**UNITED STATESSECURITIES AND EXCHANGE COMMISSION****Washington, D.C. 20549**

** **

**FORM 10-Q**

** **
| ý |   | **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** |
|---|--------|-----------------------------------------------------------------------------------------------------|

** **

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**Commission File Number 001-31333**

 

**For the quarterly period ended September 30, 2003**

** **

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** **

**Eon Labs, Inc.******(Exact Name of Registrant as Specified in its Charter)

 

| **Delaware**                                               |   | **13-3653818**                           |
|------------------------------------------------------------|--------|------------------------------------------|
| (State  or Other Jurisdiction of Incorporation)            |   | (I.R.S.  Employer Identification Number) |
|                                                       |   |                                     |
| **227-15 North Conduit Avenue**

**Laurelton, New York**   |   | **11413**                                |
| (Address  of Principal Executive Offices)                  |   | (Zip  Code)                              |
|                                                       |   |                                     |
| **(718) 276-8600**                                         |
| (Registrant’s  Telephone Number, Including Area Code) |

 

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Indicate by check mark whether the Registrant(1) has filed all reports required by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the Registrant was required to file such reports) and(2) has been subject to such filing requirements for the past90 days: Yes ý No o

 

Indicate by check mark whether the Registrantis an accelerated filer (as defined in Rule 12b-2 of the Securities ExchangeAct of 1934).  Yes ý No o

 

As of November 10, 2003, there were 44,282,448shares of the Registrant’s Common Stock, $0.01 par value per share,outstanding.

 

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**Eon Labs,Inc. and SubsidiariesTable of Contents**

 
| PART I.            | FINANCIAL INFORMATION                                                                                                                   |   |
|--------------------|-----------------------------------------------------------------------------------------------------------------------------------------|--------|
|               |                                                                                                                                    |   |
| ITEM 1.            | Financial Statements                                                                                                                    |   |
|               |                                                                                                                                    |   |
|               | Condensed  Consolidated Balance Sheets as of September 30, 2003 (unaudited) and December  31, 2002                                      |   |
|               |                                                                                                                                    |   |
|               | Condensed  Consolidated Statements of Income (unaudited) for the Three and Nine Months  Ended September 30, 2003 and September 30, 2002 |   |
|               |                                                                                                                                    |   |
|               | Condensed  Consolidated Statements of Cash Flows (unaudited) for the Nine Months Ended  September 30, 2003 and September 30, 2002       |   |
|               |                                                                                                                                    |   |
|               | Notes  to Condensed Consolidated Financial Statements (unaudited)                                                                       |   |
|               |                                                                                                                                    |   |
| ITEM 2.            | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                                             |   |
|               |                                                                                                                                    |   |
| ITEM 3.            | Quantitative and Qualitative Disclosure about  Market Risk                                                                              |   |
|               |                                                                                                                                    |   |
| ITEM 4             | Controls and Procedures                                                                                                                 |   |
|               |                                                                                                                                    |   |
| PART II.           | OTHER INFORMATION                                                                                                                       |   |
|               |                                                                                                                                    |   |
| ITEM  2.           | Changes  in Securities and Use of Proceeds                                                                                              |   |
|               |                                                                                                                                    |   |
| ITEM 6.            | Exhibits and Reports on Form 8-K                                                                                                        |   |
|               |                                                                                                                                    |
| SIGNATURES         |                                                                                                                                    |
|               |                                                                                                                                    |
| EXHIBIT 31.1  | Certifications pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002                                                               |   |
|               |                                                                                                                                    |   |
| EXHIBIT 31.2  | Certifications pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002                                                               |   |
|               |                                                                                                                                    |   |
| EXHIBIT 32.1  | Certification Pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002                |   |
|               |                                                                                                                                    |   |
| EXHIBIT  32.2 | Certification Pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002                |   |

 

2

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**Eon Labs, Inc. and SubsidiariesCondensed Consolidated Balance Sheets******(dollars in thousands, except per share amounts)

 
|                                                                                                                                                                                                                           |                                                              | **September  30, 2003** |    | **December  31, 2002** |   |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-------------------------------------------------------------------|-------------------------|---------|------------------------|--------|
|                                                                                                                                                                                                                           |                                                              | **(Unaudited)**         |    |                   |   |
| **Assets**                                                                                                                                                                                                                     |                                                              |                    |    |                   |   |
|                                                                                                                                                                                                                           |                                                              |                    |    |                   |   |
| **Current assets**                                                                                                                                                                                                             |                                                              |                    |    |                   |   |
| Cash and cash equivalents                                                                                                                                                                                                      |                                                              | $                       | 46,778  |                   | $      | 62,323 |   |
| Investments                                                                                                                                                                                                                    |                                                              | 88,833                  |    | 24,961                 |   |
| Accounts receivable, net                                                                                                                                                                                                       |                                                              | 15,451                  |    | 23,822                 |   |
| Inventories                                                                                                                                                                                                                    |                                                              | 57,865                  |    | 41,946                 |   |
| Deferred tax assets, net                                                                                                                                                                                                       |                                                              | 42,449                  |    | 43,648                 |   |
| Prepaid expenses and other current assets                                                                                                                                                                                      |                                                              | 27,388                  |    | 10,682                 |   |
|                                                                                                                                                                                                                           |                                                              |                    |    |                   |   |
| **Total current assets**                                                                                                                                                                                                       |                                                              | 278,764                 |    | 207,382                |   |
|                                                                                                                                                                                                                           |                                                              |                    |    |                   |   |
| Property, plant and equipment, net                                                                                                                                                                                             |                                                              | 49,204                  |    | 42,788                 |   |
| Goodwill and other intangible assets, net                                                                                                                                                                                      |                                                              | 73,880                  |    | 76,701                 |   |
| Other assets                                                                                                                                                                                                                   |                                                              | 1,177                   |    | 3,000                  |   |
|                                                                                                                                                                                                                           |                                                              |                    |    |                   |   |
| **Total assets**                                                                                                                                                                                                               |                                                              | $                       | 403,025 |                   | $      | 329,871 |   |
|                                                                                                                                                                                                                           |                                                              |                    |    |                   |   |
| **Liabilities and Stockholders’ Equity**                                                                                                                                                                                  |                                                              |                    |    |                   |   |
|                                                                                                                                                                                                                           |                                                              |                    |    |                   |   |
| **Current liabilities**                                                                                                                                                                                                        |                                                              |                    |    |                   |   |
| Accounts payable                                                                                                                                                                                                               |                                                              | $                       | 11,850  |                   | $      | 10,974 |   |
| Accrued liabilities                                                                                                                                                                                                            |                                                              | 74,652                  |    | 48,785                 |   |
| Current portion of note payable                                                                                                                                                                                                |                                                              | —                  |    | 4,530                  |   |
|                                                                                                                                                                                                                           |                                                              |                    |    |                   |   |
| **Total current liabilities**                                                                                                                                                                                                  |                                                              | 86,502                  |    | 64,289                 |   |
|                                                                                                                                                                                                                           |                                                              |                    |    |                   |   |
| **Long-term liabilities**                                                                                                                                                                                                      |                                                              |                    |    |                   |   |
| Deferred tax liabilities, net                                                                                                                                                                                                  |                                                              | 6,998                   |    | 6,998                  |   |
| Deferred revenue                                                                                                                                                                                                               |                                                              | 257                     |    | 430                    |   |
|                                                                                                                                                                                                                           |                                                              |                    |    |                   |   |
| **Total liabilities**                                                                                                                                                                                                          |                                                              | 93,757                  |    | 71,717                 |   |
|                                                                                                                                                                                                                           |                                                              |                    |    |                   |   |
| Contingencies (Notes 8 and 9)                                                                                                                                                                                                  |                                                              |                    |    |                   |   |
|                                                                                                                                                                                                                           |                                                              |                    |    |                   |   |
| **Stockholders’ equity**                                                                                                                                                                                                  |                                                              |                    |    |                   |   |
| Common stock, par value $.01 per share; 70,000,000 shares authorized;  44,359,542 and 44,077,282 shares issued;   44,287,042 and 44,077,282 shares outstanding at September 30, 2003 and  December 31, 2002, respectively |                                                              | 444                     |    | 441                    |   |
| Preferred stock, par value $.01 per share; 5,000,000 shares  authorized and no shares issued or outstanding at September 30, 2003 and  December 31, 2002                                                                       |                                                              | —                  |    | —                 |   |
| Additional paid-in capital                                                                                                                                                                                                     |                                                              | 195,104                 |    | 192,662                |   |
| Retained earnings                                                                                                                                                                                                              |                                                              | 116,597                 |    | 65,639                 |   |
| Accumulated other comprehensive income                                                                                                                                                                                         |                                                              | 15                      |    | 44                     |   |
|                                                                                                                                                                                                                           |                                                              | 312,160                 |    | 258,786                |   |
| Less:                                                                                                                                                                                                                          | Unearned deferred stock-based compensation                        |                    | (296    | )                      | (632   | ) |
|                                                                                                                                                                                                                           | Treasury stock at cost;  72,500 shares at September 30, 2003 |                    | (2,596  | )                      | — |   |
| **Total stockholders’ equity**                                                                                                                                                                                            |                                                              | 309,268                 |    | 258,154                |   |
| **Total liabilities and stockholders’ equity**                                                                                                                                                                            |                                                              | $                       | 403,025 |                   | $      | 329,871 |   |

 

Theaccompanying notes are an integral part of these condensed consolidatedfinancial statements.

