UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-Q

 

 

Commission file number 1-6571

 

SCHERING-PLOUGH CORPORATION

(Exact name of registrant as specified in its charter)

 

 

 

 

Registrant’s telephone number, including area code:

(908) 298-4000

 

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

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer þ     Accelerated Filer o     Non-accelerated Filer o

 

Indicate whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes o     No þ

 

Common Shares Outstanding as of June 30, 2006: 1,481,323,452

 

 

PART I. FINANCIAL INFORMATION

 

 

SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES

 

STATEMENTS OF CONDENSED CONSOLIDATED OPERATIONS

(Unaudited)

(Amounts in millions, except per share figures)

 

 

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES

 

STATEMENTS OF CONDENSED CONSOLIDATED CASH FLOWS

(Unaudited)

(Amounts in millions)

 

 

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

(Amounts in millions, except per share figures)

 

 

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

 

SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

These unaudited condensed consolidated financial statements of Schering-Plough Corporation and subsidiaries (the Company), included herein have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (SEC) for reporting on Form 10-Q. Certain information and disclosures normally included in financial statements prepared in accordance with U.S. Generally Accepted Accounting Principles have been condensed or omitted pursuant to such SEC rules and regulations. Certain prior year amounts have been reclassified to conform to the current year presentation. These statements should be read in conjunction with the accounting policies and notes to consolidated financial statements included in the Company’s 2005 Annual Report on Form 10-K.

 

In the opinion of the Company’s management, the financial statements reflect all adjustments necessary for a fair statement of the operations, cash flows and financial position for the interim periods presented.

 

 

On June 1, 2006, the Company announced changes to its manufacturing operations in Puerto Rico and New Jersey that will streamline its global supply chain and further enhance the Company’s long-term competitiveness. The Company’s manufacturing operations in Manati, Puerto Rico, will be phased out during 2006 and additional workforce reductions in Las Piedras, Puerto Rico and New Jersey will take place. In total, the actions taken will result in the elimination of approximately 1,100 positions. Approximately 500 positions were eliminated in the second quarter of 2006.

 

Special Charges

 

Special charges for the three and six months ended June 30, 2006 totaled $80 million related to the changes in the Company’s manufacturing operations, consisting of $25 million of severance and $55 million of fixed asset impairments.

 

Special charges for the three months ended June 30, 2005 totaled $259 million primarily related to an increase in litigation reserves for the Massachusetts investigation of $250 million with the majority of the remaining amount related to charges as a result of the consolidation of the Company’s U.S. biotechnology organizations. Additional information regarding litigation reserves is also included in Note 15 “Legal, Environmental and Regulatory Matters” in this 10-Q. Special charges for the six months ended June 30, 2005 totaled $286 million.

 

Cost of Sales

 

Included in cost of sales for the three and six months ended June 30, 2006 is $13 million of accelerated depreciation and $45 million of inventory write-offs related to the announced closure of the Company’s manufacturing facilities in Manati, Puerto Rico.

 

The following table summarizes the activities reflected in the Condensed Consolidated Financial Statements for the special charges and manufacturing streamlining for the three and six months ended June 30, 2006:

 

 

SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

 

 

In May 2000, the Company and Merck & Co., Inc. (Merck) entered into two separate sets of agreements to jointly develop and market certain products in the U.S. including (1) two cholesterol-lowering drugs and (2) an allergy/asthma drug. In December 2001, the cholesterol agreements were expanded to include all countries of the world except Japan. In general, the companies agreed that the collaborative activities under these agreements would operate in a virtual joint venture to the maximum degree possible by relying on the respective infrastructures of the two companies. These agreements generally provide for equal sharing of development costs and for co-promotion of approved products by each company.

 

The cholesterol agreements provide for the Company and Merck to jointly develop ezetimibe (marketed as ZETIA in the U.S. and Asia and EZETROL in Europe):

 

i. as a once-daily monotherapy;

 

ii. in co-administration with any statin drug; and

 

iii. as a once-daily fixed-combination tablet of ezetimibe and simvastatin (Zocor), Merck’s cholesterol-modifying medicine. This combination medication (ezetimibe/simvastatin) is marketed as VYTORIN in the U.S. and as INEGY in many international countries.

 

ZETIA/EZETROL (ezetimibe) and VYTORIN/INEGY (the combination of ezetimibe/simvastatin) are approved for use in the U.S. and have been launched in many international markets.

 

The Company utilizes the equity method of accounting in recording its share of activity from the Merck/Schering-Plough cholesterol joint venture. As such, the Company’s net sales do not include the sales of the joint venture. The cholesterol joint venture agreements provide for the sharing of operating income generated by the joint venture based upon percentages that vary by product, sales level and country. In the U.S. market, the Company receives a greater share of profits on the first $300 million of annual ZETIA sales. Above $300 million of annual ZETIA sales, Merck and Schering-Plough (the Partners) generally share profits equally. Schering-Plough’s allocation of the joint venture income is increased by milestones recognized. Further, either Partner’s share of the joint venture’s income from operations is subject to a reduction if the Partner fails to perform a specified minimum number of physician details in a particular country. The Partners agree annually to the minimum number of physician details by country.

 

The Partners bear the costs of their own general sales forces and commercial overhead in marketing joint venture products around the world. In the U.S., Canada, and Puerto Rico, the cholesterol agreements provide for a reimbursement to each Partner for physician details that are set on an annual basis. This reimbursed amount is equal to each Partner’s physician details multiplied by a contractual fixed fee. Schering-Plough reports this reimbursement as part of equity income from the cholesterol joint venture. This amount does not represent a reimbursement of specific, incremental and identifiable costs for the Company’s detailing of the cholesterol products in these markets. In addition, this reimbursement amount is not reflective of the Company’s sales effort related to the joint venture as the Company’s sales force and related costs associated with the joint venture are generally estimated to be higher.

 

During the three and six months ended June 30, 2005, the Company recognized milestones of $6 million and $20 million related to certain European approvals of VYTORIN.

