**UNITED STATES**

**SECURITIES 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** |
|------------|----------------------------------------------------------------------------------------------|

** **

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**CommissionFile Number 011-31333**

** **

**For thequarterly period ended September 30, 2002**

** **

**or**

** **
| **o** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|-----------------------------------------------------------------------------------------------------|

** **

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** **

**Eon Labs, Inc.**

(Exact Name of Registrantas 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

 

As of November 14, 2002, there were 43,559,902 shares of theRegistrant’s Common Stock, $0.01 par value per share, outstanding.

 

 

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**Eon Labs, Inc. and Subsidiaries**

**Table of Contents**

 
| PART I.            | FINANCIAL INFORMATION                                                                                                   |                                                                                                                                    |
|--------------------|-------------------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------------------------------------------------|
|               |                                                                                                                    |                                                                                                                                    |
|               | ITEM 1.                                                                                                                 | Financial Statements                                                                                                                    |   |
|               |                                                                                                                    |                                                                                                                                    |   |
|               |                                                                                                                    | Condensed  Consolidated Balance Sheets as of December 31, 2001 and September 30, 2002  (unaudited)                                      | 3 |
|               |                                                                                                                    |                                                                                                                                    |   |
|               |                                                                                                                    | Condensed  Consolidated Statements of Income (unaudited) for the Three and Nine Months  Ended September 30, 2001 and September 30, 2002 | 4 |
|               |                                                                                                                    |                                                                                                                                    |   |
|               |                                                                                                                    | Condensed  Consolidated Statements of Cash Flows (unaudited) for the Nine Months Ended  September 30, 2001 and September 30, 2002       | 5 |
|               |                                                                                                                    |                                                                                                                                    |   |
|               |                                                                                                                    | Notes  to Condensed Consolidated Financial Statements (unaudited)                                                                       | 6 |
|               |                                                                                                                    |                                                                                                                                    |   |
|               | ITEM  2.                                                                                                                | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                             | 14 |
|               |                                                                                                                    |                                                                                                                                    |   |
|               | ITEM  3.                                                                                                                | Quantitative  and Qualitative Disclosure about Market Risk                                                                              | 22 |
|               |                                                                                                                    |                                                                                                                                    |   |
|               | ITEM 4                                                                                                                  | Controls  and Procedures                                                                                                                | 22 |
|               |                                                                                                                    |                                                                                                                                    |   |
| PART  II.          | OTHER  INFORMATION                                                                                                      | 24                                                                                                                                      |
|               |                                                                                                                    |                                                                                                                                    |
|               | ITEM  1.                                                                                                                | Legal  Proceedings                                                                                                                      | 24 |
|               |                                                                                                                    |                                                                                                                                    |   |
|               | ITEM  2.                                                                                                                | Changes  in Securities and Use of Proceeds                                                                                              | 24 |
|               |                                                                                                                    |                                                                                                                                    |   |
|               | ITEM  5.                                                                                                                | Other  Information                                                                                                                      | 24 |
|               |                                                                                                                    |                                                                                                                                    |   |
|               | ITEM  6.                                                                                                                | Exhibits  and Reports on Form 8-K                                                                                                       | 26 |
|               |                                                                                                                    |                                                                                                                                    |   |
| SIGNATURES         |                                                                                                                    | 27                                                                                                                                      |
|               |                                                                                                                    |                                                                                                                                    |   |
| EXHIBIT  99.1 | Certification Pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |                                                                                                                                    |
|               |                                                                                                                    |                                                                                                                                    |
| EXHIBIT  99.2 | 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 Subsidiaries**

**Condensed Consolidated Balance Sheets**

(dollars in thousands, except per share amounts)

 
|                                                                                                                                                                                                                           |   | **December 31,   2001** |    | **September 30,   2002** |   |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|---------|--------------------------|--------|
|                                                                                                                                                                                                                           |   |                    |    | **(Unaudited)**          |   |
| **Assets**                                                                                                                                                                                                                     |   |                    |    |                     |   |
|                                                                                                                                                                                                                           |   |                    |    |                     |   |
| **Current  assets**                                                                                                                                                                                                            |   |                    |    |                     |   |
| Cash and cash  equivalents                                                                                                                                                                                                     |   | $                       | 17,624  |                     | $      | 40,945 |   |
| Restricted cash  in escrow                                                                                                                                                                                                     |   | 877                     |    | 806                      |   |
| Investments                                                                                                                                                                                                                    |   | —                  |    | 19,328                   |   |
| Accounts  receivable, net of allowances of $6,882 and $53,649 in 2001 and 2002,  respectively                                                                                                                                  |   | 27,290                  |    | 53,403                   |   |
| Inventories                                                                                                                                                                                                                    |   | 31,192                  |    | 39,903                   |   |
| Deferred tax  assets, net                                                                                                                                                                                                      |   | 19,566                  |    | 19,566                   |   |
| Prepaid expenses  and other current assets                                                                                                                                                                                     |   | 4,478                   |    | 18,815                   |   |
| Due from related  party                                                                                                                                                                                                        |   | 200                     |    | 76                       |   |
|                                                                                                                                                                                                                           |   |                    |    |                     |   |
| **Total  current assets**                                                                                                                                                                                                      |   | 101,227                 |    | 192,842                  |   |
|                                                                                                                                                                                                                           |   |                    |    |                     |   |
| Property, plant  and equipment, net                                                                                                                                                                                            |   | 38,496                  |    | 41,644                   |   |
| Goodwill and  other intangible assets, net                                                                                                                                                                                     |   | 78,805                  |    | 77,814                   |   |
| Other assets                                                                                                                                                                                                                   |   | 874                     |    | 2,380                    |   |
|                                                                                                                                                                                                                           |   |                    |    |                     |   |
| **Total  assets**                                                                                                                                                                                                              |   | $                       | 219,402 |                     | $      | 314,680 |   |
|                                                                                                                                                                                                                           |   |                    |    |                     |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                                                                 |   |                    |    |                     |   |
|                                                                                                                                                                                                                           |   |                    |    |                     |   |
| **Current  liabilities**                                                                                                                                                                                                       |   |                    |    |                     |   |
| Accounts payable                                                                                                                                                                                                               |   | $                       | 10,430  |                     | $      | 12,272 |   |
| Accrued expenses  and other liabilities                                                                                                                                                                                        |   | 37,301                  |    | 47,986                   |   |
| Current portion  of note payable                                                                                                                                                                                               |   | 24,400                  |    | 4,444                    |   |
|                                                                                                                                                                                                                           |   |                    |    |                     |   |
| **Total current liabilities**                                                                                                                                                                                                  |   | 72,131                  |    | 64,702                   |   |
|                                                                                                                                                                                                                           |   |                    |    |                     |   |
| **Long-term  liabilities**                                                                                                                                                                                                     |   |                    |    |                     |   |
| Long-term  portion of note payable                                                                                                                                                                                             |   | 2,353                   |    | —                   |   |
| Deferred tax  liabilities, net                                                                                                                                                                                                 |   | 7,153                   |    | 7,153                    |   |
| Deferred revenue                                                                                                                                                                                                               |   | 660                     |    | 489                      |   |
| Loans and  advances from Hexal AG                                                                                                                                                                                              |   | 90,114                  |    | —                   |   |
|                                                                                                                                                                                                                           |   |                    |    |                     |   |
| **Total  liabilities**                                                                                                                                                                                                         |   | 172,411                 |    | 72,344                   |   |
|                                                                                                                                                                                                                           |   |                    |    |                     |   |
| Contingencies  (Note 8)                                                                                                                                                                                                        |   |                    |    |                     |   |
|                                                                                                                                                                                                                           |   |                    |    |                     |   |
| **Stockholders’  equity**                                                                                                                                                                                                 |   |                    |    |                     |   |
|                                                                                                                                                                                                                           |   |                    |    |                     |   |
| Class A voting  common stock, par value $.01 per share; 60,000,000 shares authorized, no shares  issued or outstanding at December 31, 2001, and no shares authorized or  outstanding at September 30, 2002                    |   | —                  |    | —                   |   |
| Common stock,  par value $.01 per share; no shares authorized or outstanding at December 31,  2001, and 70,000,000 authorized and 43,559,902 outstanding at September 30,  2002                                                |   | —                  |    | 436                      |   |
| Class B  convertible, non-voting common stock, par value $.01 per share; 3,000,000  shares authorized and no shares issued or outstanding at December 31, 2001;  and no shares authorized or outstanding at September 30, 2002 |   | —                  |    | —                   |   |
| Preferred stock,  par value $.01 per share, Series A convertible; 35,000,000 shares authorized,  30,000,000 issued and outstanding at December 31, 2001 and no shares  authorized or outstanding at September 30, 2002         |   | 300                     |    | —                   |   |
| Preferred stock,  par value $.01 per share; no shares authorized and no shares issued or  outstanding at December 31, 2001, and 5,000,000 shares authorized and no  shares issued or outstanding at September 30, 2002         |   | —                  |    | —                   |   |
| Additional  paid-in capital                                                                                                                                                                                                    |   | 26,101                  |    | 190,380                  |   |
| Retained  earnings                                                                                                                                                                                                             |   | 22,376                  |    | 52,409                   |   |
| Accumulated  other comprehensive income                                                                                                                                                                                        |   | —                  |    | 31                       |   |
|                                                                                                                                                                                                                           |   | 48,777                  |    | 243,256                  |   |
| Less:  Unearned deferred stock-based compensation                                                                                                                                                                         |   | (1,786                  | )       | (920                     | )      |
| **Total  stockholders’ equity**                                                                                                                                                                                           |   | 46,991                  |    | 242,336                  |   |
| **Total  liabilities and stockholders’ equity**                                                                                                                                                                           |   | $                       | 219,402 |                     | $      | 314,680 |   |

