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PAR PHARMACEUTICAL COMPANIES, INC. - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) Forward-Looking Statements Certain statements in this Quarterly Report constitute "forward-looking statements" within the meaning of securities laws, including those concerning management's expectations with respect to future financial performance, trends and future events, particularly relating to sales of current products and the development, approval and introduction of new products. To the extent that any statements made in this Quarterly Report contain information that is not historical, such statements should be considered forward-looking. These statements are often, but not always, made using words such as "estimates," "plans," "projects," "anticipates," "continuing," "ongoing," "expects," "intends," "believes," "forecasts" or similar words and phrases. Such forward-looking statements are subject to known and unknown risks, uncertainties and contingencies, many of which are beyond our control, which could cause actual results and outcomes to differ materially from those expressed in this Quarterly Report. These forward-looking statements are based on our current expectations, plans and assumptions that we have made in light of our experience in the industry, as well as our perceptions of historical trends, current conditions, expected future developments and other factors we believe are appropriate under the circumstances and at the time such statements were made. Although we believe that these forward-looking statements are based on reasonable assumptions, you should be aware that many factors (including the factors discussed under "Risk Factors" in our reports previously filed with the Securities and Exchange Commission and other reports we may make available from time to time) could affect our actual financial results or results of operations and could cause actual results to differ materially from those expressed in the forward-looking statements. Caution should be taken with respect to such statements, and you should not place undue reliance on any such forward-looking statements. Any forward-looking statements included in this Quarterly Report are made as of the date of this Quarterly Report only, and, we assume no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise. The following discussion should be read in conjunction with our Condensed Consolidated Financial Statements and related Notes to Condensed Consolidated Financial Statements contained elsewhere in this Quarterly Report. MERGER OVERVIEW Par Pharmaceutical Companies, Inc. (the "Company," "we," "us" or "our") was acquired on September 28, 2012 through a merger transaction with Sky Growth Acquisition Corporation, a wholly-owned subsidiary of Sky Growth Holdings Corporation ("Holdings"). Holdings and its subsidiaries were formed by investment funds affiliated with TPG Capital, L.P. ("TPG" and, together with certain affiliated entities, collectively, the "Sponsor"). The acquisition was accomplished through a reverse subsidiary merger of Sky Growth Acquisition Corporation with and into the Company, with the Company being the surviving entity (the "Merger"). Subsequent to the Merger, we became an indirect, wholly owned subsidiary of Holdings. After that time, we continued our operations as a specialty generic pharmaceutical company, except that we ceased to be a public company, and our common stock ceased to be traded on The New York Stock Exchange. Holdings is a holding company with no operations of its own and has no ability to service interest or principal payments other than through any dividends it may receive from the Company. To finance the Merger, the Sponsor arranged for an offering of $490,000 thousand in aggregate principal amount of 7.375% Senior Notes due 2020 (the "Notes") by Sky Growth Acquisition Corporation. The proceeds from the Notes offering, together with the proceeds of our new senior secured credit facilities described below (the "Senior Credit Facilities"), the cash equity contributions by the Sponsor and the Company's cash on hand, were used to fund the consummation of the Merger, the repayment of certain outstanding indebtedness of the Company (Predecessor) and the payment of related fees and expenses. The Senior Credit Facilities were comprised of a $1,442 million senior secured term loan ("Term Loan Facility") and a $150 million senior secured revolving credit facility ("Revolving Facility") at June 30, 2014. We filed a Form S-4 Registration Statement to exchange our unregistered Notes issued in connection with the Merger for Notes that are registered with the SEC. Our Form S-4 Registration Statement was declared effective as of August 27, 2013. The exchange offer closed on September 30, 2013 and 100% of our Notes issued in connection with the Merger were tendered and exchanged for registered Notes. The Merger had a significant impact on our financial condition and our results of operations are significantly different after September 28, 2012. For instance, as a result of the Merger, our borrowings and interest expense significantly increased. Also, the application of acquisition method accounting as a result of the Merger required that our assets and liabilities be adjusted to their fair value, which resulted in an increase in our depreciation and amortization expense. Excess of purchase price over the fair value of our net assets and identified intangible assets was allocated to goodwill. Further, the Merger impacted our organizational structure. These changes to our organizational structure and the impact of the Merger discussed above could significantly affect our income tax expense. COMPANY OVERVIEW Par Pharmaceutical Companies, Inc. operates primarily in the United States as two business segments, our generic products division ("Par Pharmaceutical" or "Par") engaged in the development, manufacture and distribution of generic pharmaceuticals, and Strativa Pharmaceuticals ("Strativa"), our branded products division. The introduction of new products at prices that generate adequate gross margins is critical to our ability to generate economic value and ultimately the creation of adequate returns for our owners. Par Pharmaceutical, our generic products division, creates economic value by optimizing our current generic product portfolio and our pipeline of potential high-value first-to-file and first-to- 41 -------------------------------------------------------------------------------- market generic products. When an abbreviated new drug application ("ANDA") is filed with the FDA for approval as a generic equivalent of a brand drug, the filer must certify that (i) no patents are listed with the FDA covering the corresponding brand product, (ii) the listed patents have expired, (iii) any patent listed with the FDA as covering the brand product is about to expire, in which case the ANDA will not become effective until the expiration of such patent, or (iv) the patent listed as covering the brand drug is invalid or will not be infringed by the manufacture, sale or use of the new drug for which the ANDA is filed (commonly known as a "Paragraph IV" certification). We and our development partners seek to be the first to file an ANDA containing a Paragraph IV certification (a "first-to-file" ANDA) or ANDAs that will otherwise allow us to introduce the first generic version of a brand product (a "first-to-market" product), because the first generic manufacturer to receive regulatory approval from the FDA for a generic version of a particular brand product is often able to capture a substantial share of the generic market. Our branded products division, Strativa Pharmaceuticals, seeks to acquire, develop, manufacture and distribute niche, proprietary pharmaceutical products. Our existing branded products are Nascobal® Nasal Spray and Megace® ES. Recent Developments On February 20, 2014, we completed our acquisition of JHP Group Holdings, Inc. and its subsidiaries (collectively, "JHP"), a privately-held, specialty sterile products pharmaceutical company. The acquisition was accomplished through a reverse subsidiary merger of an indirect subsidiary of the Company with and into JHP Group Holdings, Inc., in which JHP Group Holdings, Inc. was the surviving entity and became an indirect, wholly owned subsidiary of the Company (the "JHP Acquisition"). The consideration for the JHP Acquisition consisted of $488 million in cash, subject to certain customary working capital adjustments. The Company financed the JHP Acquisition with proceeds received in connection with the debt financing provided by third party lenders of $395 million and an equity contribution of $110 million from certain investment funds associated with TPG. Among the primary reasons we acquired JHP and the factors that contributed to the preliminary recognition of goodwill were the JHP Acquisition immediately expanded our presence into the rapidly growing market for injectables and other sterile products, such as ophthalmics. The result is a broader and more diversified product portfolio, and an expanded development pipeline. With its high-barrier-to-entry products, JHP represents a complement to our strategy and product line. JHP also has a reputation for high-quality products and a strong record of regulatory compliance, which had driven its steady revenue growth prior to our acquisition. JHP operates principally through its operating subsidiary, JHP Pharmaceuticals, LLC, was renamed Par Sterile