for financing
activities in 2005 includes the payment of dividends on common and preferred
shares of $308 million and the repayment of $1.2 billion of commercial paper
borrowings. The net cash provided in the prior year reflected proceeds of $1.4
billion from the preferred stock issuance partially offset by the payment of
dividends on common shares of $243 million and the net repayment of commercial
paper and other short term borrowings of $173 million.
During 2004, operating activities on a worldwide basis generated
insufficient cash to fund capital expenditures and dividends. Due to the
geographic mix of product sales and profits and the corporate and R&D cash
requirements in the U.S., this annual cash flow deficit is particularly
pronounced when disaggregated on a geographic basis. Foreign operations generate
cash in excess of local cash needs. The U.S. operations must fund dividend
payments, the vast majority of research and development costs and U.S. capital
expenditures. The Company borrowed funds and issued equity securities during
2004 to finance U.S. operations, and continued to accumulate cash in its
foreign-based subsidiaries.
On an annual basis in 2005, management expects that dividends and capital
expenditures on a worldwide basis may again exceed cash generated from operating
activities and that U.S. operations will continue to generate negative cash
flow. Future payments regarding litigation, investigations and/or tax
assessments will likely increase cash needs.
37
As the Company's financial situation has begun to improve, the Company is
moving forward with additional investments to enhance its infrastructure and
business. This includes expected capital expenditures of up to $300 million over
the next several years for a pharmaceutical sciences center. The center will
allow the Company to streamline and integrate the Company's drug development
process, where products are moved from the drug discovery pipeline to market.
There will be additional related expenditures to upgrade equipment and staffing
for the center.
Cash requirements in the U.S. during the first nine months of 2005
including operating cash needs, capital expenditures and dividends on common and
preferred shares approximated $1.7 billion. During the first half of 2005 the
Company began the process of repatriating approximately $9.4 billion of
previously unremitted foreign earnings pursuant to the AJCA. The repatriations
of qualified funds under the AJCA are expected to fund U.S. cash needs for the
intermediate term.
The funding of additional anticipated repatriations under the AJCA during
2005 will require the utilization of substantially all of the Company's current
and anticipated 2005 foreign cash and short-term investments, and may
necessitate a limited amount of borrowing by certain foreign subsidiaries in
order to fully fund dividends repatriated under the AJCA. The Company has the
ability to factor selected international accounts receivable, arrange new credit
facilities, or utilize its $1.5 billion revolving bank credit facility to
provide additional liquidity to fund the repatriations or provide working
capital to its foreign subsidiaries until such time as non-U.S. cash and
short-term investment balances are restored.
Total cash, cash equivalents and short-term investments less total debt was
approximately $1.9 billion at September 30, 2005.
BORROWINGS AND CREDIT FACILITIES
On November 26, 2003, the Company issued $1.25 billion aggregate principal
amount of 5.3% senior unsecured Notes due 2013 and $1.15 billion aggregate
principal amount of 6.5% senior unsecured Notes due 2033 (collectively the
Notes). Proceeds from this offering of $2.4 billion were used for general
corporate purposes, including repaying commercial paper outstanding in the U.S.
Upon issuance, the Notes were rated A3 by Moody's Investors Service (Moody's)
and A+ (on Credit Watch with negative implications) by Standard & Poor's (S&P).
The interest rates payable on the Notes are subject to adjustment. If the rating
assigned to the Notes by either Moody's or S&P is downgraded below A3 or A-,
respectively, the interest rate payable on that series of Notes would increase.
See Note 13 "Short and Long-Term Debt and Other Commitments" to the Condensed
Consolidated Financial Statements for additional information.
On July 14, 2004, Moody's lowered its rating on the Notes to Baa1.
Accordingly, the interest payable on each note increased 25 basis points
effective December 1, 2004. Therefore, on December 1, 2004, the interest rate
payable on the Notes due 2013 increased from 5.3% to 5.55%, and the interest
rate payable on the Notes due 2033 increased from 6.5% to 6.75%. This adjustment
to the interest rate payable on the Notes will increase the Company's interest
expense by approximately $6 million annually.
The Company has a revolving credit facility from a syndicate of major
financial institutions. During March 2005, the Company negotiated an increase in
the bank commitments under this credit facility from $1.25 billion to $1.5
billion with no changes in the basic terms of the pre-existing credit facility.
Concurrently with the increase in commitments under this facility, the Company
terminated early a separate $250 million line of credit which would have matured
in May 2006. There was no outstanding balance under this facility at the time it
was terminated.