 

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

 

3

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**Eon Labs, Inc. and Subsidiaries**

**Condensed Consolidated Statements ofIncome**

(dollars in thousands, except per share amounts) (unaudited)

 
|                                                |   | **For the three months ended   September 30,** |   | **For the nine months ended   September 30,** |       |
|-----------------------------------------------------|--------|------------------------------------------------|--------|-----------------------------------------------|------------|
|                                                |   | **2001**                                       |   | **2002**                                      | ** ** | **2001** | ** ** | **2002** | ** ** |
|                                                |   |                                           |   |                                          |       |   |   |   | ** ** |
| Net sales                                           |   | $                                              | 42,545 |                                          | $          | 75,351 |   | $ | 124,227 |   | $ | 175,549 |   |
| Cost of sales                                       |   | 18,890                                         |   | 35,081                                        |       | 53,657 |   | 83,763 |   |
|                                                |   |                                           |   |                                          |       |   |   |   |   |
| **Gross  profit**                                   |   | 23,655                                         |   | 40,270                                        |       | 70,570 |   | 91,786 |   |
|                                                |   |                                           |   |                                          |       |   |   |   |   |
| Operating  expenses                                 |   |                                           |   |                                          |       |   |   |   |   |
| Selling, general  and administrative expenses:      |   |                                           |   |                                          |       |   |   |   |   |
| Amortization of  goodwill and other intangibles     |   | 1,780                                          |   | 940                                           |       | 5,340 |   | 2,820 |   |
| Deferred stock  appreciation rights compensation    |   | 3,279                                          |   | —                                        |       | 9,837 |   | — |   |
| Other selling,  general and administrative expenses |   | 6,475                                          |   | 11,399                                        |       | 19,035 |   | 24,627 |   |
| Research and  development expenses                  |   | 3,240                                          |   | 3,974                                         |       | 8,351 |   | 10,240 |   |
|                                                |   |                                           |   |                                          |       |   |   |   |   |
| **Total  operating expenses**                       |   | 14,774                                         |   | 16,313                                        |       | 42,563 |   | 37,687 |   |
|                                                |   |                                           |   |                                          |       |   |   |   |   |
| **Operating  income**                               |   | 8,881                                          |   | 23,957                                        |       | 28,007 |   | 54,099 |   |
|                                                |   |                                           |   |                                          |       |   |   |   |   |
| Other income  (expense), net                        |   |                                           |   |                                          |       |   |   |   |   |
| Interest income                                     |   | 107                                            |   | 353                                           |       | 347 |   | 519 |   |
| Interest expense                                    |   | (2,341                                         | )      | (310                                          | )          | (7,027 | ) | (3,754 | ) |
| Other income,  net                                  |   | —                                         |   | 39                                            |       | 6 |   | 50 |   |
|                                                |   |                                           |   |                                          |       |   |   |   |   |
| **Total  other income (expense), net**              |   | (2,234                                         | )      | 82                                            |       | (6,674 | ) | (3,185 | ) |
|                                                |   |                                           |   |                                          |       |   |   |   |   |
| Income before  income taxes                         |   | 6,647                                          |   | 24,039                                        |       | 21,333 |   | 50,914 |   |
|                                                |   |                                           |   |                                          |       |   |   |   |   |
| Provision for  income taxes                         |   | (3,004                                         | )      | (9,856                                        | )          | (9,642 | ) | (20,881 | ) |
|                                                |   |                                           |   |                                          |       |   |   |   |   |
| **Net  income**                                     |   | $                                              | 3,643  |                                          | $          | 14,183 |   | $ | 11,691 |   | $ | 30,033 |   |
|                                                |   |                                           |   |                                          |       |   |   |   |   |
| Net income per  common share                        |   |                                           |   |                                          |       |   |   |   |   |
| Basic                                               |   | $                                              | — |                                          | $          | 0.33 |   | $ | — |   | $ | 1.44 |   |
| Diluted                                             |   | $                                              | 0.11   |                                          | $          | 0.31 |   | $ | 0.37 |   | $ | 0.77 |   |
|                                                |   |                                           |   |                                          |       |   |   |   |   |
| Weighted average  common shares outstanding         |   |                                           |   |                                          |       |   |   |   |   |
| Basic                                               |   | —                                         |   | 43,559,902                                    |       | — |   | 20,845,282 |   |
| Diluted                                             |   | 31,680,528                                     |   | 45,387,515                                    |       | 31,680,528 |   | 39,134,205 |   |

 

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

 

4

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**Eon Labs, Inc. and Subsidiaries**

**Condensed Consolidated Statements ofCash Flows**

(dollars in thousands) (unaudited)

 
|                                                                               |   | **For the nine  months ended  September 30,** |       |
|------------------------------------------------------------------------------------|--------|-----------------------------------------------|------------|
|                                                                               |   | **2001**                                      | ** ** | **2002** | ** ** |
| **Cash flows from operating  activities**                                          |   |                                          | ** ** |   | ** ** |
| Net income                                                                         |   | $                                             | 11,691     |   | $ | 30,033 |   |
| Adjustments to reconcile net income to net cash provided by operating  activities: |   |                                          | ** ** |   | ** ** |
| Provision for accounts receivable allowances                                       |   | (3,574                                        | )          | 46,767 |   |
| Depreciation and amortization                                                      |   | 7,767                                         |       | 5,692 |   |
| Deferred compensation                                                              |   | 9,837                                         |       | 866 |   |
| Amortization of deferred revenue                                                   |   | (422                                          | )          | (171 | ) |
| Amortization of discount on note payable                                           |   | 2,009                                         |       | 1,063 |   |
| Interest paid in-kind                                                              |   | 4,899                                         |       | 2,463 |   |
| Changes in assets and liabilities:                                                 |   |                                          | ** ** |   | ** ** |
| Accounts receivable                                                                |   | (1,797                                        | )          | (72,880 | ) |
| Inventories                                                                        |   | (6,068                                        | )          | (8,711 | ) |
| Prepaid expenses and other current assets                                          |   | (3,420                                        | )          | (14,337 | ) |
| Other assets                                                                       |   | (559                                          | )          | (1,506 | ) |
| Accounts payable                                                                   |   | 2,331                                         |       | 1,842 |   |
| Accrued expenses and other liabilities                                             |   | 414                                           |       | 9,540 |   |
| Deferred revenue                                                                   |   | 325                                           |       | — |   |
| **Net cash provided by operating  activities**                                     |   | 23,433                                        |       | 661 |   |
|                                                                               |   |                                          | ** ** |   | ** ** |
| **Cash flows from investing  activities**                                          |   |                                          | ** ** |   | ** ** |
| Capital expenditures                                                               |   | (2,656                                        | )          | (6,020 | ) |
| Purchases of short-term investments                                                |   | —                                        |       | (19,297 | ) |
| **Net cash used in investing  activities**                                         |   | (2,656                                        | )          | (25,317 | ) |
|                                                                               |   |                                          |       |   |   |
| **Cash flows from financing  activities**                                          |   |                                          | ** ** |   | ** ** |
| Decrease in loans and advances to Hexal AG                                         |   | (8,335                                        | )          | (66,942 | ) |
| Payment on seller note                                                             |   | —                                        |       | (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                                                 |   | 158                                           |       | 812 |   |
| Decrease in restricted cash                                                        |   | 701                                           |       | 71 |   |
| **Net cash (used in) provided by  financing activities**                           |   | (7,476                                        | )          | 47,977 |   |
|                                                                               |   |                                          | ** ** |   | ** ** |
| **Net increase in cash and cash  equivalents**                                     |   | 13,301                                        |       | 23,321 |   |
|                                                                               |   |                                          | ** ** |   | ** ** |
| Cash and cash equivalents at beginning of period                                   |   | 6,378                                         |       | 17,624 |   |
|                                                                               |   |                                          | ** ** |   | ** ** |
| Cash and cash equivalents at end of period                                         |   | $                                             | 19,679     |   | $ | 40,945 |   |
|                                                                               |   |                                          | ** ** |   | ** ** |
| Non-cash investing activities:                                                     |   |                                          |       |   |   |   |   |
| Unrealized gain on investments                                                     |   | $                                             | **—** |   | $ | 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 |   |