Products, LLC ("Par Sterile") subsequent to the JHP Acquisition. Par Sterile will continue its activities as a leading specialty pharmaceutical company that develops, manufactures and markets sterile injectable products. Par Sterile marketed a portfolio of 14 specialty injectable products, including Aplisol® and Adrenalin®, and had developed a pipeline of approximately 30 products, 17 of which have been submitted for approval to the U.S. Food and Drug Administration at the time of the JHP Acquisition. Par Sterile's products are predominately sold to hospitals through the wholesale distribution channel. Par Sterile targets products with limited competition due to difficulty in manufacturing and/or the product's market size. Par Sterile's manufacturing facility in Rochester, Michigan, has the capability to manufacture small-scale clinical through large-scale commercial products. Par Sterile will be reported with Par Pharmaceutical (Generics Products Division) for financial reporting purposes. Our recent achievements included significant product launches, such as digoxin, dexmethlphenidate, clonidine ER, and fenofibric acid, execution of several business development agreements, and passing all FDA inspections. Generally, products that we have developed internally contribute higher gross-margin percentages than products that we sell under supply and distribution agreements, because under such agreements, we typically pay a percentage of the gross or net profits (or a percentage of sales) to our strategic partners. In July 2011, we received a notice letter from a generic pharmaceutical manufacturer, TWi Pharmaceuticals, Inc., advising that it has filed an ANDA with the FDA containing a Paragraph IV certification referencing Megace® ES, one of our two current brand products, and we subsequently received similar notices from two other generic manufacturers. We sued the first generic filer on its challenge to U.S. Patent 7,101,576 held by our licensor, Alkermes Pharma Ireland Limited (Elan), which is the last-to-expire patent listed in the Orange Book for Megace® ES. On February 21, 2014, the U.S. District Court for the District of Maryland issued an opinion invalidating the '576 patent on obviousness grounds. We are appealing the Court's decision. The first generic filer has disclosed its intent to launch its ANDA product should it receive final FDA approval. Any such launch of a generic version of Megace® ES would have a material adverse impact on our brand sales of Megace® ES. In January 2013, we initiated a restructuring of Strativa in anticipation of entering into a settlement agreement and corporate integrity agreement that terminated the U.S Department of Justice's investigation of Strativa's marketing of Megace® ES, discussed below. We reduced our Strativa workforce by approximately 70 people, with the majority of the reductions in the sales force. The remaining Strativa sales force has been reorganized into a single sales team of approximately 60 professionals who will focus their marketing efforts principally on Nascobal® Nasal Spray. In connection with these actions, we incurred expenses for severance and other employee-related costs as well as the termination of certain contracts. On March 5, 2013, we entered into the settlement agreement with the U.S. Department of Justice. The settlement agreement provided for a payment by the Company of an aggregate amount of approximately $45 million (plus interest and fees), which we paid in the second quarter of 2013, and included a plea agreement with the New Jersey Criminal Division of the Department of Justice in which the Company admitted to a single count of misdemeanor misbranding, a civil settlement with the U.S. Department of Justice, a state settlement encompassing 49 states (one state declined to participate due to the small amount of its potential recovery), and a release from each of these entities in favor of the Company related to the practices at issue in the terminated investigation. 42 -------------------------------------------------------------------------------- Additionally, we entered into a Corporate Integrity Agreement (CIA) with the Office of the Inspector General of the United States Department of Health and Human Services (OIG). In exchange for agreeing to enter into the CIA, we received assurance that the OIG will not exercise its ability to permissively exclude the Company from doing business with the Federal government. The CIA includes such requirements as enhanced training time, enhanced monitoring of certain functions, and annual reports to the OIG through an independent review organization. Activities that are traditionally covered by a CIA that are currently dormant at the Company will not trigger additional obligations or costs unless and until we decide to engage in those activities. Although our compliance activities increased under the CIA, we believe the terms to be reasonable and not unduly burdensome. Par Pharmaceutical - Generic Products Division Our strategy for our generic products division is to continue to differentiate ourselves by carefully choosing product opportunities with expected minimal competition. We target high-value, first-to-file or first-to-market product opportunities. By leveraging our expertise in research and development, manufacturing and distribution, and business development, we are able to effectively and efficiently pursue these opportunities and support our partners. Par is an attractive business partner because of our strong commercialization track record and presence in the generic trade. Our key generic products (budesonide, bupropion ER, divalproex, propafenone, and clonidine ER) accounted for approximately 33% of total consolidated revenues and a significant percentage of total consolidated gross margins for the quarter ended June 30, 2014. We began selling divalproex, a generic version of Depakote®, in 2011 after the completion of our acquisition of Anchen Incorporated and its subsidiary Anchen Pharmaceuticals, Inc. (collectively, "Anchen"). A third party manufactures this product for us and we package the product. Our sales volume and unit price were benefited by the exit of a competitor from this market in late June 2013. Two additional competitors entered the market in the third quarter of 2013. Any disruption in supply due to manufacturing or transportation issues, as well as additional competition, could have a negative effect on our revenues and gross margins. We began selling propafenone, the generic version of Rythmol® SR, in 2011. We were awarded 180 days of marketing exclusivity for being the first to file an ANDA containing a Paragraph IV certification for this product. We manufacture and distribute this product, and, as of June 30, 2014, we believe we were the single source generic supplier for this product. The market entry of any competition to this product will result in declines in sales volume and unit price, which would negatively impact our revenues and gross margins. We began selling budesonide, the generic version of Entocort ® EC, in June 2011 as the authorized generic distributor pursuant to a supply and distribution agreement with AstraZeneca. We are one of two competitors in this market. We do not control the manufacturing of the product, and any disruption in supply due to manufacturing or transportation issues, as well as additional competition, could have a negative effect on our revenues and gross margins. On November 17, 2011, we completed our acquisition of Anchen. The Anchen assets we acquired included five marketed generic products, including bupropion ER (generic version of Wellbutrin XL®). We have multiple competitors in these markets. In October 2013, we launched clonidine ER, the generic version of Kapvay® XR, upon FDA approval of our ANDA. We had no competition in this market through June 30, 2014. In addition, our investments in generic product development, including projects with development partners, are expected to yield new ANDA filings. These ANDA filings are expected to lead to product launches based on one or more of the following: expiry of the relevant 30-month stay period; patent expiry date; and expiry of regulatory exclusivity. However, such potential product launches may be delayed or may not occur due to various circumstances, including extended litigation, outstanding citizens petitions, other regulatory requirements set forth by the FDA, and stays of litigation. These ANDA filings would be significant mileposts for us, as we expect many of these potential products to be first-to-file/first-to-market opportunities with gross margins in excess of the average of our current portfolio. As of June 30, 2014, we or our strategic partners had approximately 90 ANDAs pending with the FDA, which included approximately 34 first-to-file opportunities or potential first-to-market product opportunities. No assurances can be given that we or any of our strategic partners will successfully complete the development of any of these potential products either under development or proposed for development, that regulatory approvals will be granted for any such product, that any approved product will be produced in commercial quantities or sold profitably. Strativa Pharmaceuticals - Branded Products Division For Strativa, in the near term we plan to continue to invest in the marketing and sales of our existing products (Nascobal® Nasal Spray and Megace® ES). In addition, in the longer term, we plan to continue to consider new strategic licenses and