UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

 

 

 

Form 10-Q

 

 

 

Commission file number: 1-11397

 

 

 

 

Valeant Pharmaceuticals International

(Exact name of registrant as specified in its charter)

 

 

(949) 461-6000

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  þ     Accelerated filer  o     Non-accelerated filer  o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

The number of outstanding shares of the registrant’s Common Stock, $0.01 par value, as of May 1, 2007 was 95,023,955.

 

 

VALEANT PHARMACEUTICALS INTERNATIONAL

 

INDEX

 

 

VALEANT PHARMACEUTICALS INTERNATIONAL

CONSOLIDATED CONDENSED BALANCE SHEETS
As of March 31, 2007 and December 31, 2006
(In thousands, except par value data)

 

 

The accompanying notes are an integral part of these consolidated condensed financial statements.

VALEANT PHARMACEUTICALS INTERNATIONAL

CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
For the three months ended March 31, 2007 and 2006
(Unaudited, in thousands, except per share data)

 

 

The accompanying notes are an integral part of these consolidated condensed financial statements.

VALEANT PHARMACEUTICALS INTERNATIONAL

CONSOLIDATED CONDENSED STATEMENT OF COMPREHENSIVE INCOME
For the three months ended March 31, 2007 and 2006
(Unaudited, in thousands)

 

 

The accompanying notes are an integral part of these consolidated condensed financial statements.

VALEANT PHARMACEUTICALS INTERNATIONAL

CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
For the three months ended March 31, 2007 and 2006
(Unaudited, in thousands)

 

 

The accompanying notes are an integral part of these consolidated condensed financial statements.

VALEANT PHARMACEUTICALS INTERNATIONAL

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

 

In the consolidated condensed financial statements included herein, “we,” “us,” “our,” “Valeant,” and the “Company” refer to Valeant Pharmaceuticals International and its subsidiaries. The condensed consolidated financial statements have been prepared by us, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared on the basis of accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. The results of operations presented herein are not necessarily indicative of the results to be expected for a full year. Although we believe that all adjustments (consisting only of normal, recurring adjustments) necessary for a fair presentation of the interim periods presented are included and that the disclosures are adequate to make the information presented not misleading, these consolidated condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in our annual report on Form 10-K for the year ended December 31, 2006.

 

 

Organization:  We are a global specialty pharmaceutical company that develops, manufactures and markets a broad range of pharmaceutical products. In addition, we generate alliance revenue from out-licensed products, including milestone payments from Schering-Plough Ltd. (“Schering-Plough”) related to pradefovir and royalty revenues from the sale of ribavirin by Schering-Plough and F. Hoffman-LaRoche (“Roche”).

 

Principles of Consolidation:  The accompanying consolidated condensed financial statements include the accounts of Valeant Pharmaceuticals International, its wholly owned subsidiaries and all of its majority-owned subsidiaries. All significant intercompany account balances and transactions have been eliminated.

 

Marketable Securities:  We invest in investment grade securities and classify these securities as available-for-sale as they typically have maturities of one year or less and are highly liquid. As of March 31, 2007 and December 31, 2006, the fair market value of these securities approximated cost.

 

Derivative Financial Instruments:  Our accounting policies for derivative instruments are based on whether they meet our criteria for designation as hedging transactions, either as cash flow or fair value hedges. Our derivative instruments are recorded at fair value and are included in other current assets, other assets, accrued liabilities or debt. Depending on the nature of the hedge, changes in the fair value of the hedged item are either offset against the change in the fair value of the hedged item through earnings or recognized in other comprehensive income until the hedged item is recognized in earnings.

 

Comprehensive Income:  We have adopted the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 130, Reporting Comprehensive Income. Accumulated other comprehensive income consists of accumulated foreign currency translation adjustments, unrealized losses on marketable equity securities, pension funded status and changes in the fair value of derivative financial instruments.

 

Per Share Information:  Basic earnings per share are computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding. In computing diluted earnings per share, the weighted-average number of common shares outstanding is adjusted to reflect the effect of potentially dilutive securities including options, warrants, and convertible debt; income available to common stockholders is adjusted to reflect any changes in income or loss that would result from the issuance of the dilutive common shares.

 

Stock-Based Compensation Expense:  We have adopted SFAS No. 123 (revised 2004), Share-Based Payment, (“SFAS 123(R)”) which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors including employee stock options and employee stock purchases under our Employee Stock Purchase Plan based on estimated fair values.

 

In order to estimate the fair value of stock options we use the Black-Scholes option valuation model, which was developed for use in estimating the fair value of publicly traded options which have no vesting restrictions and are fully transferable. Option valuation models require the input of subjective assumptions which can vary over time.

 

VALEANT PHARMACEUTICALS INTERNATIONAL

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS — (Continued)

Additional information about our stock option programs and the assumptions used in determining the fair value of stock-based compensation are contained in Note 8.

 

Assets Held for Sale:  We have entered into a letter of intent for the sale for our manufacturing plants in Puerto Rico and Birsfelden, Switzerland. At March 31, 2007 the net book values of these facilities are classified as assets held for sale in the accompanying consolidated condensed financial statements.

 

Use of Estimates:  The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ materially from those estimates.

