KING PHARMACEUTICALS INC - 10-Q Quarterly Report

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

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FORM 10-Q

(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2003

OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM TO

COMMISSION FILE NO. 0-24425

KING PHARMACEUTICALS, INC.
(Exact name of registrant as specified in its charter)

TENNESSEE 54-1684963
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

501 FIFTH STREET, BRISTOL, TN 37620
(Address of principal executive offices) (Zip Code)

REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE:
(423) 989-8000

Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ]

Number of shares outstanding of Registrant's common stock as of July 24,
2003: 241,036,135

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PART I -- FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

KING PHARMACEUTICALS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(IN THOUSANDS)

See accompanying notes.
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KING PHARMACEUTICALS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)

See accompanying notes.
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KING PHARMACEUTICALS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
AND OTHER COMPREHENSIVE INCOME
(UNAUDITED)
(IN THOUSANDS, EXCEPT SHARE DATA)

See accompanying notes.
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KING PHARMACEUTICALS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)

See accompanying notes.
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KING PHARMACEUTICALS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2003 AND 2002
(UNAUDITED)
(IN THOUSANDS)

1. GENERAL

The accompanying unaudited interim condensed consolidated financial
statements of King Pharmaceuticals, Inc. ("King" or the "Company") have been
prepared by the Company in accordance with the instructions to Form 10-Q and
Rule 10-01 of Regulation S-X, and accordingly, they do not include all of the
information and footnotes required by generally accepted accounting principles
for complete financial statements. In the opinion of management, all adjustments
(consisting of items of a normal recurring nature) considered necessary for a
fair presentation have been included. Operating results for the three months
ended March 31, 2003 are not necessarily indicative of the results that may be
expected for the year ending December 31, 2003. These consolidated statements
should be read in conjunction with the audited consolidated financial statements
and notes thereto included in the Company's Annual Report on Form 10-K for the
year ended December 31, 2002. The year-end condensed balance sheet was derived
from the audited consolidated financial statements but does not include all
disclosures required by generally accepted accounting principles.

These consolidated financial statements include the accounts of King and
its wholly-owned subsidiaries: Monarch Pharmaceuticals, Inc.; Parkedale
Pharmaceuticals, Inc. ("Parkedale"); King Pharmaceuticals Research and
Development, Inc.; Jones Pharma Incorporated ("Jones"); Meridian Medical
Technologies, Inc. ("Meridian"); Monarch Pharmaceuticals Ireland Limited and
King Pharmaceuticals of Nevada, Inc. All intercompany transactions and balances
have been eliminated in consolidation.

Certain amounts from the prior consolidated financial statements have been
reclassified to conform to the presentation adopted in 2003.

2. STOCK COMPENSATION

The Company has adopted the disclosure-only provision of SFAS No. 123,
"Accounting for Stock Based Compensation." Accordingly, since options were
granted at fair value, no compensation cost has been recognized for stock
options granted to date. Had compensation cost for these plans been determined
for options granted, consistent with SFAS No. 123, the Company's net income and
diluted income per common share would have decreased to the following pro forma
amounts:

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KING PHARMACEUTICALS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The fair value of each option grant is estimated on the date of grant using
the Black-Scholes option pricing model. The following weighted-average
assumptions were used for grants for the three months ended March 31, 2003:

Expected life of option..................................... 4.00
Risk-free interest rate..................................... 2.72%
Expected volatility......................................... 71.91%
Expected dividend yield..................................... 0.00%

No options were issued during the quarter ended March 31, 2002.

3. EARNINGS PER SHARE

The basic and diluted income per common share was determined using the
following share data:

For the three months ended March 31, 2003, options to purchase 1,406 shares
of common stock were not included in the computation of diluted earnings per
share because their inclusion would have been antidilutive and would have
reduced the loss per share.

4. INVENTORIES

Inventories consist of the following:

5. ACQUISITIONS

On January 8, 2003, the Company completed its acquisition of Meridian.
Meridian is a leading manufacturer of auto-injectors for the self-administration
of injectable pharmaceuticals. The Company believes the acquisition of Meridian
will provide additional lines of pharmaceutical products, auto-injector
technology and pipeline opportunities. The Company paid a cash price of $44.50
per common share to Meridian shareholders, totaling approximately $246,800, and
incurred $6,500 of expenses related to the

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KING PHARMACEUTICALS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

transaction. Of the total purchase price, $140,400 was assigned to identifiable
intangible assets, $18,000 to in-process research and development, which was
expensed during the first quarter of 2003 and included in research and
development expense, and $113,057 to goodwill. None of the goodwill is expected
to be deductible for tax purposes. The identifiable intangible assets have been
assigned useful lives with a weighted-average range of 32.3 years. The purchase
price allocation among the assets acquired and the assignment of lives to the
intangible assets are preliminary and subject to further evaluation, as the
Company has not yet finalized its valuation of tangible assets acquired. The
acquisition will be allocated to the Meridian Medical Technologies segment. The
Company financed the acquisition using available cash on hand.

As mentioned above, $18,000 of the purchase price was allocated to an
in-process research and development project, an auto-injector pre-filled with
diazepam indicated for, among other things, the treatment of epileptic seizures
and management of anxiety disorders. The value of the in-process research and
development project was expensed on the date of acquisition, as it had not
received regulatory approval and had no alternative future use. The project was
valued through the application of a probability-weighted, discounted cash flow
approach by independent valuation specialists. The estimated cash flows were
projected over a 30-year period utilizing a discount rate of 21%. Pre-tax
margins (after an adjustment to reflect the use of auto-injector core
technology) were assumed to be -10% in 2003 and increasing to 23% in 10 years.
The estimated cost to complete the project was less than $700. The project was
submitted to the U.S. Food and Drug Administration ("FDA") as an abbreviated new
drug application ("ANDA"), which references an approved new drug application
("NDA") owned by the United States Army for a diazepam-filled auto-injector
currently manufactured under contract exclusively by Meridian. The application
for the project is under review by the FDA and the Company must satisfactorily
respond to chemistry, microbiology, manufacturing and other questions from the
FDA, that arise as a result of its normal review and approval process. The
Company anticipates FDA approval of the project during 2004. The project was
substantially complete as of the valuation date. The success of the project is
dependent upon whether the FDA approves the ANDA for our diazepam-filled
auto-injector. The Company is not aware of any issues with respect to the FDA's
review of the ANDA. Even if the project is not successfully completed, it would
not materially adversely affect the Company's results of operations.

The following is a condensed balance sheet of Meridian as of January 8,
2003 and reflects the preliminary allocation of the purchase price described
above:

The following unaudited pro forma summary presents the financial
information as if the acquisition of Meridian had occurred on January 1, 2003
for the three months ended March 31, 2003 information and January 1, 2002 for
the three months ended March 31, 2002 information. These pro forma results have
been

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KING PHARMACEUTICALS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

prepared for comparative purposes and do not purport to be indicative of what
would have occurred had the acquisition been made on January 1, 2002 or January
1, 2003, nor is it indicative of future results.

