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, 2003, 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 Israel, Canada and the United
States. 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 the United States. During the past three
years, three major drug wholesalers in the United States accounted for the
following proportion of our total consolidated sales in millions:
2003 2002 2001
Customer Amount Percent Amount Percent Amount Percent
AmerisourceBergen Corporation $ 62.7 20 % $ 46.5 22 % $ 19.4 13 %
McKesson Corporation $ 53.0 17 % $ 25.4 12 % $ 22.3 15 %
Cardinal Health, Inc. $ 28.4 9 % $ 19.0 9 % $ 13.4 9 %
We also sell active pharmaceutical ingredients to unaffiliated customers
around the world. Sales of active pharmaceutical ingredients to third parties
have historically represented
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less than 1% 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.
Thus, our future operating results are dependent on, among other factors, our
ability to introduce new products. In addition, the operating results are
dependent on the impact of pricing pressures on existing products. These pricing
pressures are inherent in the generic pharmaceutical industry.
In 2003 and 2002, sales of seven product lines contributed approximately
54% and 53% of our consolidated sales, respectively. These seven product lines
include four topical product families and three oral product families.
Clotrimazole and betamethasone dipropionate cream, our generic equivalent of
Lotrisone® cream, which we introduced into the market in May 2001, contributed
approximately 10% and 16% to our consolidated sales during 2003 and 2002,
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 to our total revenues of these seven product
lines as well as other product lines may increase or decrease in the future.
Cost of goods sold consists of direct costs and allocated costs. Direct
costs consist of raw materials, packaging materials and direct labor identified
with a specific product. Allocated costs are costs not associated with a
specific product. Since the allocation of various elements of overhead to
individual products or product lines is to some extent 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® cream.
Certain customary industry selling practices affect our supply of working
capital, including, but not limited to providing favorable payment terms to
customers and discounting selling prices through the issuance of free products
as well as other incentives within a specified time frame if a customer
purchases more than a specified threshold of a product. These incentives are
provided principally with the intention of maintaining or expanding our
distribution at the expense of competing products.
For example, the payment terms that we typically provide to our U.S.
customers vary from 30 to more than 90 days, with the longer terms typically
allowed to customers purchasing higher volumes of a product. Similarly, the cash
discounts that we offer may range from two to more than ten percent, 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 accommodate market demand, we try to maintain
adequate levels of inventories. Increased demand for existing products and
preparation for new product
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launches, the exact timing of which cannot be determined accurately, has
resulted in higher levels of inventory. However, anticipated growth in sales of
any individual product or of all products may not materialize. Consequently,
inventories prepared for these sales may become obsolete and have to be written
off.
Critical Accounting Policies
Our significant accounting policies are described in Note 2 to our
Consolidated Financial Statements, which we have prepared in accordance with
accounting principles generally accepted in the United States. The preparation
of these financial statements requires us to make estimates and judgements 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 currently
available information, our 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. Since the factors
underlying these assumptions are subject to change over time, the estimates on
which they are based are subject to change accordingly.
The following is a summary of certain policies that have a critical 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. Revenue is recognized when delivery to our customers
has occurred. When we recognize and record revenue from the sale of our
pharmaceutical products, we simultaneously record an estimate of various future
costs related to the sale. This has the effect of reducing the amount of
reported 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, 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. In addition, it is customary in the generic industry to
grant customers shelf-stock adjustments based on customers' existing levels of
inventory and the decrease in market price of the related product. When market
prices for our product decline, we may elect to provide shelf-stock adjustments
and thereby allow customers with existing inventories to compete at the lower
product price. These shelf-stock adjustments are intended to support our market
position and to promote customers' loyalty.
Functional and Reporting Currency. A majority of our revenues is generated,
and a substantial portion of our expenses is incurred, in U.S. dollars. Hence,
the U.S. dollar is our functional and reporting currency. Monetary accounts that
are maintained in other currencies are re-measured into dollars in accordance
with Statement No. 52 of the Financial Accounting Standards Board.
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Product Rights. Our rights in licensed or acquired products are stated at
cost, less accumulated amortization. Product rights are amortized using the
straight-line method over their estimated useful lives ranging from five to
twenty years. We determine amortization periods for product rights based on our
assessment of various factors impacting estimated useful lives and cash flows
generated by the acquired products. These factors include a product's position
in its life cycle, the existence of like products in the marketplace, various
other competitive and regulatory issues, and contractual terms. Significant
changes to any of these factors may result in a reduction in a product right's
useful life and acceleration of related amortization expense which could cause
our operating income, net income and earnings per share to decline.