The existing $1.5 billion credit facility matures in May 2009 and requires
the Company to maintain a total debt to capital ratio of no more than 60
percent. This credit line is available for general corporate purposes and is
considered as support to the Company's commercial paper borrowings. Borrowings
under the credit facility may be drawn by the U.S. parent company or by its
wholly-owned foreign subsidiaries when accompanied by a parent guarantee. This
facility does not require compensating balances; however, a
38
nominal commitment fee is paid. As of September 30, 2005, no funds have been
drawn down under this facility. The Company may utilize this facility to fund
repatriations under the AJCA or to provide additional liquidity or working
capital to its foreign subsidiaries until such time as non-U.S. cash and
investment balances are restored. However, any borrowing under the facility to
fund repatriations will occur only to the extent the facility is not otherwise
necessary to support commercial paper borrowings.
At September 30, 2005, short-term borrowings totaled approximately $361
million. The commercial paper ratings discussed below have not significantly
affected the Company's ability to issue or rollover its outstanding commercial
paper borrowings at this time. However, the Company believes the ability of
commercial paper issuers, such as the Company, with one or more short-term
credit ratings of P-2 from Moody's, A-2 from S&P and/or F2 from Fitch Ratings
(Fitch) to issue or rollover outstanding commercial paper can, at times, be less
than that of companies with higher short-term credit ratings. In addition, the
total amount of commercial paper capacity available to such issuers is typically
less than that of higher-rated companies. The Company maintains sizable lines of
credit with commercial banks, as well as cash and short-term investments held by
U.S. and foreign-based subsidiaries, to serve as alternative sources of
liquidity and to support its commercial paper program.
The Company's current unsecured senior credit ratings and outlook are as
follows:
<Table>
<Caption>
SENIOR UNSECURED
CREDIT RATINGS LONG-TERM SHORT-TERM OUTLOOK
- ---------------- --------- ---------- --------
Moody's Investors Service............................ Baa1 P-2 Negative
Standard & Poor's.................................... A- A-2 Negative
Fitch Ratings........................................ A- F-2 Negative
</Table>
The Company's credit ratings could decline below their current levels. The
impact of such decline could reduce the availability of commercial paper
borrowing and would increase the interest rate on the Company's long-term debt.
As discussed above, the Company believes that the repatriation of funds under
the AJCA of 2004 will allow the Company to fund its U.S. cash needs for the
intermediate term.
FINANCIAL ARRANGEMENTS CONTAINING CREDIT RATING DOWNGRADE TRIGGERS
The Company had an interest rate swap arrangement in effect with a
counterparty bank. The arrangement utilized two long-term interest rate swap
contracts, one between a foreign-based subsidiary of the Company and a bank and
the other between a U.S. subsidiary of the Company and the same bank. The two
contracts had equal and offsetting terms and were covered by a master netting
arrangement. The contract involving the foreign-based subsidiary permitted the
subsidiary to prepay a portion of its future obligation to the bank, and the
contract involving the U.S. subsidiary permitted the bank to prepay a portion of
its future obligation to the U.S. subsidiary. Prepayments totaling $1.9 billion
were made under both contracts as of December 31, 2004.
The terms of the swap contracts, as amended, called for a phased
termination of the swaps based on an agreed repayment schedule that was to begin
no later than March 31, 2005. Termination would require the Company and the
counterparty each to repay all prepayments pursuant to the agreed repayment
schedule. The Company, at its option, was allowed to accelerate the termination
of the arrangement and associated scheduled repayments for a nominal fee.
On February 28, 2005, the Company's foreign-based subsidiary and U.S.
subsidiary each gave notice to the counterparty of their intent to terminate the
arrangement. On March 21, 2005, the Company terminated these swap agreements and
all associated repayments were made by the respective obligors. The termination
of this arrangement did not have a material impact on the Company's Statement of
Condensed Consolidated Operations.