6. INTANGIBLE ASSETS

The following table reflects the components of intangible assets as of
March 31, 2003:

As discussed above, during the quarter ended March 31, 2003 the Company
recorded $113,057 and $140,400 of goodwill and intangible assets, respectively,
as a result of the acquisition of Meridian. All of the goodwill will be recorded
as part of the Meridian Medical Technologies segment.

Amortization expense for the three months ended March 31, 2003 and 2002 was
$16,025 and $11,091, respectively. Estimated annual amortization expense at
March 31, 2003 for each of the five succeeding fiscal years is as follows:

During January 2003, the Company was notified of the approval by the FDA of
a second generic fludrocortisone acetate, USP, a product that will represent
additional competition for the Company's Florinef(R) (fludrocortisone acetate,
USP) product. The Company has completed its impairment review and has recorded
an impairment charge in the amount of $110,970 in the first quarter of 2003
reflecting the reduction in the fair value of the Florinef(R) intangible assets.
The Company determined the fair value of its Florinef(R) product based on
management's current discounted cash flow projections for the product.
Florinef(R) is included in the Company's branded pharmaceutical reporting
segment.

During the fourth quarter of 2002, the Company recorded a charge related to
the liability associated with the amount of the purchase commitments in excess
of expected demand for the Lorabid(R) product. At March 31, 2003, the excess
purchase commitment accrual remains at $49,877.

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KING PHARMACEUTICALS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

7. ACCOUNTING DEVELOPMENTS

In January 2003, the Financial Accounting Standards Board issued SFAS No.
148, "Accounting for Stock-Based Compensation-Transition and Disclosure, an
amendment of FASB Statement No. 123." SFAS No. 148 provides alternative methods
of transition to the fair value based method of accounting for stock-based
employee compensation. It also amends the disclosure requirements of SFAS No.
123. The disclosure provisions of SFAS No. 148 were adopted by the Company for
the fiscal year ended December 31, 2002 and did not have any impact on the
Company's financial statement. See Note 2 for the new required disclosures of
stock compensation resulting from SFAS No. 148.

In July 2002, the Financial Accounting Standards Board issued SFAS No. 146,
"Accounting for Exit or Disposal Activities." SFAS No. 146 addresses the
recognition, measurement, and reporting of costs that are associated with exit
and disposal activities, including costs related to terminating a contract that
is not a capital lease and termination benefits that employees who are
involuntarily terminated receive under the terms of a one-time benefit
arrangement that is not an ongoing benefit arrangement or an individual
deferred-compensation contract. SFAS No. 146 supercedes Emerging Issues Task
Force Issue No. 94-3, "Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred
in a Restructuring)." SFAS No. 146 was effective for exit or disposal activities
of the Company initiated after December 31, 2002.

In May 2002, the Financial Accounting Standards Board issued SFAS No. 145,
"Revision of FAS Nos. 4, 44 and 64, Amendment of FAS 13 and Technical
Corrections as of April 2002." SFAS No. 145 is effective for fiscal periods
beginning after May 15, 2002. The primary impact on the Company of adoptings FAS
No. 145 will be that gains and losses incurred upon the extinguishment of debt
will no longer qualify for treatment as an extraordinary item in the income
statement but will be presented as non-operating gain or loss. Accordingly, for
purposes of comparison in the Company's 2003 Form 10-K, the Company will
reclassify the loss incurred on the extinguishment of debt during the year ended
December 31, 2001 as other expense.

8. CONTINGENCIES

FEN/PHEN LITIGATION

Many distributors, marketers and manufacturers of anorexigenic drugs have
been subject to claims relating to the use of these drugs. Generally, the
lawsuits allege that the defendants (1) misled users of the products with
respect to the dangers associated with them, (2) failed to adequately test the
products and (3) knew or should have known about the negative effects of the
drugs, and should have informed the public about the risks of such negative
effects. The actions generally have been brought by individuals in their own
right and have been filed in various state and federal jurisdictions throughout
the United States. They seek, among other things, compensatory and punitive
damages and/or court supervised medical monitoring of persons who have ingested
the product. The Company is one of many defendants in 10 lawsuits that claim
damages for personal injury arising from the Company's production of the
anorexigenic drug phentermine under contract for GlaxoSmithKline. The Company
expects to be named in additional lawsuits related to the Company's production
of the anorexigenic drug under contract for GlaxoSmithKline.

While the Company cannot predict the outcome of these suits, the Company
believes that the claims against it are without merit and intends to vigorously
pursue all defenses available to it. The Company is being indemnified in all of
these suits by GlaxoSmithKline for which the Company manufactured the
anorexigenic product, provided that neither the lawsuits nor the associated
liabilities are based upon the independent negligence or intentional acts of the
Company, and intends to submit a claim for all unreimbursed costs to the
Company's product liability insurance carrier. However, in the event that
GlaxoSmithKline is unable to satisfy or fulfill its obligations under the
indemnity, the Company would have to defend the lawsuits and be

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KING PHARMACEUTICALS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

responsible for damages, if any, that are awarded against it or for amounts in
excess of the Company's product liability coverage. A reasonable estimate of
possible losses related to these suits cannot be made.

In addition, Jones is a defendant in approximately 577 multi-defendant
lawsuits involving the manufacture and sale of dexfenfluramine, fenfluramine and
phentermine. These suits have been filed in various jurisdictions throughout the
United States, and in each of these suits Jones is one of many defendants,
including manufacturers and other distributors of these drugs. Although Jones
has not at any time manufactured dexfenfluramine, fenfluramine, or phentermine,
Jones was a distributor of a generic phentermine product and, after the
acquisition of Abana Pharmaceuticals, was a distributor of Obenix, its branded
phentermine product. The plaintiffs in these cases claim injury as a result of
ingesting a combination of these weight-loss drugs and are seeking compensatory
and punitive damages as well as medical care and court supervised medical
monitoring. The plaintiffs claim liability based on a variety of theories
including but not limited to, product liability, strict liability, negligence,
breach of warranty, and misrepresentation.

Jones denies any liability incident to the distribution of Obenix or its
generic phentermine product and intends to pursue all defenses available to it.
Jones has tendered defense of these lawsuits to its insurance carriers for
handling and they are currently defending Jones in these suits. The
manufacturers of fenfluramine and dexfenfluramine have settled many of these
cases. In the event that Jones' insurance coverage is inadequate to satisfy any
resulting liability, Jones will have to resume defense of these lawsuits and be
responsible for the damages, if any, that are awarded against it.

While the Company cannot predict the outcome of these suits, management
believes that the claims against Jones are without merit and intends to
vigorously pursue all defenses available. The Company is unable to disclose an
aggregate dollar amount of damages claimed because many of these complaints are
multi-party suits and do not state specific damage amounts. Rather, these claims
typically state damages as may be determined by the court or similar language
and state no specific amount of damages against Jones. The Company, at this
time, cannot provide an aggregate dollar amount of damages claimed or a
reasonable estimate of possible losses related to the lawsuits.