 

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

 

5

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**Eon Labs, Inc. and Subsidiaries**

**Notes to Condensed ConsolidatedFinancial Statements**

(dollars in thousands, except per share amounts)

 

**1.****              Basis ofPresentation**

 

The condensed consolidatedfinancial statements included herein have been prepared by Eon Labs,Inc. (the “Company”) without audit pursuant to the rules and regulations of theUnited States Securities and Exchange Commission.  Certain information and footnote disclosures normally included infinancial statements prepared in accordance with generally accepted accountingprinciples have been condensed or omitted pursuant to such rules andregulations.  In the opinion ofmanagement, the accompanying unaudited condensed consolidated financialstatements reflect all adjustments (consisting only of normal recurring accruals)necessary for a fair presentation of the financial position as ofSeptember 30, 2002 and results of operations and cash flows for theperiods presented.  The consolidatedbalances as of December 31, 2001 were derived from audited financialstatements but do not include all disclosures required by generally acceptedaccounting principles.  The accompanyingcondensed consolidated financial statements have been prepared in accordancewith accounting standards for interim financial statements and should be readin conjunction with the Company’s audited consolidated financial statements andthe notes thereto for the year ended December 31, 2001.  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 andReorganization***

Prior to the reorganizationdescribed below, Hexal Pharmaceuticals, Inc. (“HPI”), a wholly-ownedUnited States subsidiary of Santo Holding (Deutschland) GmbH (“Santo” or the“Parent”), which is under common control with Hexal AG, owned 50% of theoutstanding capital stock of the Company. The remaining 50% was owned by EonHoldings, Inc. (“EHI”), whose principal asset was its 50% ownership of theCompany.

 

Effective May 22, 2002, in conjunctionwith the initial public offering of the Company’s common stock, the Company wascombined with HPI and EHI into a single entity through a series ofreorganization mergers. EHI was merged with and into HPI and HPI wassubsequently merged with and into the Company. This reorganization wasaccounted for as a merger of entities under common control and the accounts ofthe companies were combined in a manner similar to a pooling of interestseffective January 1, 2000. The condensed consolidated financial statementsfor the three and nine months ended September 30, 2001 and 2002 reflectresults on a combined basis.

 

***Shipping and Handling Costs***

The Company classifiesshipping and handling costs as part of selling, general and administrativeexpenses.  Shipping and handling costswere $0.5 million and $1.0 million in the three months endedSeptember 30, 2001 and 2002, respectively, and $1.3 million and $2.2million for the nine months ended September 30, 2001 and 2002, respectively.

 

***Investments***

The Company invests in publiclytraded debt securities which are categorized as securities available-for-saleand are carried at fair value, with unrealized gains and losses excluded

 

6

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from income and recordeddirectly to stockholders’ equity.  Themarket value of such securities exceeded book value by $0.03 million atSeptember 30, 2002.  Accordingly,recording comprehensive income items (unrealized gains on marketablesecurities) increases net income by $0.03 million for the nine months endedSeptember 30, 2002.

 

# **2.**              InitialPublic Offering and Shareholders’ Equity

# ** **

On June 11, 2002, the Company completed its initialpublic offering of common stock, which resulted in net proceeds of $139,236 andthe issuance of 10,200,813 shares of common stock.  Upon the consummation of the Company’s initial public offering,all of the previously outstanding shares of the Company’s preferred stock wereconverted into 30,000,000 shares of common stock and warrants were exercisedresulting in the issuance of 1,680,528 shares of common stock.  Immediately following the closing of theCompany’s initial public offering, debt of $25,178 due to Hexal AG wasconverted into 1,678,561 shares of common stock and debt of $66,942 due toHexal AG was paid with the proceeds of the offering.

 

***Stock Splits***

In May 2002, the Companyeffected a 30-for-1 stock split of the Company’s preferred stock and theCompany’s non-voting common stock with no change in par value. Additionalpaid-in capital, preferred stock, common stock, per share and sharesoutstanding data in the unaudited Condensed Consolidated Financial Statementsand Notes to the unaudited Condensed Consolidated Financial Statements havebeen retroactively restated to reflect this stock split.

 

In May 2002, the outstanding 30,000,000 preferredshares were converted to common stock. In addition, the Company changed thenumber of shares of authorized preferred stock to 5,000,000, increased thenumber of shares of authorized voting common stock to 70,000,000 and convertedshares of non–voting common stock to shares of a single class of commonstock.

 

***Deferred Stock-Based Compensation***

The Company amortized deferred stock compensation of$288 and $866 during the three and nine months ended September 30, 2002,respectively.

 

# **3.**              Earnings Per Share

 

Basicnet income per share is computed by dividing net income by the weightedaverage number of common shares outstanding for the period. There were nocommon shares outstanding for the three and nine months ended September 30,2001.  For the three and nine monthsended September 30, 2002, diluted earnings per share reflect the conversion ofpreferred stock and the potential dilution of warrants.  Diluted earnings per share for the three andnine months ended September 30, 2002 include 30,000,000 shares of preferredstock assumed converted to common and the dilutive effect of warrants of1,680,528 shares.  Basic weightedaverage shares outstanding for the three and nine months ended September 30,

 

7

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2002 reflect the impact of common shares issuedresulting from the conversion of 30,000,000 shares of preferred stock convertedto common stock, the exercise by warrant holders of 1,680,528 shares, debt of$25,178 converted to 1,678,561 shares and the issuance of 10,200,813 shares inconnection with the Company’s initial public offering.  The issuance of such shares resulted inbasic weighted average shares outstanding of 43,559,902 and 20,845,282 for thethree and nine months ended September 30, 2002.   The weighted average common shares outstanding used forcalculating basic earnings per share are significantly higher for the threemonths ended September 30, 2002 than for the nine month period because therewere no common shares outstanding until May 23, 2002.  Weighted average shares outstanding on a diluted basis for the2002 periods reflect the shares issued as noted above, assuming that thepreferred stock that was converted to common was outstanding for the fullnine-month period and the diluted effect of stock options of 1,827,613 and 1,811,164 for the three andnine-month periods ended September 30, 2002, respectively, which resulted inweighted average shares outstanding on a diluted basis of 45,387,515 and39,134,205, respectively.

 

# **4.**              Adoption of New Accounting Pronouncements

# ** **

InJuly 2001, the Financial Accounting Standards Board issued SFASNo. 142, “Goodwill and Other Intangible Assets.”  SFAS No. 142 modifies the accounting and reporting foracquired intangible assets at the time of acquisition and in subsequentperiods.  Intangible assets which havefinite lives must be amortized over their estimated useful life. Intangibleassets with indefinite lives will not be amortized, but evaluated annually forimpairment.  The Company has completedits impairment assessment and determined that there is no impairment ofgoodwill or identifiable intangibles upon initial adoption of SFASNo. 142. SFAS No. 142 is effective for fiscal years beginning afterDecember 15, 2001.  The value ofthe Company’s existing products is an intangible asset with a finite life thatis being amortized over 10 years. The Company’s goodwill and workforce intangibles which were beingamortized over 15 and 5 year lives, respectively, have not been amortizedduring the nine-month period ended September 30, 2002. Had this pronouncementbeen retroactively applied, net income would have increased approximately $835and $2,505, respectively, and diluted earnings per share would have increased$0.03 per share and $0.08 per share, respectively, in the three and nine monthsended September 30, 2001.  In 2002, theCompany transferred the net book value of its workforce intangible of $1,136 togoodwill, resulting in goodwill of $47,107.  The recorded amount of the existing product intangible of $37,600,before accumulated amortization of $6,893 as of September 30, 2002, will beamortized through 2010 with annual charges of $3,760.

 

In October 2001, the Financial AccountingStandards Board issued SFAS No. 144, “Accounting for the Impairment orDisposal of Long-Lived Assets,” that replaces SFAS No. 121, “Accountingfor the Impairment of Long-Lived Assets and for Long-Lived Assets to beDisposed of.”  SFAS No. 144requires that long-lived assets be measured at the lower of carrying amount orfair value, less cost to sell, whether reported in continuing operations or indiscontinued operations. SFAS No. 144 is effective for fiscal yearsbeginning after

 

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December 15, 2001.  The adoption of SFAS No. 144 did not have a material impacton the measurement of its long-lived assets.