acquisitions to expand Strativa's product portfolio. In July 2005, we received FDA approval for our first NDA and began marketing Megace® ES (megestrol acetate) oral suspension. Megace® ES is indicated for the treatment of anorexia, cachexia or any unexplained significant weight loss in patients with a diagnosis of AIDS and utilizes the Megace® brand name that we have licensed from Bristol-Myers Squibb Company. We promoted Megace® ES as our primary brand product from 2005 through March 2009. With the acquisition of Nascobal® in March 43 -------------------------------------------------------------------------------- 2009, Strativa increased its sales force and turned its focus on marketing both products. Refer to "Recent Developments" above for an update on related patent litigation. As of January 31, 2013, we reduced our Strativa workforce by approximately 70 people in anticipation of entering into a settlement agreement terminating the U.S. Department of Justice's investigation into Strativa's sales and marketing practices of Megace® ES. In connection with the settlement, the Company entered into a corporate integrity agreement with the Office of Inspector General of the U.S. Department of Health & Human Services. We expect the sales decline trend for Megace® ES experienced over the last few years as a result of an increasingly difficult reimbursement climate to continue or accelerate as the effects of the reduction of product detailing after January 31, 2013 are experienced and/or when generic competition enters this market. On March 31, 2009, we acquired the worldwide rights to Nascobal® (cyanocobalamin, USP) Nasal Spray from QOL Medical, LLC. As of March 31, 2014, our current brand field sales force of approximately 60 people are focusing the majority of their detailing efforts on Nascobal® Nasal Spray. OTHER CONSIDERATIONS Sales and gross margins of our products depend principally on (i) our ability to introduce new generic and brand products and the introduction of other generic and brand products in direct competition with our products; (ii) the ability of generic competitors to quickly enter the market after our relevant patent or exclusivity periods expire, or during our exclusivity periods with authorized generic products, diminishing the amount and duration of significant profits we generate from any one product; (iii) the pricing practices of competitors and the removal of competing products from the market; (iv) the continuation of our existing license, supply and distribution agreements and our ability to enter into new agreements; (v) the consolidation among distribution outlets through mergers, acquisitions and the formation of buying groups; (vi) the willingness of generic drug customers, including wholesale and retail customers, to switch among drugs of different generic pharmaceutical manufacturers; (vii) our ability to procure approval of ANDAs and NDAs and the timing and success of our future new product launches; (viii) our ability to obtain marketing exclusivity periods for our generic products; (ix) our ability to maintain patent protection of our brand products; (x) the extent of market penetration for our existing product line; (xi) customer satisfaction with the level, quality and amount of our customer service; and (xii) the market acceptance of our current branded products and the successful development and commercialization of any future in-licensed branded product pipeline. Net sales and gross margins derived from generic pharmaceutical products often follow a pattern based on regulatory and competitive factors that we believe to be unique to the generic pharmaceutical industry. As the patent(s) for a brand name product and the related exclusivity period(s) expire, the first generic manufacturer to receive regulatory approval from the FDA for a generic equivalent of the product is often able to capture a substantial share of the market. At that time, however, the brand company may license the right to distribute an "authorized generic" product to a competing generic company. As additional generic manufacturers receive regulatory approvals for competing products, the market share and the price of those products have typically declined - often significantly - depending on several factors, including the number of competitors, the price of the brand product and the pricing strategy of the new competitors. Net sales and gross margins derived from brand pharmaceutical products typically follow a different pattern. Sellers of brand pharmaceutical products benefit from years of being the exclusive supplier to the market due to patent protections for the brand products. The benefits include significantly higher gross margins relative to sellers of generic pharmaceutical products. However, commercializing brand pharmaceutical products is more costly than generic pharmaceutical products. Sellers of brand pharmaceutical products often have increased infrastructure costs relative to sellers of generic pharmaceutical products and make significant investments in the development and/or licensing of these products without a guarantee that these expenditures will result in the successful development or launch of brand products that will prove to be commercially successful. Selling brand products also tends to require greater sales and marketing expenses to create a market for the products than is necessary with respect to the sale of generic products. The patents protecting a brand product's sales are also subject to attack by generic competitors. Specifically, after patent protections expire, or after a successful challenge to the patents protecting one of our brand products, generic products can be sold in the market at a significantly lower price than the branded version, and, where available, may be required or encouraged in preference to the branded version under third party reimbursement programs, or substituted by pharmacies for branded versions by law. In addition to the substantial costs and uncertainty of product development, we typically incur significant legal costs in bringing certain generic products to market. Litigation concerning patents and proprietary rights is often protracted and expensive. Pharmaceutical companies with patented brand products routinely sue companies that seek approval to produce generic forms of their products for alleged patent infringement or other violations of intellectual property rights, which delays and may prevent the entry of such generic products into the market. In the case of an ANDA filed with a Paragraph IV certification, the overwhelming majority are subject to litigation by the brand company, because bringing suit triggers a 30-month statutory delay of FDA approval of the ANDA. Because the major portion of our current business involves the development, approval and sale of generic versions of brand products, many with a Paragraph IV certification, the threat of litigation, the outcome of which is inherently uncertain, is always present. Such litigation is often costly and time-consuming, and could result in a substantial delay in, or prevent, the introduction and/or marketing of our generic products, which could have a material adverse effect on our business, financial condition, prospects and results of operations. 44 -------------------------------------------------------------------------------- RESULTS OF OPERATIONS Results of operations, including segment net revenues, segment gross margin and segment operating loss information for our Par Generic Products segment and our Strativa Branded Products segment, consisted of the following: Revenues Total revenues of our top selling products were as follows: Three months ended Six months ended June 30, June 30, ($ amounts in thousands) 2014 June 30, 2013 $ Change 2014 June 30, 2013 $ Change Product Par Pharmaceutical Budesonide (Entocort® EC) $ 38,266 $ 45,027 $ (6,761 ) $ 75,615 $ 95,430 $ (19,815 ) Bupropion ER (Wellbutrin XL®) 18,423 11,565 6,858 34,765 19,817 14,948 Divalproex (Depakote®) 15,511 (7,653 ) 23,164 35,917 (6,227 ) 42,144 Propafenone (Rythmol SR®) 15,266 17,337 (2,071 ) 36,377 34,496 1,881 Metoprolol succinate ER (Toprol-XL®) 12,096 13,527 (1,431 ) 26,213 32,929 (6,716 ) Clonidine ER (Kapvay®) 11,308 - 11,308 22,367 - 22,367 Lamotrigine (Lamictal XR®) 10,262 10,535 (273 ) 20,396 30,646 (10,250 ) Rizatriptan (Maxalt®) 1,597 3,466 (1,869 ) 3,795 37,014 (33,219 ) Par Sterile Products 35,544 - 35,544 49,728 - 49,728 Other 115,575 113,115 2,460 237,042 228,838 8,204 Other product related revenues 4,986 8,196 (3,210 ) 10,425 14,974 (4,549 ) Total Par Pharmaceutical Revenues $ 278,834 $ 215,115 $ 63,719 $ 552,640 $ 487,917 $ 64,723 Strativa Megace® ES $ 7,779 $ 11,018 $ (3,239 ) $ 15,932 $ 21,553 $ (5,621 ) Nascobal® Nasal Spray 8,172 6,801 1,371 14,496 13,003 1,493 Other (35 ) (236 ) 201 (46 ) (479 ) 433 Other product related revenues 655 971 (316 ) 1,467 1,871 (404 ) Total Strativa Revenues $ 16,571 $ 18,554 $ (1,983 ) $ 31,849 $ 35,948 $ (4,099 ) Three months ended Percentage of Total Revenues June 30, June 30,($ amounts in thousands) June 30, 2014 June 30, 2013 $ Change % Change 2014 2013 Revenues: Par Pharmaceutical $ 278,834 $ 215,115 $ 63,719 29.6 % 94.4 % 92.1 % Strativa 16,571 18,554 (1,983 ) (10.7 %) 5.6 % 7.9 % Total revenues $ 295,405 $ 233,669 $ 61,736 26.4 % 100.0 % 100.0 % Six months ended Percentage of Total Revenues June 30, June 30, ($ amounts in thousands) June 30, 2014 June 30, 2013 $ Change % Change 2014 2013 Revenues: Par Pharmaceutical $ 552,640 $ 487,917 $ 64,723 13.3 % 94.6 % 93.1 % Strativa 31,849 35,948 (4,099 ) (11.4 %) 5.4 % 6.9 % Total revenues $ 584,489 $ 523,865 $ 60,624 11.6 % 100.0 % 100.0 % 45-------------------------------------------------------------------------------- Par Pharmaceutical Three Months Ended June 30, 2014 v. 2013 The increase in generic segment revenues for the three months ended June 30, 2014 as compared to the prior year period was primarily due to increases in revenues of: • Par Sterile products, which were acquired in our February 20, 2014 acquisition of JHP; • divalproex, which benefited from a competitor exiting the market in June 2013 as the result of FDA compliance issues and the non-recurrence of a large contractual gross-to-net price adjustment to a major customer that occurred in the prior year; • clonidine HCl ER, which launched in the fourth quarter of 2013; • bupropion ER, which benefited from competitors that were not able to supply product to the market. The net increase in "Other" is mainly driven by the launches of fluvoxamine maleate ER in first quarter of 2013 that continues to benefit from a lack of competition in this market, fenofibric acid in the third quarter of 2013, dexmethylphenidate in the fourth quarter of 2013, and the first quarter 2014 launch of digoxin. These increases were tempered by revenue declines for modafinil, morphine, and fentanyl patch as the result of competition in each of these markets, which had a negative impact on both price and volume for each product. The increases noted above for the three months ended June 30, 2014 were tempered by decreases in the revenues of: • budesonide, principally due to price declines resulting from competition; • rizatriptan, which we launched in January 2013 as the authorized generic, declined quickly after several competitors entered this market in July 2013; • on-going competition on all SKUs (packaging sizes) of metoprolol succinate ER, which had a negative impact on both price and volume. Six Months Ended June 30, 2014 v. 2013 The increase in generic segment revenues for the six months ended June 30, 2014 as compared to the prior year period was primarily due to increases in revenues of: • Par Sterile products, which were acquired in our February 20, 2014 acquisition of JHP; • divalproex, which benefited from a competitor exiting the market in June 2013 as the result of FDA compliance issues and the non-recurrence of a large contractual gross-to-net price adjustment to a major customer that occurred in the prior year; • clonidine HCl ER, which launched in the fourth quarter of 2013; • bupropion ER, which benefited from competitors that were not able to supply product to the market. The net increase in "Other" is mainly driven by the launches of fluvoxamine maleate ER in first quarter of 2013 that continues to benefit from a lack of competition in this market, fenofibric acid in the third quarter of 2013, dexmethylphenidate in the fourth quarter of 2013, and the first quarter 2014 launch of digoxin. These increases were tempered by a revenue decline for modafinil as the result of competition, which had a negative impact on both price and volume. The increases noted above for the six months ended June 30, 2014 were tempered by decreases in the revenues of: • rizatriptan, which we launched in January 2013 as the authorized generic, declined quickly after several competitors entered this market in July 2013; • budesonide principally due to price declines resulting from competition; • lamotrigine, which experienced a higher level of competition in 2014 as compared to 2013 when it launched. Net sales of contract-manufactured products (which are manufactured for us by third parties under contract) and licensed products (which are licensed to us from third-party development partners and also are generally manufactured by third parties) comprised a significant percentage of our total product revenues for the three and six months ended June 30, 2014 and June 30, 2013. The significance of the percentage of our product revenues is primarily driven by the launches of products like divalproex, digoxin, budesonide and metoprolol succinate ER. We are substantially dependent upon contract-manufactured and licensed products for our overall sales, and any inability by our suppliers to meet demand could adversely affect our future sales. 46 --------------------------------------------------------------------------------Strativa Three Months Ended and Six Months Ended June 30, 2014 v. 2013 The decrease in the Strativa segment revenues for the three months ended and six months ended June 30, 2014 as compared to the comparable periods in 2013 was primarily due to net sales declines of Megace® ES primarily as a result of decreased volume. These decreases were tempered by revenue growth for Nascobal® primarily due to better pricing. Gross Revenues to Total Revenues Deductions Generic drug pricing at the wholesale level can create significant differences between our invoice price and net selling price. Wholesale customers purchase product from us at invoice price, then resell the product to specific healthcare providers on the basis of prices negotiated between us and the providers. The difference between the wholesalers' purchase price and the typically lower healthcare providers' purchase price is refunded to the wholesalers through a chargeback credit. We record estimates for these chargebacks as well as sales returns, rebates and incentive programs, and the sales allowances for all our customers at the time of sale as deductions from gross revenues, with corresponding adjustments to our accounts receivable reserves and allowances. We have the experience and the access to relevant information that we believe necessary to reasonably estimate the amounts of such deductions from gross revenues. Some of the assumptions we use for certain of our estimates are based on information received from third parties, such as wholesale customer inventory data and market data, or other market factors beyond our control. The estimates that are most critical to the establishment of these reserves, and therefore would have the largest impact if these estimates were not accurate, are estimates related to expected contract sales volumes, average contract pricing, customer inventories and return levels. We regularly review the information related to these estimates and adjust our reserves accordingly if and when actual experience differs from previous estimates. With the exception of the product returns allowance, the ending balances of account receivable reserves and allowances generally are eliminated during a two-month to four-month period, on average. We recognize revenue for product sales when title and risk of loss have transferred to our customers and when collectability is reasonably assured. This is generally at the time that products are received by the customers. Upon recognizing revenue from a sale, we record estimates for chargebacks, rebates and incentives, returns, cash discounts and other sales reserves that reduce accounts receivable. Our gross revenues for the six month periods ended June 30, 2014 and 2013 before deductions for chargebacks, rebates and incentive programs (including rebates paid under federal and state government Medicaid drug reimbursement programs), sales returns and other sales allowances were as follows: Six months ended June 30, Percentage of June 30, Percentage of ($ amounts in thousands) 2014 Gross Revenues 2013 Gross Revenues Gross revenues $ 1,341,422 $ 1,086,052 Chargebacks (396,493 ) 29.6 % (287,424 ) 26.5 % Rebates and incentive programs (194,296 ) 14.5 % (126,347 ) 11.6 % Returns (16,290 ) 1.2 % (24,683 ) 2.3 % Cash discounts and other (117,153 ) 8.7 % (89,272 ) 8.2 % Medicaid rebates and rebates due under other U.S. Government pricing programs (32,701 ) 2.4 % (34,461 ) 3.2 % Total deductions (756,933 ) 56.4 % (562,187 ) 51.8 % Total revenues $ 584,489 43.6 % $ 523,865 48.2 % The total gross-to-net adjustments as a percentage of gross revenues increased for the six months ended June 30, 2014 compared to the six months ended June 30, 2013 primarily due to: • Chargebacks: the increase was primarily driven by customer mix as a result of shift in business from non-wholesalers to wholesalers and higher bupropion and zolpidem volume which have higher overall rates, tempered by the favorable impact of divalproex volume which has a lower rate relative to the overall product portfolio. 