39
REGULATORY AND COMPETITIVE ENVIRONMENT IN WHICH THE COMPANY OPERATES
The Company is subject to the jurisdiction of various national, state and
local regulatory agencies and is, therefore, subject to potential administrative
actions. The FDA in the U.S. is particularly important. It is a central
regulator of the Company's business and has jurisdiction over all the Company's
businesses and administers requirements covering the testing, safety,
effectiveness, approval, manufacturing, labeling and marketing of the Company's
products. From time to time, agencies, including the FDA, may require the
Company to address various manufacturing, advertising, labeling or other
regulatory issues, such as those noted below relating to the Company's current
manufacturing issues. Failure to comply with governmental regulations can result
in delays in the release of products, seizure or recall of products, suspension
or revocation of the authority necessary for the production and sale of
products, discontinuance of products, fines and other civil or criminal
sanctions. Any such result could have a material adverse effect on the Company's
financial position and its results of operations. Additional information
regarding government regulations that may affect future results is provided in
Part I, Item I, Business, in the Company's 2004 10-K. Additional information
about cautionary factors that may affect future results is provided under the
caption "Cautionary Factors That May Affect Future Results (Cautionary
Statements Under the Private Securities Litigation Reform Act of 1995)" in this
Management's Discussion and Analysis of Financial Condition and Results of
Operations.
Since 2001, the Company has been working with the FDA to resolve issues
involving the Company's compliance with current Good Manufacturing Practices
(cGMP) at certain of its manufacturing sites in New Jersey and Puerto Rico. As
described in more detail in Note 15 "Consent Decree" to the Condensed
Consolidated Financial Statements, in 2002, the Company reached a formal
agreement with the FDA to enter into a consent decree. Under the terms of the
consent decree, the Company made payments totaling $500 million and agreed to
revalidate the manufacturing processes at these sites. These manufacturing sites
have remained open throughout this period; however, the consent decree has
placed significant additional controls on production and release of products
from these sites, including review and third-party certification of production
activities. The third-party certifications and other cGMP improvement projects
have resulted in higher costs as well as reduced output at these facilities. In
addition, the Company has found it necessary to discontinue certain profitable
older products. The Company's research and development operations have also been
negatively impacted by the decree because these operations share common
facilities with the manufacturing operations.
The consent decree requires the Company to complete a number of actions,
including completion of a comprehensive cGMP Workplan for the Company's
manufacturing facilities in New Jersey and Puerto Rico that are covered by the
decree and revalidation programs of the finished drug products and bulk active
pharmaceutical ingredients manufactured at the covered manufacturing facilities.
The Company continues to make steady progress in fulfilling consent decree
obligations with the FDA. The Company completed the revalidation programs for
bulk active pharmaceutical ingredients by September 30, 2005, as required, and
is working toward its goal of completing the cGMP Workplan and revalidation of
finished drugs by December 31, 2005 in order to be in a position to request by
May of 2007 to have the decree lifted. As described in more detail in Note 15
"Consent Decree" to the Condensed Consolidated Financial Statements, in the
event certain actions agreed upon in the consent decree are not satisfactorily
completed on time, the FDA may assess payments for each deadline missed.
Although the Company believes it has made significant progress in meeting
its obligations under the consent decree, it is possible that the Company may
fail to complete a Significant Step or a revalidation by the prescribed
deadline, the third-party expert may not certify the completion of the
Significant Step or revalidation, or the FDA may disagree with an expert's
certification of a Significant Step or revalidation. In such a case, it is
possible that the FDA may assess payments as described in Note 15.
Recently, clinical trials and post-marketing surveillance of certain
marketed drugs within the industry have raised safety concerns that have led to
recalls, withdrawals or adverse labeling of marketed products. In addition,
these situations have raised concerns among some prescribers and patients
relating to the safety and efficacy of pharmaceutical products in general. The
Company maintains a process for
40
monitoring and addressing adverse events and other new data relating to its
products around the world. In addition, Company personnel have regular, open
dialogue with the FDA and other regulators and review product labels and other
materials on a regular basis and as new information becomes known.
Uncertainties inherent in government regulatory approval processes,
including, among other things, delays in approval of new products, formulations
or indications, may also affect the Company's operations. The effect of
regulatory approval processes on operations cannot be predicted.
As described more specifically in Note 16 "Legal, Environmental and
Regulatory Matters" to the Condensed Consolidated Financial Statements, the
pricing, sales and marketing programs and arrangements, and related business
practices of the Company and other participants in the health care industry are
under increasing scrutiny from federal and state regulatory, investigative,
prosecutorial and administrative entities. These entities include the Department
of Justice and its U.S. Attorney's Offices, the Office of Inspector General of
the Department of Health and Human Services, the FDA, the Federal Trade
Commission (FTC) and various state Attorneys General offices. Many of the health
care laws under which certain of these governmental entities operate, including
the federal and state anti-kickback statutes and statutory and common law false
claims laws, have been construed broadly by the courts and permit the government
entities to exercise significant discretion. In the event that any of those
governmental entities believes that wrongdoing has occurred, one or more of them
could institute civil or criminal proceedings, which, if instituted and resolved
unfavorably, could subject the Company to substantial fines, penalties and
injunctive or administrative remedies, including exclusion from government
reimbursement programs. The Company also cannot predict whether any
investigations will affect its marketing practices or sales. Any such result
could have a material adverse impact on the Company's results of operations,
cash flows, financial condition, or its business.