 

In April 2002, the Financial Accounting StandardsBoard issued SFAS No. 145 “Rescission of FAS Nos. 4, 44, and 64, Amendment ofSFAS 13, and Technical Corrections as of April 2002”.  This Statementamends SFAS No. 13, *Accounting for Leases,*to eliminate an inconsistency between the required accounting forsale-leaseback transactions and the required accounting for certain leasemodifications that have economic effects that are similar to sale-leasebacktransactions as well as other existing authoritative pronouncements to makevarious technical corrections, clarify meanings, or describe theirapplicability under changed conditions.   SFAS No. 145 is effective forfiscal years beginning after December 31, 2002.  The Company does notanticipate that the adoption of SFAS No. 145 will have a material impact on theconsolidated financial statements.

 

In June 2002, the Financial Accounting Standards Boardissued SFAS No. 146 “Accounting for Costs Associated with Exit or DisposalActivities”.  This Statement addresses financial accounting and reportingfor costs associated with exit or disposal activities and nullifies EmergingIssues Task Force (“EITF”) Issue No. 94-3, “Liability Recognition for CertainEmployee Termination Benefits and Other Costs to Exit an Activity (includingCertain Costs Incurred in a Restructuring).” SFAS No. 146 is effective forfiscal years beginning after December 31, 2002.   The Company does notanticipate that the adoption of SFAS No. 146 will have a material impact on theconsolidated financial statements.

 

# **5.**              Inventories

 

Inventories consist of thefollowing:

 
|            |   | **December 31,  2001** |   | **September 30,  2002** |   |
|-----------------|--------|------------------------|--------|-------------------------|--------|
| Raw material    |   | $                      | 16,909 |                    | $      | 19,008 |   |
| Work-in-process |   | 6,026                  |   | 9,576                   |   |
| Finished goods  |   | 8,257                  |   | 11,319                  |   |
|            |   |                   |   |                    |   |
|            |   | $                      | 31,192 |                    | $      | 39,903 |   |

 

# **6.**              Line of Credit

# ** **

OnFebruary 8, 2002, the Company entered into a three-year $25 millioncredit agreement, which is collateralized by accounts receivable and inventory.Interest on any borrowing under the line will accrue at the rate of interestequal to either the adjusted LIBOR rate plus 1.5%, the prime rate or the fixedrate (as set by the bank).  The ratewill depend upon the terms of the selected borrowings.  The agreement has covenants which requirethe maintenance of certain financial ratios including leverage, consolidateddebt and asset

 

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coverage, as defined. At September 30, 2002, there were no borrowings outstanding under theline of credit.

** **

# **7.**              Related Party Transactions

# ** **

Theamounts due to Hexal AG increased from $90,114 at December 31, 2001to $92,120 at March 31, 2002 due to interest charges of $1,468 and advances of $538.  The balance was extinguished in May 2002 by acash payment of $66,942 with the balance of $25,178 settled through theissuance of 1,678,561 shares of common stock. Additional interest charges were $995 for the three months ended June30, 2002. There were no interest charges for the three months ended September30, 2002.

 

During the three and nine months ended September 30,2002, the Company incurred royalty expense of $491 and $2,296 to Hexal AG.  Subsidiaries of Hexal AG returned$0.1 million of products to the Company in the nine months ended September 30,2002.

 

The Company reimbursed Hexal AG $0.1 million forexpenditures that Hexal incurred on behalf of the Company during the threemonths ended September 30, 2002.

 

Included in accrued expenses are amounts due to HexalAG of $206 at September 30, 2002.

** **

# **8.**              Litigation

# ** **

***Product Liability******Litigation***

*** ***

*Fen-phen Litigation*

Since May 1997, the Company and certain of itscustomers have been named as defendants in numerous product liability lawsuits,some of which are class actions, filed in various state and federal courts inconnection with its manufacture of phentermine hydrochloride.  These lawsuits typically name as defendantsmanufacturers and distributors of phentermine and two other anti-obesity drugs,fenfluramine and dexfenfluramine. Fenfluramine and phentermine were prescribed in combination in anoff-label use commonly called “fen-phen,” while dexfenfluramine was generallyprescribed alone.  The plaintiffs inthese cases (the “fen-phen cases”) claim that taking these drugs results ininstances of valvular heart disease, primary pulmonary hypertension, and otherinjuries.  Plaintiffs seek payment ofunspecified damages and medical monitoring of people who took either thefen-phen combination or fenfluramine or dexfenfluramine alone.  In September 1997, the manufacturers offenfluramine and dexfenfluramine agreed with the Food and Drug Administration(“FDA”) to voluntarily withdraw both products from the market.  The FDA has not requested that phenterminebe withdrawn from the market.

 

During 2000, the United States District Court for theEastern District of Pennsylvania, the federal court before which all federalcases were consolidated for discovery, found that proposed anti-phentermine“causation” testimony by two expert witnesses was not supported by scientificevidence and thus would be barred. These two experts were the only “national”

 

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anti-phentermine “causation” experts identified in theconsolidated federal litigation, and were to have been “generic” experts inhundreds of cases.  The Court’s decisionto substantially curb their testimony has resulted in many cases beingdismissed.

 

Additionally, in August 2000, the United StatesDistrict Court for the Eastern District of Pennsylvania certified a nationwidesettlement class and approved a proposed settlement put forth by Wyeth(formerly American Home Products), the principal defendant in the fen-phenlitigation.  The settlement excludesclaims for certain serious medical conditions. The Court’s order became final in January 2002. Although claims against Eon were not part of this settlement, theCompany believes this settlement will result in additional cases beingdismissed as to the Company, its customers and other phentermine defendants.

 

While the number of lawsuits being filed has decreasedsubstantially, the Company expects additional, similar lawsuits to befiled.  The Company and its outsidecounsel believe that the Company has substantial defenses to these claims,though the ultimate outcome cannot be determined.  As of October 30, 2002, over 96% of the fen-phen cases filed against theCompany had been dismissed.  All of thedismissals in “fen-phen cases” were accomplished without the Company paying anyjudgments or settlements.

 

*PhentermineLitigation*

Additionally, the Company has been named as adefendant in several cases alleging injury from the use of phentermine alone,and in one case alleging injury from the use of the Company’s phentermine incombination with phenylpropanolamine (PPA) made by another company.  One of these cases was recently resolved,and discovery and trial preparation in the balance of these cases isongoing.  The Company believes it hassubstantial defenses to these claims, though their ultimate outcome cannot be determined.

 

*DefenseCosts Related To Fen-Phen And Phentermine Litigation*

The Company has exhausted its insurance coverage for allfen-phen claims, and for non–combination phentermine claims that allegeingestion prior to June 1998. Because predicting the ultimate outcome of those lawsuits is notpossible, no provision for any liability has been reflected in the Company’sfinancial statements.  Defense costs arebeing expensed as incurred.  Such costsfor the three months and nine months ended September 30, 2002, were $1.4million and $3.1 million, respectively.

 

Gross sales of phentermine by the Company for thethree months and for the nine months ended September 30, 2002, were $6.2million and $25.9 million, respectively.

 

*Other Product Liability Litigation*

Inaddition to the litigation described above, the Company has been namedas a defendant in several other product liability lawsuits.  Three of the lawsuits allege injury orwrongful death from the use of Company–manufactured pharmaceuticalscontaining phenylpropanolamine (PPA). The Company manufactured two low-volume prescription products containingPPA that were discontinued in 1999 and 2000, respectively.  The single wrongful death claim, a

 

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federal case, was dismissed without prejudice in theCompany’s favor in November 2001 because plaintiffs failed to prosecutethe claim, and plaintiffs have indicated that they might seek to reinstate thecase.  A second case was served on theCompany in January 2002 and was subsequently dismissed withoutprejudice.  The third case was served onthe Company in June 2000.  All federalcases involving PPA claims are subject to transfer to the nationwide,multi-district litigation now pending in the United States District Court forthe Western District of Washington.

 

Finally, the Company was a defendant in a lawsuitalleging injury from use of leuprolide acetate, a drug that is distributed bythe Company. The plaintiff alleged various injuries from taking the drug.  The Company was defended in this action bythe supplier’s insurance company, which recently settled the case at no cost tothe Company.

 

*Indemnity Related to Fen-phenand Phentermine Litigation*

The Company’s product liability coverage was obtainedon a claims made basis and covers liability for judgments and settlements andlegal defense costs.  On or aboutApril 2000, the Company had exhausted all its available product liabilitycoverage for all fen-phen claims and for non–combination phentermine claimsthat allege ingestion prior to June 1998 that aggregated approximately$48 million.  Beginning inMay 2000, the Company began to provide for legal defense costs based onservices rendered on behalf of the Company and its customers.  Coinciding with the exhaustion of itsinsurance coverage, the Company entered into negotiations with several of itscustomers to reduce legal costs by streamlining their legal defense structureand or by increasing their contributions to defense costs.  The Company has obtained written agreementswith these customers.

 

***PatentInfringement Litigation***

*** ***

In2000, Novartis Pharmaceuticals Corporation filed an action in the UnitedStates District Court for the District of Delaware alleging that bymanufacturing, using, selling and offering to sell cyclosporine capsules theCompany is infringing on a Novartis patent. Novartis seeks injunctive relief aswell as an unspecified amount of damages and has also asserted a claim that thealleged infringement was willful, that the case is therefore exceptional and thatNovartis should therefore be awarded the attorney fees it has incurred in theaction.  The Company has denied that ithas infringed any valid patent claims. The Company has also alleged affirmatively, among other things, that thepatent is invalid and that it is not infringed by the Company’s manufacture,use, sale or offer to sell its cyclosporine capsules.  In September 2002 the court adjourned the scheduled trial of thisaction and indicated that it would enter judgment in the Company’s favor thatits cyclosporine product does not infringe Novartis’s patent. The court has notyet issued or entered the judgment.  TheCompany’s potential liability and expenses in this matter are not covered byinsurance.  An adverse outcome in thislitigation could result in the Company being unable to market cyclosporine,which could materially harm profits and cash flows, and could result in payingdamages, costs, expenses and fees that could have a material impact on theCompany’s financial performance.

 

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In January 2001, Apotex, Inc. filed anaction in the United States District Court for the Eastern District of New Yorkalleging that by manufacturing, selling and offering to sell cyclosporinecapsules the Company is infringing a patent of which Apotex alleges it is theexclusive licensee.  Apotex seeksinjunctive relief as well as an unspecified amount of damages and has alsoasserted a claim that the alleged infringement was willful, that the case istherefore exceptional and that Apotex should therefore be awarded the attorney feesit has incurred in the action. The Company’s potential liability and expensesin this matter are not covered by insurance. An adverse outcome in this litigation could result in the Company beingunable to market cyclosporine, which could materially harm profits and cashflows, and could result in paying damages, costs, expenses and fees that couldhave a material impact on the Company’s financial performance.

 

The Company has denied that it has infringed any validpatent claims asserted by Apotex, has alleged affirmatively, among otherthings, that the patent is invalid and that it is not infringed by the Company’smanufacture, sale or offer to sell its cyclosporine capsules.

 

Inaddition, the Company has been named in several other patentinfringement actions alleging that the  Company has infringed patents by filing anapplication with the FDA for approval to market products before the plaintiffs’patents expire.  In general, plaintiffsseek judgments precluding the FDA from approving the Company’s application tomarket the product before their patent expires and have asserted claims thatthe alleged infringement was willful, that the action is therefore exceptionaland that plaintiffs should therefore be awarded the attorney fees they haveincurred in the action.

 

The Company and its outside counsel believe that theCompany has substantial defenses and counterclaims to these above patentinfringement actions, though the ultimate outcome cannot be determined.

 

Becausepredicting the ultimate outcome of these actions is not possible, no provisionfor any liability has been reflected in the Company’s financial statements.

 

***Other Litigation***

*** ***

TheCompany is in other litigationincidental to its business activities. The ultimate disposition of such lawsuits will not materially affect theCompany’s financial statements.

 

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**ITEM 2****– MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION 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 Registration Statement on FormS-1 (File No. 333-83638) (the “Form S-1”) and the unaudited interim condensedconsolidated financial statements included in Item 1 of this Quarterly Reporton Form 10-Q.

 

**NINE MONTHS ENDED SEPTEMBER 30, 2001COMPARED WITH NINE MONTHS ENDED SEPTEMBER 30, 2002**

** **

**Net sales.**  Netsales increased 41.3% from $124.2 million for the nine months ended September30, 2001 to $175.5 million for the comparable period in 2002.  The net sales increase was attributableprimarily to sales of products that were introduced after September 30, 2001.  These products include Lovastatin USP,Metformin HCl, Nabumetone, Lisinopril, USP, Lisinopril/HCTZ, Tizanidine HCl,Nizatidine, USP, and a Dextroamphetamine and Amphetamine Mixed Saltsproduct.  Other factors impacting salesfor the nine months ended September 30, 2002 included an increase in unitvolumes of existing products and changes in product mix and unit prices.  The change in product mix and price had anunfavorable impact principally due to a decline in both unit volume and sellingprices of Fluvoxamine Maleate and a decline in unit volume of Phentermine HCl,USP.  Additional competitive activitycaused the decrease in Fluvoxamine Maleate unit volume and price.  Phentermine HCl, USP sales in the ninemonths ended September 30, 2001 reflected an increase in unit volume from therefilling of distribution channels following a shortage of the product in themarket due to the limited availability of the active pharmaceutical ingredient.

 

**Grossprofit.**  Gross profit as a percentage of net salesdecreased from 56.8% for the nine months ended September 30, 2001 to 52.3% inthe comparable period in 2002.  Thedecrease was primarily due to a decrease in sales and margins for Phentermine HCl, USP and FluvoxamineMaleate, which had higher gross profit margins than most of the Company’s otherproducts in 2001.  The Company’s grossprofit margins are dependent on several factors, including product sales mix,cost, volume and competitive activity.

 

**Amortizationof goodwill and other intangibles. **Amortization of goodwill and otherintangibles decreased $2.5 million from $5.3 million for the nine months endedSeptember 30, 2001 to $2.8 million in the comparable period in 2002.  The decrease was the result of the adoption of SFAS No. 142“Goodwill and Other Intangible Assets”, which the Company adopted on January 1,2002. Under SFAS No. 142, goodwill and intangibles with indefinite lives are nolonger amortized but are evaluated annually for impairment.  Therefore, the Company is no longer requiredto amortize its goodwill and workforce intangible assets.

 

**Deferredstock appreciation rights compensation. **Deferred stockappreciation rights compensation was $9.8 million for the nine months endedSeptember 30, 2001.  There were nocharges for stock appreciation rights in the comparable period in 2002 because the Company’s StockAppreciation Rights Plan was converted to a Stock Option Plan as of September30, 2001.

 

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**Otherselling, general and administrative. **Other selling, general and administrativeexpenses increased $5.6 million from $19.0 million for the nine months endedSeptember 30, 2001 to $24.6 million in the comparable period in 2002.  As a percentage of sales, other selling,general and administrative expenses decreased 1.3% from 15.3% for the ninemonths ended September 30, 2001 to 14.0% in the comparable period in 2002.  The increase was principally due toincreases of $2.7 million in compensation costs (which included $0.9 million ofdeferred compensation), $2.1 million in insurance, $0.8 million in freight and$1.0 million in other expenses, offset by a decrease of $1.0 million in legalexpenses.  The decrease in legal expenseis the net impact of a decrease in phentermine litigation of $2.4 millionoffset by an increase of $1.4 million in other legal expenses, principally relatedto patent challenges.

 

**Researchand development. **Research and development expenses increased$1.9 million from $8.4 million for the nine months ended September 30, 2001 to $10.2 million in the comparableperiod in 2002.  The increase wasattributable to an increase of $2.8 million related to generic drug developmentoffset by a decrease of $0.9 million related to certain basic researchcontracts unrelated to our business that were transferred in March 2002 to anunrelated entity.  The increase in genericdrug development costs was principally attributed to increases in costs relatedto personnel, bio-studies, materials, and supplies.  The increase in R&D spending reflects an acceleration ofproduct development activities that are focused on expanding theCompany’s product line.

 

**Operatingincome. **Operating income increased $26.1 million from $28.0 million for thenine months ended September 30, 2001 to $54.1 million for the comparable periodin 2002.  The increase in operatingincome was the result of increased sales and gross profit, lower amortizationexpense and the elimination of deferred stock appreciation rights compensationexpense, offset by an increase in other selling, general and administrative andresearch and development costs.

** **

**Interestincome (expense). **Net interest expense decreased $3.4 millionfrom $6.7 million for the nine months ended September 30, 2001 to $3.2 millionfor the comparable period in 2002.  Thedecrease in interest expense was primarily the result of a decrease in outstandingdebt during 2002.

 

**Taxes onincome. **Taxes on income increased $11.2 million from $9.6 million for the ninemonths ended September 30, 2001 to $20.9 million in the comparable 2002period.  The effective tax ratedecreased from 45.2% to 41.0% due to the elimination of non-deductible goodwillamortization in 2002.  The increase wasthe result of higher income during 2002.

 

**Netincome. **Net income increased $18.3 million from $11.7 million for the nine months endedSeptember 30, 2001 to $30.0 million for the comparable 2002 period for thereasons described above.

 

**THREE MONTHS ENDED SEPTEMBER 30, 2001COMPARED WITH THREE MONTHS ENDED SEPTEMBER 30, 2002**

** **

**Net sales. **Netsales increased 77.1% from $42.5 million for the three months ended September30, 2001 to $75.4 million for the comparable period in 2002.  The net sales increase was attributableprimarily to sales of products that were introduced after September 30, 2001.  These

 

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products include Lovastatin, USP, Metformin HCl, Nabumetone,Lisinopril, USP, Lisinopril/HCTZ, Tizanidine HCl, Nizatidine, USP, and aDextroamphetamine and Amphetamine Mixed Salts product.  Other factors impacting sales for the threemonths ended September 30, 2002 included a small net decrease in unit volumesof existing products and changes in product mix and unit prices.  Thechange in unit volume, product mix and price had an unfavorable impactprincipally due to a decline in selling prices and unit volume of FluvoxamineMaleate and a decline in unit volume of Phentermine HCl, USP.  Additional competitive activity caused thedecrease in Fluvoxamine Maleate price. Phentermine HCl, USP sales in the three months ended September 30, 2001reflected an increase in unit volume from the refilling of distributionchannels following a shortage of the product in the market due to the limitedavailability of the active pharmaceutical ingredient.

 

**Grossprofit. **Gross profit as a percentage of net salesdecreased from 55.6% for the three months ended September 30, 2001 to 53.4% inthe comparable period in 2002.  Thedecrease was primarily due to a decrease in sales for Phentermine HCl, USP andFluvoxamine Maleate, products that had higher gross profit margins than most ofthe Company’s other products in 2001. The Company’s gross profit margins are dependent on several factors,including product sales mix,cost, volume and competitive activity. Higher production volume in the third quarter 2002 had a modestfavorable impact that partially offset an unfavorable change in product mix.

 

**Amortizationof goodwill and other intangibles. **Amortization of goodwill and otherintangibles decreased $0.8 million from $1.8 million for the three months endedSeptember 30, 2001 to $0.9 million in the comparable period in 2002.  The decrease was the result of the adoptionof SFAS No. 142 “Goodwill and Other Intangible Assets”, which the Companyadopted on January 1, 2002. Under SFAS No. 142, goodwill and intangibles withindefinite lives are no longer amortized but are evaluated annually forimpairment.  Therefore, the Company isno longer required to amortize its goodwill and workforce intangible assets.

 

**Deferredstock appreciation rights compensation. **Deferred stockappreciation rights compensation was $3.3 million for the three months endedSeptember 30, 2001.  There were nocharges for stock appreciation rights in the comparable period in 2002 becausethe Company’s Stock Appreciation Rights Plan was converted to a Stock OptionPlan as of September 30, 2001.

 

**Otherselling, general and administrative. **Other selling, general and administrativeexpenses increased $4.9 million from $6.5 million for the three months endedSeptember 30, 2001 to $11.4 million in the comparable period in 2002.  As a percentage of sales, other selling,general and administrative expenses decreased 0.1% from 15.2% for the threemonths ended September 30, 2001 to 15.1% in the comparable period in 2002. The increase was principally due to increases of $1.5 million incompensation costs (which included $0.3 million of deferred compensation), $1.6million in insurance, $0.4 million in freight, $0.8 million in legal expenses,primarily associated with patent challenges, and $0.6 million in otherexpenses.

 

**Researchand development. **Research and development expenses increased$0.7 million from $3.2 million for the three months ended September 30, 2001 to $4.0 million in the comparableperiod in 2002.  The increase wasattributable to an increase of $1.4 million related to generic drug developmentoffset by a decrease of $0.7 million related to certain basic researchcontracts unrelated to our business that were transferred in March 2002 to anunrelated entity.  The

 

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increase in generic drug development costswas principally attributed to increases in costs related to personnel,bio-studies, materials, and supplies. The increase in R&D spending reflects an acceleration of productdevelopment activities that are focused on expanding the Company’s product line.

** **

**Operatingincome. **Operating income increased $15.1 million from$8.9 million for the three months ended September 30, 2001 to $24.0 million forthe comparable period in 2002.  Theincrease in operating income was the result of increased sales and grossprofit, lower amortization expense and the elimination of deferred stockappreciation rights compensation expense, offset by an increase in otherselling, general and administrative costs, and research and development costs.

 

**Interestincome (expense). **Net interest expense decreased $2.3 milliongoing from net interest expense of  $2.2million for the three months ended September 30, 2001 to net interest income ofless than $0.1 million for the comparable period in 2002.  Interest expense decreased $2.0 million from$2.3 million for the three months ended September 30, 2002 to $0.3 million forcomparable period in 2002 due to a decrease in outstanding debt.  Interest income increased from $0.1 millionfor the three months ended September 30, 2002 to $0.4 million for comparableperiod in 2002, as investment balances were higher as result of the proceedsfrom the initial public offering.

 

**Taxes onincome.****  **Taxes on income increased $6.9 million from $3.0 million for the threemonths ended September 30, 2001 to $9.9 million in the comparable period in 2002. The effective tax rate decreased from 45.2% to 41.0% due to theelimination of non-deductible goodwill amortization in 2002.  The increase was the result of higher incomeduring 2002.

 

**Netincome. **Net income increased $10.5 million from $3.6million for the three months ended September 30, 2001 to $14.2 million for the comparable period in 2002 for the reasons describedabove.

 

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**LIQUIDITY AND CAPITAL RESOURCES**

** **

Cash and cash equivalents were $17.6 million at December 31, 2001 ascompared to $40.9 million at September 30, 2002.  Additionally, the Company has investments in marketablesecurities of $19.3 million at September 30, 2002.

 

At September 30, 2002, the Company’s total debt of $4.4 million wasclassified as current and is shown under the balance sheet caption “currentportion of note payable”.   The debtrepresents the remaining balance on a note issued in connection with the acquisitionof EHI.  At September 30, 2002 the notehad a remaining discounted value of $4.4 million and a face value of $4.8million.  A Principal payment of $4.8million is due on September 30, 2003. The payment is subject to acceleration under the note agreement ifcertain EBITDA levels are reached.  TheCompany expects to have EBITDA levels in excess of the acceleration thresholds,and expects to pay the balance during the first quarter of 2003.

 

On February 8, 2002, the Company secured athree-year $25 million credit facility with a borrowing cost of LIBOR plus 1.5%or the bank’s prime rate.  The creditfacility, which is for working capital purposes, had no outstanding borrowingsagainst it at September 30, 2002.

 

Stockholders’ equity increased from $47.0 million at December 31, 2001to $242.3 million at September 30, 2002. Stockholders’ equity was increased by the proceeds from our initialpublic offering of  $139.2 million,$25.2 million for the capitalization of Hexal AG debt, earnings of $30.0 millionfor the nine months ended September 30, 2002 and $0.9 million for theamortization of deferred compensation costs.

 

The Company’s initial public offering generated proceeds to the Companyof $139.2 million, net of offering expenses. 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 EonHoldings, Inc.; and (iii) $2.0 million has been used for general workingcapital purposes.  At September 30,2002, the remaining balance of $60.3 million of the proceeds was available forgeneral corporate purposes.

 

During the nine months ended September 30, 2002, the Company generated net cash of$23.3 million.

 

Operations generated $0.7 million, which resulted from net earnings of$30.0 million, non-cash items totaling $56.7 million and an increase in workingcapital, which used $86.1 million. A $46.8 million provision for accountsreceivable allowances is the major non-cash component.  The most significant working capitalrequirement related to a $72.9 million increase in accounts receivableresulting from higher sales and the timing of customers’ payments.  Working capital was also used to fundincreases in inventory, prepaid expenses and other assets of $8.7 million,$14.3 million and $1.5 million, respectively. The increase in prepaid expenses is primarily related to insurance andincome taxes.  An increase in accountspayables and accruals of $11.4 million partially offset the working capitalincreases.

 

Outflows from investing activities for this period totaling $25.3million were the aggregate of capital expenditures of $6.0 million and theinvestment in short-term marketable debt securities of $19.3 million.

 

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Financing activities generated $48.0 million for the period.  The cash generated from financing activitiesis the net of $139.2 million in net proceeds raised in the Company’s initial public offering, $0.8 million of advancesreceived from a related party and a $0.1 million decrease in restricted cashoffset by $92.1 million of debt repayments.

 

The Company is involved in variouslitigation matters in which the potential liabilities and/or related expensesare not covered by insurance.  Inaddition, an adverse outcome in patent litigation with Novartis and Apotexinvolving cyclosporine capsules could result in the Company being unable to market this product which wouldmaterially harm its profits andcash flows and could result in theCompany paying damages, cost, expenses, and fees that could have amaterial adverse impact on its financial performance.  In September 2002, the court adjourned the scheduled Novartistrial and indicated that it would enter judgment in the Company’s favor statingthat the Company’s cyclosporine product does not infringe Novartis’s patent.The court has not yet issued or entered the judgment.  See the Company’s Form S-1 and the notes to the Company’s nine months unauditedcondensed consolidated financial statements.

 

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, legal defense costs and debtservice.  The Company anticipates that its operating cash flows, togetherwith its available borrowings under its credit facility and current cashbalances will be sufficient to meet all of its working capital, capitalexpenditures and debt payment requirements for both the short-term andforeseeable future.

 

**CRITICAL ACCOUNTING POLICIES**

 

The Company’s critical accounting policies arethose policies that are important to the portrayal of its financial conditionand results of operations and require management’s subjective judgments.  As a result, these judgments are subject toan inherent degree of uncertainty.  TheCompany bases its judgments on its experience and various other assumptionsthat the Company believes to be reasonable under the circumstances.  On an ongoing basis, the Company evaluatesits estimates, including those related to revenues, returns, inventories,income taxes and litigation.  Our actualresults could differ from these estimates under different assumptions orconditions.  The Company believes thefollowing accounting policies to be critical:

 

Revenues are recognized when the products arereceived by the customer, which represents the point when the risks and rewardsof ownership are transferred to the customer. Sales are shown net of discounts, rebates, contract pricing adjustmentsand returns, which are estimated based on our experience.  Discounts, rebates and contract pricingadjustments are recorded as a reduction of sales based on agreed upon termswith the Company’s customers at the time of sale.  The Company calculates a reserve for discounts and rebates basedupon actual sales under such arrangements. Reserves for contract pricing adjustments represent the differencebetween the prices wholesalers are billed by the Company and the prices billedto their customers to whom the Company has given contract prices.  In determining a reserve for contractpricing adjustments, the Company takes into account an estimate of thepercentage of product sales

 

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subject to such pricing adjustments based onhistorical trends.  Historical trendsare adjusted for new product introductions and changes in wholesaler orcontract prices.

 

Shelf stock adjustments are provided following areduction in the prices 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 thetime of sale, relate primarily to returns of expiring products.  The Company utilizes historical trends toestimate the amount of products to be returned due to product expiration.

 

In determining whether liabilities should berecorded for pending litigation claims, the Company must assess the allegationsmade and the likelihood that it will successfully defend itself.  When the Company believes it is probablethat it will not prevail in a particular matter, it will then make an estimateof the amount of liability based in part on advice of outside legal counsel.

 

**IMPACT OF RECENTLY ISSUED ACCOUNTINGSTANDARDS**

 

InJuly 2001, the Financial Accounting Standards Board issued SFASNo. 142, “Goodwill and Other Intangible Assets.” SFAS No. 142modifies the accounting and reporting for acquired intangible assets at thetime of acquisition and in subsequent periods. Intangible assets, which have finite lives, must be amortized over theirestimated useful life.  Intangible assetswith indefinite lives will not be amortized, but evaluated annually for impairment.  The Company has completed its impairmentassessment and determined that there is no impairment of goodwill oridentifiable intangibles upon initial adoption of SFAS No. 142.  SFAS No. 142 is effective for fiscalyears beginning after December 15, 2001. The value of the Company’s existing products is an intangible asset witha finite life that is being amortized over 10 years.  The Company’s goodwill and workforceintangibles which were being amortized over 15 and 5 year lives,respectively, have not been amortized during the nine-month period endedSeptember 30, 2002. Had this pronouncement been retroactively applied, netincome would have increased approximately $835 and $2,505, respectively, anddiluted earnings per share would have increased $0.03 per share and $0.08 pershare, respectively, in the three and nine months ended September 30,2001.  In 2002, the Company transferredthe net book value of its workforce intangible of $1,136 to goodwill, resultingin goodwill of $47,107.  The recordedamount of the existing product intangible of $37,600, before accumulatedamortization of $6,893 as of September 30, 2002, will be amortized through 2010with annual charges of $3,760.

 

In October 2001, the Financial Accounting Standards Board issuedSFAS No. 144, “Accounting for the Impairment or Disposal of Long-LivedAssets,” that replaces SFAS No. 121, “Accounting for the Impairment ofLong-Lived Assets and for Long-Lived Assets to be Disposed of.”  SFAS No. 144 requires that long-livedassets be measured at the lower of carrying amount or fair value, less cost tosell, whether reported in continuing operations or in discontinuedoperations.  SFAS No. 144 iseffective for fiscal years beginning after December 15, 2001.  The adoption of SFAS No. 144 did nothave a material impact on the measurement of its long-lived assets.

 

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In April 2002, the Financial Accounting Standards Board issued SFAS No.145 “Rescission of FAS Nos. 4, 44, and 64, Amendment of SFAS 13, and TechnicalCorrections as of April 2002”.  This Statement amends SFAS No. 13, *Accounting for Leases,* to eliminate aninconsistency between the required accounting for sale-leaseback transactionsand the required accounting for certain lease modifications that have economiceffects that are similar to sale-leaseback transactions as well as otherexisting authoritative pronouncements to make various technical corrections,clarify meanings, or describe their applicability under changed conditions.  SFASNo. 145 is effective for fiscal years beginning after December 31, 2002.  We do not anticipate that the adoption of SFAS No. 145 will have a materialimpact on the consolidated financial statements.

 

In June 2002, the Financial Accounting Standards Board issued SFAS No.146 “Accounting for Costs Associated with Exit or Disposal Activities”. This Statement addresses financial accounting and reporting for costsassociated with exit or disposal activities and nullifies Emerging Issues TaskForce (“EITF”) Issue No. 94-3, “Liability Recognition for Certain EmployeeTermination Benefits and Other Costs to Exit an Activity (including CertainCosts Incurred in a Restructuring).”  SFAS No. 146 is effective for fiscalyears beginning after December 31, 2002. We do not anticipate that the adoptionof SFAS No. 146 will have a material impact on the consolidated financialstatements.

 

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**ITEM 3****- QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUTMARKET RISK**

 

The following discusses the Company’s exposure tomarket risk related to changes in interest rates, equity prices and foreigncurrency exchange rates.  The Companydoes not believe that its exposure to market risk is material.

 

As of September 30, 2002, the Company had cashand cash equivalents of $40.9 million. Cash equivalents are interest-bearing investment grade securities,primarily short-term, highly liquid investments with maturities at the date ofpurchase of less than 90 days.  Theseinvestments are subject to interest rate risk and will decrease in value ifmarket interest rates increase.  Ahypothetical increase or decrease in the market interest rates by 10 percentfrom the rates in effect on the date of this Form 10-Q would cause the fairvalue of these short-term investments to decline by an insignificantamount.  The Company has the ability tohold these investments until maturity, and therefore it does not expect thevalue of these investments to be affected to any significant degree by theeffect of a sudden change in market interest rates.  Declines in interest rates over time will, however, reduce theCompany’s interest income.

 

The Company currently owns $19.3 million inpublicly traded debt securities which are subject to market fluctuations.

 

The Company currently does not have anyinternational operations, and currently does not enter into forward exchangecontracts or other financial instruments with respect to foreign currency.  Accordingly, the Company currently does nothave any significant foreign currency exchange rate risk.

 

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

 

As of September 30, 2002, an evaluation wasperformed under the supervision and with the participation of the Company’smanagement, including the Chief Executive Officer and the Chief FinancialOfficer, of the effectiveness of the design and operation of the Company’sdisclosure controls and procedures. Based on that evaluation, the Company’s management, including the ChiefExecutive Officer and the Chief Financial Officer, concluded that the Company’sdisclosure controls and procedures were effective as of September 30,2002.  There have been no significantchanges in the Company’s internal controls or in other factors that couldsignificantly affect the internal controls subsequent to September 30, 2002.