 

Under certain other conditions, as specified in the joint venture agreements with Merck, the Company could earn additional milestones totaling $105 million.

 

Costs of the joint venture that the Partners contractually share are a portion of manufacturing costs, specifically identified promotion costs (including direct-to-consumer advertising and direct and identifiable out-of-pocket promotion) and other agreed upon costs for specific services such as market support, market research, market expansion, a specialty sales force and physician education programs.

 

SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

 

Certain specified research and development expenses are generally shared equally by the Partners.

 

The unaudited financial information below presents summarized combined financial information for the Merck/Schering-Plough Cholesterol Partnership for the three and six months ended June 30, 2006 and 2005:

 

 

Amounts related to physician details, among other expenses, that are invoiced by Schering-Plough and Merck in the U.S., Canada and Puerto Rico are deducted from income from operations of the Partnership.

 

Schering-Plough’s share of the Partnership’s income from operations for the three and six months ended June 30, 2006 was $311 million and $577 million, respectively, and $127 million and $296 million, respectively, for the three and six months ended June 30, 2005. In the U.S. market, Schering-Plough receives a greater share of income from operations on the first $300 million of annual ZETIA sales.

 

The following unaudited information provides a summary of the components of the Company’s equity income from the cholesterol joint venture for the three and six months ended June 30, 2006 and 2005:

 

 

Equity income from the joint venture excludes any profit arising from transactions between the Company and the joint venture until such time as there is an underlying profit realized by the joint venture in a transaction with a party other than the Company or Merck.

 

Due to the virtual nature of the cholesterol joint venture, the Company incurs substantial costs, such as selling, general and administrative costs, that are not reflected in equity income and are borne by the overall cost structure of the Company. These costs are reported on their respective line items in the Statements of Condensed Consolidated Operations. The cholesterol agreements do not provide for any jointly owned facilities and, as such, products resulting from the joint venture are manufactured in facilities owned by either the Company or Merck.

 

The allergy/asthma agreements provide for the joint development and marketing by the Partners of a once-daily, fixed-combination tablet containing CLARITIN and Singulair. Singulair is Merck’s once-daily leukotriene receptor antagonist for the treatment of asthma and seasonal allergic rhinitis. In January 2002, the Merck/Schering-Plough respiratory joint venture reported on results of Phase III clinical trials of a fixed-combination tablet containing CLARITIN and Singulair. This Phase III study did not demonstrate sufficient added benefits in the treatment of seasonal allergic rhinitis. The CLARITIN and Singulair combination tablet does not have approval in any country and remains in Phase III clinical development.

 

SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

 

 

Prior to January 1, 2006, the Company accounted for its stock compensation arrangements using the intrinsic value method, which followed the recognition and measurement principles of APB Opinion No. 25, “Accounting for Stock Issued to Employees” and the related Interpretations. Prior to 2006, no stock-based employee compensation cost was reflected in net income, other than for the Company’s deferred stock units, as stock options granted under all other plans had an exercise price equal to the market value of the underlying common stock on the date of grant.

 

The Company adopted Statement of Financial Accounting Standards No. 123 (Revised 2004), “Share-Based Payment” (SFAS 123R), effective January 1, 2006. SFAS 123R requires companies to recognize compensation expense in an amount equal to the fair value of all share-based payments granted to employees. The Company elected the modified prospective transition method and therefore adjustments to prior periods were not required as a result of adopting SFAS 123R. Under this method, the provisions of SFAS 123R apply to all awards granted after the date of adoption and to any unrecognized expense of awards unvested at the date of adoption based on the grant date fair value. SFAS 123R also amends SFAS No. 95, “Statement of Cash Flows,” to require that excess tax benefits that had been reflected as operating cash flows be reflected as financing cash flows.

 

In the second quarter of 2006, the 2006 Stock Incentive Plan (the 2006 Plan) was approved by the Company’s shareholders. Under the terms of the 2006 Plan, 92 million of the Company’s authorized common shares may be granted as stock options or awarded as deferred stock units to officers and certain employees of the Company through December 2011. As of June 30, 2006, 76 million options and deferred stock units remain available for future year grants under the 2006 Plan.

 

The Company intends to utilize treasury stock to satisfy stock option exercises and for the issuance of deferred stock units.

 

For grants issued to retirement eligible employees prior to the adoption of SFAS 123R, the Company recognized compensation costs over the stated vesting period of the stock option or deferred stock unit with acceleration of any unrecognized compensation costs upon the retirement of the employee. Upon adoption of SFAS 123R, the Company recognizes compensation costs on all share-based grants made on or after January 1, 2006 over the service period, which is the earlier of the employees retirement eligibility date or the service period of the award.

 

Implementation of SFAS 123R

 

In the first quarter of 2006, the Company recognized a benefit to income of $22 million for the cumulative effect of a change in accounting principle related to two long-term compensation plans required to be accounted for as liability plans under SFAS 123R.

 

Tax benefits recognized related to stock-based compensation and related cash flow impacts were not material during the three and six months ended June 30, 2006 as the Company is in a U.S. Net Operating Loss position.

 

Stock Options

 

Stock options are granted to employees at exercise prices equal to the fair market value of the Company’s stock at the dates of grant. Stock options, under the 2006 Plan, generally vest over three years and have a term of seven years. Certain options granted under previous plans vest over longer periods ranging from three to nine years and have a term of 10 years. Compensation costs for all stock options is recognized over the requisite service period for each separately vesting portion of the stock option award. Expense is recognized,

 

SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

net of estimated forfeitures, over the vesting period of the options using an accelerated method. Expense recognized for the three and six months ended June 30, 2006 was approximately $12 million and $26 million, respectively.

 

The weighted-average assumptions used in the Black-Scholes option-pricing model for the three and six months ended June 30, 2006 and 2005 were as follows:

 

 

Dividend yields are based on historical dividend yields. Expected volatilities are based on historical volatilities of the Company’s common stock. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant for periods corresponding with the expected life of the options. The expected term of options represents the weighted average period of time that options granted are expected to be outstanding giving consideration to vesting schedules and the Company’s historical exercise patterns.