In the U.S., many of the Company's pharmaceutical products are subject to
increasingly competitive pricing as managed care groups, institutions,
government agencies and other groups seek price discounts. In the U.S. market,
the Company and other pharmaceutical manufacturers are required to provide
statutorily defined rebates to various government agencies in order to
participate in Medicaid, the veterans' health care program and other
government-funded programs.
In most international markets, the Company operates in an environment of
government-mandated cost-containment programs. Several governments have placed
restrictions on physician prescription levels and patient reimbursements,
emphasized greater use of generic drugs and enacted across-the-board price cuts
as methods to control costs. For example, Japan generally enacts biennial price
reductions and this is expected to occur in 2006. Pricing actions may also occur
in 2006 in certain major European markets.
Since the Company is unable to predict the final form and timing of any
future domestic or international governmental or other health care initiatives,
including the passage of laws permitting the importation of pharmaceuticals into
the U.S., their effect on operations and cash flows cannot be reasonably
estimated. Similarly, the effect on operations and cash flows of decisions of
government entities, managed care groups and other groups concerning formularies
and pharmaceutical reimbursement policies cannot be reasonably estimated.
The Company cannot predict what net effect the Medicare prescription drug
benefit will have on markets and sales. The new Medicare Drug Benefit (Medicare
Part D), which will take effect January 1, 2006, will offer voluntary
prescription drug coverage, subsidized by Medicare, to over 40 million Medicare
beneficiaries through competing private prescription drug plans (PDPs) and
Medicare Advantage (MA) plans. Many of the Company's leading drugs are already
covered under Medicare Part B (e.g., TEMODAR, INTEGRILIN and INTRON A). Medicare
Part B provides payment for physician services which can include prescription
drugs administered incident to a physician's services. The manner in which drugs
are reimbursed under Medicare Part B may limit Schering-Plough's ability to
offer larger price concessions or make large price increases on these drugs.
Other Schering-Plough drugs have a relatively small portion of their sales to
the Medicare population (e.g., CLARINEX, the hepatitis C franchise). The Company
could experience expanded utilization of VYTORIN and ZETIA and new drugs in the
41
Company's R&D pipeline. Of greater consequence for the Company may be the
legislation's impact on pricing, rebates and discounts.
The Company is subject to pharmacovigilance reporting requirements in many
countries and other jurisdictions, including the U.S., the European Union (EU)
and the EU member states. The requirements differ from jurisdiction to
jurisdiction, but all include requirements for reporting adverse events that
occur while a patient is using a particular drug in order to alert the
manufacturer of the drug and the governmental agency to potential problems.
During 2003, pharmacovigilance inspections by officials of the British and
French medicines agencies conducted at the request of the European Agency for
the Evaluation of Medicinal Products (EMEA) resulted in serious deficiencies in
reporting processes. The Company continues to work on its action plan to rectify
the deficiencies and provides regular updates to the EMEA. The Company does not
know what action, if any, the EMEA or national authorities will take in response
to these findings. Possible actions include further inspections, demands for
improvements in reporting systems, criminal sanctions against the Company and/or
responsible individuals and changes in the conditions of marketing
authorizations for the Company's products.
The market for pharmaceutical products is competitive. The Company's
operations may be affected by technological advances of competitors, industry
consolidation, patents granted to competitors, competitive combination products,
new products of competitors, new information from clinical trials of marketed
products or post-marketing surveillance and generic competition as the Company's
products mature. In addition, patent positions are increasingly being challenged
by competitors, and the outcome can be highly uncertain. An adverse result in a
patent dispute can preclude commercialization of products or negatively affect
sales of existing products. The effect on operations of competitive factors and
patent disputes cannot be predicted.
The Company launched OTC CLARITIN in the U.S. in December 2002. Also in
December 2002, a competing OTC loratadine product was launched in the U.S. and
private-label competition was introduced. The prescription allergy market has
been shrinking since that time. The Company continues to market prescription
CLARINEX (desloratadine) 5 mg Tablets for the treatment of allergic rhinitis.
CLARINEX is experiencing intense competition in the prescription U.S. allergy
market.