THIMEROSAL/VACCINE RELATED LITIGATION

King and Parkedale have been named as defendants in California, Illinois
and Mississippi, along with Abbott Laboratories, Wyeth, Aventis Pharmaceuticals,
and other pharmaceutical companies that have manufactured or sold products
containing the mercury-based preservative, thimerosal.

In these cases, the plaintiffs attempt to link the receipt of the
mercury-based products to neurological defects. The plaintiffs claim unfair
business practices, fraudulent misrepresentations, negligent misrepresentations,
and breach of implied warranty, which are all arguments premised on the idea
that the defendants promoted products without any reference to the toxic hazards
and potential public health ramifications resulting from the mercury-containing
preservative. The plaintiffs also allege that the defendants knew of the
dangerous propensities of thimerosal in their products.

The Company's product liability insurance carrier has been given proper
notice of all of these matters, and defense counsel is vigorously defending the
Company's interests. The Company is moving to be dismissed from the litigation
due, among other things, to lack of product identity in the plaintiffs'
complaints. In 2001, the Company was dismissed on this basis in a similar case.
The Company intends to defend these lawsuits vigorously but is unable currently
to predict the outcome or reasonably estimate the range of potential loss, if
any.

SEC INVESTIGATION AND SECURITIES LITIGATION

On March 10, 2003, the Company received a subpoena duces tecum from the SEC
with respect to an SEC investigation of King. The subpoena requested the
production of documents focusing on the years 1999
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KING PHARMACEUTICALS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

and 2000 and included all documents related to sales of King's products to
VitaRx and Prison Health Services during 1999 and 2000, the Company's "best
price" lists, all documents related to the pricing of the Company's
pharmaceutical products provided to any governmental Medicaid agency during
1999, the accrual and payment of rebates on Altace(R) from 2000 to the present,
and other general requests. On May 14, 2003, the SEC issued another subpoena
duces tecum, requesting additional documents pertaining to the products
Fluogen(R) and Lorabid(R), the King Benevolent Fund, Inc., the Company's
calculations related to Medicaid rebates, and the Audit Committee's internal
review of issues raised by the SEC investigation. The Company has cooperated,
and will continue to cooperate, in providing information to the SEC.

In connection with the Company's determination that it has underpaid
amounts due under Medicaid and other governmental pricing programs during the
period from 1998 to 2002, the Company has contacted the Centers for Medicare and
Medicaid Services, the Office of Inspector General at the Department of Health
and Human Services, and the Department of Justice. The Company expects to engage
in more detailed discussions with these and other appropriate agencies in order
to determine the precise amount of the underpayments. The Company currently
expects to make the requisite payments in the third or fourth quarter of 2003.
The SEC, the Centers for Medicare and Medicaid Services, the Office of Inspector
General, the Department of Justice and other governmental agencies that might be
investigating or might commence an investigation of the Company could impose,
based on a claim of a violation of fraud and false claims laws or otherwise,
civil and/or criminal sanctions, including fines, penalties and possible
exclusion from federal health care programs (including Medicaid and Medicare).
Some of these laws may impose liability even in the absence of specific intent
to defraud. The Company cannot predict or reasonably estimate the likelihood or
magnitude of any such sanctions at this time.

Subsequent to the announcement of the SEC investigation described above,
beginning in March 2003, 22 purported class action complaints have been filed by
holders of the Company's securities against the Company, its directors, former
directors, executive officers and former executive officers in the United States
District Court for the Eastern District of Tennessee, alleging violations of the
Securities Act of 1933 and/or the Securities Exchange Act of 1934. Plaintiffs
allege that the Company, through some of its executive officers, former
executive officers, directors and former directors, made false or misleading
statements concerning the Company's business, financial condition and results of
operations during periods beginning March 31, 1999 and continuing until March
11, 2003. Additionally, seven purported shareholder derivative complaints have
been filed in federal and state courts in Tennessee alleging a breach of
fiduciary duty, among other things, by some of the Company's officers and
directors. The allegations in these lawsuits are similar to those in the class
action litigation described above. The Company intends to defend these lawsuits
vigorously but is unable currently to predict the outcome or reasonably estimate
the range of potential loss, if any.

If any governmental sanctions are imposed, or if the Company were not to
prevail in the securities litigation, neither of which can be predicted or
reasonably estimated at this time, the Company's business, financial condition,
results of operations and cash flows could be materially adversely affected.
Responding to the SEC in its investigation, resolving the amounts owed to
governmental agencies in connection with the underpayments and defending King in
the securities litigation has resulted, and is expected to continue to result,
in a significant diversion of management's attention and resources and an
increase in professional fees.

OTHER LEGAL PROCEEDINGS

The Parkedale facility was one of six facilities owned by Pfizer subject to
a Consent Decree of Permanent Injunction issued August 1993 in United States of
America v. Warner-Lambert Company and Melvin R. Goodes and Lodewijk J.R. DeVink
(U.S. Dist. Ct., Dist. of N.J.) (the "Consent Decree"). The Company acquired the
Parkedale facility in February 1998. The Parkedale facility is currently
manufacturing pharmaceutical products subject to the Consent Decree that
prohibits the manufacture and delivery of specified drug products unless, among
other things, the products conform to current good manufacturing practices and
are

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KING PHARMACEUTICALS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

produced in accordance with an approved ANDA or NDA. The Company intends, when
appropriate, to petition for relief from the Consent Decree.

Cobalt Pharmaceuticals, Inc. has filed an ANDA with the FDA pertaining to
ramipril, the active ingredient in Altace(R), which the Company co-promotes
together with Wyeth. The allegations in Cobalt's notice relate to a composition
of matter patent for ramipril which does not expire until October 2008. A
separate patent, expiring in January 2005, also covers ramipril, but Cobalt is
not seeking FDA approval until after the expiration of this second patent in
January 2005. The Company intends to vigorously enforce and defend this patent.

The Company is involved in various routine legal proceedings incident to
the ordinary course of its business.

GOVERNMENT AGENCY PRICING

The Company and other pharmaceutical manufacturers are required to provide
statutorily defined rebates to various state and federal government agencies in
order to participate in Medicaid, the veterans health care program and other
government-funded programs. Several government agencies have placed restrictions
on physician prescription levels and patient reimbursements, emphasized greater
use of generic drugs and enacted across-the-board price cuts as methods to
control costs. The Company is unable to predict the final form and timing of any
future governmental or other health care initiatives, and therefore, their
effect on operations and cash flows cannot be reasonably estimated. Similarly,
the effect on operations and cash flows of decisions of government entities,
managed care groups, and other groups concerning formularies and pharmaceutical
reimbursement policies cannot be reasonably estimated.