 

The amount of cash received from the exercise of stock options for the three and six months ended June 30, 2006 was $5 million and $32 million, respectively. The amount of cash received for the three and six months ended June 30, 2005 was $19 million and $28 million, respectively.

 

Stock-based compensation prior to January 1, 2006 was determined using the intrinsic value method. The following table provides supplemental information for the three and six months ended June 30, 2005 as if stock-based compensation had been computed under SFAS 123:

 

 

SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

 

Summarized information about stock options outstanding and exercisable at June 30, 2006 is as follows:

 

 

The weighted-average fair value of stock options granted for the three and six months ended June 30, 2006 was $5.22. The weighted-average fair value of stock options granted for the three and six months ended June 30, 2005 was $7.12 and $7.04, respectively. The intrinsic value of stock options exercised was $1 million and $9 million for the three and six months ended June 30, 2006, respectively. The intrinsic value of stock options exercised was $6 million and $12 million for the three and six months ended June 30, 2005, respectively. The total fair value of shares vested during the three and six months ended June 30, 2006 was $26 million and $68 million, respectively. The total fair value of shares vested during the three and six-months ended June 30, 2005 was $4 million and $52 million, respectively.

 

As of June 30, 2006, the total remaining unrecognized compensation cost related to non-vested stock options amounted to $73 million, which will be amortized over the weighted-average remaining requisite service period of 2.4 years.

 

The following table summarizes stock option activities over the six months ended June 30, 2006 under the current and prior plans:

 

 

The aggregate intrinsic value of stock options outstanding at June 30, 2006 was $43 million. The aggregate intrinsic value of stock options currently exercisable at June 30, 2006 was $31 million. Intrinsic value for stock options is calculated based on the exercise price of the underlying awards and the quoted price of the Company’s common stock as of the reporting date.

 

SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

 

The following table summarizes nonvested stock option activity over the six months ended June 30, 2006 under the current and prior plans:

 

 

Deferred Stock Units

 

The fair value of deferred stock units is determined based on the number of shares granted and the quoted price of the Company’s common stock at the date of grant. Deferred stock units generally vest at the end of three years provided the employee remains in the service of the Company. Expense is recognized on a straight-line basis over the vesting period. Deferred stock units are payable in an equivalent number of common shares. Expense recognized for the three and six months ended June 30, 2006 was $36 million and $56 million, respectively. Expense recognized for the three and six months ended June 30, 2005 was $26 million and $40 million, respectively.

 

Summarized information about deferred stock units outstanding at June 30, 2006 is as follows:

 

 

The weighted-average fair value of deferred stock units granted was $19.23 for the three and six months ended June 30, 2006. The weighted-average fair value of deferred stock units granted for the three and six months ended June 30, 2005 was $20.68 and $20.67, respectively. The total fair value of deferred stock units vested during the three and six months ended June 30, 2006 was $0 and $1 million, respectively. The total fair value of deferred stock units vested during the three and six months ended June 30, 2005 was $1 million and $3 million, respectively.

 

As of June 30, 2006, the total remaining unrecognized compensation cost related to deferred stock units amounted to $240 million, which will be amortized over the weighted-average remaining requisite service period of 2.3 years.

 

SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

 

The following table summarizes deferred stock unit activity over the six months ended June 30, 2006 under the current and prior plans:

 

 

Incentive Plans

 

The Company has two compensation plans that are classified as liability plans under SFAS 123R as the ultimate cash payout of these plans will be based on the Company’s stock performance as compared to the stock performance of a peer group. Upon adoption of SFAS 123R on January 1, 2006, the Company recognized a cumulative income effect of a change in accounting principle of $22 million in order to recognize the liability plans at fair value. Income or expense amounts related to these liability plans are based on the change in fair value at each reporting date. Fair value for the plans were estimated using a lattice valuation model using expected volatility assumptions and other assumptions appropriate for determining fair value. The amount recognized, other than the impact of the cumulative effect of a change in accounting principle, in the Statements of Condensed Consolidated Operations for the three months and six months ended June 30, 2006 related to these liability awards was not material.

 

As of June 30, 2006, the total remaining unrecognized compensation cost related to the incentive plans amounted to $26 million, which will be amortized over the weighted-average remaining requisite service period of 2.2 years. This amount will vary each reporting period based on changes in fair value.

 

 

The components of other (income)/expense, net are as follows:

 

 

SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

 

 

At December 31, 2005, the Company had approximately $1.5 billion of U.S. Net Operating Losses (U.S. NOLs) for tax purposes available to offset future U.S. taxable income through 2024. The Company generated an additional U.S. NOL during the six months ended June 30, 2006.

 

The Company’s tax provisions for the three and six months ended June 30, 2006 and 2005 primarily relate to foreign taxes and do not include any benefit related to U.S. NOLs. The Company maintains a valuation allowance on its net U.S. deferred tax assets, including the benefit of U.S. NOLs, as management cannot conclude that it is more likely than not the benefit of U.S. net deferred tax assets can be realized.

 

 

The Company has defined benefit pension plans covering eligible employees in the U.S. and certain foreign countries, and the Company provides post-retirement health care benefits to its eligible U.S. retirees and their dependents.

 

The components of net pension expense were as follows:

 

 

The components of other post-retirement benefits expense were as follows:

 

 

For the three and six months ended June 30, 2006, the Company contributed $17 million and $40 million, respectively, to its retirement plans. The Company expects to contribute approximately $70 million to its retirement plans during the second half of 2006. The contribution in the U.S. may change based on the outcome of pending funding reform legislation.

 

SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

 

 

The following table reconciles the components of the basic and diluted earnings per common share (EPS) computations:

 

 

The equivalent common shares issuable under the Company’s stock incentive plans which were excluded from the computation of diluted EPS because their effect would have been antidilutive were 55 million and 100 million for the second quarter of 2006 and 2005, respectively, and 51 million and 44 million for the first six months of 2006 and 2005, respectively. Also, at June 30, 2006 and 2005, 76 million and 75 million, respectively, of common shares obtainable upon conversion of the Company’s 6 percent Mandatory Convertible Preferred Stock were excluded from the computation of diluted earnings per share because their effect would have been antidilutive.

