##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 WASHINGTON, D.C. 20549
 FORM 10-Q (Mark One) þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
  OR o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
  Commission File No. 0-19842 PolyMedica Corporation  Massachusetts
    
    
    
    04-3033368(State or other jurisdiction of
incorporation or organization)
    
    
    
    (I.R.S. Employer
Identification No.)
 11 State Street, Woburn, Massachusetts
    
    
    
    
    
    01801(Address of principal executive offices)
    
    
    
    (Zip Code)
 Registrants telephone number, including area code
    
    
    
    (781)933-2020
 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 an accelerated filer (as defined in Rule
12b-2 of the Exchange Act). Yes  þ  No  o As
of February 8, 2005, there were 27,742,686 shares of the registrants Common Stock issued
and outstanding.




---



##### Table of Contents



POLYMEDICA CORPORATION
TABLE OF CONTENTS PagePART I -
    
    FINANCIAL INFORMATIONItem 1 -
    
    Financial Statements (unaudited)Consolidated Balance Sheets as of December 31 and March 31, 2004
    
    
    3Consolidated Statements of Income for the three and nine months ended December 31, 2004 and 2003
    
    
    5Consolidated Statements of Cash Flows for the nine months ended December 31, 2004 and 2003
    
    
    6Notes to Consolidated Financial Statements
    
    
    7Item 2 -
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    18Item 3 -
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    34Item 4 -
    
    Controls and Procedures
    
    
    35PART II -
    
    OTHER INFORMATIONItem 1 -
    
    Legal Proceedings
    
    
    36Item 6 -
    
    Exhibits
    
    
    37Signatures
    
    
    
    
    38Exhibit Index
    
    
    
    
    39Ex-10.41 Letter Agreement amendment to Retirement AgreementEx-31.1 Section 302 Certification of the C.E.O.Ex-31.2 Section 302 Certification of C.F.O.Ex-32.1 Section 906 Certification of C.E.O. & C.F.O.
 2




---



##### Table of Contents



PART I - FINANCIAL INFORMATION 
 Item 1. Financial Statements PolyMedica Corporation 
 Consolidated Balance Sheets
 (Unaudited)
 (In thousands, except share and per share amounts)
 December 31,
    
    
    March 31,2004
    
    
    2004ASSETSCurrent assets:Cash and cash equivalents
    
    $
    60,174
    
    
    $
    69,229Marketable securities
    
    
    6,997
    
    
    
    7,421Restricted cash
    
    
    512
    
    
    
    512Accounts receivable (net of allowances
of $32,276 and $29,700 as of December 31
and March 31, 2004, respectively)
    
    
    70,473
    
    
    
    63,828Inventories
    
    
    28,912
    
    
    
    18,745Deferred income taxes
    
    
    18,331
    
    
    
    18,331Income tax receivable
    
    
    
    
    
    
    2,530Prepaid expenses and other current assets
    
    
    6,069
    
    
    
    4,438Total current assets
    
    
    191,468
    
    
    
    185,034Property, plant and equipment, net
    
    
    61,605
    
    
    
    61,659Goodwill
    
    
    5,946
    
    
    
    5,946Customer lists, net
    
    
    7,926
    
    
    
    383Direct-response advertising, net
    
    
    72,269
    
    
    
    64,953Other assets
    
    
    555
    
    
    
    1,193Total assets
    
    $
    339,769
    
    
    $
    319,168
 The accompanying notes are an integral part of these unaudited consolidated financial statements. 3




---



##### Table of Contents



PolyMedica Corporation
Consolidated Balance Sheets
(Unaudited)(In thousands, except share and per share amounts) December 31,
    
    
    March 31,2004
    
    
    2004LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    9,441
    
    
    $
    11,874Accrued expenses
    
    
    20,827
    
    
    
    21,872Current portion, capital lease obligations
    
    
    551
    
    
    
    292Total current liabilities
    
    
    30,819
    
    
    
    34,038Capital lease and other obligations
    
    
    1,369
    
    
    
    1,691Deferred income taxes
    
    
    24,611
    
    
    
    24,611Total liabilities
    
    
    56,799
    
    
    
    60,340Commitments and contingenciesShareholders equity:Preferred stock, $0.01 par value; 2,000,000
shares authorized, none issued or outstanding
    
    
    
    
    
    
    Common stock, $0.01 par value; 50,000,000 shares
authorized; 27,730,010 and 26,674,520 shares
issued as of December 31 and March 31, 2004
    
    
    277
    
    
    
    267Additional paid-in capital
    
    
    151,858
    
    
    
    136,236Retained earnings
    
    
    130,835
    
    
    
    122,325Total shareholders equity
    
    
    282,970
    
    
    
    258,828Total liabilities and shareholders equity
    
    $
    339,769
    
    
    $
    319,168
 The accompanying notes are an integral part of these unaudited consolidated financial statements. 4




---



##### Table of Contents



PolyMedica Corporation 
 Consolidated Statements of Income
 (Unaudited)
 (In thousands, except per share amounts)
 Three Months Ended
    
    
    Nine Months EndedDec. 31,
    
    
    Dec. 31,
    
    
    Dec. 31,
    
    
    Dec. 31,2004
    
    
    2003
    
    
    2004
    
    
    2003Net revenues
    
    $
    114,063
    
    
    $
    106,463
    
    
    $
    336,682
    
    
    $
    310,622Cost of sales
    
    
    46,079
    
    
    
    40,399
    
    
    
    134,173
    
    
    
    114,428Gross margin
    
    
    67,984
    
    
    
    66,064
    
    
    
    202,509
    
    
    
    196,194Selling, general and administrative expenses
    
    
    45,934
    
    
    
    62,733
    
    
    
    141,120
    
    
    
    155,855Settlement charge
    
    
    
    
    
    
    
    
    
    
    29,987
    
    
    
    Income from operations
    
    
    22,050
    
    
    
    3,331
    
    
    
    31,402
    
    
    
    40,339Other income and expense:Investment income
    
    
    424
    
    
    
    174
    
    
    
    1,004
    
    
    
    501Interest expense and other
    
    
    (26
    )
    
    
    (20
    )
    
    
    (63
    )
    
    
    (59
    )398
    
    
    
    154
    
    
    
    941
    
    
    
    442Income before income taxes
    
    
    22,448
    
    
    
    3,485
    
    
    
    32,343
    
    
    
    40,781Income tax provision
    
    
    8,351
    
    
    
    1,317
    
    
    
    11,620
    
    
    
    15,415Net income
    
    $
    14,097
    
    
    $
    2,168
    
    
    $
    20,723
    
    
    $
    25,366Net income per weighted average share:Basic
    
    $
    0.51
    
    
    $
    0.08
    
    
    $
    0.76
    
    
    $
    1.01Diluted
    
    $
    0.50
    
    
    $
    0.08
    
    
    $
    0.74
    
    
    $
    0.98Cash dividend per share
    
    $
    0.15
    
    
    $
    0.15
    
    
    $
    0.45
    
    
    $
    0.40Weighted average shares, basic
    
    
    27,501
    
    
    
    25,645
    
    
    
    27,216
    
    
    
    25,062Weighted average shares, diluted
    
    
    28,162
    
    
    
    26,636
    
    
    
    27,841
    
    
    
    25,930
 The accompanying notes are an integral part of these unaudited consolidated financial statements. 5




---



##### Table of Contents



PolyMedica Corporation 
 Consolidated Statements of Cash Flows
 (Unaudited)
 (In thousands)
 Nine Months EndedDec. 31,2004
    
    
    2003Cash flows from operating activities:Net income
    
    $
    20,723
    
    
    $
    25,366Adjustments to reconcile net income to net cash flows:Impairment of direct-response advertising
    
    
    
    
    
    
    14,443Depreciation and amortization
    
    
    7,684
    
    
    
    5,989Deferred income taxes
    
    
    
    
    
    
    (4,875
    )Amortization of direct-response advertising
    
    
    27,519
    
    
    
    32,628Direct-response advertising expenditures
    
    
    (34,835
    )
    
    
    (42,431
    )Provision for bad debts
    
    
    15,993
    
    
    
    16,807Provision for sales allowances/returns
    
    
    13,219
    
    
    
    14,792Loss on disposal or sale of equipment
    
    
    691
    
    
    
    240Loss on impairment of customer list
    
    
    152
    
    
    
    Stock-based compensation
    
    
    
    
    
    
    246Changes in assets and liabilities:Accounts receivable
    
    
    (35,857
    )
    
    
    (20,870
    )Income tax receivable
    
    
    2,530
    
    
    
    Inventories
    
    
    (10,167
    )
    
    
    (1,357
    )Prepaid expenses and other assets
    
    
    (1,694
    )
    
    
    (454
    )Accounts payable
    
    
    (2,433
    )
    
    
    (9,295
    )Accrued expenses and other liabilities
    
    
    (904
    )
    
    
    7,661Net cash flows provided by operating activities
    
    
    2,621
    
    
    
    38,890Cash flows from investing activities:Purchase of marketable securities
    
    
    (10,535
    )
    
    
    (11,448
    )Proceeds from maturing marketable securities
    
    
    10,958
    
    
    
    5,799Purchase of property, plant and equipment
    
    
    (6,354
    )
    
    
    (14,859
    )Purchase of customer lists
    
    
    (8,722
    )
    
    
    (338
    )Net cash flows used for investing activities
    
    
    (14,653
    )
    
    
    (20,846
    )Cash flows from financing activities:Proceeds from issuance of common stock
    
    
    15,632
    
    
    
    17,318Contributions to deferred compensation plans
    
    
    (141
    )
    
    
    (364
    )Payment of dividends declared on common stock
    
    
    (12,213
    )
    
    
    (10,007
    )Payment of capital lease and note payable obligations
    
    
    (301
    )
    
    
    (2,282
    )Net cash flows provided by financing activities
    
    
    2,977
    
    
    
    4,665Net change in cash and cash equivalents
    
    
    (9,055
    )
    
    
    22,709Cash and cash equivalents at beginning of period
    
    
    69,229
    
    
    
    27,162Cash and cash equivalents at end of period
    
    $
    60,174
    
    
    $
    49,871Supplemental disclosure of cash flow information:Assets purchased under capital lease
    
    $
    979
    
    
    $
    247Disposal of equipment
    
    
    1,304
    
    
    