 

Recent Accounting Pronouncements:

 

FIN 48.  In June 2006, the Financial Accounting Standards Board (the “FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109” (“FIN 48”), which clarifies the accounting for uncertainty in income taxes recognized in accordance with SFAS No. 109, “Accounting for Income Taxes.” FIN 48 applies to all income tax positions taken on previously filed tax returns or expected to be taken on a future tax return. FIN 48 prescribes a benefit recognition model with a two-step approach: a more-likely-than-not recognition criterion and a measurement attribute that measures the position as the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement. If it is not more likely than not that the benefit will be sustained on its technical merits, no benefit will be recorded. FIN 48 also requires that the amount of interest expense and income to be recognized related to uncertain tax positions be computed by applying the applicable statutory rate of interest to the difference between the tax position recognized in accordance with FIN 48 and the amount previously taken or expected to be taken in a tax return. Our continuing practice is to record interest and penalties related to income tax matters in income tax expense.

 

FIN 48 became effective for Valeant as of January 1, 2007. The change in net assets as a result of applying this pronouncement is recorded as a change in accounting principle with the cumulative effect of the change required to be treated as an adjustment to the opening balance of accumulated deficit. As a result of the adoption of FIN 48, we recognized an increase of $1,560,000 to the beginning balance of accumulated deficit on the balance sheet. Additional information about the adoption of FIN 48 and its effect on our financial statements is contained in Note 7.

 

SFAS No. 155.  In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments, amendment of FASB Statements No. 133 and 140” (“SFAS No. 155”). SFAS No. 155 gives entities the option of applying fair value accounting to certain hybrid financial instruments in their entirety if they contain embedded derivatives that would otherwise require bifurcation under SFAS No. 133. SFAS No. 155 became effective for Valeant as of January 1, 2007. The adoption of this standard did not have a material impact on our financial statements.

 

SFAS No. 157.  In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS No. 157). SFAS No. 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements but does not change the requirements to apply fair value in existing accounting standards. Under SFAS No. 157, fair value refers to the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the market in which the reporting entity transacts. The standard clarifies that fair value should be based on the assumptions market participants would use when pricing the asset or liability. SFAS No. 157 will be effective for Valeant as of January 1, 2008 and we are currently assessing the impact that SFAS No. 157 may have on our financial statements.

 

SFAS 159.  In February 2007 the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities”, (SFAS 159) which provides companies with an option to report selected financial assets and liabilities at fair value. The objective of SFAS 159 is to reduce both complexity in accounting for financial

 

VALEANT PHARMACEUTICALS INTERNATIONAL

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS — (Continued)

instruments and the volatility in earnings caused by measuring related assets and liabilities differently. SFAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. SFAS 159 does not eliminate any disclosure requirements included in other accounting standards. We have not yet determined if we will elect to apply the options presented in SFAS 159, the earliest effective date that we can make such an election is January 1, 2008.

 

EITF 06-3.  In June 2006, the FASB ratified the Emerging Issues Task Force’s Issue No. 06-3, “How Sales Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross Versus Net Presentation)” (“EITF 06-3”). EITF 06-3 provides guidance on disclosing the accounting policy for the income statement presentation of any tax assessed by a governmental authority that is directly imposed on a revenue-producing transaction between a seller and a customer on either a gross (included in revenues and costs) or a net (excluded from revenues) basis. In addition, EITF 06-3 requires disclosure of any such taxes that are reported on a gross basis as well as the amounts of those taxes in interim and annual financial statements for each period for which an income statement is presented. EITF 06-3 was effective for Valeant as of January 1, 2007. Valeant presents revenue net of sales taxes. The adoption of this standard did not have a material impact on Valeant.

 

Reclassifications:  Certain prior year items have been reclassified to conform to the current year presentation, with no effect on previously reported net income or stockholders’ equity.

 

 

On April 3, 2006, we announced a restructuring program to reduce costs and accelerate earnings growth.

 

The program is primarily focused on our research and development and manufacturing operations. The objective of the restructuring program as it relates to research and development activities is to focus our efforts and expenditures on two late stage projects currently in development. The restructuring program is designed to rationalize our investments in research and development efforts in line with our financial resources. In December 2006 we sold our HIV and cancer development programs and certain discovery and pre-clinical assets to Ardea Biosciences, Inc. (formerly IntraBiotics Pharmaceuticals) (“Ardea”), with an option for us to reacquire rights to commercialize the HIV program outside of the United States and Canada upon Ardea’s completion of Phase 2b trials. In March 2007, we sold our former headquarters building in Costa Mesa, California, where our former research laboratories were located, for net proceeds of $36,758,000.

 

The restructuring program is also expected to reduce selling, general and administrative expenses primarily through consolidation of the management functions in fewer administrative groups to achieve greater economies of scale. Management and administrative responsibilities for our regional operations in Australia, Africa and Asia, which had been managed as a separate business unit, have been combined with those of other regions.

 

We recorded a charge of $7,238,000 in the three months ended March 31, 2007, in connection with our decision to implement the restructuring program. Severance charges recorded in the three months ended March 31, 2007 total $3,781,000 and relate to employees whose positions were eliminated in the restructuring. When completed, we anticipate that approximately 850 employees in total will be impacted by the restructuring, the majority of whom work in the two manufacturing facilities selected for disposition. The charge in the three months ended March 31, 2007 included $2,050,000 related to 202 employees at our manufacturing facility in Humacao, Puerto Rico and $895,000 related to 10 employees in our sales and marketing operations in Spain. Currently, employee severance charges have been accrued for 480 employees.