 

 

Comprehensive income/(loss) is comprised of the following:

 

 

SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

 

 

Inventories consisted of the following:

 

 

 

The components of other intangible assets, net are as follows:

 

 

These intangible assets are amortized on the straight-line method over their respective useful lives. The residual value of intangible assets is estimated to be zero. Amortization expense for the three and six months ended June 30, 2006 was $13 million and $24 million, respectively, and $14 million and $25 million for the three and six months ended June 30, 2005, respectively. Annual amortization expenses related to these intangible assets for the years 2007 to 2012 is expected to be approximately $50 million.

 

 

Short-term borrowings primarily consist of bank loans and commercial paper. Short-term borrowings at June 30, 2006 and December 31, 2005 totaled $430 million and $1.3 billion, respectively.

 

 

The Company has three reportable segments: Prescription Pharmaceuticals, Consumer Health Care and Animal Health. The segment sales and profit data that follow are consistent with the Company’s current management reporting structure. The Prescription Pharmaceuticals segment discovers, develops, manufactures and markets human pharmaceutical products. The Consumer Health Care segment develops, manufactures and markets over-the-counter, foot care and sun care products, primarily in the U.S. The Animal Health segment discovers, develops, manufactures and markets animal health products.

 

SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

 

Net sales by segment:

 

 

Profit by segment:

 

 

Schering-Plough’s net sales do not include sales of VYTORIN and ZETIA that are marketed in the partnership with Merck, as the Company accounts for this joint venture under the equity method of accounting (see Note 3, “Equity Income From Cholesterol Joint Venture,” for additional information). The Prescription Pharmaceuticals segment includes equity income from the cholesterol joint venture.

 

“Corporate and other” includes interest income and expense, foreign exchange gains and losses, headquarters expenses, special charges and other miscellaneous items. The accounting policies used for segment reporting are the same as those described in Note 1, “Summary of Significant Accounting Policies,” in the Company’s 2005 10-K.

 

For the three and six months ended June 30, 2006, “Corporate and other” included special charges of $80 million related to the changes to the Company’s manufacturing operations in the U.S. and Puerto Rico announced in June 2006, all of which related to the Prescription Pharmaceuticals segment (see Note 2, “Special Charges and Manufacturing Streamlining,” for additional information).

 

For the three and six months ended June 30, 2005, “Corporate and other” included special charges of $259 million and $286 million, respectively, primarily related to an increase in litigation reserves for the Massachusetts investigation (see Note 15, “Legal, Environmental and Regulatory Matters,” for additional information) with the majority of the remaining amount related to charges as a result of the consolidation of the Company’s U.S. biotechnology organizations. It is estimated that special charges of $259 million for the three months ended June 30, 2005 related to the Prescription Pharmaceuticals segment. Special charges for the six months ended June 30, 2005 is estimated to be as follows: Prescription Pharmaceuticals — $282 million, Consumer Health Care — $2 million, Animal Health — $1 million and Corporate and other — $1 million.

 

SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

 

Sales of products comprising 10 percent or more of the Company’s U.S. or international sales for the three and six months ended June 30, 2006, were as follows:

 

 

The Company does not disaggregate assets on a segment basis for internal management reporting and, therefore, such information is not presented.

 

 

In May 2002, the Company agreed with the FDA to the entry of a Consent Decree to resolve issues related to compliance with current Good Manufacturing Practices (cGMP) at certain of the Company’s facilities in New Jersey and Puerto Rico (the “Consent Decree” or the “Decree”).

 

In summary, the Decree required the Company to make payments totaling $500 million in two equal installments of $250 million, which were paid in 2002 and 2003. In addition, the Decree required the Company to complete revalidation programs for manufacturing processes used to produce bulk active pharmaceutical ingredients and finished drug products at the covered facilities, as well as to implement a comprehensive cGMP Work Plan for each such facility. The Decree required the foregoing to be completed in accordance with strict schedules, and provided for possible imposition of additional payments in the event the Company did not adhere to the approved schedules. Final completion of the work was made subject to certification by independent experts, whose certifications were in turn made subject to FDA acceptance.

 

Although the Company has reported to the FDA that it has completed both the revalidation programs and the cGMP Work Plan, third party certification of the Work Plan is still pending. It is possible that the third party expert may not certify the completion of a Work Plan Significant Step or that the FDA may disagree with the expert’s certification. In such an event, it is possible that FDA may assess additional payments as permitted under the Decree, and as described in more detail below.

 

In general, the cGMP Work Plan contained 212 Significant Steps whose timely and satisfactory completion are subject to payments of $15 thousand per business day for each deadline missed. These payments may not exceed $25 million for 2002, and $50 million for each of the years 2003, 2004 and 2005. These payments are subject to an overall cap of $175 million. The Company would expense any such additional payments assessed under the Decree if and when incurred.

 

Under the terms of the Decree, provided that the FDA has not notified the Company of a significant violation of FDA law, regulations, or the Decree in the five year period since the Decree’s entry, May 2002 through May 2007, the Company may petition the court to have the Decree dissolved and the FDA will not oppose the Company’s petition.

 

SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

 

 

Background

 

The Company is involved in various claims, investigations and legal proceedings.

 

The Company records a liability for contingencies when it is probable that a liability has been incurred and the amount can be reasonably estimated. The Company adjusts its liabilities for contingencies to reflect the current best estimate of probable loss or minimum liability as the case may be. Where no best estimate is determinable, the company records the minimum amount within the most probable range of its liability. Expected insurance recoveries have not been considered in determining the amounts of recorded liabilities for environmental-related matters.

 

If the Company believes that a loss contingency is reasonably possible, rather than probable, or the amount of loss cannot be estimated, no liability is recorded. However, where a liability is reasonably possible, disclosure of the loss contingency is made.