47--------------------------------------------------------------------------------• Rebates and incentive programs: the increase was primarily driven by higher divalproex (volume and rate) and lamotrigine (rate), as well as the impact of Walgreens and AmerisourceBergen Corporation alliance. • Returns: the decrease in the rate was primarily driven by non-recurring increase to the rizatriptan returns reserve in the prior year following additional competition, coupled with decrease in fluvoxamine reserve and lower than expected returns for other products, primarily metoprolol and Megace® ES. • Cash discounts and other: the increase in rate was primarily due to customer mix, including the impact of the Walgreens and AmerisourceBergen Corporation alliance coupled with pricing adjustments for products that had competitive changes in their respective markets, primarily bupropion (price protection as result of price increase effective in June 2014), lamotrigine and metoprolol, partially offset by impact of prior year price protection related to a divalproex price increase. • Medicaid rebates and rebates due under other U.S. Government pricing programs: decrease as a percentage of gross revenues primarily due to a reduction in Medicaid accrual based upon additional available information related to Managed Medicaid utilization in California, coupled with lower amounts due under certain U.S. Government and state pricing programs (e.g., TriCare and Medicaid) due to lower utilization of our subject drugs (e.g., modafinil, Megace® ES, Nascobal®, and rizatriptan). The following tables summarize the activity for the six months ended June 30, 2014 and June 30, 2013 in the accounts affected by the estimated provisions described above ($ amounts in thousands): Six months ended June 30, 2014 (Provision) Provision recorded reversal recorded Par beginning Par Sterile for current period for prior period Credits Accounts receivable reserves balance beginning balance sales sales processed Ending balance Chargebacks $ (48,766 ) $ (5,886 ) $ (396,493 ) $ - (1) $ 392,889 $ (58,256 ) Rebates and incentive programs (75,321 ) (5,489 ) (194,296 ) - 186,739 (88,367 ) Returns (78,181 ) (4,398 ) (16,290 ) - 12,534 (86,335 ) Cash discounts and other (37,793 ) (1,792 ) (115,705 ) (1,448 ) (3) 114,187 (42,551 ) Total $ (240,061 ) $ (17,565 ) $ (722,784 ) $ (1,448 ) $ 706,349 $ (275,509 ) Accrued liabilities (2) $ (35,829 ) $ (382 ) $ (35,506 ) $ 2,805 (4) $ 41,397 $ (27,515 ) Six months ended June 30, 2013 (Provision) reversal Provision recorded recorded for Beginning for current period prior period Credits Accounts receivable reserves balance sales sales processed Ending balance Chargebacks $ (41,670 ) $ (287,424 ) $ - (1) $ 279,334 $ (49,760 ) Rebates and incentive programs (59,426 ) (126,921 ) 574 121,118 (64,655 ) Returns (68,062 ) (24,683 ) - 13,664 (79,081 ) Cash discounts and other (26,544 ) (89,272 ) - 80,236 (35,580 ) Total $ (195,702 ) $ (528,300 ) $ 574 $ 494,352 $ (229,076 ) Accrued liabilities (2) $ (42,162 ) $ (34,461 ) $ - $ 35,278 $ (41,345 ) (1) Unless specific in nature, the amount of provision or reversal of reserves related to prior periods for chargebacks is not determinable on a product or customer specific basis; however, based upon historical analysis and analysis of activity in subsequent periods, we believe that our chargeback estimates remain reasonable. (2) Includes amounts due to indirect customers for which no underlying accounts receivable exists and is principally comprised of Medicaid rebates and rebates due under other U.S. Government pricing programs, such as TriCare, and the Department of Veterans Affairs. 48--------------------------------------------------------------------------------(3) During the second quarter of 2014, we recorded an additional reserve totaling approximately $1.0 million related to a dispute with a customer. (4) Based upon additional available information related to Managed Medicaid utilization in California we reduced our Medicaid accruals for the periods March 2010 through December 2013 by approximately $3.6 million. Our Medicaid accrual represents our best estimate at this time. Use of Estimates in Reserves We believe that our reserves, allowances and accruals for items that are deducted from gross revenues are reasonable and appropriate based on current facts and circumstances. It is possible, however, that other parties applying reasonable judgment to the same facts and circumstances could develop different allowance and accrual amounts for items that are deducted from gross revenues. Additionally, changes in actual experience or changes in other qualitative factors could cause our allowances and accruals to fluctuate, particularly with newly launched or acquired products. We review the rates and amounts in our allowance and accrual estimates on a quarterly basis. If future estimated rates and amounts are significantly greater than those reflected in our recorded reserves, the resulting adjustments to those reserves would decrease our reported net revenues; conversely, if actual product returns, rebates and chargebacks are significantly less than those reflected in our recorded reserves, the resulting adjustments to those reserves would increase our reported net revenues. If we were to change our assumptions and estimates, our reserves would change, which would impact the net revenues that we report. We regularly review the information related to these estimates and adjust our reserves accordingly, if and when actual experience differs from previous estimates. Gross Margin Three months ended Percentage of Total Revenues June 30, June 30, June 30, June 30, ($ in thousands) 2014 2013 $ Change 2014 2013 Gross margin: Par Pharmaceutical $ 83,884 $ 46,301 $ 37,583 30.1 % 21.5 % Strativa 9,625 12,599 (2,974 ) 58.1 % 67.9 % Total gross margin $ 93,509 $ 58,900 $ 34,609 31.7 % 25.2 % Six months ended Percentage of Total Revenues June 30, June 30, June 30, June 30, ($ in thousands) 2014 2013 $ Change 2014 2013 Gross margin: Par Pharmaceutical $ 167,529 $ 105,996 $ 61,533 30.3 % 21.7 % Strativa 20,295 24,348 (4,053 ) 63.7 % 67.7 % Total gross margin $ 187,824 $ 130,344 $ 57,480 32.1 % 24.9 % The increase in Par Pharmaceutical gross margin dollars for the three months ended June 30, 2014 as compared to the prior year period was primarily due to gross margin dollars from Par Sterile Products, which products were acquired in our acquisition of JHP as of February 20, 2014; coupled with higher divalproex gross margin dollars, which benefited from a competitor exiting the market in June 2013 and the non-recurrence of a large contractual price adjustment to a major customer that occurred in the prior year; the launches of clonidine HCl ER and dexmethylphenidate in the fourth quarter of 2013; and bupropion ER, which benefited from competitors that were not able to supply product to the market. These increases were tempered by the revenue declines of modafinil, morphine, and fentanyl patch. The increase in Par Pharmaceutical gross margin dollars for the six months ended June 30, 2014 as compared to the prior year period was primarily due to gross margin dollars from Par Sterile Products, which products were acquired in our acquisition of JHP as of February 20, 2014; coupled with higher divalproex gross margin dollars; the launches of fluvoxamine maleate ER in first quarter of 2013 that continues to benefit from a lack of competition in this market, and fenofibric acid in the third quarter of 2013, and the launches of clonidine HCl ER and dexmethylphenidate in the fourth quarter of 2013; and bupropion ER which, benefited from 49 -------------------------------------------------------------------------------- competitors that were not able to supply product to the market. These increases were tempered by the revenue declines of modafinil, morphine, fentanyl patch and lamotrigine. Strativa gross margin dollars decreased for the three and six months ended June 30, 2014 as compared to the prior year periods, primarily due to the revenue decline of Megace® ES. Operating Expenses Research and Development Three months ended Percentage of Total Revenues June 30, June 30, June 30, June 30, ($ in thousands) 2014 2013 $ Change % Change 2014 2013 Research and development: Par Pharmaceutical $ 28,231 $ 25,463 $ 2,768 10.9 % 10.1 % 11.8 % Strativa 224 348 (124 ) (35.6 )% 1.4 % 1.9 %Total research and development $ 28,455 $ 25,811 $ 2,644 10.2 % 9.6 % 11.0 % Par Pharmaceutical: The increase in Par Pharmaceutical research and development expense for the three months ended June 30, 2014 was driven by: • $3.0 million of higher employment related and other costs as the result of the JHP Acquisition; • $1.9 million of higher expense for consulting and advisory services related to Par Sterile Products and the JHP Acquisition; • $1.4 million in incremental user fees due to 21 filings in the second quarter of 2014; • $0.6 million increase in biostudy, clinical trial and material costs related to ongoing internal development of generic products; tempered by, • $3.9 million decrease in outside development costs driven by lower payments related to existing development agreements. Strativa: Strativa research and development principally reflects FDA filing fees for the three months ended June 30, 2014 and June 30, 2013. Six months ended Percentage of Total Revenues June 30, June 30, June 30, June 30, ($ in thousands) 2014 2013 $ Change % Change 2014 2013 Research and development: Par Pharmaceutical $ 62,554 $ 45,448 $ 17,106 37.6 % 11.3 % 9.3 % Strativa 501 587 (86 ) (14.7 )% 1.6 % 1.6 %Total research and development $ 63,055 $ 46,035 $ 17,020 37.0 % 10.8 % 8.8 % Par Pharmaceutical: The increase in Par Pharmaceutical research and development expense for the six months ended June 30, 2014 was driven by: • $4.0 million of higher employment related and other costs due to JHP Acquisition; • $3.6 million increase in biostudy, clinical trial and material costs related to ongoing internal development of generic products; • $2.6 million of higher expense for consulting and advisory services related to Par Sterile Products and JHP Acquisition; • $1.6 million in incremental user fees due to 26 filings during the six months ended June 30, 2014; and • $5.4 million increase in outside development costs primarily driven by payment related to one new agreement partially offset by lower payments for existing development agreements. Strativa: Strativa research and development principally reflects FDA filing fees for the six months ended June 30, 2014 and June 30, 2013. 