 

3

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**Eon Labs, Inc. and SubsidiariesCondensed Consolidated Statements of Income******(dollars in thousands, except per share amounts) (unaudited)

 
|                                               |   | **For the  three months ended  September 30,** |   | **For the  nine months ended  September 30,** |   |
|----------------------------------------------------|--------|------------------------------------------------|--------|-----------------------------------------------|--------|
|                                               |   | **2003**                                       |   | **2002**                                      |   | **2003** |   | **2002** |   |
| Net sales                                          |   | $                                              | 85,011 |                                          | $      | 75,351 |   | $ | 234,549 |   | $ | 175,549 |   |
| Cost of sales                                      |   | 37,436                                         |   | 35,081                                        |   | 106,962 |   | 83,763 |   |
|                                               |   |                                           |   |                                          |   |   |   |   |   |
| **Gross profit**                                   |   | 47,575                                         |   | 40,270                                        |   | 127,587 |   | 91,786 |   |
|                                               |   |                                           |   |                                          |   |   |   |   |   |
| Operating expenses                                 |   |                                           |   |                                          |   |   |   |   |   |
| Selling, general and administrative expenses:      |   |                                           |   |                                          |   |   |   |   |   |
| Amortization of other intangible assets            |   | 940                                            |   | 940                                           |   | 2,820 |   | 2,820 |   |
| Other selling, general and administrative expenses |   | 10,698                                         |   | 11,399                                        |   | 24,751 |   | 24,627 |   |
| Research and development expenses                  |   | 6,612                                          |   | 3,974                                         |   | 15,934 |   | 10,240 |   |
|                                               |   |                                           |   |                                          |   |   |   |   |   |
| **Total operating expenses**                       |   | 18,250                                         |   | 16,313                                        |   | 43,505 |   | 37,687 |   |
|                                               |   |                                           |   |                                          |   |   |   |   |   |
| **Operating income**                               |   | 29,325                                         |   | 23,957                                        |   | 84,082 |   | 54,099 |   |
|                                               |   |                                           |   |                                          |   |   |   |   |   |
| Other income (expense), net                        |   |                                           |   |                                          |   |   |   |   |   |
| Interest income                                    |   | 337                                            |   | 353                                           |   | 1,001 |   | 519 |   |
| Interest expense                                   |   | —                                         |   | (310                                          | )      | (300 | ) | (3,754 | ) |
| Other income, net                                  |   | 37                                             |   | 39                                            |   | 148 |   | 50 |   |
|                                               |   |                                           |   |                                          |   |   |   |   |   |
| **Total other income (expense), net**              |   | 374                                            |   | 82                                            |   | 849 |   | (3,185 | ) |
|                                               |   |                                           |   |                                          |   |   |   |   |   |
| Income before income taxes                         |   | 29,699                                         |   | 24,039                                        |   | 84,931 |   | 50,914 |   |
|                                               |   |                                           |   |                                          |   |   |   |   |   |
| Provision for income taxes                         |   | (11,880                                        | )      | (9,856                                        | )      | (33,973 | ) | (20,881 | ) |
|                                               |   |                                           |   |                                          |   |   |   |   |   |
| **Net income**                                     |   | $                                              | 17,819 |                                          | $      | 14,183 |   | $ | 50,958 |   | $ | 30,033 |   |
|                                               |   |                                           |   |                                          |   |   |   |   |   |
| Net income per common share                        |   |                                           |   |                                          |   |   |   |   |   |
| Basic                                              |   | $                                              | 0.40   |                                          | $      | 0.33 |   | $ | 1.15 |   | $ | 1.44 |   |
| Diluted                                            |   | $                                              | 0.39   |                                          | $      | 0.31 |   | $ | 1.13 |   | $ | 0.77 |   |
|                                               |   |                                           |   |                                          |   |   |   |   |   |
| Weighted average common shares outstanding         |   |                                           |   |                                          |   |   |   |   |   |
| Basic                                              |   | 44,303,416                                     |   | 43,559,902                                    |   | 44,221,539 |   | 20,845,282 |   |
| Diluted                                            |   | 45,254,141                                     |   | 45,387,515                                    |   | 45,241,479 |   | 39,134,205 |   |

 

Theaccompanying notes are an integral part of these condensed consolidatedfinancial statements.

 

4

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**Eon Labs, Inc. and SubsidiariesCondensed Consolidated Statements of Cash Flows******(dollars in thousands) (unaudited)

 
|                                                                               |   | **For the  nine months ended  September 30,** |   |
|------------------------------------------------------------------------------------|--------|-----------------------------------------------|--------|
|                                                                               |   | **2003**                                      |   | **2002** |   |
| **Cash flows from operating activities**                                           |   |                                          |   |   |   |
| Net income                                                                         |   | $                                             | 50,958 |   | $ | 30,033 |   |
| Adjustments to reconcile net income to net cash provided by operating  activities: |   |                                          |   |   |   |
| Provision for accounts receivable allowances                                       |   | 19,666                                        |   | 46,767 |   |
| Depreciation and amortization                                                      |   | 6,705                                         |   | 5,692 |   |
| Deferred compensation                                                              |   | 336                                           |   | 866 |   |
| Amortization of deferred revenue                                                   |   | (173                                          | )      | (171 | ) |
| Amortization of discount on note payable                                           |   | 269                                           |   | 1,063 |   |
| Interest paid in-kind                                                              |   | —                                        |   | 2,463 |   |
| Tax benefit from exercises of stock options                                        |   | 3,145                                         |   | — |   |
| Changes in assets and liabilities:                                                 |   |                                          |   |   |   |
| Accounts receivable                                                                |   | (11,295                                       | )      | (72,880 | ) |
| Inventories                                                                        |   | (15,919                                       | )      | (8,711 | ) |
| Prepaid expenses and other current assets                                          |   | (16,765                                       | )      | (14,213 | ) |
| Other assets                                                                       |   | 1,823                                         |   | (1,506 | ) |
| Accounts payable                                                                   |   | 876                                           |   | 1,842 |   |
| Accrued liabilities                                                                |   | 25,888                                        |   | 9,690 |   |
| **Net cash provided by operating activities**                                      |   | 65,514                                        |   | 935 |   |
|                                                                               |   |                                          |   |   |   |
| **Cash flows from investing activities**                                           |   |                                          |   |   |   |
| Capital expenditures                                                               |   | (10,300                                       | )      | (6,020 | ) |
| Purchases of short-term investments                                                |   | (63,922                                       | )      | (19,297 | ) |
| **Net cash used in investing activities**                                          |   | (74,222                                       | )      | (25,317 | ) |
|                                                                               |   |                                          |   |   |   |
| **Cash flows from financing activities**                                           |   |                                          |   |   |   |
| Decrease in loans and advances to Hexal AG                                         |   | —                                        |   | (66,942 | ) |
| Payment on seller note                                                             |   | (4,799                                        | )      | (25,201 | ) |
| Proceeds from initial public offering of common stock                              |   | —                                        |   | 142,303 |   |
| Costs of initial public offering of common stock                                   |   | —                                        |   | (3,066 | ) |
| Advances from related parties, net                                                 |   | —                                        |   | 538 |   |
| Decrease in restricted cash                                                        |   | 59                                            |   | 71 |   |
| Proceeds from exercises of stock options                                           |   | 499                                           |   | — |   |
| Purchase of treasury shares                                                        |   | (2,596                                        | )      | — |   |
| **Net cash (used in) provided by financing activities**                            |   | (6,837                                        | )      | 47,703 |   |
|                                                                               |   |                                          |   |   |   |
| **Net (decrease) increase in cash and cash equivalents**                           |   | (15,545                                       | )      | 23,321 |   |
|                                                                               |   |                                          |   |   |   |
| Cash and cash equivalents at beginning of period                                   |   | 62,323                                        |   | 17,624 |   |
|                                                                               |   |                                          |   |   |   |
| Cash and cash equivalents at end of period                                         |   | $                                             | 46,778 |   | $ | 40,945 |   |
|                                                                               |   |                                          |   |   |   |
| Non-cash investing activities:                                                     |   |                                          |   |   |   |
| Unrealized loss on investments                                                     |   | $                                             | (50    | ) | $ | 31 |   |
|                                                                               |   |                                          |   |   |   |
| Non-cash financing activities:                                                     |   |                                          |   |   |   |
| Conversion of preferred stock                                                      |   | $                                             | — |   | $ | 300 |   |
| Exercise of warrants                                                               |   | $                                             | — |   | $ | 17 |   |
| Issuance of common stock to repay loans and advances to Hexal AG                   |   | $                                             | — |   | $ | 25,178 |   |

 

Theaccompanying notes are an integral part of these condensed consolidated financialstatements.