    664
 The accompanying notes are an integral part of these unaudited consolidated financial statements. 6




---



##### Table of Contents



PolyMedica Corporation 
 Notes to Consolidated Financial Statements
 1. Basis of Presentation Company PolyMedica Corporation was organized in 1988 and has been in the medical product and
pharmaceutical business for over 15 years. Today, through our primary segment, Liberty Diabetes,
we are a leading provider of direct-to-consumer diabetes testing supplies and related services,
primarily to Medicare-eligible seniors. We provide a simple and reliable way for our patients to
obtain their supplies and medications. We communicate directly with our patients and their
physicians on a regular basis, and we bill Medicare and third-party insurers on behalf of our
patients. Through our Liberty Respiratory segment, we provide direct-to-consumer respiratory
medications, primarily to Medicare-eligible seniors. Through our Pharmaceuticals segment, we sell
prescription medications directly to existing Liberty Diabetes and Liberty Respiratory patients and
their spouses, and we also manufacture and sell prescription and over-the-counter urology products
to distributors and retailers. Accounting The accompanying interim consolidated financial statements are unaudited and have been
prepared in accordance with accounting principles generally accepted in the United States of
America for interim financial information. These consolidated financial statements include the
accounts of PolyMedica and its wholly-owned subsidiaries. All significant intercompany balances
and transactions have been eliminated in consolidation. Certain information and footnote
disclosures normally included in our annual consolidated financial statements have been condensed
or omitted. The interim consolidated financial statements, in the opinion of management, reflect
all adjustments (consisting only of normal recurring accruals) necessary to fairly present the
results as of and for the periods ended December 31, 2004 and 2003. Certain prior year amounts
have been reclassified to conform with the fiscal 2005 presentation. The results of operations for the interim periods are not necessarily indicative of the
results of operations to be expected for any future period or the entire fiscal year. Accordingly,
these interim consolidated financial statements should be read in conjunction with the audited
consolidated financial statements for the fiscal year ended March 31, 2004 which are contained in
our Annual Report on Form 10-K filed with the Securities and Exchange Commission (SEC) on June
14, 2004 and our unaudited consolidated financial statements included in our Quarterly Reports on
Form 10-Q for the periods ended June 30 and September 30, 2004 filed with the SEC on August 6 and
November 9, 2004, respectively. Consequently, the interim consolidated financial statements do not
include all disclosures normally required by accounting principles generally accepted in the United
States of America for annual audited financial statements. Revenue Recognition and Accounts Receivable We recognize revenue related to product sales to patients who have placed orders upon shipment
of such orders, provided that risk of loss has passed to the patient and we have received and
verified any written documentation required to bill Medicare, other third-party payers, and
patients. We record revenue at the amounts expected to be collected from Medicare, other
third-party payers, and directly from patients. As a result, our contractual allowances are
immaterial. Revenue recognition is delayed for product shipments for which we have not yet
received the required written documentation until the period in which the documentation is
collected and verified. Revenue related to Medicare reimbursement is calculated based on government-determined
reimbursement prices for Medicare-covered items. The reimbursements that Medicare pays are subject
to review by appropriate government regulators. Medicare reimburses at 80% of the
government-determined prices for reimbursable supplies, and we bill the remaining balance to either
third-party payers or directly to patients. Approximately $71.13 million and $71.79 million of net revenues, or 62.4% and 67.4% of consolidated
net revenues for the three months ended December 31, 2004 and 2003, respectively, were reimbursable
by Medicare for products provided to Medicare beneficiaries. Approximately $213.75 million and
$210.59 million of net revenues, or
63.5% and 67.8% of consolidated net revenues for the nine months ended December 31, 2004
and 2003, respectively, were reimbursable by Medicare for products provided to Medicare
beneficiaries. 7




---



##### Table of Contents



PolyMedica Corporation
Notes to Consolidated Financial Statements Accounts receivable allowances consist of an allowance for doubtful accounts, an allowance for
product returns,
and other sales allowances. As of December 31 and March 31, 2004, accounts receivable allowances
were $32.28 million and $29.70 million, respectively, or 31.4% and 31.8% of gross accounts
receivable, respectively. The valuation of accounts receivable is based upon the credit-worthiness of patients and
third-party payers as well as our historical collection experience. Allowances for doubtful
accounts are recorded as a selling, general and administrative expense for estimated amounts
expected to be uncollectible from third-party payers and patients. We base our estimates on our
historical collection and write-off experience, current trends, credit policy, and on our analysis
of accounts receivable by aging category. Our accounts receivable are generally due from Medicare, private insurance companies, Medicaid
and our patients. The collection process is time consuming, complex and typically involves the
submission of claims to multiple payers whose payment of claims may be contingent upon the payment
of another payer. As a result, our collection efforts may be active up to 18 months from the
initial billing date. In accordance with applicable regulatory requirements, we make reasonable and
appropriate efforts to collect our accounts receivable, including deductible and copayment amounts,
in a consistent manner for all payer classes. During the three months ended December 31, 2004 and
2003, we provided for allowances for doubtful accounts at a rate of approximately 4.5% and 5.1% of
net revenues, respectively. During the nine months ended December 31, 2004 and 2003, we provided
for allowances for doubtful accounts at a rate of approximately 4.8% and 5.4% of net revenues,
respectively. Sales allowances are recorded for estimated product returns as well as estimated claim
denials, as a reduction of revenue. We analyze sales allowances using historical data adjusted for
significant changes in volume, patient demographics, and business conditions. The reserve for sales
allowances and the rate at which we provide for such allowances are periodically adjusted to
reflect actual returns and claim denials. During the three months ended December 31, 2004 and 2003,
we provided for sales allowances at a rate of approximately 4.0% and
4.4% of gross revenues,
respectively. During the nine months ended December 31, 2004 and 2003, we provided for sales
allowances at a rate of approximately 3.8% and 4.5% of gross revenues, respectively. Accounting for Stock-Based Compensation Currently, PolyMedica accounts for its stock-based compensation plan under the recognition and
measurement principles of APB 25 and related Interpretations. We have adopted the disclosure-only
provisions of SFAS No. 148, Accounting for Stock-Based Compensation Transition and Disclosure, an
amendment of SFAS 123. Therefore, no stock-based employee compensation cost is currently reflected
in net income for stock option issuances, as all options granted under those plans had an exercise
price equal to or greater than the market value of the underlying common stock on the date of
grant. The following table illustrates the effect on net income and earnings per share if we had
applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation. 8




---



##### Table of Contents



PolyMedica Corporation
Notes to Consolidated Financial Statements Three Months Ended
    
    
    Nine Months EndedDec. 31,
    
    
    Dec. 31,
    
    
    Dec. 31,
    
    
    Dec. 31,(in thousands, except per share data)
    
    2004
    
    
    2003
    
    
    2004
    
    
    2003Net income
    
    $
    14,097
    
    
    $
    2,168
    
    
    $
    20,723
    
    
    $
    25,366Add back: Stock compensation costs, net of related
tax effect, on options granted below fair market
value
    
    
    
    
    
    
    32
    
    
    
    
    
    
    
    154Less: Stock compensation costs, net of related tax
effect, had all employee options been recorded at
fair value
    
    
    (1,332
    )
    
    
    (691
    )
    
    
    (4,000
    )
    
    
    (3,204
    )Adjusted net income
    
    $
    12,765
    
    
    $
    1,509
    
    
    $
    16,723
    
    
    $
    22,316Net income per weighted average share, basic, as
reported
    
    $
    0.51
    
    
    $
    0.08
    
    
    $
    0.76
    
    
    $
    1.01Net income per weighted average share, diluted, as
reported
    
    $
    0.50
    
    
    $
    0.08
    
    
    $
    0.74
    
    
    $
    0.98Adjusted net income per weighted average share, basic
    
    $
    0.46
    
    
    $
    0.06
    
    
    $
    0.61
    
    
    $
    0.89Adjusted net income per weighted average share,
diluted
    
    $
    0.46
    
    
    $
    0.06
    
    
    $
    0.61
    
    
    $
    0.86
 The fair value of each option granted during the three and nine months ended December 31, 2004
and 2003 is estimated on the date of grant using the Black-Scholes option pricing model with the
following weighted average assumptions: Three months ended
    
    
    Nine months endedDec. 31,
    
    
    Dec. 31,
    
    
    Dec. 31,
    
    
    Dec. 31,2004
    
    
    2003
    
    
    2004
    
    
    2003Dividend yield
    
    
    1.71
    %
    
    
    2.28
    %
    
    
    1.89
    %
    
    
    2.19
    %Expected
volatility
    
    
    47.85
    %
    
    
    91.70
    %
    
    
    71.78
    %
    
    
    92.74
    %Risk-free interest rate
    
    
    3.12
    %
    
    
    3.25
    %
    
    
    3.28
    %
    
    
    2.80
    %Expected
life
    
    
    3.75
    
    
    
    5.0
    
    
    
    4.53
    
    
    
    5.0
 Three months ended
    
    
    Nine months endedDec. 31,
    
    
    Dec. 31,
    
    
    Dec. 31,
    
    
    Dec. 31,2004
    
    
    2003
    
    
    2004
    
    
    2003Weighted average fair value of each option granted
    
    $
    12.30
    
    
    $
    16.48
    
    
    $
    16.12
    
    
    $
    15.51Weighted average fair value of each Employee Stock
Purchase Plan right granted below fair value
    
    $
    5.63
    
    
    $
    8.00
    
    
    $
    13.09
    
    
    $
    5.73
 9




---



##### Table of Contents



PolyMedica Corporation
Notes to Consolidated Financial Statements 2. Inventories Inventories consist of the following: Dec. 31,
    
    
    March 31,(in thousands)
    
    2004
    
    
    2004Raw materials
    
    $
    1,460
    
    
    $
    1,682Work in process
    
    
    571
    
    
    
    526Finished goods
    
    
    26,881
    
    
    
    16,537$
    28,912
    
    
    $
    18,745
 Due to the medical nature of the products we provide, patients frequently request supplies
before we have received the required written documentation, if applicable, to bill Medicare, other
third-party payers and patients. Because we do not recognize revenue until we have received and
verified such documentation, included in inventories as of December 31 and March 31, 2004, is $2.85
million and $2.45 million, respectively, of inventory shipped to patients for which we have
received an order but have not yet received and verified the required written documentation, if
applicable, to bill Medicare, other third-party payers and patients, and to recognize revenue. 3. Goodwill and Other Intangible Assets We have two reportable segments with goodwill: the Liberty Diabetes segment which includes the
Liberty Medical Supply, Inc. (Liberty) reporting unit; and the Pharmaceuticals segment which
includes the PolyMedica Pharmaceuticals (U.S.A.), Inc. and PolyMedica Healthcare, Inc. reporting
units. The carrying amounts of goodwill and intangible assets, excluding direct-response
advertising, as of December 31 and March 31, 2004, by reportable segment, were as follows: Dec. 31,
    
    
    March 31,(in thousands)
    
    2004
    
    
    2004Goodwill:Liberty Diabetes
    
    $
    4,951
    
    
    $
    4,951Pharmaceuticals
    
    
    995
    
    
    
    995Total consolidated goodwill
    
    $
    5,946
    
    
    $
    5,946Customer lists:Liberty Diabetes customer lists
    
    $
    10,843
    
    
    $
    2,273Accumulated amortization
    
    
    (2,917
    )
    
    
    (1,890
    )Total consolidated customer lists
    
    $
    7,926
    
    
    $
    383
 10




---



##### Table of Contents



PolyMedica Corporation
Notes to Consolidated Financial Statements On November 18, 2004, PolyMedica purchased for $3.03 million, certain diabetes business
assets of a direct-to-consumer provider of diabetes testing supplies, including a customer list and
certain other immaterial assets, but excluding working capital. The customer list is comprised of
approximately 7,500 active customers, substantially all of whom are Medicare-eligible diabetics.
From the purchase date through December 31, 2004, we had shipped to approximately 4,700 of these
customers with the expectation of shipping to additional customers in the coming months. On July 27, 2004, PolyMedica purchased for $5.50 million, certain diabetes business assets of
a direct-to-consumer provider of diabetes testing supplies, including a customer list and certain
immaterial assets, but excluding working capital. The customer list is comprised of over 15,000
active customers, substantially all of whom are Medicare-eligible diabetics. From the purchase
date through December 31, 2004, we had shipped to approximately 9,800 of these customers with the
expectation of shipping to additional customers in the coming months. Amortization expense for intangible assets was approximately $637,000 and $32,000 for the
three months ended December 31, 2004 and 2003, respectively, and approximately $1.03 million and
$145,000 for the nine months ended December 31, 2004 and 2003, respectively. As of December 31,
2004, amortization expense on existing intangibles for the remainder of fiscal 2005 and the next
four fiscal years is as follows: (table in thousands)Fourth
quarter of 2005
    