PEG-INTRON (pegylated interferon) and REBETOL (ribavirin) combination
therapy for hepatitis C has contributed substantially to sales in 2003 and 2002
and to a lesser extent in 2004. During the fourth quarter of 2002, a competing
pegylated interferon-based combination product, including a brand of ribavirin,
received regulatory approval in most major markets, including the U.S. The
overall market share of the hepatitis C franchise has declined sharply,
reflecting this new market competition. In addition, the overall market has
contracted. Management believes that the ability of PEG-INTRON and REBETOL
combination therapy to maintain market share in the international market will
continue to be adversely affected by competition in the hepatitis C marketplace.
In 2005, the Company is experiencing growth in worldwide PEG-INTRON sales due to
the launch of PEG-INTRON plus REBETOL combination therapy in Japan.
Generic forms of ribavirin entered the U.S. market in April 2004. In
October 2004, another generic ribavirin was approved by the FDA. The generic
forms of ribavirin compete with the Company's REBETOL Capsules in the U.S. U.S.
sales were insignificant in 2005. Prior to the second half of 2004, the REBETOL
patents were material to the Company's business.
As a result of the introduction of a competitor for pegylated interferon
and the introduction of generic ribavirin, the value of an important Company
product franchise has been severely diminished and earnings and cash flow have
been materially and negatively impacted.
IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
In November 2004, the Financial Accounting Standard Board (FASB) issued
Statement of Financial Accounting Standard (SFAS) 151, "Inventory Costs." This
SFAS requires that abnormal spoilage be
42
expensed in the period incurred (as opposed to inventoried and amortized to
income over inventory usage) and that fixed production facility overhead costs
be allocated over the normal production level of a facility. This SFAS is
effective for inventory costs incurred for annual periods beginning after June
15, 2005. The Company does not anticipate any material impact from the
implementation of this accounting standard.
In December 2004, the FASB issued SFAS 123R (Revised 2004), "Share-Based
Payment." SFAS 123R requires companies to recognize compensation expense in an
amount equal to the fair value of all share-based payments granted to employees.
The Company is required to implement this SFAS in the first quarter of 2006 by
recognizing compensation on all share-based grants made on or after January 1,
2006, and for the unvested portion of share-based grants made prior to January
1, 2006. The Company continues to evaluate the impact of SFAS 123R on all of its
share-based payment plans. This evaluation includes the valuation of stock
options and all other stock based performance plans, which are subject to a
number of assumptions and changes in future market conditions, including the
Company's stock price.
In March 2005, the FASB issued Interpretation No. 47 for SFAS 143
"Accounting for Conditional Asset Retirement Obligations" to clarify that the
term "conditional asset retirement obligations", as used in SFAS 143. This term
refers to a legal obligation to perform an asset retirement activity in which
the timing and/or method of settlement are conditional on a future event that
may or may not be within the control of the entity. Accordingly, an entity is
required to recognize liability for the fair value of a conditional asset
retirement obligation if the fair value of the liability can be reasonably
estimated. This interpretation is effective no later than the end of fiscal year
ending after December 15, 2005. Retrospective application is not required. The
Company is currently evaluating the effects of this interpretation.
CRITICAL ACCOUNTING POLICIES
Refer to "Management's Discussion and Analysis of Operations and Financial
Condition" in the Company's Annual Report on Form 10-K for the fiscal year ended
December 31, 2004 for disclosures regarding the Company's critical accounting
policies.
REBATES, DISCOUNTS AND RETURNS
The Company's rebate accruals for Federal and State governmental programs
were $184 million at September 30, 2005 and $155 million at December 31, 2004.
Commercial discounts, returns and other rebate accruals were $406 million at
September 30, 2005 and $382 million at December 31, 2004. These and other rebate
accruals are established in the period the related revenue was recognized
resulting in a reduction to sales and the establishment of liabilities, which
are included in total current liabilities.