 

5

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**Eon Labs, Inc. and SubsidiariesNotes to Condensed Consolidated Financial Statements******(dollars in thousands, except per share amounts)

# ** **

# **1.**              Basis of Presentation

# ** **

The condensed consolidated financial statements included herein havebeen prepared by Eon Labs, Inc. (the “Company”) without audit pursuant to therules and regulations of the United States Securities and ExchangeCommission.  Certain information andfootnote disclosures normally included in financial statements prepared inaccordance with generally accepted accounting principles have been condensed oromitted pursuant to such rules and regulations.  In the opinion of management, the accompanying unauditedcondensed consolidated financial statements reflect all adjustments (consistingonly of normal recurring accruals) necessary for a fair presentation of thefinancial position as of September 30, 2003 and results of operations and cashflows for the periods presented.  Theconsolidated balances as of December 31, 2002 were derived from auditedfinancial statements but do not include all disclosures required by generallyaccepted accounting principles.  Theaccompanying condensed consolidated financial statements have been prepared inaccordance with accounting standards for interim financial statements andshould be read in conjunction with the Company’s audited consolidated financialstatements and the notes thereto for the year ended December 31, 2002.  The results of operations for the interimperiods are not necessarily indicative of the results of operations to beexpected for the year.

 

## ***Change of Company Ownership and Reorganization***

## *** ***

Prior to the reorganization described below, HexalPharmaceuticals, Inc. (“HPI”), a wholly-owned United States subsidiary ofSanto Holding (Deutschland) GmbH, which is under common control with Hexal AG,owned 50% of the outstanding capital stock of the Company.  HPI also owned 100% of Eon Holdings, Inc.(“EHI”), whose principal asset was the remaining 50% ownership of the Company.

 

Effective May 22, 2002, in conjunction with the initial public offeringof the Company’s common stock, the Company was combined with HPI and EHI into asingle entity through a series of reorganization mergers. EHI was merged withand into HPI and HPI was subsequently merged with and into the Company. Thisreorganization was accounted for as a merger of entities under common controland the accounts of the companies were combined in a manner similar to apooling of interests effective January 1, 2000. The condensed consolidatedfinancial statements for the three and nine months ended September 30,2002 reflect results on a combined basis.

 

## ***Revenue Recognition***

## *** ***

Sales are recognized when the products are received by the customer,which represents the point when the risks and rewards of ownership aretransferred to the customer.  Discounts,rebates and contract pricing adjustments are recorded as a reduction of salesbased on agreed upon terms with the Company’s customers at the time ofsale.  The Company calculates a reservefor discounts and rebates based upon actual sales under such arrangements.  Reserves for contract pricing adjustmentsrepresent the difference between the prices wholesalers are billed by theCompany and the prices billed to their customers to whom the Company has givencontract prices.  In determining areserve for contract price adjustments, the Company takes into account anestimate of the percentage of product sales subject to such pricing adjustmentsbased on historical trends.  Historicaltrends are adjusted for new product introductions and changes in wholesaler orcontract prices.

 

Accounts receivable is presented net of allowances for discounts,rebates, contract pricing adjustments and doubtful accounts, which were $95,176and $75,510 at September 30, 2003 and December 31, 2002, respectively.

 

Estimates for returns, which are recorded at the time of sale, relateprimarily to returns of expiring products. The Company utilizes historical trends to estimate the amount ofproducts to be returned due to product expiration.

 

Accrued liabilities include $43,461 and $36,069 for returns,promotional incentives and Medicaid rebates at September 30, 2003 and December31, 2002, respectively.

 

6

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Shelf stock adjustments are provided following a reduction in theprices of any of the Company’s products due to the competitiveenvironment.  Such adjustments arecredited to the Company’s customers based on their on-hand inventoryquantities.  Reserves are generallyestablished when the Company reduces its prices.

 

## ***Shipping and Handling Costs***

## *** ***

The Company classifies shipping and handling costs as part of selling,general and administrative expenses. Shipping and handling costs were $1,219 and $970 for the threemonths ended September 30, 2003 and 2002, respectively, and $3,434 and $2,193for the nine months ended September 30, 2003 and 2002, respectively.

 

## ***Investments***

## *** ***

The Company invests in publicly traded debt securities which arecategorized as securities available-for-sale and are carried at fair value,with unrealized gains and losses excluded from income and recorded directly toaccumulated other comprehensive income. The market value of such securities exceeded book value by $23 and $73at September 30, 2003 and December 31, 2002, respectively.  At September 30, 2002, such securitiesexceeded their book value by $52. Accordingly, net income is decreased by $29 resulting in comprehensiveincome of $50,929 for the nine months ended September 30, 2003.  For the nine months ended September 30,2002, net income is increased by $31 resulting in comprehensive income of  $30,064.

 

# **2.**              Initial Public Offering andShareholders’ Equity

# ** **

On June 11, 2002, the Company completed its initial public offering ofcommon stock, which resulted in net proceeds of $139,236 and the issuance of10,200,813 shares of common stock.  Uponthe consummation of the Company’s initial public offering, all of thepreviously outstanding shares of the Company’s preferred stock were convertedinto 30,000,000 shares of common stock and warrants were exercised resulting inthe issuance of 1,680,528 shares of common stock.  Immediately following the closing of the Company’s initial publicoffering, debt of $25,178 due to Hexal AG was converted into 1,678,561 sharesof common stock, and debt of $66,942 due to Hexal AG was paid with the proceedsof the offering.

 

## ***Stock Splits***

## *** ***

In May 2002, the Company effected a 30-for-1 stock split of theCompany’s preferred stock and the Company’s non-voting common stock with nochange in par value. Additional paid-in capital, preferred stock, common stock,per share and shares outstanding data in the unaudited Condensed ConsolidatedFinancial Statements and Notes to the unaudited Condensed ConsolidatedFinancial Statements have been retroactively restated to reflect this stocksplit.

 

In May 2002, the outstanding 30,000,000 preferred shares were convertedto common stock. In addition, the Company changed the number of shares of authorizedpreferred stock to 5,000,000, increased the number of shares of authorizedvoting common stock to 70,000,000 and converted shares of non-votingcommon stock to shares of a single class of common stock.

 

***Additional Paid-In Capital***

 

Additional paid-in capital increased by $2,442 to $195,104 at September30, 2003 from $192,662 at December 31, 2002. The increase represents proceeds of $496 from the exercise of employeestock options and $1,946 of tax benefits associated with these exercisetransactions.

 

***Stock Options***

 

In the quarter ended September 30, 2003 options to purchase 550,500shares of Common Stock at an exercise price of $35.01 per share weregranted.  The stock options granted areexercisable for up to ten years following the date of the grant.  The options vest and become exercisable atthe rate of 20% per year.  During thethree months ended 

 

7

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September 30, 2003, 51,680 options with a weighted-average exerciseprice of $4.64 were exercised and 2,400 options were terminated.

 

For the nine months ended September 30, 2003, 550,500 options weregranted, 282,260 options with a weighted-average exercise price of $1.77 wereexercised and 26,400 options were terminated.

 

## ***Deferred Stock-Based Compensation***

## *** ***

The Company amortized deferred stock compensation in the amount of $112and $288 for the three months ended September 30, 2003 and 2002, respectively,and $336 and $866 for the nine months ended September 30, 2003 and 2002,respectively.

 

***Stock Repurchase Program***

 

In April 2003, the Company’s Board of Directors approved the repurchaseof up to 300,000 shares of the Company’s common stock over the next twelvemonths. The Company has adopted a plan to repurchase 125,000 shares under Rule10b5-1 under the Securities Exchange Act of 1934, as amended. Depending onmarket conditions, the Company also expects to conduct purchases in the openmarket and in privately negotiated transactions from time to time during itsnormal trading window and may enter into future plans to repurchase sharesunder Rule 10b5-1. The share purchases have commenced in the third quarter. Therepurchased shares have become treasury shares and are intended to offsetpotential dilution in the event outstanding stock options are exercised.

 

During the three months ended September 30, 2003, under the Company’splan, the Company repurchased 72,500 shares of its outstanding common stock atan average price of $35.81 per share totaling $2,596.  These transactions are accounted for under the cost method.

 

# **3.**              NetIncome Per Common Share

# ** **

Basic net income per share is computed bydividing net income by the weighted average number of common shares outstandingfor the period.  Diluted earnings pershare reflects the potential dilution of stock options, warrants, and theconversion of preferred stock.  Detailsof the calculations are as follows:

 
|                                          |   | **For the  three months ended  September 30,** |   | **For the  nine months ended  September 30,** |   |
|-----------------------------------------------|--------|------------------------------------------------|--------|-----------------------------------------------|--------|
|                                          |   | **2003**                                       |   | **2002**                                      |   | **2003** |   | **2002** |   |
|                                          |   |                                           |   |                                          |   |   |   |   |   |
| **Net income per share-basic:**               |   |                                           |   |                                          |   |   |   |   |   |
|                                          |   |                                           |   |                                          |   |   |   |   |   |
| Net income                                    |   | $                                              | 17,819 |                                          | $      | 14,183 |   | $ | 50,958 |   | $ | 30,033 |   |
|                                          |   |                                           |   |                                          |   |   |   |   |   |
| Weighted average shares outstanding-basic     |   | 44,303,416                                     |   | 43,559,902                                    |   | 44,221,539 |   | 20,845,282 |   |
| Net income per share-basic                    |   | $                                              | 0.40   |                                          | $      | 0.33 |   | $ | 1.15 |   | $ | 1.44 |   |
|                                          |   |                                           |   |                                          |   |   |   |   |   |
| **Net income per share-diluted:**             |   |                                           |   |                                          |   |   |   |   |   |
|                                          |   |                                           |   |                                          |   |   |   |   |   |
| Net income                                    |   | $                                              | 17,819 |                                          | $      | 14,183 |   | $ | 50,958 |   | $ | 30,033 |   |
|                                          |   |                                           |   |                                          |   |   |   |   |   |
| Weighted average shares outstanding-basic     |   | 44,303,416                                     |   | 43,559,902                                    |   | 44,221,539 |   | 20,845,282 |   |
| Effect of preferred stock prior to conversion |   | —                                         |   | —                                        |   | — |   | 15,603,638 |   |
| Effect of warrants prior to conversion        |   | —                                         |   | —                                        |   | — |   | 874,121 |   |
| Dilutive effect of stock options              |   | 950,725                                        |   | 1,827,613                                     |   | 1,019,940 |   | 1,811,164 |   |
|                                          |   |                                           |   |                                          |   |   |   |   |   |
| Weighted average shares-diluted               |   | 45,254,141                                     |   | 45,387,515                                    |   | 45,241,479 |   | 39,134,205 |   |
| Net income per share-diluted                  |   | $                                              | 0.39   |                                          | $      | 0.31 |   | $ | 1.13 |   | $ | 0.77 |   |
|                                               |        |                                                |        |                                               |        |  |  |  |  |  |  |  |  |  |