 

VALEANT PHARMACEUTICALS INTERNATIONAL

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS — (Continued)

 

The objective of the restructuring program as it relates to manufacturing is to further rationalize our manufacturing operations to reflect the regional nature of our existing products and further reduce our excess capacity after considering the delay in the development of taribavirin. The impairment charges include the charges related to estimated future losses that may occur upon the disposition of specific assets related to our manufacturing operations in Switzerland and Puerto Rico. The following table summarizes the restructuring costs incurred in 2006 and during the three months ended March 31, 2007:

 

 

The restructuring charges for the three months ended March 31, 2007 represent charges of $3,042,000, $2,177,000 and $2,019,000 in respect of the North America, EMEA and Corporate reporting segments respectively.

 

Cash-related charges in the above table relate to severance payments and other costs which have been either paid with cash expenditures or have been accrued and will be paid with cash in future quarters. A summary of accruals and expenditures of restructuring costs which will be paid in cash is as follows (in thousands):

 

 

We have recorded impairment charges of $534,000 related to our manufacturing plant in Humacao, Puerto Rico and $615,000 related to our manufacturing plant in Birsfelden, Switzerland in the three months ended March 31, 2007. We have entered into a letter of intent to sell these facilities and expect to complete this sale within three months. Included within this charge is $162,000 of cash-related charges.

 

 

In the three months ended March 31, 2007, we acquired product rights in the United States, Europe, and Argentina. In the United States we acquired a paid-up license to Kinetin and Zeatin, the active ingredients of Kinerase, for cash consideration of $21,000,000 and other consideration of $4,170,000. In Europe we acquired the rights to nabilone, the product we currently market as Cesamet in the United States and Canada, for $9,659,000. We acquired the rights to two products in Poland and certain products in Argentina. The aggregate cash consideration for these transactions was $31,325,000.

 

VALEANT PHARMACEUTICALS INTERNATIONAL

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS — (Continued)

 

 

In the second half of 2002, we made a strategic decision to divest our Russian pharmaceuticals segment, biomedicals segment, Photonics business, raw materials businesses and manufacturing facilities in Central Europe and Circe unit. During 2003, we disposed of the Russian pharmaceuticals segment, biomedicals segment, Photonics business and Circe unit. During 2004, we disposed of one of the raw materials businesses and manufacturing facilities in Central Europe. During 2005 we completed the sale of the remaining raw materials business and manufacturing facility in Central Europe. In the three months ended March 31, 2007 and 2006, losses from discontinued operations consisted of the disposal of remaining real estate facilities and the wind down of administrative activities associated with these operations.

 

Summarized selected financial information for discontinued operations for the three months ended March 31, 2007 and 2006 is as follows (in thousands):

 

 

The assets and liabilities of discontinued operations are stated separately as of March 31, 2007 and December 31, 2006 on the accompanying consolidated condensed balance sheets. The major assets and liabilities categories are as follows (in thousands):

 

 

Environmental contamination has been identified in the soil under a facility built by the Company which housed operations of the discontinued biomedicals segment and is currently vacant. Remediation of the site will involve excavation and disposal of the waste at appropriately licensed sites some distance from the facility. Environmental reserves have been provided for remediation and related costs that we can reasonably estimate. Remediation costs are applied against these environmental reserves as they are incurred. As assessments and

 

VALEANT PHARMACEUTICALS INTERNATIONAL

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS — (Continued)

remediation progress, these liabilities will be reviewed and adjusted to reflect additional information that becomes available. We expect that the major work on these projects will be completed in 2007. Total environmental reserves for this site were $12,471,000 and $12,660,000 as of March 31, 2007 and December 31, 2006, respectively, and are included in the liabilities of discontinued operations. Although we believe that the reserves are adequate, there can be no assurance that the amount of expenditures and other expenses which will be required relating to remediation actions and compliance with applicable environmental laws will not exceed the amounts reflected in reserves or will not have a material adverse effect on our consolidated financial condition, results of operations or cash flows. Any possible loss that may be incurred in excess of amounts provided for as of March 31, 2007 cannot be reasonably estimated.

 

 

The following table sets forth the computation of basic and diluted earnings per share (in thousands, except per share data):

 

 

For the three months ended March 31, 2006, options to purchase 1,746,000 weighted average shares of common stock were not included in the computation of earnings per share because we incurred a loss and the effect would have been anti-dilutive.

 

For the three months ended March 31, 2007 and 2006, options to purchase 9,659,000 and 9,324,000 weighted average shares of common stock, respectively, were also not included in the computation of earnings per share because the option exercise prices were greater than the average market price of the Company’s common stock and, therefore, the effect would have been anti-dilutive.

 

VALEANT PHARMACEUTICALS INTERNATIONAL

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS — (Continued)

 

The following tables present the details of certain amounts included in the consolidated balance sheet at March 31, 2007 and December 31, 2006 (in thousands):

 

 

Intangible assets:  As of March 31, 2007 and December 31, 2006, intangible assets were as follows (in thousands, except life data):

 

 

VALEANT PHARMACEUTICALS INTERNATIONAL

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS — (Continued)

Estimated future amortization expenses are as follows (in thousands):

 

 

Amortization expense for the three months ended March 31, 2007 and 2006 was $19,131,000 and $17,523,000, respectively, of which $16,296,000 and $14,364,000, respectively, related to amortization of acquired product rights.

 

 

We incur losses in the United States, where our research and development activities are conducted and our corporate offices are located. We anticipate that we will realize the tax benefits associated with these losses by offsetting such losses against future taxable income resulting from products in our development pipeline, further growth in U.S. product sales and other measures. However, at this time, there is insufficient objective evidence of the timing and amounts of such future U.S. taxable income to assure realization of the tax benefits, and valuation allowances have been established to reserve those benefits. The increase in the valuation allowance for the three months ended March 30, 2007 was insignificant since the U.S. loss was insignificant. Our effective tax rate for the three months ended March 31, 2007 was affected by pre-tax losses resulting from a restructuring charge of $3,042,000 in Puerto Rico for which we do not expect to realize income tax benefits. A provision for income taxes of $7,292,000 was recorded for this period which primarily represents the taxes payable on earnings in tax jurisdictions outside the United States, interest on U.S. liabilities recorded in conjunction with the 1997 - 2001 IRS examination and state and local taxes.

 

In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109” (“FIN 48”), which clarifies the accounting for uncertainty in income taxes recognized in accordance with SFAS No. 109, “Accounting for Income Taxes.” FIN 48 became effective for Valeant as of January 1, 2007. As a result of the adoption of FIN 48, we recognized an increase of $1,560,000 to the beginning balance of accumulated deficit on the balance sheet. At January 1, 2007 we had $122,697,000 of unrecognized benefits, of which $32,225,000 would reduce our effective tax rate, if recognized.

 

Of the total unrecognized tax benefits at the adoption date, $24,799,000 was recorded as an offset against a valuation allowance. To the extent such portion of unrecognized tax benefits is recognized at the time when a valuation allowance no longer exists, the recognition would affect our tax rate.

 

Our continuing practice is to recognize interest and penalties related to income tax matters in income tax expense. As of January 1, 2007, we had recorded $18,432,000 for interest and $2,602,000 for penalties. We accrued additional $862,000 of interest during the quarter ended March 31, 2007.

 

In 2005, we recorded $57,092,000 as an estimate of additional tax expense expected to result from the IRS examination of the U.S. income tax returns for the years ended December 31, 1997 through 2001. The net impact to the tax provision was $22,153,000 after reversal of the valuation allowance for losses that would be recognized if

 

VALEANT PHARMACEUTICALS INTERNATIONAL

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS — (Continued)

these examination adjustments were realized. Interest and penalties have also been accrued which bring the balance of the reserve for these items to $27,000,000.

 

The most significant adjustments proposed by the IRS for this period resulted from a transaction in 1999, when the Company restructured its operations by contributing the stock of several non-U.S. subsidiaries to a wholly owned Dutch company. At the time of the restructuring, the Company intended to avail itself of the non-recognition provisions of the Internal Revenue Code to avoid generating taxable income on the intercompany transfer. One of the requirements under the non-recognition provisions was to file Gain Recognition Agreements with the Company’s timely filed 1999 U.S. Income Tax Return. We discovered and voluntarily informed the IRS that the Gain Recognition Agreements had been inadvertently omitted from the 1999 tax return. The IRS denied our request to rule that reasonable cause existed for the failure to provide the agreements and proposed an adjustment that would increase taxable income by approximately $120,000,000.

 

We have been pursuing resolution of the IRS examination of the U.S. income tax returns for the years ended December 31, 1997 through 2001 through a formal appeals process which we expect to be completed in the next six months. As a result, it is reasonably possible that $78,872,000 of the unrecognized benefits will reverse within the next twelve months, which will reduce the liability for uncertain tax positions by $80,413,000 (including the effect on deferred tax assets, interest and penalties). The provision for income taxes is expected to be reduced by $20,000,000 to $25,000,000, primarily related to resolution of the gain recognition issue which arose for the year ended December 31, 1999. The difference will adjust the deferred tax assets and the valuation allowance.

 

We are currently under audit by the IRS for the 2002 through 2004 tax years. For the U.S., all years prior to 1997 are closed under the statute. Although the examination process is expected to be completed in 2007, we expect to begin a formal appeal for proposed adjustments with which we do not agree. Our significant subsidiaries are open to tax examinations for years ending in 2001 and later.

 

 

In May 2006, our stockholders approved our 2006 Equity Incentive Plan (the “Incentive Plan”), which is an amendment and restatement of our 2003 Equity Incentive Plan. The number of shares of common stock under the Incentive Plan was 22,304,000 in the aggregate at March 31, 2007. The Incentive Plan provides for the grant of incentive stock options, nonqualified stock options, stock appreciation rights, restricted stock awards, phantom stock awards and stock bonuses (collectively, “awards”) to our key employees, officers, directors, consultants and advisors. Options granted under the Incentive Plan must have an exercise price that is not less than 100% of the fair market value of the common stock on the date of grant and a term not exceeding 10 years. Under the Incentive Plan shares may be issued as phantom stock awards or restricted stock unit awards for which a participant pays less than the fair market value of the common stock on the date of grant. Generally, options vest ratably over a four-year period from the date of grant.

 

VALEANT PHARMACEUTICALS INTERNATIONAL

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS — (Continued)

 

The following table sets forth information relating to the Incentive Plan (in thousands, except per share data):

 

 

The schedule below reflects the number of outstanding and exercisable options as of March 31, 2007 segregated by price range (in thousands, except per share and life data):

 

 

SFAS No. 123(R) Assumptions and Fair Value:  The fair value of options granted in 2007 and 2006 was estimated at the date of grant using the Black-Scholes option-pricing model with the following assumptions:

 

 

The aggregate intrinsic value of the stock options outstanding at March 31, 2007 was $20,327,000. The aggregate intrinsic value of the stock options that are both outstanding and exercisable at March 31, 2007 was $18,933,000. During the three months ended March 31, 2007 stock options with an aggregate intrinsic value of

 

VALEANT PHARMACEUTICALS INTERNATIONAL

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS — (Continued)

$2,150,000 were exercised. Intrinsic value is the “in the money” valuation of the options or the difference between market and exercise prices. The fair value of options that vested in the three months ended March 31, 2007, as determined using the Black-Scholes valuation model, was $1,442,000.

 

2003 Employee Stock Purchase Plan:  In May 2003, our stockholders approved the Valeant Pharmaceuticals International 2003 Employee Stock Purchase Plan (the “ESPP”). The ESPP provides employees with an opportunity to purchase common stock at a 15% discount. There are 7,000,000 shares of common stock reserved for issuance under the ESPP, plus an annual increase on the first day of our fiscal year for a period of ten years, commencing on January 1, 2005 and ending on January 1, 2015, equal to the lower of (i) 1.5% of the shares of common stock outstanding on each calculation date, (ii) 1,500,000 shares of common stock, or (iii) a number of shares that may be determined by the Compensation Committee. In 2006, we issued 64,000 shares of common stock for proceeds of $938,000 under the ESPP. In the three-month period ended March 31, 2007, 24,703 shares were issued for proceeds of $359,000.

 

Phantom Stock Awards:  Non-employee members of our board of directors receive compensation in the form of phantom stock grants, cash retainers and meeting fees for each meeting they attend during the year. Directors also have the option to receive phantom stock awards in lieu of fees otherwise payable in cash. During the three months ended March 31, 2007 and the year ended December 31, 2006, we granted our non-employee directors 6,614 and 69,874 shares of phantom stock, respectively. The phantom stock issued to non-employee directors in these periods had a fair value of $118,000 and $1,179,000, respectively. Each share of phantom stock granted to non-employee directors vests over one year or less, is entitled to dividend equivalent shares and is exchanged for a share of the Company’s common stock one year after the director ceases to serve as a member of the Company’s Board. Each share of phantom stock granted to certain officers of the company vests 50 percent three years after grant with the balance vesting equally in years four and five after grant, is entitled to dividend equivalent shares and is exchanged for a share of the Company’s common stock upon vesting. During 2007 and 2006, the Company recorded non-cash charges related to the vesting of phantom stock of $341,000 and $1,235,000, respectively. As of March 31, 2007 and December 31, 2006, there were 275,138 and 268,524 shares of phantom stock outstanding, respectively. In prior years the Company assumed outstanding employee stock options in connection with the Ribapharm acquisition. Stock compensation expense recorded in connection with these stock options totaled $117,000 and $771,000 for the year ended December 31, 2006.

 

A summary of stock compensation expense for our stock incentive plans is presented below (in thousands):

 

 

VALEANT PHARMACEUTICALS INTERNATIONAL

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS — (Continued)

Stock compensation expense was charged to the following accounts (in thousands):

 

 

Future stock compensation expense for restricted stock and stock option incentive awards outstanding at March 31, 2007 is as follows (in thousands):

 

 

Dividends:  We declared and paid quarterly cash dividends of $0.0775 per share for the first quarter of 2006. We did not pay dividends for the first quarter of 2007.

 

 

We are involved in several legal proceedings, including the following matters (Valeant was formerly known as ICN Pharmaceuticals, Inc.):

 

Securities Class Actions:

 

Derivative Actions Related to Ribapharm Bonuses:  We were a nominal defendant in a shareholder derivative lawsuit pending in state court in Orange County, California, styled James Herrig, IRA v. Milan Panic et al. This lawsuit, which was filed on June 6, 2002, purported to assert derivative claims on our behalf against certain of our current and/or former officers and directors. The lawsuit asserted claims for breach of fiduciary duties, abuse of control, gross mismanagement and waste of corporate assets. The plaintiff sought, among other things, damages and a constructive trust over cash bonuses paid to the officer and director defendants in connection with the Ribapharm offering. In March 2007, the complaint was dismissed, with prejudice. The court has retained jurisdiction to consider an application for attorneys’ fees and expenses by plaintiff’s counsel.

 

On October 1, 2002, several of our former and current directors, as individuals, as well as Valeant, as a nominal defendant, were named as defendants in a second shareholder’s derivative complaint filed in the Delaware Court of Chancery, styled Paul Gerstley v. Norman Barker, Jr. et al. The original complaint in the Delaware action purported to state causes of action for violation of Delaware General Corporation Law Section 144, breach of fiduciary duties and waste of corporate assets in connection with the defendants’ management of our company.