 

The Company reviews the status of all claims, investigations and legal proceedings on an ongoing basis, including related insurance coverages. From time to time, the Company may settle or otherwise resolve these matters on terms and conditions management believes are in the best interests of the Company. Resolution of any or all claims, investigations and legal proceedings, individually or in the aggregate, could have a material adverse effect on the Company’s results of operations, cash flows or financial condition.

 

Resolution (including settlements) of matters of the types set forth in the remainder of this Note, and in particular under Investigations, frequently involve fines and penalties of an amount that would be material to its results of operations, cash flows or financial condition. Resolution of such matters may also involve injunctive or administrative remedies that would adversely impact the business such as exclusion from government reimbursement programs, which in turn would have a material adverse impact on the business, future financial condition, cash flows or the results of operations. There are no assurances that the Company will prevail in any of the matters discussed in the remainder of this Note, that settlements can be reached on acceptable terms (including the scope of the release provided and the absence of injunctive or administrative remedies that would adversely impact the business such as exclusion from government reimbursement programs) or in amounts that do not exceed the amounts reserved. Even if an acceptable settlement were to be reached, there can be no assurance that further investigations or litigations will not be commenced raising similar issues, potentially exposing the Company to additional material liabilities. The outcome of the matters discussed below under Investigations could include the commencement of civil and/or criminal proceedings involving the imposition of substantial fines, penalties and injunctive or administrative remedies, including exclusion from government reimbursement programs. Total liabilities reserved reflect an estimate (and in the case of the Investigations, a current estimate of the liability), and any final settlement or adjudication of any of these matters could possibly be less than, or could materially exceed the liabilities recorded in the financial statements and could have a material adverse impact on the Company’s financial condition, cash flows or operations. Further, the Company cannot predict the timing of the resolution of these matters or their outcomes.

 

Except for the matters discussed in the remainder of this Note, the recorded liabilities for contingencies at June 30, 2006, and the related expenses incurred during the three and six months ended June 30, 2006, were not material. In the opinion of management, based on the advice of legal counsel, the ultimate outcome of these matters, except matters discussed in the remainder of this Note, will not have a material impact on the Company’s results of operations, cash flows or financial condition.

 

SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

 

Patent Matters

 

DR. SCHOLL’S FREEZE AWAY Patent.  On July 26, 2004, OraSure Technologies filed an action in the U.S. District Court for the Eastern District of Pennsylvania alleging patent infringement by Schering-Plough HealthCare Products by its sale of DR. SCHOLL’S FREEZE AWAY wart removal product. The complaint seeks a permanent injunction and unspecified damages, including treble damages.

 

Investigations

 

Massachusetts Investigation.  The U.S. Attorney’s Office for the District of Massachusetts is investigating a broad range of the Company’s sales, marketing and clinical trial practices and programs along with those of Warrick Pharmaceuticals (Warrick), the Company’s generic subsidiary. The investigation is focused on the following alleged practices: providing remuneration to managed care organizations, physicians and others to induce the purchase of Schering pharmaceutical products; off-label marketing of drugs; and submitting false pharmaceutical pricing information to the government for purposes of calculating rebates required to be paid to the Medicaid program. The Company is cooperating with this investigation.

 

The outcome of this investigation could include the commencement of civil and/or criminal proceedings involving the imposition of substantial fines, penalties and injunctive or administrative remedies, including exclusion from government reimbursement programs. The Company has recorded a liability of $500 million related to this investigation as well as the investigations described below under “AWP Investigations” and the state litigation described below under “AWP Litigation.” If the Company is not able to reach a settlement at the current estimate, the resolution of this matter could have a material adverse impact on the Company’s results of operations (beyond what has been reflected to date if the Company is not able to reach a settlement at the current estimate), cash flows, financial condition and/or its business.

 

AWP Investigations.  The Company continues to respond to existing and new investigations by the Department of Health and Human Services, the Department of Justice and several states into industry and Company practices regarding average wholesale price (AWP). These investigations relate to whether the AWP used by pharmaceutical companies for certain drugs improperly exceeds the average prices paid by providers and, as a consequence, results in unlawful inflation of certain government drug reimbursements that are based on AWP. The Company is cooperating with these investigations. The outcome of these investigations could include the imposition of substantial fines, penalties and injunctive or administrative remedies.

 

NITRO-DUR Investigation.  In August 2003, the Company received a civil investigative subpoena issued by the Office of Inspector General of the U.S. Department of Health and Human Services, seeking documents concerning the Company’s classification of NITRO-DUR for Medicaid rebate purposes, and the Company’s use of nominal pricing and bundling of product sales. The Company is cooperating with the investigation. It appears that the subpoena is one of a number addressed to pharmaceutical companies concerning an inquiry into issues relating to the payment of government rebates.

 

Pricing Matters

 

AWP Litigation.  The Company continues to respond to existing and new litigation by certain states and private payors into industry and Company practices regarding average wholesale price (AWP). These litigations relate to whether the AWP used by pharmaceutical companies for certain drugs improperly exceeds the average prices paid by providers and, as a consequence, results in unlawful inflation of certain reimbursements for drugs by state programs and private payors that are based on AWP. The complaints allege violations of federal and state law, including fraud, Medicaid fraud and consumer protection violations, among other claims. In the majority of cases, the plaintiffs are seeking class certifications. In some cases, classes have

 

SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

been certified. The outcome of these litigations could include substantial damages, the imposition of substantial fines, penalties and injunctive or administrative remedies.

 

Securities and Class Action Litigation

 

Federal Securities Litigation.  Following the Company’s announcement that the FDA had been conducting inspections of the Company’s manufacturing facilities in New Jersey and Puerto Rico and had issued reports citing deficiencies concerning compliance with current Good Manufacturing Practices, several lawsuits were filed against the Company and certain named officers. These lawsuits allege that the defendants violated the federal securities law by allegedly failing to disclose material information and making material misstatements. Specifically, they allege that the Company failed to disclose an alleged serious risk that a new drug application for CLARINEX would be delayed as a result of these manufacturing issues, and they allege that the Company failed to disclose the alleged depth and severity of its manufacturing issues. These complaints were consolidated into one action in the U.S. District Court for the District of New Jersey, and a consolidated amended complaint was filed on October 11, 2001, purporting to represent a class of shareholders who purchased shares of Company stock from May 9, 2000 through February 15, 2001. The complaint seeks compensatory damages on behalf of the class. The Court certified the shareholder class on October 10, 2003. Discovery is ongoing.