50 --------------------------------------------------------------------------------Selling, General and Administrative Expenses Three months ended Percentage of Total Revenues June 30, June 30, June 30, June 30, ($ in thousands) 2014 2013 $ Change % Change 2014 2013 Selling, general and administrative: Par Pharmaceutical $ 33,230 $ 27,412 $ 5,818 21.2 % 11.9 % 12.7 % Strativa 10,622 9,410 1,212 12.9 % 64.1 % 50.7 % Total selling, general and administrative $ 43,852 $ 36,822 $ 7,030 19.1 % 14.8 % 15.8 % The net increase in selling, general and administrative expenditures for the three months ended June 30, 2014 principally reflects: • $3.4 million of higher employment related costs due to JHP Acquisition and higher accrued sales bonus related to increased Nascobal® revenue; • $2.2 million of higher legal expenses primarily due to increased ANDA related activities; and • $0.9 million of higher expense for consulting and advisory services related to services related to acquisitions and other business development activities. Six months ended Percentage of Total Revenues June 30, June 30, June 30, June 30, ($ in thousands) 2014 2013 $ Change % Change 2014 2013 Selling, general and administrative: Par Pharmaceutical $ 71,239 $ 57,418 $ 13,821 24.1 % 12.9 % 11.8 % Strativa 23,579 20,199 3,380 16.7 % 74.0 % 56.2 % Total selling, general and administrative $ 94,818 $ 77,617 $ 17,201 22.2 % 16.2 % 14.8 % The net increase in selling, general and administrative expenditures for the six months ended June 30, 2014 principally reflects: • $6.6 million of expense related to additional borrowings and repricing of our Term Loan Facility plus associated transaction fees of $0.5 million; • $3.6 million of higher employment related costs due to JHP Acquisition and higher accrued sales bonus for Nascobal® revenue; • $2.4 million of higher legal expenses primarily due to increased ANDA related activities; and • $2.4 million of higher expense for consulting and advisory services related to services related to acquisitions and other business development activities. Intangible Assets Impairment Three months ended Six months ended ($ in thousands) June 30, 2014 June 30, 2013 June 30, 2014 June 30, 2013 Intangible asset impairment $ 35,863 $ 466 $ 77,621 $ 466 During the six months ended June 30, 2014, we recorded intangible asset impairments totaling $77,621 thousand for six products not expected to achieve their originally forecasted operating results and one discontinued product. Additionally we partially impaired one IPR&D project from the JHP Acquisition due to an adverse court ruling pertaining to the related patent litigation. During the six months ended June 30, 2013, we ceased selling a product that had been acquired with the divested products from the Watson/Actavis Merger and recorded a total corresponding intangible asset impairment of $466 thousand. 51 --------------------------------------------------------------------------------Settlements and Loss Contingencies, net Three months ended Six months ended ($ in thousands) June 30, 2014 June 30, 2013 June 30, 2014 June 30, 2013 Settlements and Loss Contingencies, net $ - $ 3,300 $ - $ 3,300 During the three and six month periods ended and June 30, 2013, we recorded an incremental provision of $3.3 million related to AWP litigation claims. Restructuring costs Three months ended Six months ended ($ in thousands) June 30, 2014 June 30, 2013 June 30, 2014 June 30, 2013 Restructuring costs $ 2,866 $ - $ 4,012 $ 1,816 2014 Subsequent to the JHP Acquisition, we eliminated approximately 20 redundant positions within Par Pharmaceutical and accrued severance and other employee-related costs for those employees affected by the workforce reduction in 2014. ($ amounts in thousands) Non-Cash Charge Related to Inventory and/or Reversals, Initial Additional Intangible Reclass or Liabilities at Restructuring Activities Charge Charge Cash Payments Assets Transfers June 30, 2014 Severance and employee benefits to be paid in cash $ 1,146 $ 2,866 $ (744 ) $ - $ - $ 3,268 Total restructuring costs line item $ 1,146 $ 2,866 $ (744 ) $ - $ - $ 3,268 2013 In January 2013, we initiated a restructuring of Strativa, our branded pharmaceuticals division, in anticipation of entering into a settlement agreement and corporate integrity agreement that terminated the U.S Department of Justice's ongoing investigation of Strativa's marketing of Megace® ES. We reduced our Strativa workforce by approximately 70 people, with the majority of the reductions in the sales force. The remaining Strativa sales force has been reorganized into a single sales team of approximately 60 professionals who focus their marketing efforts principally on Nascobal® Nasal Spray. In connection with these actions, we incurred expenses for severance and other employee-related costs as well as the termination of certain contracts. ($ amounts in thousands) Non-Cash Charge Related to Inventory and/or Initial Intangible Reversals, Reclass or Liabilities at Restructuring Activities Charge Cash Payments Assets Transfers June 30, 2014 Severance and employee benefits to be paid in cash $ 1,413 $ (1,409 ) $ - $ (4 ) $ - Asset impairments and other 403 - (403 ) - - Total restructuring costs line item $ 1,816 $ (1,409 ) $ (403 ) $ (4 ) $ - 52-------------------------------------------------------------------------------- Operating (Loss) Income Three months ended June 30, June 30, ($ in thousands) 2014 2013 $ Change Operating (loss) income: Par Pharmaceutical $ (8,560 ) $ (10,341 ) $ 1,781 Strativa (8,967 ) 2,842 (11,809 ) Total operating (loss) income $ (17,527 ) $ (7,499 ) $ (10,028 ) For the three months ended June 30, 2014, the decrease in our operating income as compared to prior year was primarily due to intangible asset impairments, coupled with additional research and development expense for payments related to existing product development agreements and additional selling, general and administrative expenditures related to the JHP Acquisition, tempered by increased gross margin dollars for key products and new product launches subsequent to the second quarter of 2013. Six months ended June 30, June 30, ($ in thousands) 2014 2013 $ Change Operating (loss) income: Par Pharmaceutical $ (31,571 ) $ (817 ) $ (30,754 ) Strativa (20,111 ) 1,927 (22,038 )Total operating (loss) income $ (51,682 ) $ 1,110 $ (52,792 ) For the six months ended June 30, 2014, the decrease in our operating income as compared to prior year was primarily due to intangible asset impairments, coupled with additional research and development expense for payments related to existing product development agreements and additional selling, general and administrative expenditures related to the JHP Acquisition, tempered by increased gross margin dollars for key products and new product launches subsequent to the second quarter of 2013. Interest Income Three months ended Six months ended ($ in thousands) June 30, 2014 June 30, 2013 June 30, 2014 June 30, 2013 Interest income $ - $ 20 $ 14 $ 56 Interest income principally includes interest income derived from money market and other short-term investments. Interest Expense Three months ended Six months ended ($ in thousands) June 30, 2014 June 30, 2013 June 30, 2014 June 30, 2013 Interest expense $ (27,499 ) $ (23,612 ) $ (52,966 ) $ (47,648 ) Interest expense for the three and six month periods ended June 30, 2014 and June 30, 2013 was principally comprised of interest related to the Notes and the Senior Credit Facilities. See "Financing" below for further details on the Senior Credit Facilities and the Notes. 53 -------------------------------------------------------------------------------- Loss on Debt Extinguishment Three months ended Six months ended ($ in thousands) June 30, 2014 June 30, 2013 June 30, 2014 June 30, 2013 Loss on debt extinguishment $ - $ - $ (3,989 ) $ (7,335 ) During the three months ended March 31, 2014 and in conjunction with the JHP Acquisition, we entered into the Incremental Term B-2 Joinder Agreement (the "Joinder") among us, Holdings, and certain of our subsidiaries, and our lenders. Under the terms of the Joinder, we borrowed an additional $395 million of New Tranche B Term Loans from the lenders participating therein for the purpose of consummating our acquisition of JHP. We also repriced our Term Loan Facility at the same time lowering our effective borrowing rate by 25 basis points. Based on these actions and the decision of certain lenders not to remain a party to our Term Loan Facility, we recorded a loss on debt extinguishment of approximately $4 million that represents a proportionate share of deferred financing costs that were written off. During the six months ended June 30, 2013, we refinanced our Term Loan Facility. As a result, $5.9 million of existing deferred financing costs and a portion of the related $10.5 million soft call premium were recorded as a loss on debt extinguishment for the portion of the associated transactions that were classified as extinguishment of debt. Income Taxes Three months ended Six months ended ($ in thousands) June 30, 2014 June 30, 2013 June 30, 2014 June 30, 2013 Benefit for income taxes $ (18,106 ) $ (9,300 ) $ (42,338 ) $ (17,280 ) Effective tax rate 40 % 30 % 39 % 32 % The income tax benefit was based on the applicable federal and state tax rates for those periods (see Notes to Condensed Consolidated Financial Statements - Note 14 - "Income Taxes"). The effective tax rate for the three months ended June 30, 2014 reflects our nondeductible portion of the annual pharmaceutical manufacturers' fee under the Patient Protection and Affordable Care Act, more than offset by benefits for deductions specific to U.S. domestic manufacturing companies and a benefit related to determination of deductibility of certain settled AWP litigation. The effective tax rate for the three months ended June 30, 2013 reflects our nondeductible portion of the annual pharmaceutical manufacturers' fee under the Patient Protection and Affordable Care Act, offset by benefits for deductions specific to U.S. domestic manufacturing companies. The effective tax rate for the six months ended June 30, 2014 reflects our nondeductible portion of the annual pharmaceutical manufacturers' fee under the Patient Protection and Affordable Care Act, more than offset by benefits for deductions specific to U.S. domestic manufacturing companies and a benefit related to determination of deductibility of certain settled AWP litigation. The effective tax rate for the six months ended June 30, 2013 reflects our nondeductible portion of the annual pharmaceutical manufacturers' fee under the Patient Protection and Affordable Care Act, offset by benefits for deductions specific to U.S. domestic manufacturing companies. 