    $
    7112006
    
    
    2,3622007
    
    
    2,0362008
    
    
    1,9992009
    
    
    818Total
    
    $
    7,926
 4.  Direct-Response Advertising In accordance with Statement of Position 93-7 (SOP 93-7), direct-response advertising and
associated costs for our diabetes supplies and related products, included in the Liberty Diabetes
segment for the periods presented are capitalized and amortized to selling, general and
administrative expenses over a four-year period. The amortization rate is such that 55% of such
costs are expensed on a straight-line basis over two years from the date they are incurred, and the
remaining 45% is expensed on a straight-line basis over the next two years. Management assesses the
realizability of the amounts of direct-response advertising costs reported as assets at each
balance sheet date by comparing the carrying amounts of such assets to the probable remaining
future net cash flows expected to result directly from such advertising. If the carrying amount of the
assets exceeds the probable remaining future net cash flows expected to result directly from such
assets, an impairment loss is recognized in an amount equal to that excess. We perform net
realizable value tests of our direct-response advertising asset at each reporting period and
whenever events or changes in circumstance suggest that the carrying value may not be recoverable
and record any impairment as a cost of continuing operations. Advertising that does not
meet the capitalization requirements of SOP 93-7 is expensed in the
current period. Any change in existing accounting rules or a business change that impacts expected net cash
flows or that shortens the period over which such net cash flows are estimated to be realized,
currently four years for our diabetes products could result in accelerated charges against our
earnings. In addition, new or different marketing initiatives that may not qualify for
direct-response advertising could result in accelerated charges against our earnings. Due to the reduction in reimbursement rates for inhalation drugs under the Medicare
Prescription Drug, Improvement and Modernization Act of 2003 (the Medicare Modernization Act,) we
expect that our Liberty Respiratory segment will continue to generate less revenue and earnings
than it has historically. As a result, we recorded
a $14.44 million impairment charge of Liberty Respiratorys direct-response advertising asset in
December 2003 to adjust the assets carrying value down to its net realizable value. 11




---



##### Table of Contents



PolyMedica Corporation
Notes to Consolidated Financial Statements In accordance with SOP 93-7, we recorded the following activity related to our direct-response
advertising asset for the periods presented: Three months ended
    
    
    Nine months endedDec. 31,
    
    
    Dec. 31,
    
    
    Dec. 31,
    
    
    Dec. 31,(in thousands)
    
    2004
    
    
    2003
    
    
    2004
    
    
    2003Capitalized direct-response advertising
    
    $
    12,606
    
    
    $
    13,466
    
    
    $
    34,835
    
    
    $
    42,431Direct-response advertising amortization
    
    
    9,422
    
    
    
    11,374
    
    
    
    27,519
    
    
    
    32,628Impairment of direct-response advertising
asset
    
    
    
    
    
    
    14,443
    
    
    
    
    
    
    
    14,443Change in direct-response advertising asset,
net
    
    $
    3,184
    
    
    $
    (12,351
    )
    
    $
    7,316
    
    
    $
    (4,640
    )Beginning direct-response advertising asset,
net
    
    
    69,085
    
    
    
    71,772
    
    
    
    64,953
    
    
    
    64,061Ending direct-response advertising asset, net
    
    $
    72,269
    
    
    $
    59,421
    
    
    $
    72,269
    
    
    $
    59,421
 5. New Accounting Pronouncements In December 2004, the FASB issued SFAS 123R, which replaces SFAS 123, Accounting for
Stock-Based Compensation, and supersedes APB Opinion 25, Accounting for Stock Issued to Employees.
SFAS 123R requires that the cost of share-based compensation (including those with employees and
non-employees) be recognized in the financial statements. SFAS 123R applies to all share-based
compensation including shares, share options, and other equity instruments or that require
settlement by the issuance of an entitys shares or other equity instruments. We are required to
adopt SFAS 123R effective July 1, 2005 and are currently in the process of evaluating its impact on
our results of operations. 6.  Accrued Expenses Accrued expenses consist of the following: Dec. 31,
    
    
    March 31,(in thousands)
    
    2004
    
    
    2004Compensation and benefits
    
    $
    9,399
    
    
    $
    9,514Income tax payable
    
    
    5,257
    
    
    
    Other
    
    
    6,171
    
    
    
    12,358$
    20,827
    
    
    $
    21,872
 As of December 31 and March 31, 2004 amounts accrued for compensation and benefits consisted
primarily of earned, but unpaid employee compensation, severance accruals, and estimated bonus
payments. Amounts classified as other consisted primarily of a settlement accrual and amounts
reserved for overpayments by Medicare and others, discussed below. On November 3, 2004, we announced that we had entered into a civil settlement agreement with
the United States Department of Justice (DOJ) and the Office of Inspector General of the
Department of Health and Human
Services (OIG) regarding those agencies investigations of Liberty and Liberty Home
Pharmacy. We accrued a charge of $29.99 million during the quarter ended September 30, 2004 to
provide for the settlement amount and estimated related costs, which was in addition to $5.71
million that was previously accrued for estimated overpayments by 12




---



##### Table of Contents



PolyMedica Corporation
Notes to Consolidated Financial Statements Medicare and others in the fiscal
year ended March 31, 2004. In accordance with the terms of the settlement agreement, we funded
the $35 million payment in November 2004. See Note 7, Commitments and Contingencies;
Contingencies; U.S. Attorneys Office, to our consolidated financial statements for further
detail. As of December 31, 2004, there was $1.37 million of amounts reserved for overpayments by
Medicare and others included in the other category in the table above, for amounts due to Medicare,
secondary insurers and Medicare beneficiaries related to a change in interpretation of the
reimbursement formula for albuterol and ipratropium combinations furnished by our Liberty
Respiratory segment, discussed in more detail in Note E to our consolidated financial statements in
our Annual Report on Form 10-K for the fiscal year ended March 31, 2004, filed with the SEC on June
14, 2004. We reduced the accrual related to the reimbursement formula for albuterol and ipratropium
by $376,000 and $884,000 in the three and nine months ended December 31, 2004, respectively. The governments Medicare regulations are complex and sometimes subjective and therefore may
require managements interpretation. Accruals for overpayments by Medicare and others also occur
in the normal course of business when, based on our assessment of the facts and circumstances, we
believe that the amounts due are probable and estimable. 7. Commitments and Contingencies Contingencies U.S. Attorneys Office  settled on November 3, 2004 We disclosed previously that the U.S. Attorneys Office for the Southern District of Florida,
with the assistance of the FBI and the OIG, was investigating allegations of healthcare fraud,
improper revenue recognition and obstruction of justice by Liberty and Liberty Home Pharmacy. This
investigation was civil and criminal. On November 3, 2004, we entered into a civil settlement agreement with the DOJ and the OIG.
In accordance with the terms of the settlement agreement, we made a one-time payment of $35 million
in November 2004. Under the agreement, we admitted no wrongdoing and were provided with a release
of all claims under investigation, covering the period from October 1, 1998 to June 30, 2002, by
the DOJ and OIG. In addition, the governments release included the billing issue for the period
from August 1, 1997 through June 30, 2003, studied by an outside consulting firm as described in
more detail in our Quarterly Report on Form 10-Q for the quarter ended September 30, 2004, filed
with the SEC on November 9, 2004. No additional payments will be required in connection with the
results of the study conducted by this outside consulting firm, including the previously disclosed
$12 million contingency relating to a category of claims where our documentation was consistent
with the quantity of supplies shipped and billed, but was not strictly in accordance with Medicare
rules. The agreement reflects that the parties entered into the settlement to avoid the risk and
expense of continued investigation and litigation. As part of the civil settlement, on November 8, 2004 we entered into a five-year corporate
integrity agreement. This agreement provides for an annual review of a sample of our Medicare
claims by an independent review organization for a 3 to 5 year period, and obligates us to continue
our compliance program and the measures we have implemented to promote our compliance with Medicare
regulations. We have also received a non-prosecution agreement, in which the United States Attorneys
Office for the Southern District of Florida has agreed not to prosecute the Company, Liberty or
Liberty Home Pharmacy in connection with the allegations that were the subject matter of the
criminal investigation. 13




---



##### Table of Contents



PolyMedica Corporation
Notes to Consolidated Financial Statements Class Action Lawsuit On November 27, 2000, Richard Bowe SEP-IRA filed a purported class action lawsuit in the
United States District Court for the District of Massachusetts against PolyMedica and Steven J.
Lee, PolyMedicas former Chief Executive Officer and Chairman of the Board, on behalf of himself
and purchasers of common stock. The lawsuit seeks an unspecified amount of damages, attorneys fees
and costs and claims violations of Sections 10(b), 10b-5, and 20(a) of the Securities Exchange Act
of 1934 (the Exchange Act), alleging various statements were misleading with respect to our
revenue and earnings based on an alleged scheme to produce fictitious sales. Several virtually
identical lawsuits were subsequently filed in the United States District Court for the District of
Massachusetts against PolyMedica. On July 30, 2001, the Court granted the plaintiffs motion to
consolidate the complaints under the caption In re: PolyMedica Corp. Securities Litigation, Civ.
Action No. 00-12426-REK. Plaintiffs filed a consolidated amended complaint on October 9, 2001. The consolidated amended
complaint extended the class period to October 26, 1998 through August 21, 2001, and named as
defendants PolyMedica, Liberty, and certain former officers of PolyMedica. Defendants moved to
dismiss the consolidated amended complaint on December 10, 2001. Plaintiffs filed their opposition
to this motion on February 11, 2002, and defendants filed a reply memorandum on March 11, 2002. The
Court denied the motion without a hearing on May 10, 2002. On June 20, 2002, defendants filed
answers to the consolidated amended complaint. On January 28, 2004, plaintiffs filed a motion for class certification to which defendants
filed an opposition on February 27, 2004. Plaintiffs filed a reply memorandum on April 12, 2004
followed by additional briefing by the parties. The Court heard oral argument on the motion on June
2, 2004. On September 8, 2004, the court allowed the plaintiffs motion and certified the class.
On September 21, 2004, the defendants filed a petition requesting that they be permitted to appeal
the decision to the First Circuit Court of Appeals. The plaintiffs filed a response to the
defendants petition on October 7, 2004, opposing defendants request to appeal the class
certification. Also on October 7, 2004, the Court stayed sending notice of the class action
pending a ruling on defendants appeal of class certification. Discovery is ongoing in the
underlying suit. We believe that we have meritorious defenses to the claims made in the consolidated amended
complaint and intend to contest the claims vigorously. We are unable to express an opinion as to
the likely outcome of this litigation. An unfavorable outcome could have a material effect on our
financial position and results of operations. 8. Segment Information Our reportable segments are strategic business units or divisions that offer different
products. These units have separate financial information that is evaluated by senior management.
The segments are as follows: Liberty Diabetes Through our Liberty Diabetes segment, we provide diabetes testing supplies
and related products and services to patients suffering from diabetes and related chronic diseases.
We communicate directly with our patients and their physicians on a regular basis, and we bill
Medicare and third-party insurers on behalf of our patients. We offer a wide array of diabetes
supplies from a broad range of manufacturers. Liberty Respiratory Through our Liberty Respiratory segment, we provide prescription
respiratory medications and supplies to patients suffering from chronic obstructive pulmonary
disease (COPD) and other breathing disorders. Pharmaceuticals Through our Pharmaceuticals segment, we provide prescription medications
directly to existing Liberty Diabetes and Liberty Respiratory patients and sell to distributors
prescription urology and suppository products, over-the-counter female urinary discomfort products,
and home medical diagnostic kits. Selling, general and administrative expenses attributable to PolyMedicas corporate
headquarters are allocated to the operating segments according to the segments relative percentage
of total net revenues. Selling, general and administrative expenses incurred by Liberty Healthcare
Group, Inc., part of the Liberty Diabetes segment, that were incurred on behalf of all of our
businesses located in Florida for shared services, are allocated to each Liberty reporting 14




---



##### Table of Contents



PolyMedica Corporation
Notes to Consolidated Financial Statements unit primarily in accordance with the reporting units relative percentage of
total Liberty net revenues, employees and square footage in addition to managements estimates. Effective for the quarter ended June 30, 2004, we changed the way we segment cash, cash
equivalents and marketable securities, in order to reflect how management currently views these
assets. Segment assets belonging to PolyMedicas corporate headquarters, which included $67.17
million and $76.65 million of cash, cash equivalents and marketable securities as of December 31
and March 31, 2004, respectively, are not allocated as they are considered separately for
management evaluation purposes. As a result of these allocations, the segment information may not be indicative of the
financial position or results of operations that would have been achieved had these segments
operated as unaffiliated entities. The depreciation and amortization amounts below include
amortization of direct-response advertising. We do not organize our units geographically, as our
products are sold throughout the United States only. There are no intersegment sales for the
periods presented. Information concerning the operations in these reportable segments is as
follows: Three Months Ended
    