 

8

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# **4.**              Adoption of NewAccounting Pronouncements

# ** **

In December 2002, the FinancialAccounting Standards Board (“FASB”) issued Statement of Financial AccountingStandards (“SFAS”) No. 148 “Accounting for Stock-BasedCompensation—Transition and Disclosure” that amends SFAS No. 123“Accounting for Stock-Based Compensation.”  SFAS No. 148 providesalternative methods of transition for a voluntary change to the fair valuebased method of accounting for stock-based employee compensation. SFASNo. 148 amends the disclosure requirements of Accounting Principal Board(“APB”) Opinion No. 28, “Interim Financial Reporting” and StatementNo. 123 to require prominent disclosures in both annual and interimfinancial statements about the method of accounting for stock-based employeecompensation and the effect of the method used on reporting results.  SFASNo. 148 is effective for fiscal years ending after December 15,2002.  The adoption of SFAS No. 148, except for the disclosurerequirements, had no impact on the Company’s consolidated financial statements.The additional required disclosures have been provided below.

 

The Company provides pro formadisclosure of stock-based compensation, as measured under the fair valuerequirements of SFAS No. 123, “Accounting for Stock-Based Compensation”and as determined through the use of the Black-Scholes option pricingmodel.  These pro forma disclosures are provided as required under SFASNo. 148, “Accounting for Stock-Based Compensation—Transition andDisclosure.”

 

The fair value of the options wasdetermined using the Black-Scholes option pricing model with the followingassumptions:

 
|                    |   | **September 30, 2003** |   | **September 30, 2002** |   |
|-------------------------|--------|------------------------|--------|------------------------|--------|
| Dividend yield          |   | 0%                     |   | 0%                     |   |
| Volatility              |   | 45%                    |   | 45%                    |   |
| Risk-free interest rate |   | 3.0 to 4.0%            |   | 3.0 to 4.0%            |   |
| Expected life           |   | 1 to 5 years           |   | 1 to 5 years           |   |

 

A reconciliation of the Company’s netearnings to pro forma net earnings and the related pro forma earnings per shareamounts for the three and nine months ended September 30, 2003 and 2002,respectively, is provided below. For purposes of pro forma disclosure,stock-based compensation expense is recognized in accordance with theprovisions of SFAS No. 123.

 
|                                                                                                |   | **For the three months ended  September 30,** |   | **For the nine months  ended  September 30,** |   |
|-----------------------------------------------------------------------------------------------------|--------|-----------------------------------------------|--------|----------------------------------------------------|--------|
|                                                                                                |   | **2003**                                      |   | **2002**                                           |   | **2003** |   | **2002** |   |
|                                                                                                |   |                                          |   |                                               |   |   |   |   |   |
| Net income, as reported                                                                             |   | $                                             | 17,819 |                                               | $      | 14,183 |   | $ | 50,958 |   | $ | 30,033 |   |
| Adjustment to net income for pro  forma stock-based compensation expense, net of related tax effect |   | (187                                          | )      | (96                                                | )      | (440 | ) | (104 | ) |
| Pro forma net income                                                                                |   | $                                             | 17,632 |                                               | $      | 14,087 |   | $ | 50,518 |   | $ | 29,929 |   |
|                                                                                                |   |                                          |   |                                               |   |   |   |   |   |
| As reported net earnings per share:                                                                 |   |                                          |   |                                               |   |   |   |   |   |
| Basic                                                                                               |   | $                                             | 0.40   |                                               | $      | 0.33 |   | $ | 1.15 |   | $ | 1.44 |   |
| Diluted                                                                                             |   | $                                             | 0.39   |                                               | $      | 0.31 |   | $ | 1.13 |   | $ | 0.77 |   |
|                                                                                                |   |                                          |   |                                               |   |   |   |   |   |
| Pro forma net earnings per share:                                                                   |   |                                          |   |                                               |   |   |   |   |   |
| Basic                                                                                               |   | $                                             | 0.40   |                                               | $      | 0.32 |   | $ | 1.14 |   | $ | 1.44 |   |
| Diluted                                                                                             |   | $                                             | 0.39   |                                               | $      | 0.31 |   | $ | 1.12 |   | $ | 0.76 |   |

 

9

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In May 2003, the FASB issued SFAS No.150, “Accounting for Certain Financial Instruments with Characteristics of bothLiabilities and Equity.”  SFAS No. 150requires that certain financial instruments, which under previous guidance wereaccounted for as equity, must now be accounted for as liabilities.  The financial instruments affected includemandatory redeemable stock, certain financial instruments that require or mayrequire the issuer to buy back some of its shares in exchange for cash or otherassets and certain obligations that can be settled with shares of stock.  SFAS No. 150 is effective for all financialinstruments entered into or modified after May 31, 2003, and otherwise iseffective at the beginning of the first interim period beginning after June 15,2003.  The initial adoption of SFAS No.150 on July 1, 2003 did not have any impact on the Company’s consolidatedfinancial statements.

 

In November 2002, the FASB issuedInterpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements forGuarantees, Including Indirect Guarantees of Indebtedness of Others — anInterpretation of FASB Statements No. 5, 57, and 107 and Rescission of FASBInterpretation No. 34.”  Thisinterpretation expands on the existing accounting guidance and disclosurerequirements for most guarantees, including indemnifications.  It requires that at the time a companyissues a guarantee, the company must recognize an initial liability for thefair value of the obligations it assumes under that guarantee if that amount isreasonably estimable, and must disclose that information in its interim andannual financial statements.  Theprovisions for initial recognition and measurement of the liability are to beapplied on a prospective basis to guarantees issued or modified on or afterJanuary 1, 2003.  The Company’s initialadoption of this statement on January 1, 2003, did not have an impact on itsresults of operations, financial position, or cash flows.  Guarantees issued or modified after January1, 2003, will be recognized at their fair value in the Company’s financialstatements.  The Company has not issuedany guarantees as of September 30, 2003.

 

In January 2003, the FASB issuedInterpretation No. 46, “Consolidation of Variable Interest Entities.”  This interpretation provides guidance withrespect to the consolidation of certain entities, referred to as variableinterest entities (“VIE”), in which an investor is subject to a majority of therisk of loss from the VIE’s activities, or is entitled to receive a majority ofthe VIE’s residual returns.  Thisinterpretation also provides guidance with respect to the disclosure of VIEs inwhich an investor maintains an interest, but is not required toconsolidate.  The provisions of theinterpretation are effective immediately for all VIEs created after January 31,2003, or in which the Company obtains an interest after that date.  For VIEs created before February 1, 2003,the provisions are effective July 1, 2003. The Company has not acquired an interest in or created a VIE afterJanuary 31, 2003.  The Company hascompleted its assessment and determined that the adoption of thisinterpretation did not have a material impact on the Company’s financialposition or results of operations.

 

# **5.**              Inventories

# ** **

Inventories consist of the following:

 
|            |   | **September 30,  2003** |   | **December 31,  2002** |   |
|-----------------|--------|-------------------------|--------|------------------------|--------|
| Raw material    |   | $22,649                 |   | $19,937                |   |
| Work-in-process |   | 11,380                  |   | 9,655                  |   |
| Finished goods  |   | 23,836                  |   | 12,354                 |   |
|            |   |                    |   |                   |   |
|            |   | $57,865                 |   | $41,946                |   |

 

# **6.**              Line of Credit

# ** **

On February 8, 2002, the Company enteredinto a three-year $25 million credit agreement, which is collateralized byaccounts receivable and inventory. Interest on any borrowing under the linewill accrue at the rate of interest equal to either the adjusted LIBOR rateplus 1.5%, the prime rate or the fixed rate (as set by the bank).  The rate will 

 

10

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depend upon the terms of the selected borrowings.  The agreement has covenants which requirethe maintenance of certain financial ratios including leverage, consolidateddebt and asset coverage, as defined.  AtSeptember 30, 2003, there were no borrowings outstanding under the line ofcredit.