43
The following summarizes the activity in the accounts related to accrued
rebates, sales returns and discounts:
<Table>
<Caption>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------- -----------------
2005 2004 2005 2004
------- ------- ------ ------
Accrued Rebates/Returns/Discounts, Beginning of
Period....................................... $ 602 $ 617 $ 537 $ 593
----- ----- ----- -----
Provision for Rebates.......................... 114 100 379 339
Payments....................................... (124) (127) (336) (388)
----- ----- ----- -----
(10) (27) 43 (49)
----- ----- ----- -----
Provision for Returns.......................... 21 94 120 287
Returns........................................ (37) (91) (127) (236)
----- ----- ----- -----
(16) 3 (7) 51
----- ----- ----- -----
Provision for Discounts........................ 118 30 308 168
Discounts granted.............................. (104) (40) (291) (180)
----- ----- ----- -----
14 (10) 17 (12)
----- ----- ----- -----
Accrued Rebates/Returns/Discounts, End of
Period....................................... $ 590 $ 583 $ 590 $ 583
===== ===== ===== =====
</Table>
Management makes estimates and uses assumptions in recording the above
accruals. Actual amounts paid in the current period were consistent with those
previously estimated. Certain prior year amounts have been conformed to reflect
current year presentation.
DISCLOSURE NOTICE
CAUTIONARY FACTORS THAT MAY AFFECT FUTURE RESULTS (CAUTIONARY STATEMENTS UNDER
THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995)
The disclosure in this report and other written reports and oral statements
made from time to time by the Company may contain forward-looking statements
within the meaning of the Private Securities Litigation Reform Act of 1995.
Forward-looking statements do not relate strictly to historical or current facts
and are based on current expectations or forecasts of future events. You can
identify these forward-looking statements by their use of words such as
"anticipate," "believe," "could," "estimate," "expect," "forecast," "project,"
"intend," "plan," "potential," "will," and other similar words and terms. In
particular, forward-looking statements include statements relating to future
actions, ability to access the capital markets, prospective products or product
approvals, future performance or results of current and anticipated products,
sales efforts, development programs, estimates of rebates, discounts and
returns, expenses and programs to reduce expenses, the cost of and savings from
reductions in work force, the outcome of contingencies such as litigation and
investigations, growth strategy and financial results.
Any or all forward-looking statements here or in other publications may
turn out to be wrong. There are no guarantees about the Company's financial and
operational performance or the performance of the Company's stock. The Company
does not assume the obligation to update any forward-looking statement. Many
factors could cause actual results to differ from the Company's forward-looking
statements. These factors include inaccurate assumptions and a broad variety of
other risks and uncertainties, including some that are known and some that are
not. Although it is not possible to predict or identify all such factors, they
may include the following:
- Cholesterol Franchise -- The ability of the Company to generate profits
and significant operating cash flow is directly and predominantly
dependent upon the increasing profitability of the Company's cholesterol
franchise. As existing products lose patent protection, generic forms of
some of the existing well-established cholesterol management products may
be introduced. The Company
44
cannot predict reasonably what effect the introduction of generic forms of
cholesterol management products may have on VYTORIN and ZETIA.
- Other Major Products -- Products such as CLARITIN, CLARINEX, INTRON A,
PEG-INTRON, REBETOL Capsules, REMICADE, TEMODAR and NASONEX accounted for
a material portion of the Company's 2004 revenues. The impact on revenue
could be significant if any major product was to be become subject to a
problem such as the loss of its patent protection, OTC availability of
the Company's product or a competitive product (as has been disclosed for
CLARITIN and its current and potential OTC competition) or the discovery
of previously unknown side effects; there is increased competition with
the introduction of new, more effective treatment or the generic
availability of competitive products; or the product is discontinued for
any reason.
- Uncertain Pharmaceutical Product Development -- Products that appear
promising in development may fail to reach market for numerous reasons.
They may be found to be ineffective or to have harmful side effects in
clinical or pre-clinical testing, they may fail to receive the necessary
regulatory approvals, they may turn out not to be economically feasible
because of manufacturing costs or other factors or they may be precluded
from commercialization by the proprietary rights of others.
- Uncertain Regulatory and Approval Process -- There are uncertainties in
the regulatory and approval process in the U.S. and other countries,
including delays in the approval of new products and new indications and
uncertainties in the FDA approval process and uncertainties concerning
regulatory decisions regarding labeling and other matters.
- Post-Market Development -- Once a product is approved and marketed,
clinical trials of marketed products or post-marketing surveillance may
raise efficacy or safety concerns. Whether or not scientifically
justified, this new information could lead to recalls, withdrawals or
adverse labeling of marketed products, which may negatively impact sales.
Concerns of prescribers or patients relating to the safety or efficacy of
the Company's products, or other companies' products or pharmaceutical
products generally, may also negatively impact sales.
- Limited Opportunities for Obtaining or Licensing Critical Late-Stage
Products -- It may be challenging for the Company to acquire or license
critical late-stage products because it competes for these opportunities
against companies often with greater financial resources than the
Company.