9. SEGMENT REPORTING

The Company's business is classified into five reportable segments: branded
pharmaceuticals, Meridian Medical Technologies, contract manufacturing,
royalties, and all other. Branded pharmaceuticals include a variety of branded
prescription products over five therapeutic areas, including cardiovascular,
endocrinology/women's health, anti-infective, critical care and other. These
branded prescription products have been aggregated because of the similarity in
regulatory environment, manufacturing processes, methods of distribution, and
types of customer. Meridian Medical Technologies represents the design,
development, manufacture and sale of medical products and related services. The
Meridian Medical Technologies segment is a new segment in the first quarter of
2003 as a result of the acquisition of Meridian on January 8, 2003. Meridian
sells its auto-injector products to both commercial and government markets. The
principal source of revenues in the commercial market comes from its Epipen(R)
family of auto-injectors, which are prescribed primarily for severe allergic
reactions. Government revenues are principally generated from nerve agent
antidotes and other emergency medicine auto-injector products and services
marketed to the U.S. Department of Defense and other federal, state and local
agencies, particularly those involved in homeland security, as well as to
approved foreign governments. Contract manufacturing represents contract
manufacturing services provided for the government, as well as pharmaceutical
and biotechnology companies. Royalties represent products for which the Company
has transferred the manufacturing or marketing rights to corporate partners in
exchange for licensing fees or royalty payments on product sales. The
classification "all other" primarily includes Meridian's cardiopulmonary
business unit.

The Company primarily evaluates its segments based on gross profit.
Reportable segments were separately identified based on revenues, gross profit
and total assets. Revenues among the segments are presented in the individual
segments and removed through eliminations in the information below.
Substantially all of the eliminations relate to sales from the contract
manufacturing segment to the branded pharmaceutical segment.

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KING PHARMACEUTICALS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The following represents selected information for the Company's reportable
segments for the periods indicated:

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KING PHARMACEUTICALS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The following represents branded pharmaceutical revenues by therapeutic
area:

10. SUBSEQUENT EVENTS

ELAN TRANSACTION

On June 12, 2003, the Company acquired the primary care business of Elan
Corporation, plc ("Elan") and of some of its subsidiaries in the United States
and Puerto Rico, which includes the rights to two branded prescription
pharmaceutical products, including the rights to potential new formulations, of
Sonata(R) and Skelaxin(R), together with Elan's United States primary care field
sales force. Product rights subject to the agreement include those related to
Sonata(R), a nonbenzodiazepine treatment for insomnia, and Skelaxin(R), a muscle
relaxant, in the United States, its territories and possessions, and Puerto
Rico. Under the terms of the agreement, Elan's sale of Skelaxin(R) included
related NDAs, copyrights, trademarks, patents and U.S. rights to potential new
formulations of Skelaxin(R). Elan's sale of Sonata(R) included its rights to the
product, as well as certain related copyrights. The Company also acquired
certain intellectual property, regulatory, and other assets relating to
Sonata(R) directly from Wyeth. Under the terms of the agreement, the Company
secured an exclusive license to the intellectual property rights, in this
territory, of both Wyeth and Elan to the extent they relate to new formulations
of Sonata(R), other than for use in animals. The Company paid approximately
$750.0 million at closing. The $750.0 million purchase price included the
transfer of inventory with a value of approximately $40.0 million. The Company
also will pay royalties on the current formulation of Skelaxin(R) from the date
of closing and up to $71.0 million if Elan achieves certain milestones in
connection with the development of a reformulated version of Sonata(R). The
Company will also have a potential milestone payment of $15.0 million if annual
net sales of a reformation version of Sonata(R) exceed $100.0 million. The
Company also potentially will pay an additional $25.0 million milestone payment
to Elan relating to the ongoing exclusivity of Skelaxin(R) on January 2, 2004.
Prior to the closing of this transaction, the Company received a letter on March
13, 2003 from the Federal Trade Commission ("FTC") stating that the FTC was
conducting an investigation to determine whether any person has engaged in
unfair methods of competition with respect to Elan's product Skelaxin(R). The
focus of this investigation was Elan's listing in the FDA's Approved Drug
Products with Therapeutic Equivalence Evaluations, ("Orange Book") of at least
one patent claiming a method of using metaxalone, and other actions with regard
to FDA regulatory processes. As a result of this new information, the Company
commenced an investigation and asked Elan to provide additional information. On
March 17, 2003, Elan filed a lawsuit in the Supreme Court of the State of New
York seeking to compel the Company to close the transaction. On May 8, 2003, the
FTC advised Elan that it was discontinuing a portion of its investigation with
respect to this method of use patent. On May 20, 2003, the Company reached an
agreement with Elan that restructured the terms of the transaction as described
above, and, as a result, the litigation has since been dismissed.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

SKELAXIN(R) PATENT CHALLENGE

Eon Labs, Inc. ("Eon Labs") and CorePharma, LLC ("CorePharma") have each
filed an ANDA with the FDA pertaining to metaxalone, the active ingredient in
Skelaxin(R). The allegations in Eon Labs' and CorePharma's notices relate to a
patent covering a method of using metaxalone, which does not expire until
December 2021. The Company intends to enforce its rights under this patent. If
the Company is unsuccessful in enforcing this patent, its business, financial
condition, results of operations and cash flows could be materially adversely
affected.

LEVOXYL(R) PATENT CHALLENGE

Mylan Pharmaceuticals, Inc., a generic drug manufacturer, filed an ANDA
with the FDA seeking permission to market a generic version of Levoxyl(R) prior
to the expiration of U.S. Patent No. 6555581 (the "'581 patent"), a utility
patent with composition of matter claims, which was issued to the Company on
April 29, 2003 and extends through February 15, 2022. The Company received
notice of the Paragraph IV certification no earlier than April 30, 2003. The
Company has filed suit against Mylan and intends to vigorously enforce our
rights under the '581 patent being challenged. Additionally, on June 24, 2003,
the Company received a notice of Paragraph IV certification related to the '581
patent from KV Pharmaceutical Company. The Company intends to enforce its rights
under the '581 patent to the full extent of the law.

11. GUARANTOR FINANCIAL STATEMENTS

Each of the Company's subsidiaries (the "Guarantor Subsidiaries") has
guaranteed, on a full, unconditional, and joint and several basis, the Company's
performance under the $345,000, 2 3/4% Convertible Debentures due 2021 and under
the $400,000 Senior Secured Revolving Credit Facility on a joint and several
basis. There are no restrictions under the Company's financing arrangements on
the ability of the Guarantor Subsidiaries to distribute funds to the Company in
the form of cash dividends, loans or advances. The following combined financial
data provides information regarding the financial position, results of
operations and cash flows of the Guarantor Subsidiaries (condensed consolidating
financial data). Separate financial statements and other disclosures concerning
the Guarantor Subsidiaries are not presented because management has determined
that such information would not be material to the holders of the debt.

In January 2003, the Company formed Monarch Pharmaceuticals Ireland Limited
for the purpose of maintaining certain of the Company's international assets.
While Monarch Pharmaceuticals Ireland Limited is not a guarantor subsidiary, the
assets, liabilities, income and expenses are not material for the three months
ended March 31, 2003 and are included in the guarantor subsidiary column in the
guarantor subsidiary financial statements which follow.