Deferred Taxes. In 2001, we conducted a public offering of our ordinary
shares. In connection with the offering, we recorded, as of December 31, 2003,
approximately $9.5 million of deferred tax assets due to the exercise of stock
options by the selling shareholders. In the event that it appears that the
amount of these deferred tax assets is, at any time, greater than the amount
that we are likely to realize, we will reduce the amount at which we carry the
deferred tax assets accordingly. Any such reduction would result in a charge to
income, in the amount of the reduction, for the period in which the reduction
was made. For additional analysis of tax issues, please refer to Note 14 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,
2003 2002 2001
Statement of Income Data:
Sales 100 % 100 % 100 %
Cost of sales 32 38 37
Gross profit 68 62 63
Operating expenses:
Research and development, net 13 12 13
Selling, marketing, general and administrative 31 25 28
Total operating expenses 44 37 41
Operating income 24 25 22
Financial expenses, net 1 - 2
Other income, net - - -
Income before taxes on income 23 25 20
Taxes on income 4 4 3
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Year ended December 31,
2003 2002 2001
Minority interest in earnings of a subsidiary - - -
Net income 19 % 21 % 17 %
Year Ended December 31, 2003 compared with Year Ended December 31, 2002
Sales. During 2003, our sales increased $103.9 million, or 49%, from the
amount of sales we reported in 2002. Of this increase, $27.7 million, or 27%,
was attributable to the sale of products that we introduced in 2003. The balance
of this increase was attributable to increased sales of products which were sold
in both 2002 and 2003, including clotrimazole and betamethasone dipropionate
cream, our generic version of Lotrisone®, which we began to sell in May 2001.
Sales in the United States during 2003 increased $99.3 million, or 54%, from the
amount we reported in 2002. Sales in Canada increased by $2.8 million, or 22%,
and sales in Israel and other international markets increased $1.8 million, or
12%, from 2002. The products introduced during the year in the United States
included bethametasone dipropionate (augmented) cream, ammonium lactate cream
and etodolac XR tablets in three strengths, 400, 500 and 600 mg. In the United
States, we also introduced our ElixSure® line of products and the four branded
products we acquired earlier in the year from Medicis Pharmaceutical
Corporation.
Cost of Sales. Cost of sales increased by 29%, in 2003, as a result of the
49% increase in sales described above.
Gross Profit. Gross profit margin increased from 62% in 2002 to 68% in
2003. The increase reflects a higher level of branded product sales and a
favorable competitive environment for the generic products.
Research and Development. Net R&D expenses increased $14.2 million, or 54%,
in 2003. R&D expenses equaled 13% and 12% of sales in 2003 and 2002,
respectively. The increase in R&D expenses during 2003 was the result of
expanding our research facilities, recruiting additional scientists and pursuing
more projects.
Selling, General and Administrative. In 2003, SG&A increased $45.2 million,
or 86%, from the amount we recorded in 2002. Our SG&A expenses as a percentage
of sales increased from 25% in 2002 to 31% in 2003. Selling and marketing
expenses increased $32.4 million, or 162%, primarily due to the recruitment of
medical representatives and promotional campaigns, including media advertising,
aimed at supporting our branded initiatives in the United States. General and
administrative expenses increased $12.8 million, or 39%, primarily due to
investments in personnel, facilities and infrastructure necessary to accommodate
continued growth and expansion in the United States and other markets.
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Operating Income. Operating income increased $21.4 million, or 40% in 2003.
The increase was primarily the result of increased sales and improved gross
profit margins.
Financial Expenses. Financial expenses consist of interest expense and
income, and the impact of currency fluctuations. Net financial expenses
increased $1.5 million, or 962%, in 2003. The increase is primarily the result
of a higher level of interest expenses as we increased our level of borrowing
during 2003. The increase in interest expenses was partially offset by interest
income that we earned on our cash balances and from foreign currency hedging
transactions.
Taxes on Income. Due to a higher level of pre-tax income, our tax expense
increased $3.1 million, or 36%, in 2003. Our effective tax rate was 16% in both
2002 and 2003.
Net Income. Our net income increased $16.6 million from $44.6 million in
2002 to $61.2 million in 2003, an increase of 37%, based on the factors cited
above.
Year Ended December 31, 2002 compared with Year Ended December 31, 2001
Sales. During 2002, sales increased $62.0 million, or 42%, from the amount
we recorded in 2001. Of this increase, $7.6 million, or 4%, was attributable to
the sale of products that we introduced in 2002. The balance of the increase was
attributable to increased sales of products that were sold in both 2001 and
2002, including clotrimazole and betamethasone dipropionate cream, our generic
version of Lotrisone®, which we began to sell in May 2001. Sales in the United
States increased $60.1 million, or 49%, in 2002. Sales in Canada increased by
$3.8 million, or 44%, in 2002. Sales in Israel and other international markets
decreased $1.6 million, or 10%, 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% in 2002, as a
result of the 42% increase in sales described above.
Gross Profit. Gross profit increased $37.6 million, or 40% in 2002 but
gross profit margins declined from 63% in 2001 to 62% in 2002. The decrease
reflects a higher level of OTC product sales and a competitive environment for
some products, which was partially offset by an increased volume of sales for
other products.