 

# **7.**              Transactions Between the Company and RelatedParties

# ** **

The following is a summary of related party transactions:

 
|                                                             |   | **For the  three months ended  September 30,** |   | **For the  nine months ended  September 30,** |   |
|------------------------------------------------------------------|--------|------------------------------------------------|--------|-----------------------------------------------|--------|
|                                                             |   | **2003**                                       |   | **2002**                                      |   | **2003** |   | **2002** |   |
| Net sales to (returns from) subsidiaries of Hexal AG             |   | $                                              | 321    |                                          | $      | — |   | $ | 483 |   | $ | (100 | ) |
| Purchases of products and supplies from subsidiaries of Hexal AG |   | (713                                           | )      | —                                        |   | (1,031 | ) | — |   |
| Milestone payments under development contracts                   |   | (1,300                                         | )      | —                                        |   | (1,300 | ) | — |   |
| Reimbursement of other expenses                                  |   | —                                         |   | (100                                          | )      | (27 | ) | (129 | ) |
| Cyclosporine agreements with Hexal AG(a)                         |   | (1,670                                         | )      | (491                                          | )      | (4,801 | ) | (2,296 | ) |
| Interest on intercompany loans from Hexal AG                     |   | —                                         |   | —                                        |   | — |   | (2,463 | ) |
|                                                                  |        |                                                |        |                                               |        |  |  |  |  |  |  |  |  |

----

(a)         Under agreements with Hexal AG, the Company pays HexalAG based on sales of specific products, which were developed using Hexal AG’spatented technology.

 

In 2002, HPI was a party to certain research and development contractswith third parties for which Hexal AG loaned $0.7 million to HPI for thepayment of its obligations.  During2002, the research and development contracts which were unrelated to theCompany’s business were transferred to an entity that is unrelated to theCompany.

 

Included in accrued liabilities are amounts due to Hexal AG andsubsidiaries of $4,389 at September 30, 2003.

 

# **8.**              Litigation

# ** **

## ***Product Liability Litigation***

## *** ***

### *Fen-phen Litigation*

Since May 1997, the Company and certainof its customers have been named as defendants in numerous product liabilitylawsuits, some of which are class actions, filed in various state and federalcourts in connection with its manufacture and sale of phenterminehydrochloride.  These lawsuits typically name as a defendant Wyeth(formerly American Home Products Corporation), the manufacturer of twoanti-obesity drugs, fenfluramine and dexfenfluramine, and also namemanufacturers and distributors of phentermine. Fenfluramine and phentermine were prescribed in combination in anoff-label use commonly called “fen-phen,” while dexfenfluramine was generallyprescribed alone, but occasionally in combination with phentermine.  InSeptember 1997, Wyeth, the manufacturer of fenfluramine and dexfenfluramine,agreed with the Food and Drug Administration (“FDA”) to voluntarily withdrawboth products from the market.  The FDA has not requested that phenterminebe withdrawn from the market.

 

The plaintiffs in these cases (the “fen-phencases”) typically allege that the short- and long-term use of fenfluramine incombination with phentermine causes, among other things, primary pulmonaryhypertension, valvular heart disease and/or neurological dysfunction. Some lawsuits allege emotional distress caused by the purported increased riskof injury in the future, and others allege fraud or conspiracy in the marketingof fenfluramine, dexfenfluramine and phentermine.  Plaintiffs typicallyseek relief in the form of monetary damages (including economic losses, medicalcare and monitoring expenses, loss of earnings and earnings capacity, othercompensatory damages and 

 

11

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punitive damages), generally in unspecifiedamounts, on behalf of the individual or the class.  Some actions seekingclass certification ask for certain types of equitable relief, including, butnot limited to, declaratory judgments and the establishment of a researchprogram or medical surveillance fund.  Certain companies that distributedor sold the Company’s phentermine and are named as defendants in certain ofthese lawsuits seek a defense and indemnity from the Company.

 

In 2000, the United States District Court forthe Eastern District of Pennsylvania, which supervises discovery of all federalfen-phen cases in a consolidated multidistrict litigation (the “Fen-Phen MDL”),found that proposed anti-phentermine “causation” testimony by two expertwitnesses was not supported by scientific evidence and thus would bebarred.  These two experts were the only “national” anti-phentermine“causation” experts identified in the consolidated federal litigation, and wereto have been “generic” experts in hundreds of cases.  The Court’s decisionto substantially curb their testimony has resulted in many cases beingdismissed.  To date, there has been no scientific testimony accepted byany court that establishes a connection between the use of phentermine, eitheralone or in combination with fenfluramine and/or dexfenfluramine, and theinjury allegations made by plaintiffs.

 

In late 1999, Wyeth, the major defendant inthe fen-phen litigation and the former manufacturer of both fenfluramine anddexfenfluramine, announced a proposed settlement of all fen-phen claims againstit nationwide (excepting only claims for certain serious medicalconditions).  The United States District Court for the Eastern District ofPennsylvania certified a nationwide settlement class in the Fen-Phen MDL andapproved the proposed settlement, which became final inJanuary 2002.  This settlement has reduced the number of cases inwhich the Company and its distributors have been named as defendants.

 

As of September 30, 2003, the Company hadbeen named and served in approximately 6,784 fen-phen product liabilitycases.  More than 92% of these cases have been dismissed.  Since the beginning of the fen-phenlitigation, only one case has gone to trial with the Company and itsdistributors as defendants.  In that case, the Company and all thephentermine defendants, including other phentermine manufacturers anddistributors, were dismissed on motion before the presentation of any evidence.

 

While the number of lawsuits being filed hasdecreased substantially since its peak several years ago, the Company expectsadditional, similar lawsuits to be filed.  Beginning in May 2003, inresponse to an upcoming opt-out deadline in the Wyeth settlement, the Companyand its distributors have been served with an increasing number of new fen-phenclaims, and the Company has learned that a large number of new fen-phen claimshave been filed in several states.  While the Company has been served in anumber of new cases, it is not clear how many of the newly-filed cases name theCompany or its distributors, or how many new cases will be served on theCompany or its distributors in the future.

 

The Company and its outside counsel believethat the Company has substantial defenses to the fen-phen claims, though theirultimate outcome cannot be determined.  As of September 30, 2003, therehad been no finding of liability for fen-phen injury against the Company and nopayment by the Company to settle any combination-related fen-phen lawsuit.

 

***Phentermine Litigation***

 

The Company has been named as a defendant inseveral cases in which the plaintiff alleges injury from the use of phenterminealone, and in one instance the Company was named as a defendant in a state casealleging injury from the use of Company-produced phentermine in combinationwith phenylpropanolamine (“PPA”) made by another company.  Thephentermine/PPA claim was dismissed in the Company’s favor in 2003, and as ofSeptember 30, 2003 only two phentermine-only claims remained pending. Because discovery has not been completed in these remaining cases, predictingtheir ultimate outcome is not possible, and no provision for any liability hasbeen reflected in the Company’s financial statements.

 

Gross sales of phentermine by the Company forthe nine months ended September 30, 2003 and September 30, 2002 were $14,984and $25,907, respectively.

 

12

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***Other Product Liability Litigation***

 

The Company has been named as a defendant inseveral other product liability lawsuits in which plaintiffs allege thatCompany-manufactured pharmaceuticals containing phenylpropanolamine (PPA)caused injury.  PPA was removed from the market in 2000 at the FDA’srequest after a study appeared to show a potentially increased risk ofhemorrhagic stroke in certain patient cohorts.  Additionally, the Companywas recently named in two product liability lawsuit in which plaintiff allegesinjury from amiodarone HCl, a generic antiarrhythmic agent.  One of theamiodarone cases was recently dismissed in Eon’s favor.  Because discovery in the PPA cases and theremaining amiodarone is ongoing, predicting the ultimate outcome of theseactions is not possible and no provision for any liability has been reflectedin the Company’s financial statements.

 

***Defense/Indemnity Issues Related to Fen-phen and Phentermine Litigation***

 

In or about April 2000, the Companyexhausted its product liability insurance covering combination-relatedphentermine lawsuits and non-combination phentermine lawsuits resulting fromclaims regarding the ingestion of phentermine prior to June 22, 1998 on claimsmade before June 22, 2003.  Since April 2000, the Company has funded itsown defense in the fen-phen, phentermine-only and phentermine-PPA productliability lawsuits, with the exception of one phentermine-only case whereingestion occurred after June 1998.  Additionally, the Company has reachedagreements under which the Company will fund or partially fund the defense ofcertain of its distributors, and to indemnify them provided certain conditionsare met.  Further, the Company has reached defense/indemnity agreementswith several retailers, and is negotiating the resolution of several additionalclaims with other retailers.  Since April 2000, fen-phen and phenterminelitigation defense costs, and the costs of related defense agreements, have beenexpensed as incurred.

 

Under a settlement reached in October 1999with an insurance carrier, $2,250 of insurance coverage would become availablefor certain product liability claims made on or after June 22, 2003 foroccurrences prior to June 1998.  The Company has made insurance coverageclaims for fen-phen claims filed on or after June 22, 2003 which allegefen-phen use prior to June 1998, and these coverage claims are pending. Fen-phen litigation costs and the costs of related defense agreements are beingexpensed as incurred, except for costs related to claims made on or after June22, 2003 that may be covered by insurance.