54 -------------------------------------------------------------------------------- FINANCIAL CONDITION Liquidity and Capital Resources Six months ended ($ in thousands) June 30, 2014 June 30, 2013 Cash and cash equivalents at beginning of period $ 130,080 $ 36,794 Net cash provided by operating activities 27,497 20,188 Net cash used in investing activities (496,283 ) (598 ) Net cash provided by (used in) financing activities 494,633 (1,904 ) Net increase in cash and cash equivalents $ 25,847 $ 17,686 Cash and cash equivalents at end of period $ 155,927 $ 54,480 Cash provided by operations for the six months ended June 30, 2014, reflects gross margin dollars (excluding amortization) generated from revenues coupled with collection of accounts receivables. Refer below for further details of operating cash flows. Cash flows used in investing activities were primarily driven by the JHP Acquisition plus capital expenditures. Cash provided by financing activities in the six month period ended June 30, 2014 primarily represented new debt borrowings under our Senior Credit Facilities plus a capital contribution from Holdings less debt principal payments to reprice our Senior Credit Facilities coupled with other debt principal payments. Our working capital, current assets minus current liabilities, of $312 million at June 30, 2014 increased approximately $105 million from $207 million at December 31, 2013, which primarily reflects the cash generated by operations coupled with increases in other working capital items. The working capital ratio, which is calculated by dividing current assets by current liabilities, was 2.28x at June 30, 2014 compared to 1.80x at December 31, 2013. We believe that our working capital ratio indicates the ability to meet our ongoing and foreseeable obligations for at least the next 12 fiscal months. Detail of Operating Cash Flows Six months ended ($ in thousands) June 30, 2014 June 30, 2013 Cash received from customers, royalties and other $ 664,716 $ 632,201 Cash paid to distribution agreement partners (141,718 ) (172,062 ) Cash paid for inventory (137,133 ) (125,518 ) Cash paid to employees (63,453 ) (42,204 ) Payment to Department of Justice - (46,071 ) Payments related to AWP settlements (32,350 ) - Cash paid to all other suppliers and third parties (174,937 ) (169,775 ) Interest paid, net (47,280 ) (43,380 ) Income taxes paid, net (40,348 ) (13,003 ) Net cash provided by operating activities $ 27,497 $ 20,188 Sources of Liquidity Our primary source of liquidity is cash received from customers. The increase in net cash provided by operating activities for the six months ended June 30, 2014 as compared to 2013 resulted primarily from the non-recurrence of the payment related to our settlement with the U.S. Department of Justice that terminated the Department's investigation into Strativa's marketing of Megace® ES, coupled with gross margins associated with divalproex and other products launched or acquired subsequent to the second quarter of 2013. Our ability to continue to generate cash from operations is predicated not only on our ability to maintain a sustainable amount of sales of our current product portfolio, but also our ability to monetize our product pipeline and future products that we may acquire. Our future profitability depends, to a significant extent, upon our ability to introduce, on a timely basis, new generic products that are either the first to market (or among the first to market) or otherwise can gain significant market share. No assurances can be given that we or any of our strategic partners will successfully complete the development of any of these potential products either under development or proposed for development, that regulatory approvals will be granted for any such product, that any approved product will be produced in commercial quantities or that any approved product will be sold profitably. Commercializing brand pharmaceutical products is more costly than generic products. We cannot be certain that any of our brand product expenditures will 55 -------------------------------------------------------------------------------- result in the successful development or launch of brand products that will prove to be commercially successful or will improve the long-term profitability of our business. Another source of available liquidity is our Senior Credit Facilities that include a five-year Revolving Facility in an initial amount of $150 million. The Senior Credit Facilities are more fully described in the "Financing" section below. There were no outstanding borrowings from the Revolving Facility as of June 30, 2014. Uses of Liquidity Our uses of liquidity and future and potential uses of liquidity include the following: • Approximately $490 million in first quarter of 2014 for our acquisition of JHP Group Holdings, the parent company of JHP Pharmaceuticals. • Business development activities, including the acquisition of product rights, which are typically in a range near $40 million annually. As of June 30, 2014, the total potential future payments that ultimately could be due under existing agreements related to products in various stages of development were approximately $12 million. This amount is exclusive of contingent payments tied to the achievement of sales milestones, which cannot be determined at this time and would be funded through future revenue streams. • Capital expenditures of approximately$37 million are planned for 2014. • Potential liabilities related to the outcomes of litigation, such as the AWP and Santarus, Inc. matters, or the outcomes of investigations by federal authorities, such as the U.S. Department of Justice. In the event that we experience a significant loss, such loss may result in a material impact on our liquidity or financial condition when such liability is paid. • Cash paid for inventory purchases as detailed in "Details of Operating Cash Flows" above. • Cash paid to all other suppliers and third parties as detailed in "Details of Operating Cash Flows" above. • Cash compensation paid to employees as detailed in "Details of Operating Cash Flows" above. • Potential liabilities related to the outcomes of audits by regulatory agencies like the IRS. In the event that our loss contingency is ultimately determined to be higher than originally accrued, the recording of the additional liability may result in a material impact on our liquidity or financial condition when such additional liability is paid. • Normal course payables due to distribution agreement partners of approximately $65 million as of June 30, 2014 related primarily to amounts due under profit sharing agreements. We paid substantially all of the $65 million during the first two months of the third quarter of 2014. The risk of lower cash receipts from customers due to potential decreases in revenues associated with competition or supply issues related to partnered products would be generally mitigated by proportional decreases in amounts payable to distribution agreement partners. We believe that we will be able to monetize our current product portfolio, our product pipeline, and future product acquisitions and generate sufficient operating cash flows that, along with existing cash, cash equivalents and available for sale securities, will allow us to meet our financial obligations over the foreseeable future. We expect to continue to fund our operations, including our research and development activities, capital projects, in-licensing product activity and obligations under our existing distribution and development arrangements discussed herein, out of our working capital and funds available under our Senior Credit Facilities. Contractual Obligations as of June 30, 2014 The dollar values of our material contractual obligations and commercial commitments as of June 30, 2014 were as follows ($ in thousands): Amounts Due by Period Total Monetary 2015 to 2017 to 2019 and Obligation Obligations 2014 2016 2018 thereafter Other Operating leases $ 32,285 $ 3,149 $ 9,860 $ 6,313 $ 12,963 $ - Senior credit facilities 1,441,678 5,841 29,006 29,006 1,377,825 - 7.375% senior notes 490,000 - - - 490,000 - Interest payments 557,741 49,867 199,187 194,444 114,243 - Fees related to credit facilities 3,409 438 1,750 971 250 - Purchase obligations (1) 146,906 146,906 - - - - Tax liabilities (2) 18,927 - - - - 18,927 TPG Management fee (3) 26,187 2,187 8,000 8,000 8,000 - Severance payments 1,740 1,308 432 - - - Other 113 113 - - - -Total obligations $ 2,718,986 $ 209,809 $ 248,235 $ 238,734 $ 2,003,281 $ 18,927 (1) Purchase obligations consist of both cancelable and non-cancelable inventory and non-inventory items. 