- Competitive Factors -- Competitive developments that impact the Company
include technological advances by, patents granted to, and new products
developed by competitors and new and existing generic, prescription
and/or OTC products that compete with products of the Company or the
Merck/Schering-Plough Cholesterol Partnership.
- Pricing Pressure -- The Company faces increased pricing pressure in the
U.S. and abroad from managed care organizations, institutions and
government agencies and programs. In the U.S., consolidation among
customers and trends toward managed care and health care costs
containment may increase pricing pressures.
- Government Action -- U.S. legislative and regulatory action that may
impact the Company include the Medicare Prescription Drug, Improvement
and Modernization Act of 2003; possible other legislation or regulatory
action affecting, among other things, pharmaceutical pricing and
reimbursement, including Medicaid and Medicare; involuntary approval of
prescription medicines for OTC use; and other health care reform
initiatives and drug importation legislation. Legislation or regulations
in markets outside the U.S. that may impact the company include those
involving product pricing, reimbursement or access.
- Legal Proceedings -- If there are unfavorable outcomes in government
(local and federal, domestic and international) investigations,
litigation about product pricing, product liability claims, patent
45
and intellectual property disputes, antitrust matters, other litigation
and environmental concerns, this could preclude commercialization of
products, negatively affect the profitability of existing products,
materially and adversely impact Schering-Plough's financial condition and
results of operations, or contain conditions that impact business
operations, such as exclusion from government reimbursement programs.
- Consent Decree -- Failure to meet current Good Manufacturing Practices
established by the FDA and other governmental authorities can result in
delays in the approval of products, release of products, seizure or
recall of products, suspension or revocation of the authority necessary
for the production and sale of products, fines and other civil or
criminal sanctions. The resolution of manufacturing issues with the FDA
discussed in Schering-Plough's 10-Ks, 10-Qs and 8-Ks are subject to
substantial risks and uncertainties. These risks and uncertainties,
including the timing, scope and duration of a resolution of the
manufacturing issues, will depend on the ability of the Company to assure
the FDA of the quality and reliability of its manufacturing systems and
controls, and the extent of remedial and prospective obligations
undertaken by the Company.
- Patents -- Patent positions can be highly uncertain and patent disputes
are not unusual. An adverse result in a patent dispute can preclude
commercialization of products or negatively impact sales of existing
products or result in injunctive relief and payment of financial
remedies. Certain foreign governments have indicated that compulsory
licenses to patents may be granted in the case of national emergencies.
- Tax Laws -- The Company may be impacted by changes in tax laws, including
tax rate changes, new tax laws and revised tax law interpretations in
domestic and foreign jurisdictions.
- Fluctuations in Buying Patterns -- Net sales and quarterly growth
comparisons may be affected by fluctuations in the buying patterns of
major distributors, retail chains and other trade buyers, which may
result from seasonality, pricing, wholesaler buying decisions or other
factors.
- Changes in Accounting and Auditing Standards -- The Company may be
affected by accounting and audited standards promulgated by the American
Institute of Certified Public Accountants, the Financial Accounting
Standards Board, the SEC or the Public Company Accounting Oversight Board
that would require a significant change to the Company's accounting
practices.
- Economic Factors -- There are economic factors over which Schering-Plough
has no control, including changes in inflation, interest rates and
foreign currency exchange rates.
- Changes in Business and Political Positions -- There may be changes to
the Company's business and political position if there is instability,
disruption or destruction in a significant geographic region regardless
of cause, including war, terrorism, riot, civil insurrection or social
unrest; and natural or man-made disasters, including famine, flood, fire,
earthquake, storm or disease. Additionally, the Company relies on third
party relationships for its key products. Any time that third parties are
involved, there may be changes to the third parties that are outside the
control of the Company that may impact the Company's business position.
For further details and a discussion of these and other risks and
uncertainties, see Schering-Plough's past and future SEC reports and filings.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is exposed to market risk primarily from changes in foreign
currency exchange rates and, to a lesser extent, from interest rates and equity
prices. Refer to "Management's Discussion and Analysis of Operations and
Financial Condition" in the Company's 2004 10-K.
ITEM 4. CONTROLS AND PROCEDURES
Management, including the chief executive officer and the chief financial
officer, has evaluated the Company's disclosure controls and procedures as of
the end of the quarterly period covered by this
46
Form 10-Q and has concluded that the Company's disclosure controls and
procedures are effective. They also concluded that there were no changes in the
Company's internal control over financial reporting that occurred during the
Company's most recent fiscal quarter that have materially affected, or are
reasonably likely to materially affect, the Company's internal control over
financial reporting.
As part of the changing business environment in which the Company operates,
the Company is replacing and upgrading a number of information systems. This
process will be ongoing for several years. In connection with these changes, as
part of the Company's management of both internal control over financial
reporting and disclosure controls and procedures, management has concluded that
the new systems are at least as effective with respect to those controls as the
prior systems. An example of a change in information systems that occurred in
the third quarter of 2005 is the replacement of the Company's Medicaid
management system.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Material pending legal proceedings involving the Company are described in
Item 3 of the 2004 10-K. The following discussion is limited to material
developments to previously reported proceedings and new legal proceedings, which
the Company, or any of its subsidiaries, became a party during the quarter ended
September 30, 2005, or subsequent thereto, but before the filing of this report.
This section should be read in conjunction with Part I -- Item 3 of the 2004
10-K and Part II -- Item 1 of the 10-Q for the first and second quarters of
2005.
SECURITIES AND CLASS ACTION LITIGATION
Litigation filed in 2003 in the U.S. District Court in New Jersey alleging
that the Company, Richard Jay Kogan, the Company's Employee Savings Plan (Plan)
administrator, several current and former directors, and certain corporate
officers breached their fiduciary obligations to certain participants in the
Plan. The complaint seeks damages in the amount of losses allegedly suffered by
the Plan. The complaint was dismissed on June 29, 2004. The plaintiffs appealed.
On August 19, 2005 the U.S. Court of Appeals for the Third Circuit reversed the
decision of the District Court and the matter has been remanded back to the
District Court for further proceedings.
PRICING MATTERS
As described in more detail in Note 16, "Legal, Environmental and
Regulatory Matters" in the Notes to Condensed Consolidated Financial Statements,
under the heading "Pricing Matters," the Company and Warrick are defendants in a
number of lawsuits in state courts regarding average wholesale prices (AWP). The
State of West Virginia filed an action against Schering-Plough Corporation,
Schering Corp. and Warrick Pharmaceuticals on October 11, 2001 in the Circuit
Court of Kanawha County, West Virginia. Trial in the West Virginia action is
currently scheduled for November 28, 2005.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
This table provides information with respect to purchases by the Company of
its common shares during the third quarter of 2005.
47
ISSUER PURCHASES OF EQUITY SECURITIES
<Table>
<Caption>
TOTAL NUMBER OF
SHARES PURCHASED AS MAXIMUM NUMBER OF
PART OF PUBLICLY SHARES THAT MAY YET BE
TOTAL NUMBER OF AVERAGE PRICE PAID ANNOUNCED PLANS OR PURCHASED UNDER THE
PERIOD SHARES PURCHASED PER SHARE PROGRAMS PLANS OR PROGRAMS
- ------ ---------------------- ------------------ ------------------- ----------------------
July 1, 2005 through
July 31, 2005...... 2,798(1) $20.61 N/A N/A
August 1, 2005
through August 31,
2005............... 2,504(1) $21.59 N/A N/A
September 1, 2005
through September
30, 2005........... 4,674(1) $20.99 N/A N/A
Total July 1, 2005
through September
30, 2005........... 9,976(1) $21.04 N/A N/A
</Table>
- ---------------
(1) All of the shares included in the table above were repurchased pursuant to
the Company's stock incentive program and represent shares delivered to the
Company by option holders for payment of the exercise price and tax
withholding obligations in connection with stock options and stock awards.
ITEM 6. EXHIBITS
<Table>
<Caption>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
12 Computation of Ratio of Earnings to Fixed Charges
15 Awareness letter
31.1 Sarbanes-Oxley Act of 2002, Section 302 Certification for
Chairman of the Board and Chief Executive Officer
31.2 Sarbanes-Oxley Act of 2002, Section 302 Certification for
Executive Vice President and Chief Financial Officer
32.1 Sarbanes-Oxley Act of 2002, Section 906 Certification for
Chairman of the Board and Chief Executive Officer
32.2 Sarbanes-Oxley Act of 2002, Section 906 Certification for
Executive Vice President and Chief Financial Officer
</Table>
48
SIGNATURE(S)
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Schering-Plough Corporation
--------------------------------------
(Registrant)
/s/ Douglas J. Gingerella
--------------------------------------
Douglas J. Gingerella
Vice President and Controller
(Duly Authorized Officer and
Chief Accounting Officer)
Date: October 28, 2005
49