Research and Development. Net R&D expenses increased $6.8 million, or 35%
in 2002. R&D expenses equaled 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, General and Administrative. SG&A increased $10.4 million, or 25%
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% in
2002. General and administrative expenses increased $9.7 million, or 43% in
2002, primarily due to investments
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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% in 2002.
The increase was primarily the result of increased sales and improved SG&A
margin.
Financial Expenses. Net financial expenses decreased $2.4 million, or 92%
in 2002 primarily as a 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.
Taxes on Income. Due to a higher level of pre-tax income, our tax expense
increased $4.0 million, or 91% in 2002, with our 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.
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:
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Rate of Devaluation
Rate of (Appreciation) Rate of Exchange
Inflation Against U.S. Dollar of U.S. Dollar
Year Israel (1) Canada (2) Israel (1) Canada (3) Israel (1) Canada (3)
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
2003 (1.9 )% 2.0 % (7.6 )% (17.8 )% 4.38 1.30
Sources: (1) Bank of Israel. (2) Statistics Canada. (3) Bank of Canada.
B. LIQUIDITY AND CAPITAL RESOURCES
Liquidity
Cash and cash equivalents increased by $28.4 million to $159.1 million at
December 31, 2003. During 2003, we completed two private placements of bonds to
institutional investors in Israel in the aggregate amount of $110 million,
primarily to fund our capital expansion programs. Our increase in sales caused
trade accounts receivable to increase by 75%, to $120.5 million at December 31,
2003. Inventory levels increased 99% from December 31, 2002 to December 31,
2003, primarily due to strategic API acquisitions and to support increased level
of sales. Shareholders' equity increased from $269.1 million at December 31,
2002 to $347.4 million at December 31, 2003, 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 $5.2 million for the year
ended December 31, 2003 as compared to $29.6 million in the prior year. The
decrease in cash from operations is the result of increases in trade receivables
and inventory, which were partially offset by higher amortization and
depreciation, higher net income and other working capital items.
Our long-term debt outstanding as of December 31, 2003 was approximately
$181.4 million, including current maturities of $24.4 million, and was comprised
of the following:
• bonds payable of $130.4 million;
• obligations of $29.7 million under a bank credit agreement; and
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• mortgage payable, capital leases and other obligations of $21.3 million.
Our bond obligations consist of the following, in millions:
Amount Linkage Rate Maturity
$15.8 Israel CPI 8.25% 2004-2010
$48.0 Israel CPI 5.8% 2004-2014
$2.1 Dollar Libor + 2-3% 2004-2010
$64.5 Dollar 6% 2004-2010
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. In addition the bonds that we
issued during the year require that we maintain an interest coverage ratio of
2:1. The interest coverage ratio is defined as earnings before interest, taxes,
depreciation and amortization expenses, or EBITDA, divided by net interest
expenses plus the current principal repayment. We are currently in compliance
with these covenants.
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 5(d) to our consolidated financial
statements included elsewhere in this annual report.
Capital Expenditures
We invested $94.4 million in capital equipment and facilities during the
year ended December 31, 2003 and $43.2 million during the year ended December
31, 2002. These investments are principally related to expanding and upgrading
our research and development laboratories and our pharmaceutical and chemical
manufacturing facilities in Israel, Canada, Ireland and the United States and
maintaining compliance with cGMPs, while increasing manufacturing capacity. In
addition to facility-related investments, we acquired certain manufacturing and
packaging equipment to increase production capacity. We also continued to
upgrade our information systems infrastructure, to enable more efficient
production scheduling and enhanced inventory analysis. See Note 5 to our
consolidated financial statements included elsewhere in this annual report for
an analysis of property, plant and equipment activity in 2003.
Tax Matters
Tax Loss Carryforward and Effective Tax Rates
As of December 31, 2003, on an unconsolidated basis, we had an available
tax loss carryforward of $1.3 million in Israel, $3.9 million in the United
Kingdom and $37.5 million in the United States. The loss carryforward in the
United States principally resulted from the
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exercise by employees of stock options during 2001. Our consolidated effective
tax rates were 16%, 16% and 14% in 2003, 2002 and 2001, 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 specified tax benefits. We have received three approvals granting us a
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 25% for
an additional two years. Under the second approval, our undistributed income
derived from another Approved Enterprise was exempt from corporate tax for a
period of two years from 2001 and we will be eligible for a reduced tax rate of
10% to 25% for an additional eight years. Under the third approval (benefit
period starting 2003), our undistributed income 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 25% for an additional thirteen
years thereafter. All of these programs are subject to time limits imposed by
the Law for Encouragement of Capital Investments, 1959 and based upon the level
of foreign ownership in our company in each tax year. To retain the most
favorable rates we must maintain a foreign shareholders' level of at least 90%.
Currently, we exceed this level. As a result of these programs, a substantial
portion of the profits derived from products manufactured in Israel may benefit
from a reduced Israeli tax rate. Additionally, in October 2003, we submitted an
application for a fourth approval for capital investments that will be
implemented by the end of 2005.