    
    Nine Months EndedDec. 31,
    
    
    Dec. 31,
    
    
    Dec. 31,
    
    
    Dec. 31,(in thousands)
    
    2004
    
    
    2003
    
    
    2004
    
    
    2003Net Revenues:Liberty Diabetes
    
    $
    78,656
    
    
    $
    68,891
    
    
    $
    233,687
    
    
    $
    207,184Liberty Respiratory
    
    
    14,378
    
    
    
    20,349
    
    
    
    44,862
    
    
    
    60,284Pharmaceuticals
    
    
    21,029
    
    
    
    17,223
    
    
    
    58,133
    
    
    
    43,154Total
    
    $
    114,063
    
    
    $
    106,463
    
    
    $
    336,682
    
    
    $
    310,622Depreciation and Amortization Expense:Liberty Diabetes
    
    $
    11,067
    
    
    $
    8,114
    
    
    $
    30,489
    
    
    $
    23,001Liberty Respiratory
    
    
    1,070
    
    
    
    5,159
    
    
    
    4,165
    
    
    
    15,097Pharmaceuticals
    
    
    196
    
    
    
    181
    
    
    
    548
    
    
    
    519Total
    
    $
    12,333
    
    
    $
    13,454
    
    
    $
    35,202
    
    
    $
    38,617Income before Income Taxes:Liberty Diabetes
    
    $
    13,821
    
    
    $
    11,407
    
    
    $
    39,843
    
    
    $
    34,467Liberty Respiratory
    
    
    6,172
    
    
    
    5,986
    
    
    
    17,746
    
    
    
    16,744Pharmaceuticals
    
    
    2,455
    
    
    
    3,676
    
    
    
    4,741
    
    
    
    7,154Settlement accrual adjustments
    
    
    
    
    
    
    (3,141
    )
    
    
    (29,987
    )
    
    
    (3,141
    )Impairment of direct-response
advertising, asset
    
    
    
    
    
    
    (14,443
    )
    
    
    
    
    
    
    (14,443
    )Total
    
    $
    22,448
    
    
    $
    3,485
    
    
    $
    32,343
    
    
    $
    40,781
 Dec. 31,
    
    
    March 31,2004
    
    
    2004Segment assets:Liberty Diabetes
    
    $
    210,198
    
    
    $
    178,030Liberty Respiratory
    
    
    19,642
    
    
    
    21,667Pharmaceuticals
    
    
    21,901
    
    
    
    18,838Corporate Headquarters
    
    
    88,028
    
    
    
    100,633Total
    
    $
    339,769
    
    
    $
    319,168
 15




---



##### Table of Contents



PolyMedica Corporation
Notes to Consolidated Financial Statements 9. Shareholders Equity  Cash Dividends and Stock Incentive Plan In the quarter ended December 31, 2004, we paid a $0.15 per share cash dividend on 27,375,292
common shares outstanding for a total payment of $4.10 million to our common shareholders of record
as of the close of business on November 5, 2004, as compared to a $0.15 per share cash dividend on
25,575,878 common shares outstanding for a total payment of $3.84 million to our common
shareholders of record as of the close of business on November 5, 2003. In the nine months ended
December 31, 2004 and 2003, we paid total cash dividends of $12.21 million and $10.01 million,
respectively, to our common shareholders of record. At our Annual Meeting of Stockholders, held on September 17, 2004, our shareholders approved
an amendment to our 2000 Stock Incentive Plan, increasing the number of shares authorized for
issuance under the plan from 4,600,000 shares to 6,400,000 shares. 10. Calculations of Earnings Per Share Calculations of earnings per share are as follows: Three Months Ended
    
    
    Nine Months EndedDec. 31,
    
    
    Dec. 31,
    
    
    Dec. 31,
    
    
    Dec. 31,(In thousands, except per share data)
    
    2004
    
    
    2003
    
    
    2004
    
    
    2003Net income
    
    $
    14,097
    
    
    $
    2,168
    
    
    $
    20,723
    
    
    $
    25,366BASIC:Weighted average common stock outstanding, net of
treasury stock, end of period
    
    
    27,501
    
    
    
    25,645
    
    
    
    27,216
    
    
    
    25,062Net income per weighted average share, basic
    
    $
    0.51
    
    
    $
    0.08
    
    
    $
    0.76
    
    
    $
    1.01DILUTED:Weighted average common stock outstanding, net of
treasury stock, end of period
    
    
    27,501
    
    
    
    25,645
    
    
    
    27,216
    
    
    
    25,062Weighted average dilutive common stock equivalents
    
    
    661
    
    
    
    991
    
    
    
    624
    
    
    
    868Weighted average common stock and dilutive common
stock equivalents outstanding, net of treasury
stock
    
    
    28,162
    
    
    
    26,636
    
    
    
    27,841
    
    
    
    25,930Net income per weighted average share, diluted
    
    $
    0.50
    
    
    $
    0.08
    
    
    $
    0.74
    
    
    $
    0.98
 Potentially Dilutive Stock Options Options to purchase shares of common stock with exercise prices in excess of the average
market price of the common shares are not included in the computation of diluted earnings per
share. There were 412,500 outstanding options not included in the diluted earnings per share
computation for the three months ended December 31, 2004 and none in the three months ended
December 31, 2003. During the nine months ended December 31, 2004 and 2003, outstanding options to
purchase 486,500 and 361,750 shares of common stock, respectively, were not included in the
computation of diluted earnings per share because the options exercise prices were greater than
the average market price of the common shares. 11. Comprehensive Income Our total comprehensive income is equal to our net income for the three and nine months ended
December 31, 2004 and 2003. Unrealized gains (losses) on investments were not material for any
periods presented. 16




---



##### Table of Contents



PolyMedica Corporation
Notes to Consolidated Financial Statements  12.
    Subsequent Events On January 21, 2005, we announced that our Board declared a $0.15 per share cash dividend to
PolyMedica common shareholders of record as of the close of business on February 4, 2005, payable
on February 15, 2005. On January 28, 2005, Liberty entered into an agreement to purchase for $17.10 million
certain assets, consisting of a customer list, real estate, inventory, equipment and furniture from
National Diabetic Assistance Corporation, a direct-to-consumer provider of respiratory and diabetic
testing supplies. 17




---



##### Table of Contents



Item 2. Managements Discussion and Analysis of Financial Condition and Results of
Operations Future Operating Results Forward-looking statements, within the meaning of Section 27A of the Securities Act of 1933,
as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, are made throughout
this Quarterly Report on Form 10-Q. For this purpose, any statements contained herein that are not
statements of historical fact may be deemed to be forward-looking statements. Without limiting the
foregoing, the words believes, anticipates, plans, expects, seeks, estimates, and
similar expressions are intended to identify forward-looking statements. There are a number of
important factors that could cause our results to differ materially from those indicated by such
forward-looking statements, including those detailed under the caption Managements Discussion and
Analysis of Financial Condition and Results of Operations  Future Operating Results. In addition, any forward-looking statements represent our view only as of the day this
Quarterly Report on Form 10-Q was first filed with the SEC and should not be relied upon as
representing our view as of any subsequent date. While we may elect to update forward-looking
statements at some point in the future, we specifically disclaim any obligation to do so, even if
our views change. Overview PolyMedica Corporation was organized in 1988 and has been in the medical product and
pharmaceutical business for over 15 years. Today, through our primary segment, Liberty Diabetes,
we are a leading provider of direct-to-consumer diabetes testing supplies and related services,
primarily to Medicare-eligible seniors, and provide a simple and reliable way for our patients to
obtain their supplies and medications. We communicate directly with our patients and their
physicians on a regular basis, and we bill Medicare and third-party insurers on behalf of our
patients. Through our Liberty Respiratory segment, we provide direct-to-consumer respiratory
medications, primarily to Medicare-eligible seniors. Through our Pharmaceuticals segment, we sell
prescription medications directly to our existing Liberty Diabetes and Liberty Respiratory patients
and their spouses, and we also manufacture and sell prescription and over-the-counter urology
products to distributors and retailers. Liberty Diabetes Through our Liberty Diabetes segment we provide diabetes testing supplies and related products
and services to our patients suffering from diabetes. As of December 31, 2004, we had
approximately 674,000 active diabetes patients, compared to approximately 601,000 active patients
as of December 31, 2003. Approximately 98.0% of our Liberty Diabetes patients are covered by
Medicare. We meet the needs of our diabetes patients by:  
    providing mail order delivery of supplies directly to our patients homes;
    billing Medicare and/or private insurance companies directly for those diabetes
related supplies that are reimbursable;
    providing 24-hour telephone support to patients; and
    using sophisticated software and advanced order fulfillment systems to provide
diabetes related products. The Medicare Modernization Act froze for the 2004 calendar year the reimbursement rates for
diabetes testing supplies at the rates that were in effect for the 2003 calendar year. As of
January 1, 2005, reimbursement rates for diabetes test strips and lancets were reduced by the
percentage difference between the median amounts paid by the Federal Employees Health Benefit
Program in the 2002 calendar year and the amount reimbursed by the Medicare program in the 2002
calendar year. The maximum downward adjustment for test strips and lancets for calendar year 2005
is 4.1% for diabetes test strips and 5.36% for lancets, but the actual percentage decrease in
payment amounts for any particular provider will depend on the geographic distribution of its
patients. No further adjustments for test strips and lancets are expected for calendar year 2006.
Based on our interpretation of the Medicare Modernization Act, we 18




---



##### Table of Contents



currently expect an overall reduction in reimbursement rates for test strips and lancets of
approximately 3.1% in calendar year 2005. The Medicare Modernization Act also contains provisions that may have a positive effect on the
future performance of our Liberty Diabetes segment. Beginning January 1, 2005, Medicare coverage
will be provided for an initial physical examination and for regular diabetes screening tests.
This coverage may increase the incidence of diagnosis of diabetes and potentially expand the
Medicare market for testing supplies and other diabetes products. In addition, the Medicare
Modernization Act provides for coverage of insulin and syringes beginning January 1, 2006. The
Medicare Modernization Act also establishes a program for competitive bidding of certain durable
medical equipment items, including diabetes test strips, beginning in 2007. The program is
expected to be implemented in the ten largest metropolitan areas in 2007 and then gradually
implemented in less concentrated areas of the United States. If the Liberty Diabetes segment is
excluded from the bid award or the bid does not place value on Libertys patient service model, the
operating results of the Liberty Diabetes segment could be negatively affected. Liberty Respiratory Through our Liberty Respiratory segment we sell prescription respiratory medications and
supplies to our patients suffering from COPD and other breathing disorders. As of December 31,
2004, we had approximately 56,000 active respiratory patients, down from approximately 68,000
active patients as of December 31, 2003. Through our Liberty Respiratory segment we deliver
respiratory medications and supplies to our patients homes and bill Medicare and/or private
insurance companies (if applicable) directly for those prescription respiratory medications and
supplies that are reimbursable. The Medicare Modernization Act, signed into law on December 8, 2003, provided for a reduction
in reimbursement rates for inhalation drugs, which we provide through our Liberty Respiratory
segment. Specifically, beginning January 1, 2004, reimbursement for these drugs was reduced from
95% of the average wholesale price to 80% of the average wholesale price. Beginning January 1,
2005, reimbursement rates for inhalation drugs were reduced to 106% of the average price of sales
by manufacturers, a new benchmark that is determined each quarter by sales data submitted by the
drug manufacturers to CMS, plus a dispensing fee. On November 2, 2004, in the final Physician Fee
Schedule Rule for calendar 2005 issued by CMS (CMS-1429-FC), CMS announced that it would pay a
dispensing fee during calendar 2005 of $57 per 30-day order or $80 per 90-day order in addition to
the 106% of the average price of sales by manufacturers payment for inhalation drugs. The benefit
of receiving this dispensing fee will be that it should allow us to stay in the business of
providing these drugs to our patients until December 31, 2005 and at the same time allow us the
opportunity to look at a number of initiatives within the area of chronic pulmonary disease. While
Liberty Respiratory net revenues and margins will be dramatically reduced beginning January 1, 2005
as a result of these reimbursement cuts, we expect the business to be marginally profitable going
forward. Reimbursement rates and dispensing fees for these products are highly uncertain beginning
in calendar 2006, and we cannot predict our ability to provide inhalation drugs beyond calendar
2005. Despite the changing reimbursement landscape and the lack of television advertising to
attract new respiratory patients, our respiratory medication business is performing better than
expected. Our patients continue to reorder in a predictable manner. We are evaluating
opportunities to continue to build the relationship with these patients including possible
distribution of oxygen, although the barriers to entry are significant. As a result of the reimbursement reductions described above, net revenues for the three
and nine months ended December 31, 2004, as compared with the comparable prior year periods,
decreased 29.3% and 25.6%, respectively. Pharmaceuticals Through our Pharmaceuticals segment we provide prescription medications directly to consumers
and we manufacture and sell for further distribution prescription urology and suppository products
and over-the-counter female urinary discomfort products. Within our Pharmaceuticals segment, our
Liberty Pharmacy business markets and sells prescription medications primarily to our existing
Liberty Diabetes and Liberty Respiratory patients. PolyMedicas line of prescription urology
products, which includes urinary analgesics, antispasmodics, local anesthetics and analgesic
suppositories, are sold to large drug distributors in the United States. Our female urinary
discomfort products and home medical diagnostic kits are sold under our AZO brand name to a network
of large drug store chains, major supermarkets, mass merchandisers and drug distributors in the
United States. 19




---



##### Table of Contents



The Medicare Modernization Act establishes a voluntary prescription drug benefit under the
Medicare program. Beginning January 1, 2006, coverage will be available through both prescription
drug plans and Medicare Advantage prescription plans. This new benefit will include coverage for
insulin and syringes, as well as other prescription drugs. The implementation of this benefit has
yet to be clearly defined. Dependent upon the terms of the programs implementation, the outcome
could negatively impact the operating results of Liberty Pharmacy, included in our Pharmaceuticals
segment. Liberty Pharmacy was one of only 27 applicants to be approved as an issuer of a national
Medicare-approved card. This Medicare-approved prescription drug discount card program went into
effect in June 2004. This benefit may be voluntarily elected by certain Medicare beneficiaries who
do not have an existing outpatient prescription drug benefit. Sponsors of these cards offer
Medicare beneficiaries access to outpatient prescription drugs at discounted prices. Liberty
Pharmacy began distributing its own Medicare approved drug discount card to patients and their
spouses in May 2004. To date, our involvement in the drug discount card program has not materially
benefited our results of operations. In December 2003, the service benefit administrator of the Federal Employee Program, which we
refer to as FEP, notified Liberty Pharmacy and other durable medical equipment suppliers that as of
February 1, 2004 certain supplies and medications would only be reimbursable through FEPs pharmacy
benefit administrator. The service benefit administrator subsequently notified us that any
reimbursement change would be subsequent to January 1, 2005. If the reimbursement change is
implemented as proposed, processing these supplies and medications as a pharmacy benefit would
result in increased costs to some of our FEP patients as well as lower reimbursement rates to us.
We are continuing to evaluate the impact of this change. The FEP program currently comprises a
substantial portion of Liberty Pharmacys net revenues. Critical Accounting Policies There have been no material changes in our critical accounting policies from those set forth
in our Annual Report on Form 10-K for the fiscal year ended March 31, 2004, filed with the SEC on
June 14, 2004. Recent Developments In January 2005 we confirmed with the Centers for Medicare and Medicaid Services (CMS) that
it has reduced the burdens on suppliers to obtain an assignment of benefits (AOB) from Medicare
beneficiaries in certain circumstances. Specifically, CMS confirmed that its new rules that became
effective for shipments on or after January 1, 2005 no longer require a supplier to obtain an AOB
from a Medicare beneficiary in the event that Medicare payment may only be made on an
assignment-related basis (whether by statute or Medicare rule, including DMERC coverage rules) for
the item or service in question or where the supplier is a Medicare participating supplier. This
new exception to the longstanding AOB requirements is now codified in federal regulations at 42
C.F.R. 425.55(c). As Liberty and Liberty Home Pharmacy are participating suppliers (i.e. have a
formal participation agreement with CMS, not just a Medicare billing number), we may take advantage
of this new exception for all items and services we furnish through these reporting units. However,
CMS has stated that the supplier must continue to obtain a signed authorization from the patient to
bill Medicare. We are seeking further clarification, because a requirement of obtaining a signed
authorization to bill appears contrary to the cost-saving purpose of the new regulations.
Therefore, the impact of the new regulations on our future operating results is not yet clear.
This change applies to all items and services furnished on or after January 1, 2005. Other Advertising rates may fluctuate during the year, which may affect our acquisition of new
patients. We may purchase less advertising when rates are higher, which generally occurs in
November and December. As a result, our acquisition of new patients during this period is
generally reduced and our net revenues may fluctuate accordingly. We operate from manufacturing and distribution facilities located in Massachusetts and
Florida, respectively. All of our product sales are denominated in U.S. dollars. 20




---



##### Table of Contents



Period-to-period comparisons of changes in net revenues are not necessarily indicative of
results to be expected for any future period. 21




---



##### Table of Contents



Results of Operations Three Months Ended December 31, 2004 Compared to Three Months Ended December 31, 2003 Net Revenues The following table presents segment net revenues expressed as a percentage of net revenues
for the three months ended December 31, 2004 and 2003. Three Months Ended December 31,2004
    
    
    2003Net
    
    
    % Net
    
    
    Net
    
    
    % Net(in thousands)
    
    Revenues
    
    
    Revenues
    
    
    Revenues
    
    
    Revenues
    
    
    % ChangeLiberty Diabetes
    
    $
    78,656
    
    
    
    69.0
    %
    
    $
    68,891
    
    
    
    64.7
    %
    
    
    14.2
    %Liberty Respiratory
    
    
    14,378
    
    
    
    12.6
    
    
    
    20,349
    
    
    
    19.1
    
    
    
    (29.3
    )Pharmaceuticals
    
    
    21,029
    
    
    
    18.4
    
    
    
    17,223
    
    
    
    16.2
    
    
    
    22.1Total net revenues
    
    $
    114,063
    
    
    
    100.0
    %
    
    $
    106,463
    
    
    
    100.0
    %
    
    
    7.1
    %
 The increase in Liberty Diabetes net revenues of 14.2% was due primarily to the 12.1% growth
in our patient base, which grew to 674,000 active patients as of December 31, 2004, from
approximately 601,000 as of December 31, 2003. The growth in our patient base was primarily due to
the continued success of our direct-response advertising program and customer list acquisitions.
The average net revenue generated per shipment remained fairly consistent this year, as compared
with last years third quarter. The decrease in Liberty Respiratory net revenues of 29.3% was due primarily to the reduction
in reimbursement rates for inhalation drugs from 95% of the average wholesale price to 80% of the
average wholesale price effective January 1, 2004 as a result of enactment of the Medicare
Modernization Act. In anticipation of further reimbursement reductions, we suspended
direct-response television advertising for our Liberty Respiratory segment in December 2003,
resulting in the decline in our patient base of approximately 17.6% to 56,000 active patients as of
December 31, 2004 from 68,000 active patients as of December 31, 2003. The new Medicare
legislation is discussed in further detail in Overview  Liberty Respiratory. The increase in Pharmaceuticals net revenues was due primarily to the 49.6% growth in Liberty
Pharmacys direct-to-consumer sales of prescription medications, which represented 81.8% of total
Pharmaceuticals segment net revenues in the three months ended December 31, 2004, as compared with
66.8% in the three months ended December 31, 2003. The current patient base for these products
consists primarily of our existing Liberty Diabetes and Liberty Respiratory patients and their
spouses. We expect this business to help position us for the prescription drug benefit under the
Medicare Modernization Act beginning in calendar year 2006. This benefit may be voluntarily
elected by certain Medicare beneficiaries who do not have an existing outpatient prescription drug
benefit. In addition, the drug discount card may be voluntarily elected by certain Medicare
beneficiaries who do not have an existing outpatient prescription drug benefit. Sponsors of these
cards offer Medicare beneficiaries access to outpatient prescription drugs at discounted prices.
Liberty Pharmacy began distributing its Medicare approved drug discount card to patients and their
spouses in May 2004. To date, our involvement in the drug discount card program has not materially
benefited our results of operations. The growth of the other businesses included in this segment, the manufacture and sale of
over-the-counter female urinary discomfort products and prescription urology and suppository
products from our Massachusetts based facility, was less than that of Liberty Pharmacy. Revenues
generated by our Massachusetts-based businesses in the three months ended December 31, 2004,
represented less than 20% of the segments net revenues and less than 5% of total consolidated net
revenues. 22




---



##### Table of Contents



Gross Margin The following table presents segment gross margins and gross margin percentages for the three
months ended December 31, 2004 and 2003. Three Months Ended December 31,2004
    
    
    
    
    
    
    2003Gross
    
    
    Gross
    
    
    
    
    
    
    Gross
    
    
    Gross(in thousands)
    
    Margin
    
    
    Margin %
    
    
    
    
    
    
    Margin
    
    
    Margin %Gross margin:Liberty Diabetes
    
    $
    48,135
    
    
    
    61.2
    %
    
    
    
    
    
    $
    40,845
    
    
    
    59.3
    %Liberty Respiratory
    
    
    11,525
    
    
    
    80.2
    
    
    
    
    
    
    
    16,808
    
    
    
    82.6Pharmaceuticals
    
    
    8,324
    
    
    
    39.6
    
    
    
    
    
    
    
    8,411
    
    
    
    48.8Total gross margin
    
    $
    67,984
    
    
    
    59.6
    %
    
    
    
    
    
    $
    66,064
    
    
    
    62.1
    %
 Gross margin in the three months ended December 31, 2004, as compared with the three months
ended December 31, 2003, decreased primarily as a result of the 15% cut in Medicare reimbursement
for our Liberty Respiratory inhalation drugs and a 49.6% increase in Liberty Pharmacy sales,
included in our Pharmaceuticals segment, for which we have historically reported gross margins in
the 30% range. We expect that our gross margin for the foreseeable future will be lower than it has been
historically primarily as a result of the 15% Medicare reimbursement reductions for inhalation
drugs that went into effect January 1, 2004 and further Medicare reimbursement reductions that went
into effect January 1, 2005. See Overview  Liberty Diabetes and Liberty Respiratory. Selling, General and Administrative Expenses Three Months Ended December 31,% Net
    
    
    
    
    
    
    % Net(in thousands)
    
    2004
    
    
    Revenues
    
    
    2003
    
    
    RevenuesReported selling, general and administrative expenses
    
    $
    45,934
    
    
    
    40.3
    %
    
    $
    62,733
    
    
    
    58.9
    %Select components of selling, general and
administrative expenses:Direct-response advertising impairment
    
    $
    
    
    
    
    
    %
    
    $
    14,443
    
    
    
    13.6
    %Provision for doubtful accounts
    
    
    5,178
    
    
    
    4.5
    
    

    
    5,478
    
    
    
    5.1Direct-response advertising amortization
    
    $
    9,422
    
    
    
    8.3
    %
    
    $
    11,374
    
    
    
    10.7
    %
 The decrease in reported selling, general and administrative expenses as a percentage of net
revenues from 58.9% for the three months ended December 31, 2003 to 40.3% for the three months
ended December 31, 2004, was primarily driven by the $14.44 million impairment charge recorded in
the three months ended December 31, 2003 to adjust the carrying value of Liberty Respiratorys
direct-response advertising asset down to its net realizable value as a result of the Medicare
reimbursement reductions for inhalation drugs under the Medicare Modernization Act. A reduction in direct-response advertising amortization as a percentage of net revenues from
10.7% in the three months ended December 31, 2003 to 8.3% in the three months ended December 31,
2004, due to the suspension of advertising for our Liberty Respiratory segment in December 2003,
also contributed to the decrease in selling, general and administrative expenses as a percentage of
net revenues. 23




---



##### Table of Contents



Reductions in our provision for doubtful accounts as a percentage of net revenues, due
primarily to improved collection experience also contributed to the improvement (for a discussion
of the approximate $20 million increase in net accounts receivable from September 30 to December
31, 2004, see Liquidity and Capital Resources.) Investment Income The following table presents investment income earned on our cash, cash equivalents,
marketable securities and deferred compensation plan balances for the periods presented. Three Months Ended December 31,(in thousands)
    
    2004
    
    
    2003
    
    
    $ Change
    
    
    % ChangeAverage cash, cash
equivalents,
marketable
securities and
deferred
compensation plan
balances
    
    $
    86,212
    
    
    $
    51,448
    
    
    $
    34,764
    
    
    
    67.6
    %Investment income
    
    $
    424
    
    
    $
    174
    
    
    $
    250
    
    
    
    143.0
    %
 Investment income increased primarily as a result of higher average cash and cash equivalents
balances, rising interest rates, and new short term investment instruments which yielded higher
returns for the quarter ended December 31, 2004, as compared with the returns earned on investment
holdings during the quarter ended December 31, 2003. Income Taxes The following table presents the income tax provision and effective tax rates for the three
months ended December 31, 2004 and 2003. Three Months Ended December 31,(in thousands)
    
    2004
    
    
    2003Income tax provision
    
    $
    8,351
    
    
    $
    1,317Effective tax rate
    
    
    37.2
    %
    
    
    37.8
    %
 The effective tax rates for the three months ended December 31, 2004 and 2003 were higher than
the Federal U.S. statutory rates due primarily to state taxes. Nine Months Ended December 31, 2004 Compared to Nine Months Ended December 31, 2003 Net Revenues The following table presents segment net revenues expressed as a percentage of net revenues
for the nine months ended December 31, 2004 and 2003. Nine Months Ended December 31,2004
    
    
    2003Net
    
    
    % Net
    
    
    Net
    
    
    % Net(in thousands)
    
    Revenues
    
    
    Revenues
    
    
    Revenues
    
    
    Revenues
    
    
    % ChangeLiberty Diabetes
    
    $
    233,687
    
    
    
    69.4
    %
    
    $
    207,184
    
    
    
    66.7
    %
    
    
    12.8
    %Liberty Respiratory
    
    
    44,862
    
    
    
    13.3
    
    
    
    60,284
    
    
    
    19.4
    
    
    
    (25.6
    )Pharmaceuticals
    
    
    58,133
    
    
    
    17.3
    
    
    
    43,154
    
    
    
    13.9
    
    
    
    34.7Total net revenues
    
    $
    336,682
    
    
    
    100.0
    %
    
    $
    310,622
    
    
    
    100.0
    %
    
    
    8.4
    %
 24




---



##### Table of Contents



The increase in Liberty Diabetes net revenues of 12.8% was due primarily to the 12.1% growth
in our patient base, which grew to 674,000 active patients as of December 31, 2004, from
approximately 601,000 as of December 31, 2003. The average net revenue generated per shipment
remained fairly consistent. The growth in our patient base was primarily due to the continued
success of our direct-response advertising program. Our growth during the nine months ended December 31, 2004 as compared with the prior year
comparable period was below expectations as a result of the disruption caused by the two hurricanes
sustained by our Florida-based facilities, home of our Liberty Diabetes, Liberty Respiratory and
Liberty Pharmacy businesses, in the quarter ended September 30, 2004. We have estimated that the
hurricanes resulted in the loss of approximately $3.60 million of net revenues that due to the
90-day supply cycle and timing of the hurricanes at the end of the second quarter, cannot be
recovered in fiscal year 2005. The decrease in Liberty Respiratory net revenues of 25.6% was due primarily to the reduction
in reimbursement rates for inhalation drugs from 95% of the average wholesale price to 80% of the
average wholesale price effective January 1, 2004 as a result of enactment of the Medicare
Modernization Act. In addition, due to the anticipated decline in revenues and earnings, we
suspended direct-response television advertising for our Liberty Respiratory segment in December
2003, which resulted in a decline in our patient base of approximately 17.6% to 56,000 active
patients as of December 31, 2004 from 68,000 active patients as of December 31, 2003. The new
Medicare legislation is discussed in further detail in Overview  Liberty Respiratory. The increase in Pharmaceuticals net revenue was due primarily to the 53.7% growth in Liberty
Pharmacys direct-to-consumer sales of prescription medications, which represented 78.8% of total
Pharmaceuticals segment net revenues in the nine months ended December 31, 2004 compared with 69.1%
in the nine months ended December 31, 2003. The current patient base for these products consists
primarily of our existing Liberty Diabetes and Liberty Respiratory patients and their spouses. We
expect this business to help position us for the prescription drug benefit under the Medicare
Modernization Act beginning in calendar year 2006. This benefit may be voluntarily elected by
certain Medicare beneficiaries who do not have an existing outpatient prescription drug benefit.
In addition, the drug discount card may be voluntarily elected by certain Medicare beneficiaries
who do not have an existing outpatient prescription drug benefit. Sponsors of these cards offer
Medicare beneficiaries access to outpatient prescription drugs at discounted prices. Liberty
Pharmacy began distributing its Medicare approved drug discount card to patients and their spouses
in May 2004. To date, our involvement in the drug discount card program has not materially
benefited our results of operations. The growth of the other businesses included in this segment, the manufacture and sale of
over-the-counter female urinary discomfort products and prescription urology and suppository
products from our Massachusetts based facility, was less than that of Liberty Pharmacy. Revenues
generated by our Massachusetts-based businesses represented less than 25% of the segments net
revenues and less than 5% of total consolidated net revenues. Gross Margin The following table presents segment gross margins and gross margin percentages for the nine
months ended December 31, 2004 and 2003. Nine Months Ended December 31,2004
    
    
    2003Gross
    
    
    Gross
    
    
    Gross
    
    
    Gross(in thousands)
    
    Margin
    
    
    Margin %
    
    
    Margin
    
    
    Margin %Gross margin:Liberty Diabetes
    
    $
    142,929
    
    
    
    61.2
    %
    
    $
    126,188
    
    
    
    60.9
    %Liberty Respiratory
    
    
    36,031
    
    
    
    80.3
    
    
    
    49,679
    
    
    
    82.4Pharmaceuticals
    
    
    23,549
    
    
    
    40.5
    
    
    
    20,327
    
    
    
    47.1Total gross margin
    
    $
    202,509
    
    
    
    60.1
    %
    
    $
    196,194
    
    
    
    63.2
    %
 25




---



##### Table of Contents



Gross margin in the nine months ended December 31, 2004, as compared with the nine months
ended December 31, 2003, decreased primarily as a result of the 15% cut in Medicare reimbursement
for our Liberty Respiratory inhalation drugs and a 53.7% increase in Liberty Pharmacy sales, included in our Pharmaceuticals segment, for
which we have historically reported gross margins in the 30% range. A $500,000 increase in inventory reserves for shoes and inserts provided through our Liberty
Diabetes segment, also contributed to the decline in overall gross margin. Due to the low
profitability of these products, we discontinued offering them to our patients effective October
2004. We expect that our gross margin for the foreseeable future will be lower than it has been
historically primarily as a result of the 15% Medicare reimbursement cuts for inhalation drugs that
went into effect January 1, 2004 and further Medicare reimbursement reductions that went into
effect January 1, 2005. See Overview  Liberty Diabetes and Liberty Respiratory. Selling, General and Administrative Expenses Nine Months Ended December 31,% Net
    
    
    
    
    
    
    % Net(in thousands)
    
    2004
    
    
    Revenues
    
    
    2003
    
    
    RevenuesReported selling, general and administrative expenses
    
    $
    141,120
    
    
    
    41.9
    %
    
    $
    155,855
    
    
    
    50.2
    %Select components of selling, general and
administrative expenses:Direct-response advertising amortization
    
    $
    27,519
    
    
    
    8.2
    %
    
    $
    32,628
    
    
    
    10.5
    %Impairment of direct-response advertising asset
    
    
    
    
    
    
    
    
    
    
    14,443
    
    
    
    4.7Provision for doubtful accounts
    
    
    15,993
    
    
    
    4.8
    
    
    
    16,807
    
    
    
    5.4Employee compensation
    
    $
    47,897
    
    
    
    14.2
    %
    
    $
    47,336
    
    
    
    15.2
    %
 The decrease in reported selling, general and administrative expenses as a percentage of net
revenues from 50.2% for the nine months ended December 31, 2003 to 41.9% for the nine months ended
December 31, 2004, was primarily driven by the $14.44 million impairment charge recorded in the
nine months ended December 31, 2003 to adjust the carrying value of Liberty Respiratorys
direct-response advertising asset down to its net realizable value as a result of the Medicare
reimbursement reductions for inhalation drugs under the Medicare Modernization Act. Amortization of direct-response advertising as a percentage of net revenues decreased from
10.5% in the nine months ended December 31, 2003, to 8.2% in the nine months ended December 31,
2004, due primarily to a $7.60 million decrease in direct-response advertising expenditures. This
decrease is primarily the result of the December 2003 suspension of Liberty Respiratorys
direct-response advertising program. At 10.5% of net revenues, direct-response advertising
amortization for the nine months ended December 31, 2004, would have been $7.83 million more than
reported. Realized economies of scale resulting from our growing business and progress in our efforts to
identify opportunities to streamline our business were other key factors in the improvement, as
evidenced by the decrease in employee compensation as a percentage of net revenues, due primarily
to improved utilization of existing staff and fewer new hires. Had employee compensation remained
at 15.2% of net revenues as reported in the nine months ended December 31, 2003, the expense in the
nine months ended December 31, 2004 would have been approximately $3.30 million higher than
reported. Also contributing to the improvement in selling, general and administrative expenses as a
percentage of net revenues, was a reduction in our provision for doubtful accounts as a percentage
of net revenues, due primarily to 26




---



##### Table of Contents



improved collection experience (for discussion of the approximate
$20 million increase in net accounts receivable from September 30 to December 31, 2004, see
Liquidity and Capital Resources.) Settlement Charge On November 3, 2004, we announced that we had entered into a civil settlement agreement with
the DOJ and the OIG regarding those agencies investigations of Liberty and Liberty Home Pharmacy.
We accrued a charge of $29.99 million during the quarter ended September 30, 2004 to provide for
the settlement amount and estimated related costs, which was in addition to $5.71 million that was
previously accrued for estimated overpayments by Medicare and others in the fiscal year ended March
31, 2004. See Note 7, Commitments and Contingencies; Contingencies; U.S. Attorneys Office and
Note 6, Accrued Expenses, to our consolidated financial statements for further detail. In
accordance with the terms of the settlement agreement, we funded the $35 million payment in
November 2004. Investment Income The following table presents investment income earned on our cash, cash equivalents,
marketable securities and deferred compensation plan balances for the periods presented. Nine Months Ended December 31,(in thousands)
    
    2004
    
    
    2003
    
    
    $ Change
    
    
    % ChangeAverage cash, cash
equivalents,
marketable
securities and deferred
compensation plan
balances
    
    $
    72,650
    
    
    $
    44,036
    
    
    $
    28,614
    
    
    
    65.0
    %Investment income
    
    $
    1,004
    
    
    $
    501
    
    
    $
    503
    
    
    
    100.2
    %
 Investment income increased primarily as a result of higher average cash and cash equivalents
balances, rising interest rates, and new short term investment instruments which yielded higher
returns for the nine months ended December 31, 2004 as compared with the returns earned on
investment holdings during the nine months ended December 31, 2003. Income Taxes The following table presents the income tax provision and effective tax rates for the periods
presented. Nine Months Ended December 31,(in thousands)
    
    2004
    
    
    2003Income tax provision
    
    $
    11,620
    
    
    $
    15,415Effective tax rate
    
    
    35.9
    %
    
    
    37.8
    %
 The effective tax rates, excluding the effect of the settlement charge described below, for
the nine months ended December 31, 2004 and 2003 were higher than the Federal U.S. statutory rates
due primarily to state taxes. In the nine months ended December 31, 2004 we recorded a pretax
settlement charge of $29.99 million for which we recorded an income tax benefit at the full
statutory federal and state rates. The effective tax rate for the current year excluding the
settlement charge remained at 37.2%. 27




---



##### Table of Contents



Liquidity and Capital Resources The following table summarizes our sources and uses of cash during the nine months ended
December 31, 2004 and 2003. Nine Months Ended December 31,(in thousands)
    
    2004
    
    
    2003Net cash provided by operating activities
    
    $
    2,621
    
    
    $
    38,890Net cash used for investing activities
    
    
    (14,653
    )
    
    
    (20,846
    )Net cash provided by financing activities
    
    
    2,977
    
    
    
    4,665Net change in cash and cash equivalents
    
    $
    (9,055
    )
    
    $
    22,709
 Our cash and cash equivalents balance decreased $9.06 million from March 31, 2004, to $60.17
million as of December 31, 2004, driven primarily by the $35 million payment to the DOJ in November
2004, in accordance with the settlement agreement reached on November 3, 2004 and discussed in more
detail in Note 7, Commitments and Contingencies; Contingencies; U.S. Attorneys Office and Note
6, Accrued Expenses, to our consolidated financial statements. Also contributing to the decrease in cash flow from operations were lower cash collections
during the quarter ended December 31, 2004. As part of the settlement agreement with the DOJ and
OIG, we entered into a five-year corporate integrity agreement that, among other things, provides
for an annual review of a sample of our Medicare claims by an independent review organization. To
provide the best possible assurance that the documents we currently have on file for our existing
patients, as well as the documents we are collecting for new patients, meet all required standards,
management made the decision during the quarter to examine and re-verify all documents, essentially
a double check, related to existing patients as shipments to those patients were made. As a
result, we reviewed approximately 600,000 documents associated with shipments made to existing
patients during the last eight weeks of the quarter. Billing for shipments made during the period
was postponed until the re-verification process for each shipment had been completed. As a result,
billing to Medicare and others for shipments to existing patients that took place during the last
eight weeks of the quarter was delayed, as management had expected, producing a corresponding delay
in collections, causing approximately $20 million of the total reported $35.86 million increase in
our net accounts receivable, and a reduction in net cash flows provided by operating activities in
the quarter ended December 31, 2004. This is evidenced by the increase in our quarterly days sales
outstanding from 43 days in the third quarter of fiscal 2004 to 56 days in the third quarter of
fiscal 2005. Although we will continue to re-verify documents not
previously re-verified, we anticipate this effort to be
substantially completed in the fourth quarter, and we do not
anticipate the re-verification process to have a significant adverse
effect on collections in the fourth quarter. Accordingly, we expect quarterly days sales outstanding to decrease in the quarter ending March
31, 2005. As a result of our re-verification effort, we identified approximately $600,000 of
shipments made during the period, representing less than 1% of total
net revenues reported for the quarter ended December 31, 2004, for which it was unclear that we had adequate documentation to
bill the claim. Accordingly, we neither billed nor recorded revenue for those claims and are in
the process of collecting better supporting documents for those claims from our patients and their
physicians. In
addition to the increase in our accounts receivable, there was a
$10.17 million increase in reported inventory levels during the
nine months ended December 31, 2004. The increase in purchasing
activity was conducted to secure favorable inventory pricing.
Inventory levels are expected to decline in the quarter ending
March 31, 2005. Partially
offsetting the decline in collections and increased inventory
purchases, was a $9.82 million reduction in income tax
payments in the nine months ended December 31, 2004, as compared with the nine months ended
December 31, 2003. The lower tax payments in the nine months ended December 31, 2004, as compared
with the prior year comparable period, were primarily the result of lower reported net income in
the nine months ended December 31, 2004 due to the $29.99 million settlement charge recorded in the
second quarter of fiscal 2005. The $6.19 million decrease in total cash used for investing activities in the nine months
ended December 31, 2004, as compared with the nine months ended December 31, 2003, was primarily
due to a $8.50 million decrease in property, plant and equipment purchases and an increase of $5.16
million in proceeds realized from maturing marketable securities, offset by a $8.38 million
increase in purchases of certain diabetes business assets from other direct-to-consumer providers
of diabetes testing supplies. Property, plant and equipment purchases have decreased primarily as
a result of substantial reductions in building acquisitions and renovation expenditures in the
current year as compared with the prior year. 28




---



##### Table of Contents



On November 18 and July 27, 2004, PolyMedica purchased for $3.03 million and $5.50 million,
respectively, certain diabetes business assets of two direct-to-consumer providers of diabetes
testing supplies, including customer lists and certain other immaterial assets but excluding
working capital. In aggregate, the
customer lists are comprised of over 22,500 active customers, substantially all of whom are
Medicare-eligible diabetics. To the extent that we can reduce our incremental costs of attracting
additional customers through acquisitions, we will do so. Going forward, we expect acquisitions to
become an increasingly important means of growing our patient base. The $1.69 million decrease in total cash provided by financing activities in the nine months
ended December 31, 2004, as compared with the nine months ended December 31, 2003, was due
primarily to a $2.21 million increase in cash dividend payments to shareholders in the current
year. The current intention of our Board is to pay a cash dividend to PolyMedica common
shareholders on a quarterly basis for the foreseeable future. We expect the quarterly cash
dividend payment to be approximately $4 million. A decrease of $1.69 million in cash received from
the issuance of common stock in connection with stock option exercises from $17.32 million in the
nine months ended December 31, 2003 to $15.63 million in the nine months ended December 31, 2004,
was offset by a $1.98 million decrease in payments for capital lease and note payable obligations. We believe that our cash, cash equivalents and marketable securities balance as of December
31, 2004 of $67.17 million, and cash flows generated from future operations, will be sufficient to
meet working capital, capital expenditure and financing needs, including the payment of dividends
to shareholders. In the event that we undertake to make acquisitions of complementary businesses,
products or technologies, we may require substantial additional funding beyond currently available
working capital and funds generated from operations. Other factors which could negatively affect
our liquidity include, among other things, a reduction in the demand for our products, an
unfavorable outcome of pending litigation, or additional reductions in Medicare reimbursement for
our products. A significant portion of our net revenues in both our Liberty Diabetes and Liberty
Respiratory segments depend on the continued availability of Medicare reimbursement. In accordance
with the Medicare Modernization Act, on January 1, 2005 further reductions in reimbursement rates
for inhalation drugs, which we sell through our Liberty Respiratory segment, became effective and
reimbursement rates for diabetes test strips and lancets, which we sell through our Liberty
Diabetes segment, were also reduced by approximately 3%. For a further discussion of these
reimbursement rate reductions, including their financial impact on our business, please see
Overview  Liberty Diabetes and Liberty Respiratory. There have been no material changes in our contractual obligations and off-balance sheet
arrangements from those set forth in our Annual Report on Form 10-K for the fiscal year ended March
31, 2004, filed with the SEC on June 14, 2004. 29




---



##### Table of Contents



Factors Affecting Future Operating Results Our future operating results remain difficult to predict. We continue to face many risks and
uncertainties which could affect our operating results, including without limitation, those
described below. We could experience significantly reduced revenues and profits if Medicare or other government
programs change, delay or deny reimbursement Sales of a significant portion of our Liberty Diabetes, Liberty Respiratory and
Pharmaceuticals segments depend on the continued availability of reimbursement of our patients by
government and private insurance plans. Any reduction in Medicare or other government program or
private plan reimbursements currently available for our products would reduce our revenues.
Certain significant reductions under the Medicare Modernization Act are discussed inOverview 
Liberty Diabetes and Liberty Respiratory. Other reductions are possible. Without a
corresponding reduction in the cost of such products, the result would be a reduction in our
overall profit margin. Similarly, any increase in the cost of such products would reduce our
overall profit margin unless there was a corresponding increase in Medicare or other government
program reimbursement. Our profits could also be affected by the imposition of more stringent
regulatory requirements for Medicare or other government program reimbursement or adjustments to
previously reimbursed amounts. We are currently involved in litigation and could experience reduced net income if this litigation
is not resolved in our favor PolyMedica and three former officers of PolyMedica are defendants in a lawsuit alleging
violations of certain sections and rules of the Exchange Act, which was initiated in U.S. District
Court for the District of Massachusetts in November 2000. PolyMedica believes it has meritorious
defenses to the claims made against it in this action in which it is a defendant and intends to
contest the claims vigorously. We cannot accurately predict the outcome of this proceeding at this
time, and have therefore not recorded any charges relating to this proceeding. An unfavorable
outcome could cause us to be liable for damages, which would reduce our net income in any such
period. Please see Item 3 of Part I, Legal Proceedings in our Annual Report on Form 10-K for the
fiscal year ended March 31, 2004, filed with the SEC on June 14, 2004, for a more complete
description of this claim. We may be exposed to
potential risks resulting from new requirements under
Section 404 of the Sarbanes-Oxley Act of 2002 Section 404
of the Sarbanes-Oxley Act of 2002 requires that we receive the
attestation of our independent auditors of the effectiveness of our
internal controls over financial reporting (as defined in
Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934
as amended (the Exchange Act)). We must include in our fiscal 2005
annual report on Form 10-K, including our financial statements, our
assessment of the effectiveness of our internal controls over
financial reporting with our independent auditors attestation.
We have embarked on a program to review, document and test our
internal controls over financial reporting for presentation to and
review by our independent auditors. There can be no assurances that
we will receive the required attestation or that unforeseen
circumstances will result in one or more of our controls becoming
ineffective. If we are not able to implement the requirements of
Section 404 in a timely manner, our future financial performance
and the market price of our stock may be adversely affected and we
would potentially be subject to sanctions or investigation by
regulatory authorities, including the Securities and Exchange
Commission or the Nasdaq National Market. The market price of our common stock has been, and may continue to be, volatile, which may affect
our stockholders ability to sell our common stock at a profit The trading price of our common stock has been volatile and is likely to continue to be
volatile. The stock market in general, and the market for healthcare-related companies in
particular, has experienced extreme volatility. This volatility has often been unrelated to the
operating performance of particular companies. Investors may not be able to sell their common stock
at or above the price at which they purchased the stock. Prices for the common stock will be
determined in the marketplace and may be influenced by many factors, including variations in our
financial results, changes in earnings estimates by industry research analysts, investors
perceptions of us and general economic, industry 30




---



##### Table of Contents



and market conditions. We plan to continue our expansion; if we do not manage our growth successfully, our growth and
profitability may slow or stop The expansion of our operations has created significant demand on our administrative,
operational and financial personnel and other resources. Additional expansion in existing or new
markets could strain these resources and increase our need for capital. Our personnel, systems,
procedures, controls and existing space may not be adequate to support further expansion. Geopolitical events may reduce our ability to obtain favorable advertising rates for our
direct-response advertising efforts, which may increase our expenses and/or lead to a reduction in
revenues The effectiveness of our direct-response advertising is subject to the risks arising from
geopolitical events. For example, around the clock news coverage on the war in Iraq and the war on
terrorism affected our ability to obtain favorable rates for our product advertisements and thus
affected our ability to obtain new patients since we reduced our advertising. Such geopolitical
events may in the foreseeable future have a negative impact on our results of operations. by
increasing our expenses and/or leading to a reduction in our revenues. The profitability of our Liberty Diabetes and Liberty Respiratory segments will decrease if we do
not receive recurring orders from patients The profitability of our Liberty Diabetes and Liberty Respiratory segments depends in large
part on recurring and sustained reorders. Reorder rates are inherently uncertain due to several
factors, many of which are outside our control, including changing patient preferences, competitive
price pressures, patient transition to extended care facilities, patient mortality and general
economic conditions. We generally incur losses and negative cash flow with respect to the first
order from a new patient, due primarily to the marketing and regulatory compliance costs associated
with initial patient qualification. We could experience significantly reduced profits from our Liberty Diabetes segment if new
technologies that reduce or eliminate the need for consumable testing supplies are developed for
glucose monitoring The majority of our Liberty Diabetes net revenues are from consumable testing supplies, used
to draw and test small quantities of blood for the purpose of measuring and monitoring glucose
levels. Numerous research efforts are underway to develop more convenient and less intrusive
glucose measurement techniques. The commercialization and widespread acceptance of new technologies
that eliminate or reduce the need for consumable testing supplies could negatively affect our
Liberty Diabetes segment. We could experience a charge to earnings as a result of an impairment of our goodwill or other
intangible assets We are required to perform impairment tests under SFAS No. 142 annually and whenever events or
changes in circumstance suggest that the carrying value of an asset may not be recoverable. The
valuation of our goodwill and other intangible assets is based upon the results of these impairment
tests. Changes in assumptions used and forecasted results of operations for the reporting unit
carrying goodwill or other intangible assets, could affect the quantification of an impairment
value, should one exist. We could be liable for harm caused by products that we sell and may incur significant expenses in
connection with the defense of any product liability claims The sale of medical products entails the risk that users will make product liability claims.
If any such product liability claim is successful, we could be liable for a significant amount of
damages. Even if we are ultimately successful on the merits of any such claim, we could incur
significant expenses in connection with the defense of any such claim. Our insurance may not
provide adequate coverage for any such damages and/or expenses. 31




---



##### Table of Contents



We could lose patients and revenues to new or existing competitors Competition from other sellers of products offered through our Liberty Diabetes, Liberty
Respiratory and Pharmaceuticals segments, manufacturers of healthcare products, pharmaceutical
companies and other competitors is intense and expected to increase. Many of our competitors and
potential competitors are large companies with well-known names and substantial resources. These
companies may develop products and services that are more effective or less expensive than any that
we are developing or selling. They may also promote and market these products more successfully
than we promote and market our products. Loss of use of manufacturing or data storage facilities could significantly reduce revenues and
profits from our businesses We manufacture substantially all of our prescription urology and suppository products and many
of our AZO brand name products at our facility in Woburn, Massachusetts. In addition, we process
and store most of our patient data in our facility in Port St. Lucie, Florida. If we cannot use any
of these facilities as a result of the FDA, Occupational Safety and Health Administration or other
regulatory action, fire, natural disaster or other event, our revenues and profits would decrease
significantly. For example, as a result of the disruption caused by the two hurricanes sustained by
our Port St. Lucie based facilities in 2004, excluding amounts that may be reimbursed to us through
our business interruption and property and casualty insurance, we experienced reduced revenues of
approximately $3.60 million and incurred losses in excess of $1 million. If we or our suppliers do not comply with applicable government regulations, we may be prohibited
from selling our products and/or may incur fines and other expenses The majority of the products that we sell are regulated by the FDA and other regulatory
agencies. If any of these agencies mandate a suspension of production or sales of our products or
mandate a recall, we may lose sales and incur fines and other expenses until we are in compliance
with the regulations or change to another acceptable supplier. We could have difficulty selling our pharmaceuticals products if we cannot maintain and expand our
sales to distributors We rely on third party distributors to market and sell our over-the-counter female urinary
discomfort products and prescription urology and suppository products. Future sales of these
products depend in part on our maintaining and expanding marketing and distribution relationships
with pharmaceutical, medical device, personal care and other distributors and on the success of
those distributors in marketing and selling our products. Our quarterly revenues or operating results could vary, which may cause the market price of our
securities to decline We have experienced fluctuations in our quarterly operating results and anticipate that such
fluctuations could continue. Results may vary significantly depending on a number of factors,
including: -
    
    changes in reimbursement guidelines and amounts;-
    
    changes in regulations affecting the healthcare industry;-
    
    changes in suppliers;-
    
    the timing of patient orders;-
    
    the timing and cost of our advertising campaigns;-
    
    the timing of the introduction or acceptance of new products offered by us or our competitors; and-
    
    changes in the mix of our products; product costs are significantly influenced by
the product brand chosen by the patients of our mail-order diabetes supply business. We
provide a wide range of product brand
 32




---



##### Table of Contents



choices to our patients, purchased at varying
costs from suppliers. Our ability to sustain current gross margin levels is dependent
both on our ability to continue securing favorable pricing from suppliers and on the
brand choices of our patients.
 A reduction in working capital or a change in our business could prevent us from paying dividends
to shareholders A significant decline in our cash balances or a change in our business could cause us to
reduce or eliminate the payment of dividends to shareholders. We may make acquisitions that will strain our financial and operational resources We regularly review potential acquisitions of businesses products and assets. Acquisitions
involve a number of risks that might adversely affect our financial and operational resources,
including: -
    
    diversion of the attention of senior management from important business matters;-
    
    amortization of substantial intangible assets;-
    
    difficulty in retaining key personnel of an acquired business;-
    
    lack of adequate internal controls over financial reporting;-
    
    failure to assimilate operations of an acquired business;-
    
    possible operating losses and expenses of an acquired business;-
    
    exposure to legal claims for activities of an acquired business prior to acquisition; and-
    
    incurrence of debt and related interest expense.
 We may issue preferred stock with rights senior to our common stock Our articles of organization authorize the issuance of up to 2,000,000 shares of preferred
stock without shareholder approval. The shares may have dividend, voting, liquidation and other
rights and preferences that are senior to the rights of our common stock. The rights and
preferences of any such class or series of preferred stock would be established by our Board in its
sole discretion. 33




---



##### Table of Contents



Item 3. Quantitative and Qualitative Disclosures About Market Risk We own certain money market funds, commercial bonds and mutual funds that are sensitive to
market risks as part of our investment portfolio. The investment portfolio is used to preserve our
capital until it is required to fund operations, investing or financing activities. None of the
market-risk sensitive instruments held in our investment portfolio are held for trading purposes.
We do, however, hold some market-risk sensitive instruments in our executive deferred compensation
plans, for trading purposes. These investments are accounted for under SFAS No. 115, Accounting
for certain investments in Debt and Equity Securities. The investments are recorded at fair value,
and changes in fair value are recorded as compensation expense and investment income for the
period. We do not own derivative financial instruments in our investment portfolio. We do not
believe that the exposure to market risks in our investment portfolio is material. 34




---



##### Table of Contents



Item 4. Controls and Procedures (a) Evaluation of disclosure controls and procedures. PolyMedicas management, with the
participation of PolyMedicas chief executive officer and chief financial officer, evaluated the
effectiveness of PolyMedicas disclosure controls and procedures (as defined in Rules 13a-15(e) and
15d-15(e) under the Exchange Act) as of December 31, 2004. Based on this evaluation, PolyMedicas
chief executive officer and chief financial officer concluded that, as of December 31, 2004,
PolyMedicas disclosure controls and procedures were (1) designed to ensure that material
information relating to PolyMedica, including its consolidated subsidiaries, is made known to
PolyMedicas chief executive officer and chief financial officer by others within those entities,
particularly during the period in which this report was being prepared and (2) effective, in that
they provide reasonable assurance that information required to be disclosed by PolyMedica in the
reports that it files or submits under the Exchange Act is recorded, processed, summarized and
reported within the time periods specified in the SECs rules and forms. (b) Changes in internal controls. No change in PolyMedicas internal controls over financial
reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the
quarter ended December 31, 2004 that has materially affected, or is reasonably likely to materially
affect, PolyMedicas internal control over financial reporting. 35




---



##### Table of Contents



PART II  OTHER INFORMATION 
 Item 1. Legal Proceedings Please refer to Item 3 of our Annual Report on Form 10-K for the fiscal year ended March 31,
2004, filed with the SEC on June 14, 2004, for a complete description of our legal proceedings and
Item 1 of Part II of our Quarterly Reports on Form 10-Q, filed with the SEC on August 6 and
November 9, 2004 for any material developments during the quarters ended June 30 and September 30,
2004, respectively. Any material developments regarding these legal proceedings for the three
months ended December 31, 2004 are set forth below. U.S. Attorneys Office We disclosed in our prior quarterly and annual filings on Forms 10-Q and 10-K, respectively,
that the U.S. Attorneys Office for the Southern District of Florida, with the assistance of the
FBI and the OIG, was investigating allegations of healthcare fraud, improper revenue recognition
and obstruction of justice by Liberty and Liberty Home Pharmacy. This investigation was civil and
criminal. On November 3, 2004, we announced final settlement of the investigation and entered into a
civil settlement agreement with the DOJ and the OIG. Under the terms of the settlement agreement,
we admitted no wrongdoing, but agreed to make a one-time payment of $35 million. This agreement
was filed on a Form 8-K dated November 8, 2004. The DOJ and OIG have provided us with a release of
all claims that were under investigation. For a more detailed discussion of the $35 million
payment, please see Note 7, Commitments and Contingencies; Contingencies; U.S. Attorneys Office
and Note 6, Accrued Expenses, to our consolidated financial statements for further detail. As part of the civil settlement, we have entered into a 5 year corporate integrity agreement
which provides for an annual review of a sample of our Medicare claims by an independent review
organization for a 3 to 5 year period, and further obligates us to continue our compliance program
and the measures we have implemented to promote our compliance with Medicare regulations. This
corporate integrity agreement has also been filed on a Form 8-K dated November 8, 2004. We have also received a non-prosecution agreement, in which the United States Attorneys
Office for the Southern District of Florida has agreed not to prosecute the Company, Liberty or
Liberty Home Pharmacy in connection with the allegations that were the subject matter of the
criminal investigation. Class Action Lawsuit Plaintiffs filed a consolidated amended complaint on October 9, 2001. The consolidated amended
complaint extended the class period to October 26, 1998 through August 21, 2001, and named as
defendants PolyMedica, Liberty, and certain former officers of PolyMedica. Defendants moved to
dismiss the consolidated amended complaint on December 10, 2001. Plaintiffs filed their opposition
to this motion on February 11, 2002, and defendants filed a reply memorandum on March 11, 2002. The
Court denied the motion without a hearing on May 10, 2002. On June 20, 2002, defendants filed
answers to the consolidated amended complaint. On January 28, 2004, plaintiffs filed a motion for class certification to which defendants
filed an opposition on February 27, 2004. Plaintiffs filed a reply memorandum on April 12, 2004
followed by additional briefing by the parties. The Court heard oral argument on the motion on June
2, 2004. On September 8, 2004, the court allowed the plaintiffs motion and certified the class.
On September 21, 2004, the defendants filed a petition requesting that they be permitted to appeal
the decision to the First Circuit Court of Appeals. The plaintiffs filed a response to the
defendants petition on October 7, 2004, opposing defendants request to appeal the class
certification. Also on October 7, 2004, the Court stayed sending notice of the class action
pending a ruling on defendants appeal of class certification. Discovery is ongoing in the
underlying suit. 36




---



##### Table of Contents



Item 6. Exhibits See Exhibit Index immediately following this report, which is incorporated herein by
reference. 37




---



##### Table of Contents



SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly
caused this report to be signed on its behalf by the undersigned thereunto duly authorized. PolyMedica Corporation
(registrant)/s/ Patrick T. RyanPatrick T. RyanPresident and Chief Executive
Officer
(Principal Executive Officer) /s/ Fred H. Croninger IIIFred H. Croninger IIIChief Financial Officer
(Principal Financial and Accounting Officer) Dated: February 9, 2005 38




---



##### Table of Contents



Exhibit Index Exhibit
    
    
    
    Description10.41
    
    -
    
    Letter Agreement amendment to Retirement Agreement by and between the
Registrant and John K.P. Stone, III dated December 6, 2004.31.1
    
    -
    
    Certification by Chief Executive Officer pursuant to Rule 13a14(a)/15d-14(a)
of the Securities Exchange Act of 1934, as amended.31.2
    
    -
    
    Certification by Chief Financial Officer pursuant to Rule 13a14(a)/15d-14(a)
of the Securities Exchange Act of 1934, as amended.32.1
    
    -
    
    Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002.
 39