15

KING PHARMACEUTICALS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

GUARANTOR SUBSIDIARIES

CONDENSED CONSOLIDATING BALANCE SHEETS
(IN THOUSANDS)

16

KING PHARMACEUTICALS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

GUARANTOR SUBSIDIARIES

CONDENSED CONSOLIDATING STATEMENTS OF INCOME
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)

17

KING PHARMACEUTICALS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

GUARANTOR SUBSIDIARIES

CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)

18

PART I -- FINANCIAL INFORMATION

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND
FINANCIAL CONDITION

The following discussion contains certain forward-looking statements that
reflect management's current views of future events and operations. This
discussion should be read in conjunction with the following: (a) "Risk Factors"
set out below and in our Annual Report on Form 10-K for the year ended December
31, 2002, which are supplemented by the discussion which follows; (b) our
audited consolidated financial statements which are included in our Annual
Report on Form 10-K for the year ended December 31, 2002; and (c) our unaudited
consolidated financial statements and related notes thereto included in this
report.

OVERVIEW

GENERAL

The following summarizes net revenues by reportable segment (in thousands):

RESULTS OF OPERATIONS

THREE MONTHS ENDED MARCH 31, 2003 AND 2002

Revenues

Revenues increased $85.8 million, or 33.2%, to $343.8 million in 2003 from
$258.1 million in 2002, due primarily to the growth of our branded
pharmaceutical products, our acquisition of Meridian on January 8, 2003 and the
acquisition of Intal(R), Tilade(R) and Synercid(R) from Aventis on December 30,
2002.

Revenues from branded pharmaceutical products increased $59.3 million, or
25.0%, to $296.4 million in 2003 from $237.1 million in 2002. This increase was
due primarily to growth in sales of Altace(R) and Thrombin-JMI(R), and our
acquisition of Intal(R), Tilade(R), and Synercid(R). This increase was partially
offset by lower sales of other certain branded pharmaceutical products,
particularly Lorabid(R), Cortisporin(R), Levoxyl(R), and Florinef(R) during the
first quarter ended March 31, 2003. Net sales from branded pharmaceutical
products for the first quarter of 2002 have not been reduced to reflect the
estimated underpayment of amounts due under Medicaid and other governmental
pricing programs for that quarter as the underpayment was immaterial. While we
expect continued growth in net sales of our branded pharmaceuticals in the
future, we refer you to the "Risk Factors" that appear below.

Revenues from Meridian Medical Technologies was $25.6 million in 2003. This
was a new segment in the first quarter of 2003 due to the acquisition of
Meridian on January 8, 2003.

Revenues from royalties is derived from payments we receive based on sales
of Adenoscan(R) and Adenocard(R). Revenue from royalties increased $3.9 million,
or 34.0%, to $15.4 million in 2003 from $11.5 million in 2002. While we
anticipate continued growth from royalty revenues, we are not responsible for
the marketing of these products and, thus, are not able to predict whether
growth will continue, if at all, at the rate experienced in the first quarter of
2003.

Revenues from contract manufacturing decreased $3.1 million, or 32.7%, to
$6.4 million in 2003 from $9.5 million in 2002 due to lower unit volume.

19

Operating Costs and Expenses

Total operating costs and expenses increased $205.5 million, or 140.9%, to
$351.3 million in 2003 from $145.8 million in 2002. The increase was primarily
due to special items resulting in a net charge totaling $133.2 million, costs of
revenues associated with increased unit sales of our branded pharmaceutical
products, and increased fees associated with the promotion of Altace(R) under
the Co-Promotion Agreement with Wyeth. Operating costs and expenses during the
first quarter of 2003 includes special items consisting of a $111.0 million
intangible asset impairment charge related to Florinef(R), an $18.0 million
in-process research and development charge relating to our acquisition of
Meridian, and special inventory charges totaling $4.3 million primarily relating
to our acquisition of Meridian and the recall of some lots of Levoxyl(R) 300 mcg
tablets.

Special items are those particular income or expense items that our
management believes are not related to our ongoing, underlying business, are
non-recurring, or are not generally predictable. These items include, but are
not limited to, merger and restructuring expenses; non-capitalized expenses
associated with acquisitions, such as in-process research and development
charges and one-time inventory valuation adjustment charges; charges resulting
from the early extinguishment of debt; asset impairment charges; expenses of
drug recalls; and gains and losses resulting from the divestiture of assets. We
believe the identification of special items enhances an investor's analysis of
our ongoing, underlying business and of our financial results when comparing
those results to that of a previous or subsequent like period. However, it
should be noted that the determination of whether to classify an item as a
special item involves judgments by us.

Cost of revenues increased $31.9 million, or 66.3%, to $80.0 million in
2003 from $48.1 million in 2002. The increase was primarily due to costs
associated with increased unit sales of our branded pharmaceutical products,
including Altace(R) and Thrombin-JMI(R), additional product sales due to our
acquisition of Intal(R), Tilade(R), and Synercid(R), our acquisition of Meridian
and a $4.3 million special inventory charge relating to our acquisition of
Meridian and the recall of some lots of Levoxyl(R) 300 mcg tablets. As a
percentage of revenues, cost of revenues increased to 23.3% in 2003 from 18.6%
in 2002 due to the acquisition of Meridian, whose products have lower margins,
and the special inventory charge mentioned above.

Cost of revenues from branded pharmaceutical products increased $10.9
million, or 28.8%, to $48.7 million in 2003 from $37.8 million in 2002. This
increase was primarily due to increased unit sales of our Altace(R) and
Thrombin(R) product lines, additional product sales due to our acquisition of
Intal(R), Tilade(R) and Synercid(R), and special inventory charges totalling
$2.1 million primarily relating to our recall of some lots of Levoxyl(R) 300 mcg
tablets.

Cost of revenues from Meridian Medical Technologies was $17.7 million in
2003, including a $2.2 million special charge relating to our acquisition of
Meridian. This is a new segment in the first quarter of 2003 due to our
acquisition of Meridian on January 8, 2003.

Cost of revenues from royalties increased $1.1 million, or 57.9%, to $3.0
million in 2003 from $1.9 million in 2002. The increase is primarily due to our
increased royalty expense that is directly related to the increase in royalty
revenue attributable to Adenocard(R).

Cost of revenues associated with contract manufacturing increased $2.3
million, or 27.4%, to $10.7 million in 2003 from $8.4 million in 2002 due
primarily to increases in fixed overhead costs.

Selling, general and administrative expenses increased $33.9 million, or
43.2%, to $112.4 million in 2003 from $78.5 million in 2002. This increase was
primarily attributable to fees and expenses associated with the promotion of
Altace(R) under the Co-Promotion Agreement with Wyeth, the growth of our United
States field sales force, and our acquisition of Meridian. As a percentage of
revenues, selling, general, and administrative expenses increased to 32.7% in
2003 compared to 30.4% in 2002.

Depreciation and amortization expense increased $6.7 million, or 49.3%, to
$20.3 million in 2003 from $13.6 million in 2002. This increase was primarily
attributable to the amortization of the intangible assets related to our
acquisition of Intal(R), Tilade(R) and Synercid(R), the acquisition of
Prefest(R) on May 29, 2002, and the acquisition of Meridian on January 8, 2003.