 

**SPECIAL NOTE REGARDINGFORWARD-LOOKING STATEMENTS**

** **

This quarterly report on Form 10-Q reportcontains forward-looking statements relating to future events and futureperformance of the Company within the meaning of Section 27A of the SecuritiesAct of 1933 and Section 21E of the Securities Exchange Act of 1934, including,without limitation, statements regarding the Company’s expectations, beliefs,intentions or future strategies that are signified by the words “expects,”“anticipates,” “intends,” “believes” or similar language.  Actual results could differ materially fromthose anticipated in such forward-looking statements. Some specific factors that may have a significant effect on theCompany’s operating results and common stock market price include:

 

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•                  newproduct introductions;

•                  changesin the degree of competition for the Company’s products;

•                  regulatoryissues, 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;

•                  theinability to acquire sufficient supplies of raw materials;

•                  litigationand/or threats of litigation;

•                  changesin the Company’s growth rates or the Company’s competitors’ growth rates;

•                  legislativeand FDA actions with respect to the government regulation of pharmaceuticalproducts;

•                  publicconcern as to the safety of the Company’s products;

•                  changesin health care policy in the United States;

•                  conditionsin the financial markets in general or changes in general economic conditions;

•                  theCompany’s inability to raise additional capital;

•                  conditionsof other generic pharmaceutical companies or the generic pharmaceuticalindustry generally; and

•                  changesin stock market analyst recommendations regarding the Company’s common stock,other comparable companies 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.

 

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**PARTII****– OTHERINFORMATION**

 

**Item 1****- Legal Proceedings**

 

In 2000, Novartis PharmaceuticalsCorporation filed an action in the United States District Court for theDistrict of Delaware alleging that by manufacturing, using, selling andoffering to sell cyclosporine capsules the Company is infringing on a Novartispatent. Novartis seeks injunctive relief as well as an unspecified amount ofdamages and has also asserted a claim that the alleged infringement was willful, thatthe case is therefore exceptional and that Novartis should therefore be awardedthe attorney fees it has incurred in the action.  The Company has denied that it has infringed any valid patentclaims.  The Company has also allegedaffirmatively, among other things, that the patent is invalid and that it isnot infringed by the Company’s manufacture, use, sale or offer to sell itscyclosporine capsules.  In September2002 the court adjourned the scheduled trial of this action and indicated thatit would enter judgment in the Company’s favor that the Company’s cyclosporineproduct does not infringe Novartis’s patent. The court has not yet issued orentered the judgment.  The Company’spotential liability and expenses in this matter are not covered by insurance.  An adverse outcome in this litigation couldresult in the Company being unable to market cyclosporine, which couldmaterially harm its profits and cash flows, and could result in it payingdamages, costs, expenses and fees that could have a material impact on itsfinancial performance.

 

**Item2****– Changes inSecurities and Use of Proceeds**

** **

In June 2002, the Company closed an initial public offering of itscommon stock.  The RegistrationStatement on Form S-1 (File No. 333-83638) was declared effective by theSecurities and Exchange Commission on May 23, 2002 and the Company commencedthe offering on that date.  Afterdeducting underwriting discounts and commissions and the offering expenses, thenet proceeds from the offering to the Company were approximately $139.2million.

 

The Company has used proceeds from the offeringas follows: (i) $66.9 million has been used to repay debt due to Hexal AG; (ii)$10.0 million has been used to repay debt incurred in connection with theacquisition of Eon Holdings, Inc.; and (iii) $2.0 million has been used forgeneral working capital purposes.  Theremaining $60.3 million of the proceeds to the Company from the offering areinvested in cash investments and short-term investment grade debtsecurities.  The Company anticipatesusing the balance of the proceeds from the offering for general corporatepurposes, including to fund working capital, increased research and developmentto expand the Company’s product offerings and the potential acquisition ofproduct lines or companies.  The Companyhas no present understandings, commitments or agreements with respect to anyacquisitions.  The Company has notdetermined the amounts it plans to spend on any of the areas listed above orthe timing of these expenditures.

 

**Item 5****- Other Information**

** **

On October 10, 2002, the Company’s Board of Directors appointed DouglasM. Karp and Mark R. Patterson to the Company’s Board of Directors.  Messrs. Karp and Patterson, along with FrankF. Beelitz, were appointed as members of the Company’s Audit Committee.  Messrs. Karp and Patterson, along withThomas Strüngmann and Bernhard Hampl (except with respect to

 

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matters relating to Chief Executive Officer compensation), wereappointed as members of the Company’s Compensation Committee.

 

Matthias Hoth, Ph.D. resigned as the Company’ Vice President,Operations on September 18, 2002.  TheCompany appointed Nitin Sheth, Ph.D., as Vice President of Research andDevelopment on July 3, 2002 and Rathnam Kumar as Vice President ofManufacturing on October 25, 2002.

 

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**Item 6****– Exhibits and Reports on Form 8-K**

 

(a)                                  Exhibits

 

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

 

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

 

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**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 

 
|   |               | Eon Labs, Inc. |
|--------|--------------------|----------------|
|   |               |           |
|   | November  14, 2002 | By:            | /s/  Bernhard Hampl, Ph.D. |   |
|   |               |           | Bernhard  Hampl, Ph.D. |
|   |               |           | President,  Chief Executive Officer |
|   |               |           | and Director |   |
|   |               |           |   |   |
|   |               |           |   |
|   | November  14, 2002 | By:            | /s/  William F. Holt |   |
|   |               |           | William  F. Holt |
|   |               |           | Chief  Financial Officer |
|        |                    |                |  |  |  |  |

 

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**Certification**

 

I, Bernhard Hampl, Ph.D., certify that:

 

1.                                       Ihave reviewed this quarterly report on Form 10-Q of Eon Labs, Inc.;

 

2.                                       Basedon my knowledge, this quarterly report does not contain any untrue statement ofa material fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this quarterly report;

 

3.                                       Basedon my knowledge, the financial statements, and other financial informationincluded in this quarterly report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this quarterly report;

 

4.                                       Theregistrant’s other certifying officers and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and we have:

 

a)                                      designedsuch disclosure controls and procedures to ensure that material informationrelating to the registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this quarterly report is being prepared;

 

b)                                     evaluatedthe effectiveness of the registrant’s disclosure controls and procedures as ofa date within 90 days prior to the filing date of this quarterly report (the“Evaluation Date”); and

 

c)                                      presentedin this quarterly report our conclusions about the effectiveness of thedisclosure controls and procedures based on our evaluation as of the EvaluationDate;

 

5.                                       Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunction):

 

a)                                      allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the registrant’s ability to record, process, summarizeand report financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b)                                     anyfraud, whether or not material, that involves management or other employees whohave a significant role in the registrant’s internal controls; and

 

6.                                       Theregistrant’s other certifying officers and I have indicated in this quarterlyreport whether or not there were significant changes in internal controls or inother factors that could significantly affect internal controls subsequent tothe date of our most recent

 

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evaluation, including anycorrective actions with regard to significant deficiencies and materialweaknesses.

 
| Date: November 14, 2002                        |
|------------------------------------------------|
|                                           |
| /s/ Bernhard Hampl, Ph.D.                      |   |
| Bernhard Hampl, Ph.D.

Chief Executive Officer |

 

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**Certification**

 

I, William F. Holt, certify that:

 

1.                                       Ihave reviewed this quarterly report on Form 10-Q of Eon Labs, Inc.;

 

2.                                       Basedon my knowledge, this quarterly report does not contain any untrue statement ofa material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements weremade, not misleading with respect to the period covered by this quarterly report;

 

3.                                       Basedon my knowledge, the financial statements, and other financial informationincluded in this quarterly report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this quarterly report;

 

4.                                       Theregistrant’s other certifying officers and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and we have:

 

a)                                      designedsuch disclosure controls and procedures to ensure that material informationrelating to the registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this quarterly report is being prepared;

 

b)                                     evaluatedthe effectiveness of the registrant’s disclosure controls and procedures as ofa date within 90 days prior to the filing date of this quarterly report (the“Evaluation Date”); and

 

c)                                      presentedin this quarterly report our conclusions about the effectiveness of thedisclosure controls and procedures based on our evaluation as of the EvaluationDate;

 

5.                                       Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunction):

 

a)                                      allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the registrant’s ability to record, process, summarizeand report financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b)                                     anyfraud, whether or not material, that involves management or other employees whohave a significant role in the registrant’s internal controls; and

 

6.                                       Theregistrant’s other certifying officers and I have indicated in this quarterlyreport whether or not there were significant changes in internal controls or inother factors that could significantly affect internal controls subsequent tothe date of our most recent

 

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evaluation, including anycorrective actions with regard to significant deficiencies and material weaknesses.

 
| Date: November 14, 2002 |
|-------------------------|
|                    |
| /s/ William F. Holt     |   |
| William F. Holt         |
| Chief Financial Officer |

 

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