 

Shareholder Derivative Actions.  Two lawsuits were filed in the U.S. District Court for the District of New Jersey, against the Company, certain officers, directors and a former director seeking damages on behalf of the Company, including disgorgement of trading profits made by defendants allegedly obtained on the basis of material non-public information. The complaints allege a failure to disclose material information and breach of fiduciary duty by the directors, relating to the FDA inspections and investigations into the Company’s pricing practices and sales, marketing and clinical trials practices. These lawsuits are shareholder derivative actions that purport to assert claims on behalf of the Company. The two shareholder derivative actions pending in the U.S. District Court for the District of New Jersey were consolidated into one action on August 20, 2001, which is in its very early stages.

 

ERISA Litigation.  On March 31, 2003, the Company was served with a putative class action complaint filed in the U.S. District Court in New Jersey alleging that the Company, retired Chairman, CEO and President Richard Jay Kogan, the Company’s Employee Savings Plan (Plan) administrator, several current and former directors, and certain corporate officers (Messrs. LaRosa and Moore) breached their fiduciary obligations to certain participants in the Plan. The complaint seeks damages in the amount of losses allegedly suffered by the Plan. The complaint was dismissed on June 29, 2004. The plaintiffs appealed. On August 19, 2005, the U.S. Court of Appeals for the Third Circuit reversed the dismissal by the District Court and the matter has been remanded back to the District Court for further proceedings.

 

K-DUR Antitrust Litigation.  K-DUR is Schering-Plough’s long-acting potassium chloride product supplement used by cardiac patients. Following the commencement of the FTC administrative proceeding described below, alleged class action suits were filed in federal and state courts on behalf of direct and indirect purchasers of K-DUR against Schering-Plough, Upsher-Smith, Inc. (Upsher-Smith) and ESI Lederle, Inc. (Lederle). These suits claim violations of federal and state antitrust laws, as well as other state statutory and common law causes of action. These suits seek unspecified damages. Discovery is ongoing.

 

Antitrust Matters

 

K-DUR.  Schering-Plough had settled patent litigation with Upsher-Smith and Lederle, which had related to generic versions of K-DUR for which Lederle and Upsher Smith had filed Abbreviated New Drug Applications (ANDAs). On April 2, 2001, the FTC started an administrative proceeding against Schering-Plough, Upsher-Smith and Lederle alleging anti-competitive effects from those settlements. The administrative

 

SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

law judge issued a decision that the patent litigation settlements complied with the law in all respects and dismissed all claims against the Company. The FTC Staff appealed that decision to the full Commission. The full Commission reversed the decision of the administrative law judge ruling that the settlements did violate the antitrust laws. The full Commission issued a cease and desist order imposing various injunctive restraints. The federal court of appeals set aside the Commission ruling and vacated the cease and desist order. On August 29, 2005, the FTC filed a petition seeking a hearing by the U.S. Supreme Court. The Supreme Court denied the petition on June 26, 2006.

 

Pending Administrative Obligations

 

In connection with the settlement of an investigation with the U.S. Department of Justice and the U.S. Attorney’s Office for the Eastern District of Pennsylvania, the Company entered into a five-year corporate integrity agreement (CIA). As disclosed in Note 14, “Consent Decree,” the Company is subject to obligations under a Consent Decree with the FDA. Failure to comply with the obligations under the CIA or the Consent Decree can result in financial penalties.

 

Other Matters

 

Biopharma Contract Dispute.  Biopharma S.r.l. filed a claim in the Civil Court of Rome on July 21, 2004 (docket No. 57397/2004, 9^th Chamber) against certain Schering-Plough subsidiaries. The Complaint alleges that the Company did not fulfill its duties under distribution and supply agreements between Biopharma and a Schering-Plough subsidiary for distribution by Schering-Plough of generic products manufactured by Biopharma to hospitals and to pharmacists in France. This matter was settled with no material impact on the Company’s financial statements and the claim was withdrawn on July 19, 2006.

 

Tax Matters

 

In October 2001, IRS auditors asserted that two interest rate swaps that the Company entered into with an unrelated party should be recharacterized as loans from affiliated companies, resulting in additional tax liability for the 1991 and 1992 tax years. In September 2004, the Company made payments to the IRS in the amount of $194 million for income tax and $279 million for interest. The Company filed refund claims for the tax and interest with the IRS in December 2004. Following the IRS’s denial of the Company’s claims for a refund, the Company filed suit in May 2005 in the U.S. District Court for the District of New Jersey for refund of the full amount of the tax and interest. This refund litigation is currently in the discovery phase. The Company’s tax reserves were adequate to cover the above mentioned payments.

 

Environmental

 

The Company has responsibilities for environmental cleanup under various state, local and federal laws, including the Comprehensive Environmental Response, Compensation and Liability Act, commonly known as Superfund. At several Superfund sites (or equivalent sites under state law), the Company is alleged to be a potentially responsible party (PRP). The Company believes that it is remote at this time that there is any material liability in relation to such sites. The Company estimates its obligations for cleanup costs for Superfund sites based on information obtained from the federal Environmental Protection Agency (EPA), an equivalent state agency and/or studies prepared by independent engineers, and on the probable costs to be paid by other PRPs. The Company records a liability for environmental assessments and/or cleanup when it is probable a loss has been incurred and the amount can be reasonably estimated.

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and Shareholders of Schering-Plough Corporation:

 

We have reviewed the accompanying condensed consolidated balance sheet of Schering-Plough Corporation and subsidiaries (the “Corporation”) as of June 30, 2006, and the related statements of condensed consolidated operations for the three and six-month periods ended June 30, 2006 and 2005, and the statements of condensed consolidated cash flows for the six-month periods ended June 30, 2006 and 2005. These interim financial statements are the responsibility of the Corporation’s management.