 

## ***Patent Infringement Litigation***

## *** ***

On August 30, 2000, Novartis Pharmaceuticals Corporation filed acomplaint in the United States District Court for the District of Delawarealleging among other things that the Company’s generic cyclosporine productinfringes a patent owned by Novartis.  An adverse outcome in patentlitigation with Novartis involving cyclosporine capsules could result in theCompany being unable to market this product which would materially harm itsprofits and cash flows and could result in the Company paying damages, costs,expenses, and fees that could have a material adverse impact on its financialperformance.  The Company’s potential liability and expenses in thismatter are not covered by insurance.  In December 2002, the United StatesDistrict Court for the District of Delaware granted the Company’s motion forsummary judgment of non-infringement of the patent.  Novartis has appealedthe judgment to the United States Court of Appeals for the Federal Circuit. Theappeal is scheduled for oral argument on November 7, 2003. The ultimate outcomeof this lawsuit cannot be determined.

 

In January 2001, Apotex, Inc. filed an action in the United StatesDistrict Court for the Eastern District of New York alleging that bymanufacturing, selling and offering to sell cyclosporine capsules the Companyis infringing a patent of which Apotex alleged it is the exclusive licensee. Apotex seeks injunctive relief as well as an unspecified amount of damages andhas also asserted a claim that the alleged infringement was willful, that thecase is therefore exceptional and that Apotex should therefore be awarded theattorney fees it has incurred in the action.  The Company’s potentialliability and expenses in this matter are not covered by insurance.  Anadverse outcome in this litigation could result in the Company being unable tomarket cyclosporine, which could materially harm profits and cash flows, andcould result in paying damages, costs, expenses and fees that could have amaterial adverse impact on the Company’s financial performance.

 

The Company has denied that it has infringed any valid patent claimsasserted by Apotex, has alleged affirmatively, among other things, that thepatent is invalid and that it is not infringed by the Company’s manufacture,sale or offer to sell its cyclosporine capsules.

 

13

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In addition, the Company has been named in several other patentinfringement actions alleging that the Company has infringed patents by filingan application with the FDA for approval to market products before theplaintiffs’ patents expire.  In general, plaintiffs seek judgmentsprecluding the FDA from approving the Company’s application to market theproduct before their patents expire and have asserted claims that the allegedinfringement was willful, that the action is therefore exceptional and thatplaintiffs should therefore be awarded the attorney fees they have incurred inthe action.

 

The Company and its outside counsel believe that the Company hassubstantial defenses and counterclaims to these above patent infringementactions, though the ultimate outcome cannot be determined.

 

Because predicting the ultimate outcome of these actions is notpossible, no provision for any liability has been reflected in the Company’sfinancial statements.

 

***Legal Fee Recovery***

 

In August 2001, the Company was successful in defending itself in theUnited States District Court for the District of Massachusetts against a patentinfringement claim involving Nabumetone.  At the conclusion of the trial,the Company filed a motion to recover the legal fees it incurred in defendingthe action.  The motion was stayed pending the appeal of the DistrictCourt’s ruling.  The Court of Appeals affirmed the District Court decisionin August 2002.  In May 2003, the Company and the original plaintiffreached agreement regarding the Company’s motion to recover legal fees. Under the agreement the Company was reimbursed $3,500 for legal fees it hadincurred in defending itself.  The $3,500 recovery of legal fees has beenreflected in other selling, general and administrative expenses for the quarterended June 30, 2003.

 

***Other Litigation***

 

The Company is in other litigation incidental to its businessactivities.  The ultimate disposition of such lawsuits will not materiallyaffect the Company’s financial statements.

 

# **9.**              Contingencies

# ** **

## ***Rebates***

## *** ***

The Omnibus Budget Reconciliation Act of 1990, effective January 1,1991, requires drug companies to enter into a rebate agreement with the HealthCare Financing Administration of the Federal government.  The rebate agreement states that drugcompanies must pay rebates to states for drugs (prescription, non-prescriptionor biological products) sold to Medicaid recipients.  At September 30, 2003 and December 31, 2002, $4,300 and $4,055,respectively, are included in accrued liabilities as the estimated liabilityfor Medicaid rebates.

 

## ***State Medicaid Claims***

## *** ***

EHI purchased Major Pharmaceuticals, Inc. (“Major”), a distributor ofdrug products, in 1991 and sold Major in 1995. At the time of the sale, EHI established an escrow account to cover anyMedicaid drug rebate liabilities incurred by Major prior to the sale.  As of September 30, 2003, the recordedliability for such claims is $883, which management believes is adequate toresolve such matters.  The Company hasapproximately $749 as of September 30, 2003 in an escrow account to resolvesuch claims.

 

14

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**ITEM 2.****  MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

The following discussion and analysis of the Company’s financialcondition and results of operations should be read in conjunction with theconsolidated financial statements, the related notes to consolidated financialstatements and “Management’s Discussion and Analysis of Financial Condition andResults of Operations” included in the Company’s annual report on Form 10-K/Aand the unaudited interim condensed consolidated financial statements includedin Item 1 of this Quarterly Report on Form 10-Q.

 

**NINE MONTHSENDED SEPTEMBER 30, 2003 COMPARED WITH NINE MONTHS ENDED SEPTEMBER 30, 2002**

 

**Net sales.**  Net sales increased 33.6% to$234.5 million for the nine months ended September 30, 2003 from $175.5 millionin the comparable period in 2002.  Themajority of the increase was attributable to products introduced in late June2002 or thereafter.  These productsinclude Lisinopril, USP, Lisinopril/HCTZ, Tizanidine HCl, Tramadol HCl,Nizatidine, USP, a Dextroamphetamine and Amphetamine Mixed Salt Product,Mirtazapine and Midodrine HCl.  Anincrease in unit volume of several existing products also contributed to highersales for the nine months ended September 30, 2003.

 

**Grossprofit.**  Gross profit asa percentage of net sales increased to 54.4% for the nine months endedSeptember 30, 2003 compared to 52.3% in the comparable period in 2002.  The increase was primarily due to increasedutilization of manufacturing capacity, including a significant increase inproduction at the Company’s North Carolina facility.  Additionally, in 2002 there was a $2.4 million write down of araw material that will not be utilized in production.  The Company’s gross profit margins are dependent on severalfactors, including product sales mix, cost, volumes and competitive activity.

 

**Amortizationof other intangible assets. **Amortization ofother intangible assets was $2.8 million for the nine months ended September30, 2003 and for the comparable period in 2002.

 

**Otherselling, general and administrative expenses. **Other selling, general and administrative expenses increased $0.1million to $24.8 million for the nine months ended September 30, 2003 from$24.6 million for the comparable period in 2002.  Expenses for the nine months ended September 30, 2003 werereduced by a $3.5 million recovery of legal fees, as reported in the secondquarter, related to Nabumetone litigation. Excluding the recovery of legal fees, other selling, general andadministrative expenses were $28.3 million for the nine months ended September30, 2003, representing an increase of $3.6 million compared to the prioryear.  However, other selling, generaland administrative expenses, excluding the recovery of legal fees in 2003,decreased as percentage of net sales to 12.0% compared to 14.0% for the 2002period.  The increase in other selling,general and administrative expenses was principally due to higher insurancepremiums, an increase in distribution costs due to increased sales volume andincreased sales commissions.

 

**Researchand development expenses. **Research and development expenses increased $5.7 million to $15.9 millionfor the nine months ended September 30, 2003 compared to $10.2 million for thecomparable period in 2002.  The increase was attributable to an increasein generic product development costs of $6.2 million, offset by a decrease of$0.5 million related to certain basic research contracts unrelated to theCompany’s business that were transferred in March 2002 to an unrelatedentity.  The increase in generic product development costs was primarilyattributable to increases in costs related to bio-studies and materials and expensesrelating to the completion of defined milestones under third-party productdevelopment agreements. These increases reflect an acceleration of theCompany’s product development program.

 

**Operatingincome**. Operating income increased $30.0 million to $84.1 million for the ninemonths ended September 30, 2003 from $54.1 million for the comparable period in2002.  The increase in operating income was the result of increased salesand gross profit, offset by increases in research and development.

 

**Interest income(expense). **Net interest income for the nine months ended September 30, 2003 was $0.7million compared to net interest expense of $3.2 million in the comparableperiod in 2002.  A decrease in 

 

15

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outstanding debt,including the elimination of $92.1 million of intercompany debt, decreasedinterest expense by $3.5 million.  Interest income increased by $0.5million, the result of higher investment balances.

 

**Taxes onincome. **Taxeson income increased $13.1 million to $34.0 million during the nine months endedSeptember 30, 2003 from $20.9 million for the comparable period in 2002. The increase was the result of higher pre-tax income for 2003.  Theeffective tax rate decreased to 40.0% from 41.0% due principally to lower stateand local taxes in 2003.

 

**Net income.**  Net income increased $20.9million to $51.0 million for the nine months ended September 30, 2003 from$30.0 million in the comparable period in 2002 for the reasons described above.

 

**THREE MONTHSENDED SEPTEMBER 30, 2003 COMPARED WITH THREE MONTHS ENDED SEPTEMBER 30, 2002**

 

**Netsales. **Net sales increased 12.8% to$85.0 million for the three months ended September 30, 2003 from $75.4 millionfor the comparable period in 2002.  The majority of the increase wasattributable to an overall increase in unit volumes of existing products plusthe recent introductions in June 2003 of Mirtazipine and in September 2003 ofMidodrine HCl.