56--------------------------------------------------------------------------------(2) The difference between a tax position taken or expected to be taken in a tax return and the benefit recognized and measured pursuant to ASC 740-10, "Income Taxes" represents an unrecognized tax benefit. An unrecognized tax benefit is a liability that represents a potential future obligation to the taxing authorities. As of June 30, 2014, the amount represents unrecognized tax benefits, interest and penalties based on evaluation of tax positions and concession on tax issues challenged by the IRS. We do not expect to make a significant tax payment related to these long-term liabilities within the next year; however, we cannot estimate in which period thereafter such tax payments may occur. For presentation on the table above, we include the related long-term liability in the "Other" column. (3) In connection with the Merger, the Company entered into a management services agreement with an affiliate of TPG (the "Manager"). Pursuant to such agreement, and in exchange for on-going consulting and management advisory services, the Manager has a right to an annual monitoring fee paid quarterly equal to 1% of EBITDA as defined under the credit agreement for the Term Loan Facility that is part of our Senior Credit Facilities. There is an annual cap of $4 million for this fee. The Manager is also entitled to receive reimbursement for out-of-pocket expenses incurred in connection with services provided pursuant to the agreement. Financing Senior Credit Facilities In connection with the Merger, on September 28, 2012, Sky Growth Acquisition Corporation, later merged with and into the Company upon consummation of the Merger, with the Company as the surviving corporation, entered into a credit agreement (the "Credit Agreement") with a syndicate of banks, led by Bank of America, N.A., as Administrative Agent, Bank of America, N.A., Deutsche Bank Securities, Inc., Goldman Sachs Bank USA, Citigroup Global Markets, Inc., RBC Capital Markets LLC and BMO Capital Markets as Joint Lead Arrangers and Joint Lead Bookrunners, Deutsche Bank Securities, Inc. and Goldman Sachs Bank USA as Co-Syndication Agents, and Citigroup Global Markets Inc. and RBC Capital Markets LLC as Co-Documentation Agents, to provide Senior Credit Facilities comprised of the seven-year Term Loan Facility and the five-year Revolving Facility. The proceeds of the Revolving Facility are available for general corporate purposes. The Credit Agreement contains customary representations and warranties, as well as customary events of default, in certain cases subject to reasonable and customary periods to cure, including but not limited to: failure to make payments when due, breach of covenants, breach of representations and warranties, insolvency proceedings, certain judgments and any change of control. The Credit Agreement also contained various customary covenants that, in certain instances, restrict our ability to: (i) create liens on assets; (ii) incur additional indebtedness; (iii) engage in mergers or consolidations with or into other companies; (iv) engage in dispositions of assets, including entering into a sale and leaseback transaction; (v) pay dividends and distributions or repurchase capital stock; (vi) make investments, loans, guarantees or advances in or to other companies; (vii) repurchase or redeem certain junior indebtedness; (viii) change the nature of our business; (ix) engage in transactions with affiliates; and (x) enter into restrictive agreements. In addition, the Credit Agreement required us to demonstrate compliance with a maximum senior secured first lien leverage ratio whenever amounts are outstanding under the revolving credit facility as of the last day of any quarterly testing period. All obligations under the Credit Agreement were guaranteed by our material domestic subsidiaries. The interest rates payable under the Credit Agreement were based on defined published rates, subject to a minimum LIBOR rate in the case of Eurocurrency rate loans, plus an applicable margin. We were also obligated to pay a commitment fee based on the unused portion of the revolving credit facility. Repayments of the proceeds of the term loan are due in quarterly installments over the term of the Credit Agreement. Amounts borrowed under the revolving credit facility would be payable in full upon expiration of the Credit Agreement. 7.375% Senior Notes In connection with the Merger, on September 28, 2012, Sky Growth Acquisition Corporation later merged with and into the Company upon consummation of the Merger, with the Company as the surviving corporation, and issued the Notes. The Notes were issued pursuant to an indenture entered into as of the same date between the Company and Wells Fargo Bank, National Association, as trustee. Interest on the Notes is payable semi-annually on April 15 and October 15, commencing on April 15, 2013. The Notes mature on October 15, 2020. We may redeem the Notes at our option, in whole or in part on one or more occasions, at any time on or after October 15, 2015, at specified redemption prices that vary by year, together with accrued and unpaid interest, if any, to the date of redemption. At any time prior to October 15, 2015, we may redeem up to 40% of the aggregate principal amount of the Notes with the net proceeds of certain equity offerings at a redemption price equal to the sum of (i) 107.375% of the aggregate principal amount thereof, plus (ii) accrued and unpaid interest, if any, to the redemption date. At any time prior to October 15, 2015, we may also redeem the Notes, in whole or in part on one or more occasions, at a price equal to 100% of the principal amount of the notes, plus accrued and unpaid interest and a specified "make-whole premium." The Notes are guaranteed on a senior unsecured basis by our material existing direct and indirect wholly-owned domestic subsidiaries and, subject to certain exceptions, each of our future direct and indirect domestic subsidiaries that guarantees the Senior 57 -------------------------------------------------------------------------------- Credit Facilities or our other indebtedness or indebtedness of the guarantors will guarantee the Notes. Under certain circumstances, the subsidiary guarantors may be released from their guarantees without consent of the holders of Notes. The Notes and the subsidiary guarantees are our and the guarantors' senior unsecured obligations and (i) rank senior in right of payment to all of our and the subsidiary guarantors' existing and future subordinated indebtedness; (ii) rank equally in right of payment with all of our and the subsidiary guarantors' existing and future senior indebtedness; (iii) are effectively subordinated to any of our and the subsidiary guarantors' existing and future secured debt, to the extent of the value of the assets securing such debt; and (iv) are structurally subordinated to all of the existing and future liabilities (including trade payables) of each of our subsidiaries that do not guarantee the Notes. The indenture governing the Notes contains customary representations and warranties, as well as customary events of default, in certain cases subject to reasonable and customary periods to cure, including but not limited to: failure to make payments when due, breach of covenants, a payment default or acceleration equaling $40 million or more according to the terms of certain other indebtedness, failure to pay final judgments aggregating in excess of $40 million when due, insolvency proceedings, a required guarantee shall cease to remain in full force. The indenture also contains various customary covenants that, in certain instances, restrict our ability to: (i) pay dividends and distributions or repurchase capital stock; (ii) incur additional indebtedness; (iii) make investments, loans, guarantees or advances in or to other companies; (iv) engage in dispositions of assets, including entering into a sale and leaseback transaction; (v) engage in transactions with affiliates; (vi) create liens on assets; (vii) repurchase or redeem certain subordinated indebtedness, (viii) engage in mergers or consolidations with or into other companies; and (ix) change the nature of our business. The covenants are subject to a number of exceptions and qualifications. Certain of these covenants will be suspended during any period of time that (1) the Notes have Investment Grade Ratings (as defined in the indenture) from both Moody's Investors Service, Inc. and Standard & Poor's, and (2) no default has occurred and is continuing under the indenture. In the event that the Notes are downgraded to below an Investment Grade Rating, the Company and certain subsidiaries will again be subject to the suspended covenants with respect to future events. Critical Accounting Policies and Use of Estimates Our critical accounting policies are set forth in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013 . There has been no material change, update or revision to our critical accounting policies subsequent to the filing of our Annual Report for the fiscal year ended December 31, 2013. |