 

We settled the litigation with respect to ten of the defendants prior to trial. The claims with respect to defendants Milan Panic and Adam Jerney, who received Ribapharm Bonuses of $33,050,000 and $3,000,000, respectively, were tried in Delaware Chancery Court in a one-week trial beginning February 27, 2006. On July 28, 2006, we entered into a settlement agreement with Mr. Panic, which was amended on October 6, 2006. Pursuant to that settlement, Mr. Panic paid us $20,000,000. We recorded a $17,550,000 gain resulting from this settlement. The

 

VALEANT PHARMACEUTICALS INTERNATIONAL

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS — (Continued)

amount reflects the settlement proceeds net of related costs associated with the litigation and settlement arrangement.

 

On March 1, 2007, the Delaware Court of Chancery issued an opinion finding Mr. Jerney liable for breach of fiduciary duty and on March 14, 2007 entered an order requiring Mr. Jerney to pay us a total of $6,983,085. Mr. Jerney purported to file a pro se appeal on April 12, 2007. The Company has filed a motion to dismiss the appeal.

 

SEC Investigation:  We are the subject of a Formal Order of Investigation with respect to events and circumstances surrounding trading in our common stock and the public release of data from our first pivotal Phase 3 trial for taribavirin, matters regarding our stock option grants since January 1, 2000 and information about our pursuit in the Delaware Chancery Court of the return of certain bonuses paid to Milan Panic, the former chairman and chief executive officer, and others. In September 2006, our board of directors established a Special Committee to review our historical stock option practices and related accounting, and informed the SEC of these efforts. We have cooperated fully and will continue to cooperate with the SEC in its investigation. We cannot predict the outcome of the investigation.

 

Derivative Actions Related to Stock Options:  We are a nominal defendant in two shareholder derivative lawsuits pending in state court in Orange County, California, styled (i) Michael Pronko v. Timothy C. Tyson et al., and (ii) Kenneth Lawson v. Timothy C. Tyson et al. These lawsuits, which were filed on October 27, 2006 and November 16, 2006 respectively, purport to assert derivative claims on our behalf against certain of our current and/or former officers and directors. The lawsuits assert claims for breach of fiduciary duties, abuse of control, gross mismanagement, waste of corporate assets, unjust enrichment, and violations of the California Corporations Code related to the purported backdating of employee stock options. The plaintiffs seek, among other things, damages, an accounting, the rescission of stock options, and a constructive trust over amounts acquired by the defendants who have exercised Valeant stock options. On January 16, 2007, the court issued an order consolidating the two cases before Judge Ronald L. Bauer. On February 6, 2007, the court issued a further order abating the Lawson action due to a procedural defect while the Pronko action proceeds to conclusion. The plaintiff in the Pronko action filed an amended complaint on April 11, 2007. The defendants have not yet responded to the complaint. We will evaluate the amended complaint and respond accordingly.

 

We are a nominal defendant in a shareholder derivative action pending in the Court of Chancery of the state of Delaware, styled Sherwood v. Tyson, et. al., filed on March 20, 2007. This complaint also purports to assert derivative claims on the Company’s behalf for breach of fiduciary duties, gross mismanagement and waste, constructive fraud and unjust enrichment related to the alleged backdating of employee stock options. The plaintiff seeks, among other things, damages, an accounting, disgorgement, rescission and/or repricing of stock options, and imposition of a constructive trust for the benefit of the Company on amounts by which the defendants were unjustly enriched. The defendants have not yet responded to the complaint. We will evaluate the complaint and respond accordingly.

 

Patent Oppositions:  Various parties are opposing our ribavirin patents in actions before the European Patent Office (E.P.O.), and we are responding to these oppositions. One patent, which benefited from patent extensions in the major European countries that provided market protection until 2010, has been revoked by the Opposition Division of the E.P.O. We have filed an appeal within the E.P.O., and a decision on this appeal is expected in the fall of 2007. A second European patent, whose term extends to 2017, is the subject of a current opposition proceeding in the E.P.O. The oral proceedings in this opposition are scheduled to take place on June 12, 2007.

 

Should the opponents ultimately prevail against both of our ribavirin patents, the ribavirin component of the combination therapies marketed by Schering-Plough and Roche would lose patent protection in Europe. Under the terms of our license agreement with Roche, loss of patent protection would result in the cessation of royalty payments from Roche. However, since royalty payments from Schering-Plough, our other licensee of ribavirin, do

 

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not depend on the existence of a patent, payments from Schering-Plough would continue whatever the outcome of the Opposition Oral Proceeding. In either case, data exclusivity applies to these products until 2010.

 

Argentina Antitrust Matter:  In July 2004, we were advised that the Argentine Antitrust Agency had issued a notice unfavorable to us in a proceeding against our Argentine subsidiary. The proceeding involves allegations that the subsidiary in Argentina abused a dominant market position in 1999 by increasing its price on Mestinon in Argentina and not supplying the market for approximately two months. The subsidiary filed documents with the agency offering an explanation justifying its actions, but the agency has now rejected the explanation. The agency is collecting evidence prior to issuing a new decision. Argentinean law permits a fine to be levied of up to $5,000,000 plus 20% of profits realized due to the alleged wrongful conduct. Counsel in the matter advises that the size of the transactions alleged to have violated the law will unlikely draw the maximum penalty.