 

**Grossprofit. **Gross profit as a percentageof net sales increased to 56.0% for the three months ended September 30, 2003compared to 53.4% in the comparable period in 2002.  The gross margin for the quarter ended September 30, 2003reflected the benefit of lower costs on certain raw materials while the grossmargin in 2002 was unfavorably impacted by an increase in inventoryreserves.  The Company’s gross profitmargins are dependent on several factors, including product sales mix, cost,volumes and competitive activity.

 

**Amortizationof other intangible assets. **Amortization ofother intangible assets was $0.9 million for the three months ended September30, 2003 and for the comparable period in 2002.

 

**Otherselling, general and administrative expenses. **Other selling, general and administrative expenses decreased $0.7 millionto $10.7 million for the three months ended September 30, 2003 from $11.4million for the comparable period in 2002. The decrease is primarily attributable to reduced legal expensesprincipally related to phentermine litigation and lower amortization ofunearned deferred stock-based compensation.

 

** Research and development expenses. **Research and developmentexpenses increased $2.6 million to $6.6 million for the three months endedSeptember 30, 2003 compared to $4.0 million for the comparable period in2002.  The increase was primarilyattributable to higher costs related to bio-studies and materials andexpenses relating to the completion of defined milestones under third-partyproduct development agreements. These increases reflect an acceleration of theCompany’s product development program.

 

** Operating income. **Operating income increased $5.4 million to $29.3million for the three months ended September 30, 2003 from $24.0 million forthe comparable period in 2002.  The increase in operating income was theresult of increased sales and gross profit and lower other selling, general and administrative expenses offset by an increasein research and development costs.

 

**Interestincome (expense). **Net interestincome for the three months ended September 30, 2003 was $0.3 million comparedto $0.04 million in the comparable period in 2002.  The elimination ofoutstanding debt during the first quarter of 2003 resulted in a decrease ininterest expense of $0.3 million.

 

**Taxes onincome.****  **Taxes on income increased $2.0million to $11.9 million during the three months ended September 30, 2003 from$9.9 million in the comparable period in 2002.  The increase was theresult of higher pre-tax income for 2003.  The effective tax ratedecreased to 40.0% from 41.0% due principally to lower state and local taxes in2003.

 

**Net income**.  Net income increased $3.6 million to $17.8million for the three months ended September 30, 2003 from $14.2 million in thecomparable period in 2002 for the reasons described above.

 

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**LIQUIDITY AND CAPITAL RESOURCES**

 

Cash and investments increased $48.3 million to $135.6 million atSeptember 30, 2003 from $87.3 million at December 31, 2002.  Cash and cash equivalents were $46.8 millionat September 30, 2003 compared to $62.3 million at December 31, 2002.  The $15.5 million decrease in cash and cashequivalents was more than offset by a $63.9 million increase in investments.

 

The Company also has a three-year $25 million credit facility whichexpires on February 8, 2005.  Under thisfacility, the Company can borrow at LIBOR plus 1.5%, the bank’s prime rate or afixed rate.  The credit facility, whichis for working capital purposes, had no outstanding borrowings against it atSeptember 30, 2003.

 

Stockholders’ equity increased to $309.3 million at September 30, 2003from $258.2 million at December 31, 2002. Stockholders’ equity increased by $2.4 million (including tax benefits)from the exercise of employee stock options, net earnings of $51.0 million forthe nine months ended September 30, 2003 and $0.3 million for the amortizationof deferred stock-based compensation costs offset by the purchase of treasuryshares of $2.6 million.

 

During the nine months ended September 30, 2003, the Company consumed net cash of $15.5million.  Operations generated $65.5million of cash, comprised of net earnings of $51.0 million and non-cash itemstotaling $29.9 million, offset by an increase in working capital of $15.4million.  The increase in working capitalresulted from increases in accounts receivable, inventory and prepaid expensesand other current assets of $11.3 million, $15.9 million and $16.8 million,respectively.  A decrease in otherassets of $1.8 million and an increase in accounts payable and accruedliabilities of $0.9 and $25.9 million partially offset the other workingcapital increases.  The increases inaccounts receivable, inventory, accounts payable, and accrued liabilities areassociated with higher sales and production levels.  Prepaid expenses increased due to increases in prepaid insuranceand income taxes.

 

Investing activities consumed $74.2 million of cash during the ninemonths ended September 30, 2003. Approximately $63.9 million was used to purchase short-term investmentgrade debt instruments with the balance of $10.3 million used for capitalexpenditures.  The capital expendituresrelate primarily to equipment required to support increased production volumein the Company’s North Carolina facility.

 

Financing activities consumed $6.8 million of cash during the ninemonths ended September 30, 2003.  Cashof $7.4 million was used during the nine months ended September 30, 2003.  Repayment of acquisition debt and thepurchase of treasury shares consumed $4.8 million and $2.6 million,respectively.  Financing activitiesgenerated $0.6 million of cash, of which $0.5 million represents proceeds fromthe exercise of stock options.

 

The Company is involved in various litigation matters in which thepotential liabilities and/or related expenses are not covered byinsurance.  In addition, an adverseoutcome in patent litigation with Novartis and Apotex involving cyclosporinecapsules could result in the Company being unable to market this product whichwould materially harm its profits and cash flows and could result in theCompany paying damages, cost, expenses, and fees that could have a materialadverse impact on its financial performance. In December 2002, the United States District for the District ofDelaware granted the Company’s motion in the Novartis case for summary judgmentof non-infringement of the patent. Novartis appealed the judgment and the appeal is currently pending.

 

The Company does not currently have oranticipate any short-term funding requirements outside of the ordinary courseof its business, and the Company doesnot have or anticipate any liquidity concerns. The Company’s principalfuture cash requirements are associated with increased working capital tosupport future growth, capital expenditures and legal defense costs.  TheCompany anticipates that its operating cash flows, together with itsavailable borrowings under its credit facility and current cash balances, willbe sufficient to meet all of its working capital and capital expendituresrequirements for both the short-term and foreseeable future.

 

**CRITICAL ACCOUNTING POLICIES**

 

The Company’s critical accounting policies are those policies that areimportant to the portrayal of its financial condition and results of operationsand require management’s subjective judgments. As a result, these judgments are subject to an inherent degree ofuncertainty.  The Company bases itsjudgments on its experience and various 

 

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other assumptions that the Company believes to be reasonable under thecircumstances.  On an ongoing basis, theCompany evaluates its estimates, including those related to revenues, returns,inventories, income taxes and litigation. The Company’s actual results could differ from these estimates underdifferent assumptions or conditions. The Company believes the following accounting policies to be critical:

 

Sales are recognized when the products are received by the customer,which represents the point when the risks and rewards of ownership are transferredto the customer.  Sales are shown net ofdiscounts, rebates, contract pricing adjustments and returns, which areestimated based on the Company’s experience. Discounts, rebates and contract pricing adjustments are recorded as areduction of sales based on agreed upon terms with the Company’s customers atthe time of sale.  The Companycalculates a reserve for discounts and rebates based upon actual sales undersuch arrangements.  Reserves forcontract pricing adjustments represent the difference between the priceswholesalers are billed by the Company and the prices billed to their customersto whom the Company has given contract prices. In determining a reserve for contract pricing adjustments, the Companytakes into account an estimate of the percentage of product sales subject tosuch pricing adjustments based on historical trends.  Historical trends are adjusted for new product introductions andchanges in wholesaler or contract prices.

 

Shelf stock adjustments are provided following a reduction in theprices of any of the Company’s products due to the competitiveenvironment.  Such adjustments arecredited to the Company’s customers based on their on-hand inventoryquantities.  Reserves are generallyestablished when the Company reduces its prices.

 

Estimates for returns, which are recorded at the time of sale, relateprimarily to returns of expiring products. The Company utilizes historical trends to estimate the amount ofproducts to be returned due to product expiration.

 

In determining whether liabilities should be recorded for pendinglitigation claims, the Company must assess the allegations made and thelikelihood that it will successfully defend itself.  When the Company believes it is probable that it will not prevailin a particular matter, it will then make an estimate of the amount ofliability based in part on advice of outside legal counsel.

 

**IMPACT OFRECENTLY ISSUED ACCOUNTING STANDARDS**

 

In December 2002, the FASB issued SFAS No. 148 “Accounting forStock-Based Compensation-Transition and Disclosure” that amends FASB StatementNo. 123 “Accounting for Stock-Based Compensation.”  SFAS No. 148 provides alternative methods of transition for avoluntary change to the fair value based method of accounting for stock-basedemployee compensation.  SFAS No. 148amends the disclosure requirements of APB Opinion No. 28, “Interim FinancialReporting” and Statement No. 123 to require prominent disclosures in bothannual and interim financial statements about the method of accounting forstock-based employee compensation and the effect of the method used onreporting results.  SFAS No. 148 iseffective for fiscal years ending after December 15, 2002.  The adoption of SFAS No. 148, except for thedisclosure requirements, had no impact on the consolidated financialstatements.  The additional requireddisclosure is included as part of note 4 in the Notes to the CondensedConsolidated Financial Statements on Form 10-Q.