Research and development expense increased $22.0 million, to $27.6 million
in 2003 from $5.6 million in 2002, primarily due to a special charge of $18.0
million for in-process research and development relating to our
20

acquisition of Meridian. The amount of the special charge was based on the
valuation of Meridian's in-process research and development projects that have
applications under review by the FDA.

In January 2003, we were notified of the approval by the FDA of a second
generic fludrocortisone acetate USP, a product that will represent additional
competition for our Florinef(R) product. We have completed our impairment review
and have recorded an impairment charge in the amount of $111.0 million in the
first quarter of 2003 reflecting the reduction in the fair value of the
Florinef(R) intangible assets. We determined the fair value of the Florinef(R)
product based on our current discounted cash flow projections for the product.
Florinef(R) is included in our branded pharmaceutical reporting segment.

Operating Income

Operating income decreased to a $7.5 million operating loss in 2003 from
$112.3 million in operating income during 2002. This decrease was primarily due
to the special items and other factors described above, particularly the $111.0
intangible asset impairment charge related to Florinef(R).

Other Income (Expense)

Interest income decreased $2.2 million, or 46.8%, to $2.5 million in 2003
from $4.7 million in 2002 primarily due to reduced rates of return on
investments in 2003.

Interest expense increased $0.2 million, to $3.0 million in 2003 from $2.8
million in 2002.

Results in 2003 included income in the amount of $8.0 million to reflect
the decrease in the valuation allowance for the convertible notes receivable
from Novavax, Inc. Statement of Financial Accounting Standards, which we refer
to as "SFAS," No. 114, "Accounting by Creditors for Impairment of a Loan -- an
amendment of FASB Statements No. 5 and 15" requires that we treat the Novavax
convertible notes as an impaired loan because of the decline in the share price
of Novavax common stock to levels below that established by our common stock
conversion options associated with the convertible notes. We will adjust the
amount of the valuation allowance in future periods based on the value of the
underlying collateral (Novavax common stock) as of the last business day of each
respective calendar quarter or until the loan is no longer considered to be
impaired. If the Novavax common stock price declines, we may incur charges
related to the investment in the convertible notes.

Income Tax Expense

The effective tax rate in 2003 was higher than the federal statutory rate
due primarily to permanent differences related to state income taxes and
non-deductible in-process research and development charges incurred with the
Meridian acquisition. The effective tax rate of 37.1% in 2002 was higher than
the federal statutory rate of 35.0% due primarily to permanent differences
related to state income taxes.

Net Income

Due to the factors set forth above, net income decreased $78.5 million, to
a $7.2 million net loss in 2003 from $71.3 million of net income in 2002.

LIQUIDITY AND CAPITAL RESOURCES

We believe that existing balances of cash, cash equivalents and marketable
securities, cash generated from operations, existing revolving credit facility
and funds available to us under our universal shelf registration are sufficient
to finance our current operations and working capital requirements on both a
short term and long term basis. However, in the event we make significant future
acquisitions or change our capital structure, we may be required to raise funds
through additional borrowings or the issuance of additional debt or equity
securities.

On January 8, 2003, we completed our acquisition of Meridian. We paid
$44.50 per common share to Meridian shareholders, totaling approximately $246.8
million. We financed the acquisition using our available cash.

21

On June 12, 2003, we acquired the primary care business of Elan and of some
of its subsidiaries in the United States and Puerto Rico, which includes the
rights to two branded prescription pharmaceutical products, including the rights
to potential new formulations, of Sonata(R) and Skelaxin(R), together with
Elan's United States primary care field sales force. Product rights subject to
the agreement include those related to Sonata(R), a nonbenzodiazepine treatment
for insomnia, and Skelaxin(R), a muscle relaxant, in the United States, its
territories and possessions, and Puerto Rico. Under the terms of the agreement,
Elan's sale of Skelaxin(R) included related NDAs, copyrights, trademarks,
patents and U.S. rights to potential new formulations of Skelaxin(R). Elan's
sale of Sonata(R) included its rights to the product, as well as certain related
copyrights. We also acquired certain intellectual property, regulatory, and
other assets relating to Sonata(R) directly from Wyeth. Under the terms of the
agreement, we secured an exclusive license to the intellectual property rights,
in this territory, of both Wyeth and Elan to the extent they relate to new
formulations of Sonata(R), other than for use in animals. We paid approximately
$750.0 million at closing. The $750.0 million purchase price included the
transfer of inventory with a value of approximately $40.0 million. We also

- will pay royalties on the current formulation of Skelaxin(R) from the
date of closing and up to $71.0 million if Elan achieves certain
milestones in connection with the development of a reformulated version
of Sonata(R);

- have a potential milestone payment of $15.0 million if annual net sales
of a reformulation version of Sonata(R) exceed $100.0 million; and

- potentially will pay an additional $25.0 million milestone payment to
Elan relating to the ongoing exclusivity of Skelaxin(R) on January 2,
2004.

Prior to the closing of this transaction, we received a letter on March 13, 2003
from the Federal Trade Commission, or the "FTC", stating that it was conducting
an investigation to determine whether any person has engaged in unfair methods
of competition with respect to Elan's product Skelaxin(R). The focus of this
investigation was Elan's listing in the FDA's Approved Drug Products with
Therapeutic Equivalence Evaluations, which is known as the "Orange Book," of at
least one patent claiming a method of using metaxalone, and other actions with
regard to FDA regulatory processes. As a result of this new information, we
commenced an investigation and asked Elan to provide additional information. On
March 17, 2003, Elan filed a lawsuit in the Supreme Court of the State of New
York seeking to compel us to close the transaction. On May 8, 2003, the FTC
advised Elan that it was discontinuing a portion of its investigation with
respect to this method of use patent. On May 20, 2003, we reached an agreement
with Elan that restructured the terms of the transaction as described above,
and, as a result, the litigation has since been dismissed.

On March 10, 2003, we received a subpoena duces tecum from the SEC with
respect to an SEC investigation of King. The subpoena requested the production
of documents focusing on the years 1999 and 2000 and included all documents
related to sales of our products to VitaRx and Prison Health Services during
1999 and 2000, our "best price" lists, all documents related to the pricing of
our pharmaceutical products provided to any governmental Medicaid agency during
1999, the accrual and payment of rebates on Altace(R) from 2000 to the present,
and other general requests. On May 14, 2003, the SEC issued another subpoena
duces tecum, requesting additional documents pertaining to the products
Fluogen(R) and Lorabid(R), the King Benevolent Fund, Inc., our calculations
related to Medicaid rebates, and our Audit Committee's internal review of issues
raised by the SEC investigation. We have cooperated, and will continue to
cooperate, in providing information to the SEC.

In connection with our determination that we have underpaid amounts due
under Medicaid and other governmental pricing programs during the period from
1998 to 2002, we have contacted the Centers for Medicare and Medicaid Services,
the Office of Inspector General at the Department of Health and Human Services,
and the Department of Justice. We expect to engage in more detailed discussions
with these and other appropriate agencies in order to determine the precise
amount of the underpayments. We currently expect to make the requisite payments
in the third or fourth quarter of 2003. The SEC, the Centers for Medicare and
Medicaid Services, the Office of Inspector General, the Department of Justice
and other governmental agencies that might be investigating or might commence an
investigation of us could impose, based on a claim of a violation of fraud and
false claims laws or otherwise, civil and/or criminal sanctions,
22

including fines, penalties and possible exclusion from federal health care
programs (including Medicaid and Medicare). Some of these laws may impose
liability even in the absence of specific intent to defraud. We cannot predict
or reasonably estimate the likelihood or magnitude of any such sanctions at this
time. For additional information, please see the "Risk Factors" section under
the heading "If we fail to comply with our reporting and payment obligations
under the Medicaid rebate program or other governmental pricing programs, we
could be subject to additional reimbursements, penalties, sanctions and fines
which could have a material adverse effect on our business."

Subsequent to the announcement of the SEC investigation described above,
beginning in March 2003, 22 purported class action complaints have been filed by
holders of our securities against us, our directors, former directors, its
executive officers and former executive officers in the United States District
Court for the Eastern District of Tennessee, alleging violations of the
Securities Act of 1933 and/or the Securities Exchange Act of 1934. Plaintiffs
allege that we, through some of our executive officers, former executive
officers, directors and former directors, made false or misleading statements
concerning our business, financial condition and results of operations during
periods beginning March 31, 1999 and continuing until March 11, 2003.
Additionally, seven purported shareholder derivative complaints have been filed
in federal and state courts in Tennessee alleging a breach of fiduciary duty,
among other things, by some of our officers and directors. The allegations in
these lawsuits are similar to those in the class action litigation described
above. We intend to defend these lawsuits vigorously but are unable currently to
predict the outcome or reasonably estimate the range of potential loss, if any.

If any governmental sanctions are imposed, or if we were not to prevail in
the securities litigation, neither of which can be predicted or reasonably
estimated at this time, our business, financial condition, results of operations
and cash flows could be materially adversely affected. Responding to the SEC in
its investigation, resolving the amounts owed to governmental agencies in
connection with the underpayments and defending King in the securities
litigation has resulted, and is expected to continue to result, in a significant
diversion of management's attention and resources and an increase in
professional fees.

We have placed $46.5 million of our cash on hand in an interest-bearing
escrow account. This amount, which we accrued in the fourth quarter of 2002,
represents our best estimate of the extent to which we underpaid amounts due
under Medicaid and other governmental pricing programs during the period from
1998 to 2002. The accrual adjustment relates solely to the estimated
underpayments and excludes any interest, fines, penalties or other amounts that
might be owed in connection with the underpayments, as we cannot predict or
reasonably estimate their likelihood or magnitude at this time. We have
contacted the Centers for Medicare and Medicaid Services, the Office of
Inspector General at the Department of Health and Human Services, and the
Department of Justice in connection with the underpayments and expect to engage
in more detailed discussions with these and other appropriate agencies in order
to determine the precise amount of the underpayments. We expect to make the
requisite payments in the third or fourth quarter of 2003.

We drew down $125.0 million on our $400.0 million senior secured revolving
credit facility on June 3 and June 6, 2003, the proceeds of which were used to
fund a portion of the Elan acquisition on June 12, 2003.

THREE MONTHS ENDED MARCH 31, 2003

We generated net cash from operations of $77.7 million for the three months
ended March 31, 2003. Our net cash provided from operations was primarily the
result of $7.2 million net loss, adjusted for non-cash depreciation and
amortization of $20.5 million, a change in income taxes payable/receivable of
$44.3 million, an increase in accrued expenses of $19.4 million, the write-off
of in process research and development of $18.0 million, and an impairment
charge for intangible assets of $111.0 million. Primary uses of cash within
operations included an increase in accounts receivable of $35.9 million, an
increase in inventory of $27.0 million, a decrease in accounts payable of $9.5
million, a change in deferred taxes of $44.2 million and the decrease in the
reserve on convertible senior notes of $8.0 million, all of which offset the
items previously described.

23

Investing activities reduced cash flow by $28.6 million of primarily due to
the purchase of Meridian for $237.7 million, the purchase of property, plant and
equipment of $12.8 million, the purchase of product rights of $9.0 million
partially offset by net proceeds from the sale of marketable securities of
$227.2 million.

Financing activities contributed $1.6 million to cash flow due to the
exercise of employee stock options.

Certain Indebtedness and Other Matters

As of March 31, 2003, we had $346.3 million of long-term debt (including
current portion), up to $400.0 million available under our revolving credit
facility, and $616.0 million available under our universal shelf registration.
As described above, subsequently, on June 3 and June 6, 2003, we drew down
$125.0 million from the revolving credit facility to fund a portion of the
proceeds used in the acquisition of Elan's primary care business on June 12,
2003.

On September 20, 2001, we registered a $1.3 billion universal shelf
registration statement on Form S-3 with the Securities and Exchange Commission.
This universal shelf registration statement allows us to sell any combination of
debt and/or equity securities in one or more offerings up to a total of $1.3
billion. During November 2001, we completed the sale of 17,992,000 newly issued
shares of common stock for $38.00 per share ($36.67 per share net of commissions
and expenses) resulting in net proceeds of $659.8 million. At March 31, 2003,
approximately $616.0 million remains available to us under the $1.3 billion
universal shelf registration statement. Additionally, during November 2001, we
issued $345.0 million of 2 3/4% Convertible Debentures due November 15, 2021 in
a private placement.

On April 23, 2002, we established a $400.0 million five year senior secured
revolving credit facility. The facility has been collateralized in general by
all real estate with a value of $5.0 million or more and all of our personal
property and that of our significant subsidiaries. Our obligations under the
senior secured revolving credit facility are unconditionally guaranteed on a
senior basis by certain of our subsidiaries. The senior secured revolving credit
facility accrues interest at our option, at either (a) the base rate, which is
based on the prime rate or the federal funds rate plus one-half of 1%, plus an
applicable spread ranging from 0.0% to 0.75% (based on a leverage ratio) or (b)
the applicable LIBOR rate plus an applicable spread ranging from 1.0% to 1.75%
(based on a leverage ratio). In addition, the lenders under the senior secured
revolving credit facility are entitled to customary facility fees based on (a)
unused commitments under the facility and (b) letters of credit outstanding. We
incurred $4.9 million of deferred financing costs, which are being amortized
over five years, the life of the revolving credit facility. This facility
requires us to maintain a minimum net worth of no less than $1.2 billion plus
50% of our consolidated net income for each fiscal quarter after April 23, 2002,
excluding any fiscal quarter for which consolidated income is negative; an
EBITDA to interest expense ratio of no less than 3.00 to 1.00; and maintain a
funded debt to EBITDA ratio of no greater than 3.50 to 1.00 prior to April 24,
2004 and of no greater than 3.00 to 1.00 on or after April 24, 2004. As of July
28, 2003, we have complied with these covenants. As of March 31, 2003, there are
no amounts outstanding under this facility. As mentioned above, on June 3 and
June 6, 2003, we borrowed $125.0 million to fund a portion of the proceeds
required to acquire Elan's primary care business.

Capital Expenditures

Capital expenditures, including capital lease obligations, were $12.8
million and $10.8 million for the three months ended March 31, 2003 and 2002,
respectively. The principal capital expenditures during the three months ended
March 31, 2003 included property and equipment purchases, new information
technology system implementation costs and building improvements for facility
upgrades and increased capacity.

We anticipate capital expenditures, including capital lease obligations,
for the year ending December 31, 2003 of approximately $60.0 million. The
principle capital expenditures are anticipated to include property and equipment
purchases, new information technology system implementation costs, building
improvements for facility upgrades, cost associated with improving our
production capabilities, and costs associated with moving production of some of
our pharmaceutical products to our facilities in St. Louis, Missouri, and
Rochester, Michigan.

24

IMPACT OF INFLATION

We have experienced only moderate raw material and labor price increases in
recent years. We have passed some price increases along to our customers and
have benefited from rapid sales growth negating most inflationary pressures.

CRITICAL ACCOUNTING POLICIES

We have chosen accounting policies that we believe are appropriate to
accurately and fairly report our operating results and financial position, and
apply those accounting policies in a consistent manner.

The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires that management make
estimates and assumptions. Assets, liabilities, revenues and expenses, and
disclosure of contingent assets and liabilities are affected by such estimates
and assumptions. The most significant assumptions are employed in estimates used
in determining allowances for doubtful accounts, values of inventories and
intangible assets, impairment, accruals for rebates, returns and chargebacks, as
well as estimates used in applying the revenue recognition policy and accounting
for the Novavax convertible senior notes and the Co-Promotion Agreement with
Wyeth. We are subject to risks and uncertainties that may cause actual results
to differ from those estimates, such as changes in the healthcare environment,
competition, legislation and regulation. We believe the following accounting
policies are the most critical because they involve the most significant
judgments and estimates used in preparation of our consolidated financial
statements.

- Allowance for doubtful accounts. We maintain an allowance for doubtful
receivables for estimated losses resulting from the inability of our
trade customers to make required payments. We provide an allowance for
specific customer accounts where collection is doubtful and also provide
a general allowance for other accounts based on historical collection and
write-off experience. Judgment is necessary and if the financial
condition of our customers were to worsen, additional allowances may be
required.

- Inventories. Our inventories are valued at the lower of cost or market
value. We evaluate all of our inventory for short dated or slow moving
product and inventory commitments under supply agreements based on
projections of future demand and market conditions. For those units in
inventory that are so identified, we estimate their market value or net
sales value based on current realization trends. If the projected net
realizable value is less than cost, on a product basis, we provide a
provision to reflect the lower value of that inventory. This methodology
recognizes projected inventory losses at the time such losses are evident
rather than at the time goods are actually sold.

- Intangible assets. When we purchase products we classify the purchase
price, including expenses and assumed liabilities, as intangible assets.
The purchase price is allocated to product rights, trademarks, patents
and other intangibles using the assistance of valuation experts. We
estimate the useful lives of the assets by factoring in the
characteristics of the products such as: patent protection, competition
by products prescribed for similar indications, estimated future
introductions of competing products, and other issues. The factors that
drive the estimate of the life of the asset are inherently uncertain.

- Long-lived assets. We review our property and intangible assets for
possible impairment whenever events or circumstances indicate that the
carrying amount of an asset may not be recoverable. We review our
goodwill for possible impairment annually, or whenever events or
circumstances indicate that the carrying amount may not be recoverable.
Assumptions and estimates used in the evaluation of impairment may affect
the carrying value of long-lived assets, which could result in impairment
charges in future periods. Such assumptions include projections of future
cash flows and, in some cases, the current fair value of the asset. In
addition, our depreciation and amortization policies reflect judgments on
the estimated useful lives of assets.

- Accruals for rebates, returns, and chargebacks. We establish accruals
for rebates, returns, and chargebacks in the same period we recognize the
related sales. The accruals reduce revenues and are included in accrued
expenses. Accrued rebates include amounts due under Medicaid, managed
care

25

rebates and other commercial contractual rebates. We estimate accrued
rebates based on a percentage of selling price determined from historical
experience. With respect to accruals for estimated Medicaid rebates, we
evaluate our historical rebate payments by product as a percentage of
historical sales, product pricing and current contracts. At the time of
rebate payment, which generally occurs with a delay after the related
sale, we record a reduction to accrued expenses and, at the end of each
quarter, adjust accrued expenses for any differences between estimated
and actual payments. Due to estimates and assumptions inherent in
determining the amount of the rebate, rebate payments remain subject to
retroactive adjustment. Returns are accrued based on historical
experience. Chargebacks are based on the estimated days of unprocessed
claims using historical experience. In all cases, judgment is required in
estimating these reserves, and actual claims for rebates, returns and
chargebacks could be different from the estimates. Medicaid and certain
other governmental pricing programs involve particularly difficult
interpretations of relevant statutes and regulatory guidance, which are
complex and, in certain respects, ambiguous. Moreover, prevailing
interpretations of these statutes and guidance can change over time.

- Revenue recognition. Revenue is recognized when title and risk of loss
are transferred to customers, collection of sales is reasonably assured,
and we have no further performance obligations. This is generally at the
time products are received by the customer. Accruals for estimated
returns, rebates and chargebacks, determined based on historical
experience, reduce revenues at the time of sale and are included in
accrued expenses. Medicaid and certain other governmental pricing
programs involve particularly difficult interpretations of relevant
statutes and regulatory guidance, which are complex and, in certain
respects, ambiguous. Moreover, prevailing interpretations of these
statutes and guidance can change over time. Royalty revenue is recognized
based on a percentage of sales (namely, contractually agreed-upon royalty
rates) reported by third parties. For the year ended December 31, 2002,
we deferred recognition of revenue associated with a purchase of our
products by the King Benevolent Fund. We recognize the deferred revenue
as the purchased products are distributed by the King Benevolent Fund.

- Novavax convertible senior notes. Our Novavax 4% convertible senior
notes are carried at cost, with a valuation allowance which reduces the
convertible senior notes to estimated fair value. The estimated fair
value was determined by the quoted market price of the underlying
securities at the end of the period. The amount of the valuation
allowance will be adjusted in future periods based on the value of the
underlying collateral (Novavax common stock) as of the last business day
of each respective calendar quarter or until such time as the loan is no
longer considered to be impaired.

- Co-Promotion Agreement with Wyeth. We have a Co-Promotion Agreement with
Wyeth to promote Altace(R). A $75.0 million upfront fee was paid to us by
Wyeth and this fee is being amortized on a straight line basis over the
life of the agreement as a reduction of co-promotion marketing expenses.
Co-promotion fees are paid to Wyeth based on a percentage of net sales of
Altace(R). We accrue co-promotion fees paid by us at the rate expected
for the entire year. The rate is adjusted during the year, if necessary,
as it becomes clearer wha