 

Permax Product Liability Cases:  On February 8, 2007, we were served a complaint in a case captioned Kathleen M. O’Connor v. Eli Lilly & Company, Valeant Pharmaceuticals International, Amarin Corporation plc, Amarin Pharmaceuticals, Inc., Elan Pharmaceuticals, Inc., and Athena Neurosciences, Inc., Case No. 07 L 47 in the Circuit Court of the 17th Judicial Circuit, Winnebago County, Illinois. This case, which has been removed to federal court in the Northern District of Illinois, alleges that the use of Permax for restless leg syndrome caused the plaintiff to have valvular heart disease, and as a result, she suffered damages, including extensive pain and suffering, emotional distress and mental anguish. Eli Lilly, holder of the right granted by the FDA to market and sell Permax in the United States, which right was licensed to Amarin and the source of the manufactured product, has also been named in the suit. Under an agreement between Valeant and Eli Lilly, Eli Lilly will bear a portion of the liability, if any, associated with this claim. Product liability insurance exists with respect to this claim. Although it is expected that the insurance proceeds will be sufficient to cover existing claims against us, there can be no assurance that defending against any future similar claims and any resulting settlements or judgments will not, individually or in the aggregate, have a material adverse affect on our consolidated financial position, results of operation or liquidity.

 

Kali Litigation:  In March 2004, Kali Laboratories, Inc. submitted Abbreviated New Drug Application (“ANDA”) No. 76-843 with the FDA seeking approval for a generic version of Diastat^® (a diazepam rectal gel). In July 2004, Xcel Pharmaceuticals, Inc., which we acquired on March 1, 2005, filed a complaint against Kali for patent infringement of U.S. Patent No. 5,462,740 — Civil Case No. 04-3238 (JCL) pending in the United States District Court of New Jersey. The complaint alleges that Kali’s filing of ANDA No. 76-843 is an act of infringement under 35 U.S.C. §271(e)(4) of one or more claims of U.S. Patent No. 5,462,740. Kali has filed an answer and counterclaims, denying all allegations of the complaint and asserting affirmative defenses and counterclaims for non-infringement, invalidity and unenforceability under the doctrine of patent misuse due to improper filing of the lawsuit. Xcel filed a reply to the counterclaims, denying all allegations. In October 2005, Kali filed an amended answer and counterclaims asserting affirmative defenses and counterclaims for non-infringement, invalidity, unenforceability due to inequitable conduct during prosecution of the patent, and unenforceability under the doctrine of patent misuse due to improper filing of the lawsuit. In November 2005, we filed a reply to the amended counterclaims, denying all allegations. We will vigorously defend ourselves against Kali’s allegations. Fact and expert discovery has closed. The parties attended a pretrial conference on June 12, 2006. No trial date has been set.

 

Xcel filed this suit within forty-five days of Kali’s Paragraph IV certification. As a result, The Drug Price Competition and Patent Restoration Act of 1984 (the “Hatch-Waxman Act”) provided an automatic stay on the FDA’s approval of Kali’s ANDA for thirty months, which expired on November 28, 2006.

 

Trademark Litigation:  Valent U.S.A. Corporation and its wholly owned subsidiary Valent Biosciences Corporation (together “Valent Biosciences”) have expressed concerns regarding the possible confusion between Valent Biosciences’ VALENT trademark registered in connection with various chemical and agricultural products and our VALEANT trademark. Valent Biosciences has opposed the registration of the VALEANT trademark by us in certain jurisdictions, including Argentina, Australia, Brazil, Canada, Chile, China, Colombia, Czech Republic, European Union, France, Germany, Indonesia, Israel, Japan, Korea (for the VALEANT trademark in Korean characters), Malaysia, New Zealand, Romania, Slovak Republic, Spain, Switzerland, Turkey, Taiwan, Venezuela,

 

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the United Kingdom and the United States. Valent Biosciences’ oppositions in Chile, Colombia, Czech Republic, France, Indonesia, Japan, New Zealand, Romania, Slovak Republic, Spain, Switzerland, and Turkey have been denied. Valent Biosciences is appealing the denial of their opposition in Turkey. Also, we have initiated actions to cancel trademark registrations owned by Valent Biosciences in Germany, Israel, South Korea and the United Kingdom and have opposed Valent’s application to register the VALENT mark in Switzerland in connection with pharmaceuticals. We have responded or will respond to all opposition proceedings that have been filed, and the opposition proceeding in the United States is currently stayed. Valent Biosciences has also filed for cancellation of the VALEANT trademark registration in Austria. If Valent’s cancellation filing or any of its opposition proceedings are successful, we would have no trademark registration for the VALEANT mark in that particular jurisdiction and, in addition, in those jurisdictions where trademark rights accrue solely through the registration process, may have no trademark rights in the VALEANT mark in those particular jurisdictions.

 

Former ICN Yugoslavia Employees:  In December 2003, sixteen former employees of ICN Yugoslavia filed a complaint in state court in Orange County, California. Plaintiffs allege that we breached a promise by Milan Panic, who allegedly offered plaintiffs full pay and benefits if they boycotted the management installed by the Yugoslavian government following its takeover of ICN Yugoslavia. Plaintiffs’ initial complaint and first amended complaint were both dismissed by the judge in March and October 2004, respectively. However, plaintiffs appealed and the Court of Appeal reversed the trial court’s dismissal. Plaintiffs filed their second amended complaint in January 2006, alleging only unjust enrichment and constructive fraud. Discovery has closed. The parties have agreed to submit this matter to binding arbitration. An arbitration date has not been set.

 

Republic of Serbia Litigation:  In March 2006 we settled a long standing dispute with the Republic of Serbia relating to the ownership and operations of a joint venture we formerly participated in known as Galenika for $34,000,000. We received a payment of $28,000,000 in March 2006 and an additional $6,000,000 in February 2007. We recorded a gain resulting from this settlement of $34,000,000 in 2006.

 

Xcel Pharmaceuticals:  In February 2005, we filed a claim for indemnification from the former Xcel stockholders with respect to certain breaches of representation and warranties made by Xcel under the Xcel purchase agreement and certain third-party claims. Part of the Xcel purchase price was placed in an escrow fund to provide funds for any indemnification claims by Valeant. As of March 31, 2007 approximately $5,300,000 of the Xcel purchase price remained in the escrow fund. The indemnification claim is subject to arbitration, and a partial final ruling has been issued awarding the amount of the escrow fund in excess of approximately $1,500,000 to the former Xcel stockholders, who have filed for a motion to confirm the partial final order. We are evaluating our options regarding this matter, including to seek vacatur of the partial final order. We have taken a charge of $3,800,000 for this matter in the three months ended March 31, 2007. The final arbitration hearings are scheduled for June 2007.

 

Other:  We are a party to other pending lawsuits and subject to a number of threatened lawsuits. While the ultimate outcome of pending and threatened lawsuits or pending violations cannot be predicted with certainty, and an unfavorable outcome could have a negative impact on us, at this time in the opinion of management, the ultimate resolution of these matters will not have a material effect on our consolidated financial position, results of operations or liquidity.

 

 

In the April 2006 strategic restructuring, the pharmaceutical segment formerly described as Asia, Africa, and Australia was eliminated for segment reporting purposes, with the operations in this former segment combined with the remaining three segments. We thus now have three reportable pharmaceutical segments, which comprise our pharmaceutical operations in:

 

 

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In addition, we have a research and development division. As part of the restructuring announced on April 3, 2006, certain of our discovery and pre-clinical development assets were sold on December 21, 2006 to Ardea.

 

The segment information below for the three months ended March 31, 2006 has been restated from our previous presentations to reflect our new segment structure as described above.

 

The following table sets forth the amounts of our segment revenues and operating income for the three months ended March 31, 2007 and 2006 (in thousands):

 

 

 

 

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NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS — (Continued)

The following table sets forth our total assets by segment as of March 31, 2007 and December 31, 2006 (in thousands):

 

 

The following table sets forth our long-term assets by segment as of March 31, 2007 and December 31, 2006 (in thousands):

 

 

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NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS — (Continued)

The following table summarizes the largest of our product lines by therapeutic class based on sales for the three months ended March 31, 2007 and 2006 (in thousands):

 

 

 

 

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NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS — (Continued)

 

During the three months ended March 31, 2007 two customers accounted for more than 10% of consolidated product sales. During this period, sales to McKesson Corporation and its affiliates were $28,873,000 in the United States, Canada, and Mexico and sales to Cardinal Health were $18,649,000 in the United States. In the three months ended March 31, 2006, sales to McKesson Corporation and its affiliates were $23,068,000 and sales to Cardinal Health were $18,112,000.

 

 

We have reported the royalties received from the sale of ribavirin by Schering-Plough and Roche separately from our specialty pharmaceuticals product sales revenue since these royalties were first received in 1998. In 2007, we have begun presenting these royalty revenues within a new category of revenues, “alliance revenue.” The following table provides the details of our alliance revenue in the three months ended March 31, 2007 and the three months ended March 31, 2006 (in thousands):

 

 

The licensing payment of $19,200,000 was received from Schering-Plough as the initial payment to us in the licensing of pradefovir. Alliance revenue for the three months ended March 31, 2007 also included a $50,000 payment from an unrelated third party for a license to certain intellectual property assets.

 

We are a global specialty pharmaceutical company that develops, manufactures and markets a broad range of pharmaceutical products, primarily in the areas of neurology, infectious disease, and dermatology. Our marketing and promotion efforts focus on our Promoted Products, which include products marketed globally, regionally or locally with annual sales in excess of $5 million. Our products are currently sold in more than 100 markets around the world, with our primary focus on the United States, Canada, Mexico, the United Kingdom, France, Italy, Poland, Germany and Spain.

 

Our primary value driver is a specialty pharmaceutical business with a global platform. We believe that our global reach and marketing agility make us unique among specialty pharmaceutical companies, and provide us with the ability to leverage compounds in the clinical stage and commercialize them in major markets around the world. In addition, we receive alliance revenue in the form of pradefovir licensing payments from Schering-Plough and royalties from the sale of ribavirin by Schering-Plough and Roche, although such royalties are expected to decline as a result of market competition and ultimately the loss of patents and data exclusivity in European markets and Japan.

 

Specialty Pharmaceuticals