 

We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

 

Based on our reviews, we are not aware of any material modifications that should be made to such condensed consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.

 

We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Schering-Plough Corporation and subsidiaries as of December 31, 2005, and the related statements of consolidated operations, stockholders’ equity, and cash flows for the year then ended (not presented herein); and in our report dated February 28, 2006, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 2005 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

 

As discussed in Note 4 to the condensed consolidated financial statements, effective January 1, 2006, the Corporation adopted Statement of Financial Accounting Standards No. 123 (Revised 2004), “Share-Based Payment”.

 

/s/ Deloitte & Touche LLP

 

Parsippany, New Jersey
July 28, 2006

 

 

EXECUTIVE OVERVIEW

 

Overview of the Company

 

Schering-Plough (the Company) discovers, develops, manufactures and markets medical therapies and treatments to enhance human health. The Company also markets leading consumer brands in the over-the-counter (OTC), foot care and sun care markets and operates a global animal health business.

 

As a research-based pharmaceutical company, a core strategy of Schering-Plough is to invest substantial funds in scientific research with the goal of creating therapies and treatments with important medical and commercial value. Consistent with this core strategy, the Company has been increasing its investment in research and development, and this trend is expected to continue at historic levels or greater. Research and development activities focus on mechanisms to treat serious diseases. There is a high rate of failure inherent in such research and, as a result, there is a high risk that the funds invested in research programs will not generate financial returns. This risk profile is compounded by the fact that this research has a long investment cycle. To bring a pharmaceutical compound from the discovery phase to the commercial phase may take a decade or more.

 

There are two sources of new products: products acquired through acquisition and licensing arrangements, and products in the Company’s late-stage research pipeline. With respect to acquisitions and licensing, there are limited opportunities for obtaining or licensing critical late-stage products, and these limited opportunities typically require substantial amounts of funding. The Company competes for these opportunities against companies often with greater financial resources. Accordingly, it may be challenging for the Company to acquire or license critical late-stage products that will have a positive material financial impact.

 

The Company supports commercialized products with manufacturing, sales and marketing efforts. The Company is also moving forward with additional investments to enhance its infrastructure and business, including capital expenditures for the development process, where products are moved from the drug discovery pipeline to markets, information technology systems, and post-marketing studies and monitoring.

 

Certain past events remain relevant to understand the Company’s current challenges. These events include but were not limited to, entering into a formal Consent Decree with the FDA in 2002 and the investigations related to certain of the Company’s sales and marketing practices by the U.S. Attorney’s Office for the District of Massachusetts.

 

Beginning in April 2003, the Board of Directors named Fred Hassan as the new Chairman of the Board and Chief Executive Officer of Schering-Plough Corporation. Under his leadership, a new leadership team was recruited and a six- to eight-year, five-phase Action Agenda was formulated with the goal of stabilizing, repairing and turning around the Company. In October 2005, the Company announced that it entered the third phase of the Action Agenda, the Turnaround phase.

 

The Company’s financial situation continues to improve, as discussed below. The Company’s cholesterol franchise products, VYTORIN and ZETIA, are the primary drivers of this improvement. ZETIA is the Company’s novel cholesterol absorption inhibitor. VYTORIN is the combination of ZETIA and Zocor, Merck & Co., Inc.’s (Merck) statin medication. These two products have been launched through a joint venture between the Company and Merck. ZETIA (ezetimibe), marketed in Europe as EZETROL, is marketed for use either by itself or together with statins for the treatment of elevated cholesterol levels. VYTORIN (ezetimibe/simvastatin), marketed as INEGY internationally, has been launched in more than 35 countries and ZETIA/EZETROL in more than 80 countries.

 

The Company currently expects its cholesterol franchise to continue to grow. The financial commitment to compete in the cholesterol reduction market is shared with Merck and profits from the sales of VYTORIN and ZETIA are also shared with Merck. The operating results of the joint venture with Merck are recorded using the equity method of accounting. Outside of the joint venture with Merck, in the Japanese market, Bayer Healthcare will co-market the Company’s cholesterol-absorption inhibitor, ZETIA, upon approval. Due to a backlog of new drug applications in Japan, the Company cannot precisely predict the timing of this approval.

The cholesterol-reduction market is the single largest pharmaceutical category in the world. VYTORIN and ZETIA are competing in this market, and on a combined basis, these products have continued to grow in terms of market share during 2006. As a franchise, the two products together have captured more than 15 percent of both new and total prescriptions in the U.S. cholesterol management market (based on June 2006 IMS data). The Company believes that total prescription data is a better measure of market share during this period of generic introductions.

 

During 2005 and 2006, the Company’s results of operations and cash flows have been driven significantly by the performance of VYTORIN and ZETIA. As a result, the Company’s ability to generate profits is predominantly dependent upon the performance of the VYTORIN and ZETIA cholesterol franchise, which dependence is expected to continue for some time. For the three and six months ended June 30, 2006, equity income from the cholesterol joint venture was $355 million and $666 million, respectively, and net income available to common shareholders was $237 million and $587 million, respectively. Additional information regarding the joint venture with Merck is also included in Note 3, “Equity Income from Cholesterol Joint Venture,” in this 10-Q. Although it is expected that operating cash flow and existing cash and short-term investments will fund the Company’s operations for the intermediate term, as discussed in more detail below, future cash flows are also dependent upon the performance of VYTORIN and ZETIA. The Company must generate profits and cash flows to maintain and enhance its infrastructure and business as discussed above.

