EDGAR Pro
About EDGAR Online | Login



The following is an excerpt from a 20-F SEC Filing, filed by TARO PHARMACEUTICAL INDUS ... on 5/23/2003.

Jump to : 


  
						

ITEM 5. OPERATING AND FINANCIAL REVIEW AND PROSPECTS

A. OPERATING RESULTS

The following discussion should be read in conjunction with our consolidated financial statements and related notes for the three years ended December 31, 2002 and as of December 31, 2002 and 2001, which are included elsewhere in this annual report.

OVERVIEW

We are a multinational, science-based pharmaceutical company. We develop, manufacture and market prescription and OTC pharmaceutical products, as well as active pharmaceutical ingredients, primarily in the United States, Canada and Israel. Our primary areas of focus include topical creams and ointments, liquids, capsules and tablets. We operate principally through three entities: Taro Israel and two of its subsidiaries, Taro Canada and Taro U.S.A.

We generate most of our revenues from the sales of prescription and OTC pharmaceutical products. Portions of our OTC products are sold as private label products primarily to chain drug stores, food stores, drug wholesalers, drug distributors and mass merchandisers. In 2002, 2001 and 2000, AmerisourceBergen Corporation, a major drug wholesaler and currently our largest customer, accounted for approximately 22%, 13%, and 8% of our consolidated sales, respectively.

We also sell active pharmaceutical ingredients to unaffiliated customers around the world. Sales of active pharmaceutical ingredients to third parties have historically represented less than 2% of consolidated revenues. Our primary reason for manufacturing active pharmaceutical ingredients is to support our pharmaceutical manufacturing operations.

Due to increased competition from other generic pharmaceutical manufacturers as they gain regulatory approvals to manufacture generic products, selling prices and related profit margins tend to decrease as products mature.

36
Thus, our future operating results are dependent on, among other factors, our ability to introduce new products.

In 2002 and 2001, sales of six product lines contributed approximately 51% and 56% of our consolidated sales, respectively. These six product lines include four topical product families and two oral product families. Clotrimazole and Betamethasone Dipropionate Cream, our generic equivalent of Lotrisone(R) cream, which we introduced to the marketplace in May 2001, contributed approximately 16% and 19% to our consolidated sales during 2002 and 2001, respectively.

Our sales of these and other product lines are subject to market conditions and other factors. We are therefore unable to predict the extent, if any, to which the relative contribution of these six and other product lines to our total revenues may increase or decrease in the future.

Cost of goods sold consists of direct costs and allocated costs. Direct costs consist of raw material, packaging material and direct labor identified with a specific product. Allocated costs are costs not associated with a specific product. However, since the allocation of various elements of overhead to individual products or product lines is therefore arbitrary, it is not practical to determine the specific amount or percentage of our profits that may be attributed to any individual product or product line, including our generic equivalent of Lotrisone(R) cream.

Certain customary industry selling practices affect our supply of working capital, including:

o our granting favorable payment terms to customers in connection with their purchasing higher volumes of a product than they would routinely purchase within their normal buying cycle; and

o our discounting selling prices through the issuance of free goods as well as other incentives within a specified time frame if a customer purchases more than a specified amount of a product.

For example, the payment terms that we typically provide to our U.S. customers vary from 30 to as many as 90 days, with the longer terms typically allowed to customers purchasing higher volumes of a product. Similarly, the discounts that we offer may range from two to ten percent (2-10%), with the higher discounts offered in connection with larger sales.

Industry practice requires that pharmaceutical products be made available to customers on demand from existing stock levels rather than on a made-to-order basis. Therefore, in order to adequately accommodate market demand, we try to maintain adequate levels of inventories. The growth of our sales in the past few years has resulted in higher levels of inventory in anticipation of additional business for new products and from new customers, the exact timing of which cannot be determined accurately.

37
SIGNIFICANT ACCOUNTING PRINCIPLES AND POLICIES

U.S. GAAP. Our financial statements are prepared in accordance with accounting principles, and audited annually in accordance with auditing standards, generally accepted in the United States. A discussion of the significant accounting policies, which we follow in preparing our financial statements, is set forth in Note 2 to our consolidated financial statements included elsewhere in this annual report. The following is a summary of certain principles that have a substantial impact upon our financial statements and, we believe, are most important to keep in mind in assessing our financial condition and operating results:

REVENUE RECOGNITION. When we recognize and record revenue from the sale of our pharmaceutical products, we simultaneously record an estimate of various costs, which reduce product sales. These costs include our estimates of product returns, rebates, chargebacks and other sales allowances. In addition, we may record allowances for shelf-stock adjustments when appropriate. We base our estimates for these sales allowances on a variety of factors, including actual return experience of products returned and other products, rebate agreements for each product and estimated sales by our wholesale customers to other third parties who have contracts with us. Actual experience associated with any of these items may differ materially from our estimates. We conduct a review of the factors that influence our estimates periodically. When we find that actual product returns, credits and other allowances differ from our established reserves we make the necessary adjustments.

FUNCTIONAL AND REPORTING CURRENCY. A majority of our revenues is generated, and a substantial portion of our expenses are incurred, in U.S. dollars. Hence, the U.S. dollar is our functional and reporting currency and monetary accounts maintained in other currencies are re-measured into dollars in accordance with Statement No. 52 of the Financial Accounting Standards Board.

USE OF ESTIMATES. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. We evaluate, on an ongoing basis, our estimates, including those related to bad debts, income taxes and contingencies. We base our estimates on historical experience and various other assumptions that we believe to be reasonable under the circumstances. The results of these assumptions are the basis for determining the carrying values of assets and liabilities that are not readily apparent from other sources. These estimates may vary under different conditions.

DEFERRED TAXES. With respect to the tax benefit resulting from our public offering, we record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. While we have considered future taxable income and ongoing prudent and feasible tax planning

38
strategies in assessing the need for the valuation allowance, in the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of our net recorded amount, an adjustment to the deferred tax asset would not increase income in the period such determination was made. However, should we determine that we would not be able to realize all or part of our net deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made. For additional analysis of tax issues, please refer to Note 16 of our consolidated financial statements included elsewhere in this annual report.

RESULTS OF OPERATIONS

The following table sets forth, for the periods indicated, selected items from our consolidated statement of income as a percentage of total sales:

YEAR ENDED DECEMBER 31, ----------------------- 2002 2001 2000 ---- ---- ---- STATEMENT OF INCOME DATA: Sales...................................................... 100% 100% 100% Cost of sales.............................................. 38 37 40 -- -- -- Gross profit............................................... 62 63 60 Operating expenses: Research and development, net.......................... 12 13 14 Selling, marketing, general and administrative......... 25 28 31 -- -- -- Total operating expenses........................ 37 41 45 Operating income........................................... 25 22 15 Financial expenses, net.................................... - 2 4 Other income, net.......................................... - - - Income before taxes on income.............................. 25 20 11 Taxes on income............................................ 4 3 2 - - - Minority interest in earnings of a subsidiary.............. - - - --- --- -- Net income................................................. 21% 17% 9% ==== ==== ===

YEAR ENDED DECEMBER 31, 2002 COMPARED WITH YEAR ENDED DECEMBER 31, 2001

SALES. Sales increased $62.0 million, or 42%, from $149.2 million in 2001 to $211.6 million in 2002. Of such increase, $7.6 million, or 4%, was attributable to the sale of products that we introduced in 2002. The balance of

39
such increase was attributable to increased sales of products which were sold in both 2001 and 2002, including Clotrimazole and Betamethasone Dipropionate Cream, our generic version of Lotrisone(R), which we began to sell in May 2001. Sales in the United States increased $60.1 million, or 49%, from $123.8 million in 2001 to $183.9 million in 2002. Sales in Canada increased by $3.8 million, or 44%, from $9.0 million in 2001 to $12.8 million in 2002. Sales in Israel and other international markets decreased $1.6 million, or 10%, from $16.5 million in 2001 to $14.9 million in 2002. The products introduced during the year in the United States were Amcinonide Cream, Ketoconazole Cream and Econazole Nitrate Cream.

COST OF SALES. Cost of sales increased $24.8 million, or 45%, from $54.7 million in 2001 to $79.5 million in 2002 as a result of the increase in sales described above.

GROSS PROFIT. Gross profit increased $37.6 million, or 40%, from $94.5 million in 2001 to $132.1 million in 2002. Gross profit margin declined from 63% in 2001 to 62% in 2002. The decrease in gross margin in 2002 reflects a higher level of OTC product sales and a competitive environment for certain products, which was offset by increased volume for other products.

RESEARCH AND DEVELOPMENT. Net R&D expenses increased $6.8 million, or 35%, from $19.6 million in 2001 to $26.4 million in 2002. R&D expenses comprised 12% and 13% of sales in 2002 and 2001, respectively. The increase in R&D expenses during 2002 was the result of expanding our research facilities, recruiting additional scientists and pursuing more projects.

SELLING, MARKETING, GENERAL AND ADMINISTRATIVE. SG&A increased $10.4 million, or 25%, from $42.1 million in 2001 to $52.5 million in 2002. Our SG&A expenses as a percentage of sales declined from 28% in 2001 to 25% in 2002. Selling and marketing expenses increased $0.8 million, or 4%, from $19.2 million in 2001 to $20.0 million in 2002. General and administrative expenses increased $9.7 million, or 43%, from $22.8 million in 2001 to $32.5 million in 2002, primarily due to investments in personnel, facilities and infrastructure necessary to accommodate continued growth and expansion in both the United States and international markets.

OPERATING INCOME. Operating income increased $20.5 million, or 62%, from $32.8 million, or 22% of sales, in 2001 to $53.3 million, or 25% of sales, in 2002. The increase was primarily the result of increased sales and improved SG&A margin.

FINANCIAL EXPENSES. Financial expenses consist of interest expense and income, bank credit line maintenance fees and impact of currency fluctuations. Net financial expenses decreased $2.4 million, or 92%, from $2.6 million in 2001 to $0.2 million in 2002. The decrease is primarily the result of interest income realized from the high cash balance maintained during 2002. This income nearly offset most of the company's cost of borrowing.

40
TAXES ON INCOME. Due to a higher level of pre-tax income, our tax expense increased $4.0 million, or 91%, from $4.4 million in 2001 to $8.4 million in 2002, with the effective tax rate increasing from 14% in 2001 to 16% in 2002.

NET INCOME. Our net income increased $18.6 million from $26.0 million in 2001 to $44.6 million in 2002, an increase of 71%, based on the factors cited above.

YEAR ENDED DECEMBER 31, 2001 COMPARED WITH YEAR ENDED DECEMBER 31, 2000

SALES. Sales increased $45.4 million, or 44%, from $103.8 million in 2000 to $149.2 million in 2001. Of such increase, $31.8 million, or 70%, was attributable to the sale of products that we introduced in 2001. The balance of such increase was attributable to increased sales of products that were sold in both 2000 and 2001. Sales in the United States increased $39.2 million, or 46%, from $84.6 million in 2000 to $123.8 million in 2001. Sales in Canada increased by $3.3 million, or 58%, from $5.7 million in 2000 to $9.0 million in 2001. Sales in Israel and other international markets increased $3.0 million, or 22%, from $13.5 million in 2000 to $16.5 million in 2001. The most significant products introduced in the United States during the year were: Clotrimazole and Betamethasone Dipropionate Cream, Amiodarone Hydrochloride Tablets, Enalapril Maleate Tablet and Enalapril Maleate and Hydrochlorothiazide Tablets.

COST OF SALES. Cost of sales increased $13.5 million, or 33%, from $41.2 million in 2000 to $54.7 million in 2001. Cost of sales grew at a slower pace than sales due to the introduction of new products and increased manufacturing efficiency.

GROSS PROFIT. Gross profit increased $31.9 million, or 51%, from $62.6 million in 2000 to $94.5 million in 2001. Gross profit margin improved from 60% in 2000 to 63% in 2001. The increase in gross margin in 2001 reflects higher sales volume, reduction in unit production costs and an increased contribution from new products that traditionally exhibit higher profit margin.

RESEARCH AND DEVELOPMENT. Net R&D expenses increased $5.0 million, or 34%, from $14.6 million in 2000 to $19.6 million in 2001. R&D expenses comprised 13% of sales in 2001 and 14% of sales in 2000. The increase in R&D expenses during 2001 was the result of expanding our research facilities, recruiting additional scientists and pursuing more projects.

SELLING, MARKETING, GENERAL AND ADMINISTRATIVE. SG&A increased $10.2 million, or 32%, from $31.9 million in 2000 to $42.1 million in 2001. Our SG&A expenses as a percentage of sales were 29% in 2001 and 31% in 2000. Selling and marketing expenses increased from $13.6 million in 2000 to $19.3 million in 2001 primarily due to promotion initiatives in relation to the introduction of new products. General and administrative expenses increased $4.5 million, or 25%, from $18.3 million in 2000 to $22.8 million in 2001, primarily due to investments in personnel and infrastructure necessary to accommodate continued growth and expansion in international markets.

41
OPERATING INCOME. Operating income increased $16.7 million, or 104%, from $16.1 million in 2000 to $32.8 million in 2001. The increase was primarily the result of increased sales and improved gross margins.

FINANCIAL EXPENSES. Net financial expenses decreased $1.3 million, or 33%, from $3.9 million in 2000 to $2.6 million in 2001. While our outstanding indebtedness increased to $55.3 million at December 31, 2001 from $44.6 million at December 31, 2000, a greater portion of our debt was long-term and therefore effective interest rates on our borrowings were lower in 2001 than in 2000. We also realized a financial gain, which offset some of the expenses, due to our significant cash position during the fourth quarter resulting from our successful public offering, positive cash flows from operations, decrease in interest rates and favorable foreign currency exchanges.

TAXES ON INCOME. Income tax expenses increased $1.9 million, or 76%, from $2.5 million in 2000 to $4.4 million in 2001, with the effective tax rate decreasing to 14% from 20% in the prior year.

NET INCOME. Our net income increased $16.0 million from $10.0 million in 2000 to $26.0 million in 2001, an increase of 160%, based on the factors cited above.

IMPACT OF INFLATION, DEVALUATION, (APPRECIATION) AND EXCHANGE RATES ON RESULTS OF OPERATIONS, LIABILITIES AND ASSETS

We conduct manufacturing, marketing and research and development operations primarily in Israel, Canada and the United States. As a result, we are subject to risks associated with fluctuations in the rates of inflation and foreign exchange in each of these countries.

The following table sets forth the annual rate of inflation, the devaluation (appreciation) rate of the NIS and the Canadian dollar against the U.S. dollar and the exchange rates between the U.S. dollar and each of the NIS and the Canadian dollar at the end of the year indicated:

RATE OF RATE OF DEVALUATION RATE OF EXCHANGE YEAR INFLATION (APPRECIATION) OF U.S. DOLLAR AGAINST U.S. DOLLAR ----------------------------------------------------------------------------------------------------------------------------------- Israel Canada Israel Canada Israel Canada ------ ------ ------ ------ ------ ------ 1998 8.6% 1.9% 17.6% 7.3% 4.16 1.53

1999 1.3% 2.6% (0.2%) (5.9%) 4.15 1.44

2000 0.0% 3.2% (2.7%) 3.9% 4.04 1.50

2001 1.4% 0.7% 9.3% 6.2% 4.42 1.59

2002 6.5% 3.9% 7.2% (1.2)% 4.74 1.58

42

B. LIQUIDITY AND CAPITAL RESOURCES

LIQUIDITY

Cash and cash equivalents were $130.7 million at December 31, 2002 as compared to $150.7 million at December 31, 2001. The two major reasons for this $20.0 million decrease were the acquisition of the assets of Thames Pharmacal Company, Inc. and our facilities expansion programs. The increase in sales caused trade accounts receivable to increase by 68%, to $69.0 million at December 31, 2002, from $41.1 million at year-end 2001. Inventory levels increased 46% from December 31, 2001 to December 31, 2002, primarily to support increased sales. Shareholders' equity increased from $218.4 million at December 31, 2001 to $269.1 million at December 31, 2002, principally due to net income contribution to retained earnings and tax benefits related to the exercise of stock options.

We generated cash from operations amounting to $29.6 million for the year ended December 31, 2002 as compared to $27.4 million in the prior year. The increase in cash from operations is the result of increases in net income, amortization and depreciation, which were partially offset by other working capital items.

Our long-term debt (including current maturities of $8.0 million) outstanding as of December 31, 2002 was approximately $55.1 million and was comprised of the following:

o bonds payable of $20.7 million;

o obligations of $29.7 million under a bank credit agreement;

o mortgage payable of $3.9 million; and o capital lease obligations of $0.8 million.

The bonds are not transferable or traded by us, but may be transferred by the bondholders," and are secured by floating charges placed on all of our assets other than on the shares of our non-Israeli subsidiaries. The bonds are either linked to the Israeli consumer price index, or CPI, and bear interest of 8.25% or linked to the U.S. dollar and bear interest at varying interest rates between LIBOR +2% to LIBOR +3% per year and are for a term of approximately ten years. We have a contract to hedge our exposure to CPI fluctuations in Israel. Under the bond agreements, our debt to equity ratio may not be greater than 2:1 and our current ratio may not be lower than 1:1. Our bank credit agreements contain similar financial covenants. We are currently in compliance with these covenants.

43
We anticipate that our operating cash flow, together with available borrowings under our credit facilities and cash balances, will be sufficient to meet all of our working capital, capital expenditure and interest requirements for both the short term and the foreseeable future. As for commitments for future capital expenditures please see Note 6(f) to our consolidated financial statements included elsewhere in this annual report.

CAPITAL EXPENDITURES

We invested $43.2 million in the year ended December 31, 2002 and $19.3 million in the year ended December 31, 2001 in capital equipment and facilities. These investments principally related to expanding and upgrading our research and development laboratories and our pharmaceutical and chemical manufacturing facilities in Israel, Canada and the United States and maintaining compliance with cGMP, while increasing manufacturing capacity. In addition to facility-related investments, we also acquired certain manufacturing and packaging equipment that should increase production capacity. We also continued to upgrade our information systems infrastructure, allowing for more efficient production scheduling and enhanced inventory analysis. See Note 6 to our consolidated financial statements included elsewhere in this annual report for an analysis of property, plant and equipment activity in 2002.

TAX MATTERS

TAX LOSS CARRYFORWARD AND EFFECTIVE TAX RATES

As of December 31, 2002, on an unconsolidated basis, we had an available tax loss carryforward of $1.4 million in Israel, $3.3 million in the United Kingdom and $59.2 million in the United States. The loss carryforward in the United States resulted from the exercise of certain options during 2001. Our consolidated effective tax rates were 16%, 14% and 20% in 2002, 2001 and 2000, respectively.

APPROVED ENTERPRISE STATUS IN ISRAEL

Israeli companies are generally subject to tax at the rate of 36% of taxable income. However, our facilities in Israel have received Approved Enterprise status from the Israel Investment Center, which entitles us to receive certain tax benefits. We have elected to receive an alternative package of benefits under the Law for Encouragement of Capital Investments. We have received four approvals granting us an alternative package of benefits, subject to compliance with applicable requirements. Under the first approval, our undistributed income derived from one Approved Enterprise will be exempt from corporate tax for a period of four years from 2001, and we will be eligible for a reduced tax rate of between 10% to 15% for an additional two years (taking into account the time limits imposed by the Law for Encouragement of Capital Investments, 1959). Under the second approval, our undistributed income

44
derived from another Approved Enterprise will be exempt from corporate tax for a period of two years from 2001 and we will be eligible for a reduced tax rate of between 10% to 15% for an additional eight years. Under the third approval (benefit period starting 2003) and the fourth approval, our undistributed income derived from the third and fourth Approved Enterprises will be exempt from corporate tax for a period of two years following implementation of the plan. We will be eligible for a reduced tax rate of between 10% to 15% for an additional eight years thereafter. As a result, a substantial portion of the profits derived from products manufactured in Israel may benefit from a reduced Israeli tax rate.

C. RESEARCH AND DEVELOPMENT, PATENTS, TRADE MARKS AND LICENSES

Most of our sales are derived from products that are the result of our own research and development. We believe that our research and development activities have been a principal contributor to our achievements to date and that our future performance will depend, to a significant extent, upon the results of these activities.

In 1991, we formed Taro Research Institute Ltd., or the Institute, for the purpose of consolidating our pharmaceutical and chemical research activities. The Institute coordinates all of our research and development activities on a global basis.

Recruiting talented scientists is essential to the success of our research and development programs. Approximately 20% of our employees work in our worldwide research and development programs. More than 58 of our scientists hold either M.D. or Ph.D. degrees.

We currently conduct research and development in three principal areas:

o generic pharmaceuticals, where our programs have resulted in our developing and introducing a wide range of pharmaceutical products (including tablets, capsules, injectables, suspensions, solutions, creams and ointments) that are equivalent to numerous brand-name products whose patents and FDA exclusivity periods have expired;

o proprietary pharmaceuticals and delivery systems, in which we are developing T-2000 and products utilizing the NonSpil(TM) delivery system; and

o organic and steroid chemistry, where our programs have enabled us to synthesize the active ingredients used in many of our products.

GENERIC PHARMACEUTICALS

In 2002, we received multiple product approvals in Canada, Israel and the United States. The following table sets forth the approvals in the United States by the FDA during 2002:

45
GENERIC NAME BRAND NAME EQUIVALENT

Amiodaron Tablets 100mg, 400mg Cordarone(R) Amcinonide Cream Cyclocort(R) Ketoconazole Cream Nizoral(R) Econazole Nitrate Cream Spectazole(R) Loratadine Syrup* Claritin(R)

* Tentative approval

Currently, 21 of our ANDAs and 1 NDA are being reviewed by the FDA. In addition, there are multiple products for which either developmental or internal regulatory work is in process. The applications pending before the FDA are at various stages in the review process, and there can be no assurance that we will be able to successfully complete any remaining testing or that, upon completion of such testing, approvals for any of the applications currently under review at the FDA will be granted. In addition, there can be no assurance that the FDA will not grant approvals for competing products submitted by our competitors.

PROPRIETARY TECHNOLOGIES

T-2000

We are currently conducting Phase II studies on T-2000, our patented non-sedating barbiturate compound. This product is currently intended for the treatment of epilepsy and essential tremor, but may have other indications. It is intended to be a long-acting, non-sedating anticonvulsant that permits increased patient compliance and reduced side effects.

T-2000 must complete Phase II testing, successfully undergo Phase III studies and obtain regulatory approval in order to reach the market. There can be no assurance of the successful completion of Phase II or Phase III testing, the approval by the FDA of the drug or the commercial success of this drug.

NONSPIL(TM)

We also continue to work on the NonSpil(TM) liquid drug delivery system, which allows liquid medications to pour, but not spill, thereby increasing the accuracy of dosage and ease of use.

46
NonSpil(TM) development activities include improving product formulations, refining taste and texture, "scaling up" from laboratory sized manufacturing to commercial sized manufacturing and preparing the marketing program for this new delivery system. While there can be no assurance of commercial success, we hope to introduce NonSpil(TM) formulations in commercial markets where it can contribute to both pediatric and geriatric healthcare.

PATENTS, TRADEMARKS AND LICENSES

Since 1986, we have received patents in the United States for:

o anticonvulsant, tranquilizer and muscle relaxant drugs; o groups of antiarrhythmic drugs;

o novel oral delivery for pharmaceutical and related products; and

o the synthesis and formulation of some of our products.

To date, none of these patents has been commercialized.

WE HAVE REGISTERED TRADEMARKS IN THE UNITED STATES AND IN CANADA. MOREOVER, WE HAVE RECENTLY ACQUIRED THE RIGHTS TO USE THE A/T/S(R), KERASAL(R), OVIDE(R), PRIMSOL(R) AND TOPICORT(R) TRADEMARKS IN THE UNITED STATES. TARO U.S.A. CURRENTLY DOES NOT USE TRADEMARKS IN THE SALE AND MARKETING OF ITS GENERIC PRODUCTS. WE DO NOT BELIEVE THAT ANY SINGLE PATENT, TRADEMARK OR LICENSE IS OF MATERIAL IMPORTANCE TO US IN RELATION TO OUR CURRENT COMMERCIAL ACTIVITIES.

D. TREND INFORMATION

NOT APPLICABLE.