 

In May 2003, the FASB issued SFAS No.150, “Accounting for Certain Financial Instruments with Characteristics of bothLiabilities and Equity.”  SFAS No. 150requires that certain financial instruments, which under previous guidance wereaccounted for as equity, must now be accounted for as liabilities.  The financial instruments affected includemandatory redeemable stock, certain financial instruments that require or mayrequire the issuer to buy back some of its shares in exchange for cash or otherassets and certain obligations that can be settled with shares of stock.  SFAS No. 150 is effective for all financialinstruments entered into or modified after May 31, 2003, and otherwise iseffective at the beginning of the first interim period beginning after June 15,2003.  The initial adoption of SFAS No.150 on July 1, 2003 did not have any impact on the Company’s consolidatedfinancial statements.

 

In November 2002, the FASB issuedInterpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements forGuarantees, Including Indirect Guarantees of Indebtedness of Others — an Interpretationof FASB Statements No. 5, 57, and 107 and Rescission of FASB Interpretation No.34.”  This interpretation expands on theexisting accounting guidance and disclosure requirements for most guarantees,including indemnifications.  It requiresthat at the time a company issues a guarantee, the company must recognize aninitial liability for the fair value of the obligations it assumes under thatguarantee if that amount is reasonably estimable, and must disclose that 

 

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information in its interim and annualfinancial statements.  The provisionsfor initial recognition and measurement of the liability are to be applied on aprospective basis to guarantees issued or modified on or after January 1, 2003.  The Company’s initial adoption of thisstatement on January 1, 2003, did not have an impact on its results ofoperations, financial position, or cash flows. Guarantees issued or modified after January 1, 2003, will be recognizedat their fair value in the Company’s financial statements.  The Company has not issued any guarantees asof September 30, 2003.

 

In January 2003, the FASB issuedInterpretation No. 46, “Consolidation of Variable Interest Entities.”  This interpretation provides guidance withrespect to the consolidation of certain entities, referred to as variableinterest entities (“VIE”), in which an investor is subject to a majority of therisk of loss from the VIE’s activities, or is entitled to receive a majority ofthe VIE’s residual returns.  Thisinterpretation also provides guidance with respect to the disclosure of VIEs inwhich an investor maintains an interest, but is not required toconsolidate.  The provisions of theinterpretation are effective immediately for all VIEs created after January 31,2003, or in which the Company obtains an interest after that date.  For VIEs created before February 1, 2003,the provisions are effective July 1, 2003. The Company has not acquired an interest in or created a VIE afterJanuary 31, 2003.  The Company hascompleted its assessment and determined that the adoption of thisinterpretation did not have a material impact on the Company’s financialposition or results of operations.

 

**ITEM 3** - QUANTITATIVE ANDQUALITATIVE DISCLOSURE ABOUT MARKET RISK

** **

The following discusses the Company’s exposure to market risk relatedto changes in interest rates, equity prices and foreign currency exchangerates.  The Company does not believethat its exposure to market risk is material.

 

As of September 30, 2003, the Company had cash and cash equivalents of$46.8 million.  Cash equivalents areinterest-bearing investment grade securities, primarily short-term, highlyliquid investments with maturities at the date of purchase of less than 90days.  These investments are subject tointerest rate risk and will decrease in value if market interest ratesincrease.  A hypothetical increase inthe market interest rates by 10 percent from the rates in effect on the date ofthis Form 10-Q would cause the fair value of these short-term investments todecline by an insignificant amount.  TheCompany has the ability to hold these investments until maturity, and thereforeit does not expect the value of these investments to be affected to anysignificant degree by the effect of a sudden change in market interestrates.  Declines in interest rates overtime will, however, reduce the Company’s interest income.

 

The Company currently owns $88.8 million in publicly traded debtsecurities which are subject to market fluctuations.  These investments are subject to interest rate risk and willdecrease in value if market interest rates increase.  A hypothetical increase in the market interest rates by 10percent from the rates in effect on the date of this Form 10-Q would cause thefair value of these short-term investments to decline by an insignificantamount.  However, the Company has theability to hold these investments until maturity, and therefore, it does notexpect to realize any loss upon a sudden change in market interest rates.

 

The Company does not have any international operations or anysignificant assets or liabilities denominated in foreign currencies, andcurrently does not enter into forward exchange contracts or other financialinstruments with respect to foreign currency transactions.  Accordingly, the Company currently does nothave any significant foreign currency exchange rate risk.

 

**ITEM 4****- CONTROLS AND PROCEDURES**

 

As of September 30, 2003, an evaluation was performed under thesupervision and with the participation of the Company’s management, includingthe Chief Executive Officer and the Chief Financial Officer, of theeffectiveness of the design and operation of the Company’s disclosure controlsand procedures.  Based on that evaluation,the Company’s management, including the Chief Executive Officer and the ChiefFinancial Officer, concluded that the Company’s disclosure controls andprocedures were effective as of September 30, 2003.  There have been no significant changes in the Company’s internalcontrols or in other factors that could significantly affect the internalcontrols subsequent to September 30, 2003.

 

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**SPECIALNOTE REGARDING FORWARD-LOOKING STATEMENTS**

 

This quarterly report on Form 10-Q report contains forward-lookingstatements relating to future events and future performance of the Companywithin the meaning of Section 27A of the Securities Act of 1933 and Section 21Eof the Securities Exchange Act of 1934, including, without limitation,statements regarding the Company’s expectations, beliefs, intentions or futurestrategies that are signified by the words “expects,” “anticipates,” “intends,”“believes” or similar language.  Actualresults could differ materially from those anticipated in such forward-lookingstatements.  Some specific factors thatmay have a significant effect on the Company’s operating results and commonstock market price include:

 

•                  new product introductions;

•                  changes in the degree ofcompetition for the Company’s products;

•                  regulatory issues,including, but not limited to, receipt of ANDA approvals from the FDA,compliance with FDA or other agency regulations or the lack or failure ofeither of the foregoing;

•                  the inability to acquiresufficient supplies of raw materials;

•                  litigation and/or threats oflitigation;

•                  changes in the Company’sgrowth rates or the Company’s competitors’ growth rates;

•                  legislative and FDA actionswith respect to the government regulation of pharmaceutical products;

•                  public concern as to thesafety of the Company’s  products;

•                  changes in health carepolicy in the United States;

•                  conditions in the financialmarkets in general or changes in general economic conditions;

•                  the Company’s inability toraise additional capital;

•                  conditions of other generic pharmaceuticalcompanies or the generic pharmaceutical industry generally; and

•                  changes in stock marketanalyst recommendations regarding the Company’s common stock, other comparablecompanies or the generic pharmaceutical industry generally.

 

All forward-looking statements included in this document are based oninformation available to the Company on the date hereof, and the Companyassumes no obligation to update any forward-looking statements. The Companycautions investors that its business and financial performance are subject tosubstantial risks and uncertainties.

 

**PART II****— OTHERINFORMATION**

 

**ITEM 2 —CHANGES IN SECURITIES AND USE OF PROCEEDS**

 

In June 2002, the Company closed an initial public offering of itscommon stock.  The Registration Statementon Form S-1 (File No. 333-83638) was declared effective by the Securities andExchange Commission on May 23, 2002 and the Company commenced the offering onthat date.  After deducting underwritingdiscounts and commissions and the offering expenses, the net proceeds from theoffering to the Company were approximately $139.2 million.

 

The Company has used proceeds from the offering as follows: (i) $66.9million has been used to repay debt due to Hexal AG; (ii) $10.0 million hasbeen used to repay debt incurred in connection with the acquisition of EHI; and(iii) $2.0 million has been used for general working capital purposes.  The remaining $60.3 million of the proceedsto the Company from the offering are invested in cash investments andshort-term investment grade debt securities. The Company anticipates using the balance of the proceeds from theoffering for general corporate purposes, including funding working capital,increased research and development expenditures to expand the Company’s productofferings and the potential acquisition of product lines or companies.  The Company has no present understandings,commitments or agreements with respect to any acquisitions.  The Company has not determined the amountsit plans to spend on any of the areas listed above or the timing of theseexpenditures.

 

**ITEM 6****— EXHIBITSAND REPORTS ON FORM 8-K**

 

(a)           Exhibits

 

31.1                           Certificationspursuant to Section 302 of the Sarbanes-Oxley Act of 2002

 

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31.2                           Certifications pursuantto Section 302 of the Sarbanes-Oxley Act of 2002

 

32.1                           CertificationPursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of theSarbanes-Oxley Act of 2002

 

32.2                           CertificationPursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of theSarbanes-Oxley Act of 2002

 

(b)                                 Reports on Form8-K

 

On August 8, 2003, the Company filed aCurrent Report on Form 8-K reporting the Press Release regarding earnings forthe quarter ended June 30, 2003.

 

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**SIGNATURES**

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, the Registrant has duly caused thisreport to be signed on its behalf by the undersigned thereunto duly authorized.

 
|              | Eon Labs, Inc. |
|-------------------|----------------|
|              |           |   |
| November 13, 2003 | By:            | /s/ Bernhard Hampl, Ph.D. |
|              |           | Bernhard Hampl, Ph.D.

President, Chief Executive  Officer and Director |
|              |           |   |
|              |           |   |
| November 13, 2003 | By:            | /s/ William F. Holt |
|              |           | William F. Holt

Chief Financial Officer |

 

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