 

Sales of VYTORIN and ZETIA may be impacted by the introduction of new innovative competing treatments and generic versions of existing products. Currently, the U.S. cholesterol lowering market is adjusting to the entry into the market of generic forms of Zocor and generic forms of Pravachol. The Company cannot reasonably predict what effect the introduction of generic forms of cholesterol management products may have on VYTORIN and ZETIA, although the decisions of government entities, managed care groups and other groups concerning formularies and reimbursement policies could potentially negatively impact the dollar size and/or growth of the cholesterol management market, including VYTORIN and ZETIA. A material change in the sales or market share of VYTORIN and ZETIA would have a significant impact on the Company’s operations and cash flow.

 

REMICADE is prescribed for the treatment of immune-mediated inflammatory disorders such as rheumatoid arthritis, early rheumatoid arthritis, psoriatic arthritis, Crohn’s disease, ankylosing spondylitis, plaque psoriasis and ulcerative colitis. REMICADE is the Company’s second largest marketed pharmaceutical product line (after the cholesterol franchise). This product is licensed from and manufactured by Centocor, Inc., a Johnson & Johnson company. The Company has the exclusive marketing rights to this product outside of the U.S., Japan, and certain Asian markets. During 2005, the Company exercised an option under its contract with Centocor for license rights to develop and commercialize golimumab, a fully human monoclonal antibody, in the same territories as REMICADE. Golimumab is currently in Phase III trials. Centocor believes these rights to golimumab expire in 2014, while the Company believes these rights extend beyond 2014. The parties are working together to move forward with their collaboration on golimumab, and steps are being taken to resolve the difference of opinion as to the expiration date.

 

As is typical in the pharmaceutical industry, the Company licenses manufacturing, marketing and/or distribution rights to certain products to others, and also manufactures, markets and/or distributes products owned by others pursuant to licensing and joint venture arrangements. Any time that third parties are involved, there are additional factors relating to the third party and outside the control of the Company that may create positive or negative impacts on the Company. VYTORIN, ZETIA and REMICADE are subject to such arrangements and are key to the Company’s current business and financial performance.

 

In addition, any potential strategic alternatives may be impacted by the change of control provisions in those arrangements, which could result in VYTORIN and ZETIA being acquired by Merck or REMICADE reverting back to Centocor. The change in control provision relating to VYTORIN and ZETIA is included in the contract with Merck, filed as Exhibit 10(q) to the Company’s 10-K, and the change of control provision relating to REMICADE is contained in the contract with Centocor, filed as Exhibit 10(u) to the Company’s 10-K.

Current State of the Business

 

Net sales in the second quarter of 2006 were $2.8 billion or 11 percent higher than the second quarter of 2005. As discussed below, the sales increase was driven primarily by the growth of REMICADE, NASONEX, and PEG-INTRON. The sales growth included a 1 percent unfavorable impact from foreign exchange.

 

The Company had net income available to common shareholders of $237 million and $587 million, respectively, for the three and six months ended June 30, 2006 as compared to a net loss of $70 million in the second quarter of 2005 and net income of $35 million for the first six months of 2005. The net income available to common shareholders for the three and six months ended June 30, 2006 included charges totaling $138 million related to actions to streamline the Company’s manufacturing operations. The six months ended June 30, 2006 included an income item of $22 million resulting from the cumulative effect of a change in accounting principle, net of tax, related to the implementation of SFAS 123R related to stock-based compensation. For the three and six months ended June 30, 2005, net income available to common shareholders included special charges of $259 million (see Note 2, “Special Charges and Manufacturing Streamlining,” for additional information).

 

Many of the Company’s manufacturing sites operate below capacity. The Company’s manufacturing sites subject to the Consent Decree remained open while the Company was performing its revalidation and cGMP Work Plan obligations under decree. However, the Consent Decree work placed significant additional controls on production and release of products from these sites, which increased costs and slowed production and led to a reduction in the product mix at the sites. Further, the Company’s research and development operations were negatively impacted by the Consent Decree because these operations share common facilities with the manufacturing operations. Although certain costs, such as those associated with third party certifications, are decreasing as the Company goes through the process of certifying the Work Plan, other financial impacts will continue, such as the costs of the new processes that will continue to be used and the reduced product mix and volumes at the sites.

 

Pursuant to the Company’s continuing work to enhance long-term competitiveness, on June 1, 2006, the Company announced plans to close manufacturing facilities in Manati, Puerto Rico and additional changes to its manufacturing operations in Puerto Rico and New Jersey that will streamline its global supply chain (see Note 2, “Special Charges and Manufacturing Streamlining,” and Discussion of Operating Results for additional information).

 

The Company continually reviews the business, including manufacturing operations, to identify actions that will enhance long-term competitiveness. However, the Company’s manufacturing cost base is relatively fixed, and actions to significantly reduce the Company’s manufacturing infrastructure involve complex issues. As a result, shifting products between manufacturing plants can take many years due to construction and regulatory requirements, including revalidation and registration requirements. The Company continues to review the carrying value of manufacturing assets for indications of impairment. Future events and decisions may lead to additional asset impairments or related costs.

 

During 2005, the Company repatriated approximately $9.4 billion of previously unremitted foreign earnings at a reduced tax rate as provided by the American Jobs Creation Act of 2004 (AJCA). Repatriating funds under the AJCA benefited the Company by allowing the Company to fund U.S. cash needs while preserving U.S. NOLs.

 

DISCUSSION OF OPERATING RESULTS

 

Net Sales

 

A significant portion of net sales is made to major pharmaceutical and health care products distributors and major retail chains in the U.S. Consequently, net sales and quarterly growth comparisons may be affected by fluctuations in the buying patterns of major distributors, retail chains and other trade buyers. These fluctuations may result from seasonality, pricing, wholesaler buying decisions or other factors.

Consolidated net sales for the three months ended June 30, 2006 totaled $2.8 billion, an increase of $286 million or 11 percent compared with the same period in 2005. For the six months ended June 30, 2006, consolidated net sales totaled $5.4 billion, an increase of $469 million or 10 percent as compared to the same period in 2005. Consolidated net sales for the three and six months ended June 30, 2006 reflected higher volumes tempered by an unfavorable impact from foreign exchange of 1 percent and 3 percent, respectively.

 

Net sales for the three and six months ended June 30, 2006 and 2005 were as follows: