Chattem, Inc (CHTT) - Description of business

Company Description
Except as otherwise indicated, all references in this Form 10-K to “we”, “us”, “our” or “Chattem” refer to Chattem, Inc. and our subsidiaries. In addition, in this Form 10-K, our fiscal years ended November 30, 2004, November 30, 2005 and November 30, 2006 are referred to as fiscal 2004, fiscal 2005 and fiscal 2006, respectively, and our fiscal year ending on November 30, 2007 is referred to as fiscal 2007. Brand names that are italicized in this Form 10-K refer to trademarks that we own or license. General Founded in 1879, we are a leading marketer and manufacturer of a broad portfolio of branded over-the-counter (“OTC”) healthcare products, toiletries and dietary supplements, in such categories as topical pain care, medicated skin care products, medicated dandruff shampoos, dietary supplements and other OTC and toiletry products. Our portfolio of products includes well-recognized brands such as: • Icy Hot,   Aspercreme and Capzasin - topical pain care;   • Gold Bond - medicated skin care products; • Selsun Blue and Selsun Salon - medicated dandruff shampoos; • Dexatrim, Garlique and New Phase - dietary supplements; • Other OTC and toiletry products such as Pamprin, a menstrual analgesic; Herpecin-L, a lip care product; Benzodent, a dental analgesic cream; and toiletries such as Bullfrog, a line of sunscreens; UltraSwim, a chlorine-removing shampoo; Sun-In , a hair lightener. Our products target niche markets that are often outside the focus of larger companies where we believe we can achieve and sustain significant market share through innovation and strong advertising and promotion support. Many of our products are among the U.S. market leaders in their respective categories. For example, our portfolio of topical pain care brands and our Gold Bond medicated body powders have the leading U.S. market share in these categories. We support our brands through extensive and cost-effective advertising and promotion, the expenditures for which represented approximately 32% of our total revenues in fiscal 2006. We sell our products nationally through mass merchandiser, drug and food channels, principally utilizing our own sales force. Our experienced management team has grown our business by developing product line extensions, increasing market penetration of our existing products and acquiring brands. Recent product line extensions include Bullfrog Mosquito Coast, Gold Bond Ultimate Softening Lotion and Icy Hot   Pro-Therapy knee and back support with therapeutic pain relieving inserts. On January 2, 2007, we acquired the U.S. rights to five consumer and OTC brands for $410 million from Johnson & Johnson (“J&J Acquisition”). The acquired brands are: ACT , an anti-cavity mouthwash/mouth rinse; Unisom , an OTC sleep-aid; Cortizone , a hydrocortisone anti-itch product; Kaopectate , an anti-diarrhea product; and Balmex , a diaper rash product. We will continue to seek opportunities to acquire attractive brands in niche markets. We intend to drive growth through strong marketing and promotional programs, new product development and acquisitions of new brands. Competitive Strengths We believe that the following key competitive strengths are critical to our continuing success: Diverse and broad portfolio of well-recognized branded products. We currently market a diverse and broad portfolio of 27 brands in a variety of different product categories, including topical pain care, medicated dandruff shampoos, medicated skin care products, toiletries and dietary supplements. Our products are marketed under well-recognized brand names, such as our portfolio of topical pain care brands lcy Hot, Aspercreme, Flexall , Sportscreme , Capzasin and Arthritis Hot , as well as Gold Bond , Selsun Blue, Dexatrim and Garlique . The brand names added to our portfolio from the J&J Acquisition are ACT , Unisom, Cortizone, Kaopectate and Balmex . Our presence in diverse product categories reduces our exposure to changing consumer demand or weakness in any single category. Significant presence in niche markets. We acquire and develop brands that compete in small to medium sized niche markets where we believe we can achieve significant market presence and build brand equity. Our products often face less  competitive pressures because we focus on these markets that are frequently outside the core product areas of larger consumer products and pharmaceutical companies. This focus provides us with the opportunity to develop strong brand equity, identify and respond to consumer trends and leverage our strong selling and distribution capabilities in these markets. High margins and efficient operating structure. We are able to achieve high gross margins as a result of our ability to build and maintain brand equity, our significant market presence in niche markets and efficiencies in purchasing, manufacturing and distribution. In addition, we seek to tightly control our expenses, which strengthens our operating margins. Our high margins and resulting strong cash flow allow us to withstand temporary fluctuations in our product markets that could have adverse effects on our business. Proven advertising and promotion strategy. We aggressively build awareness and consumer loyalty of our brands through extensive and cost-effective advertising strategies that emphasize the competitive strengths of our products. We rely principally on television and radio advertising and to a lesser extent, print advertising and promotional programs. We strive to achieve cost efficiencies in our advertising by being opportunistic in our purchase of media and through control of our production costs. We also maintain the flexibility to allocate purchased media time among our key brands to respond quickly to changing consumer trends and to support our growing brands. We believe our well-developed advertising and promotion platform allows us to quickly and efficiently launch and support newly acquired brands and product line extensions as well as increase market penetration of existing brands. Advertising and promotion expenditures represented approximately 32% of our total revenues in fiscal 2006. Given the importance of our products’ brand equity we expect to maintain a significant level of spending on advertising and promotion. Established national sales and distribution network. We have an established national sales and distribution network that sells to mass merchandiser, drug and food retailers such as Wal-Mart Stores, Inc., Walgreen Co. and The Kroger Co. In fiscal 2006, sales to our top ten customers constituted approximately 73% of our total sales, which allows us to target our selling efforts to our key customers and tailor specific programs to meet their needs. Our fiscal 2006 sales to Wal-Mart Stores, Inc. accounted for approximately 36% of our total revenues. Through targeted sales and utilization of our established network, including our approximately 43 person sales force, we believe we can effectively sell and distribute newly acquired brands and product line extensions while maintaining tight controls over our selling expenses. Focused new product development. We strive to increase the value of our base brands while obtaining an increased market presence through product line extensions. In fiscal 2006, our product development expenditures were $4.2 million. During the past several years, we have expanded our product development staff and completed a new 10,000 square foot research and development facility. We rely on internal market research as well as consultants to identify new product formulations and line extensions that we believe appeal to the needs of consumers. Recent examples of product line extensions include Bullfrog Mosquito Coast , Gold Bond Ultimate Softening Lotion and Icy Hot   Pro-Therapy . In fiscal 2006, we introduced eight new product line extensions and have eight new product launches scheduled for fiscal 2007. Business Strategy Our strategy to achieve future growth is to generate new sales through strong marketing and promotional programs, new product development and acquisitions of new brands. Brand management and growth . We seek to increase market share for our major brands through focused marketing of our existing products and product line extensions while maintaining market share for our smaller brands. Our marketing strategy is to position our products to meet consumer preferences identified through extensive use of market and consumer research. We intend to channel advertising and promotion resources to those brands that we feel exhibit the most potential for growth. We also intend to increase our new product line extension activities as evidenced by our increased research and development spending, the expansion of our product development staff and construction of a research and product development facility in 2003. In addition, we continually evaluate the profit potential of and markets for our brands and, in instances where our objectives are not realized, will dispose of under-performing brands and redeploy the resulting cash assets. For example, in fiscal 2000, we sold the Ban ® (a registered trademark of Kao Corporation) product line of antiperspirants and deodorants in response to major shifts in the competitive environment in this product category and the resulting prospect of declining sales, and in fiscal 2005, we sold the pHisoderm line of skin care products, a brand that was no longer consistent with our brand strategy. Strategic acquisitions. We intend to identify and acquire brands in niche markets where we believe we can achieve a significant market presence through our established advertising and promotion platform, sales and distribution network and research and development capabilities. We target brands with sales that are highly responsive to increased advertising support, provide an opportunity for product line extensions through our research and development efforts and have the potential to meet our high gross margin goals. On January 2, 2007, we completed the J&J Acquisition and acquired the U.S. rights to the following  five OTC brands: ACT , an anti-cavity mouthwash/mouth rinse; Unisom , an OTC sleep-aid; Cortizone , a hydrocortisone anti-itch product; Kaopectate , an anti-diarrhea product; and Balmex , a diaper rash product. We will continue to seek opportunities to acquire attractive brands in niche markets. Developments During Fiscal 2006 In the first quarter of fiscal 2006, we introduced or completed the introduction of the following product line extensions: Icy Hot Pro-Therapy , Selsun Salon,   Bullfrog   Mosquito Coast , Garlique CardioAssist , Capzasin Back & Body Patch and Pamprin Max. In the second quarter of fiscal 2006, we introduced Dexatrim Max 2 O. Gold Bond Ultimate Softening Lotion was introduced in the fourth quarter of 2006. On November 30, 2005, we called our $75.0 million of Floating Rate Senior Notes for full redemption on December 30, 2005. The terms of the indenture for the Floating Rate Senior Notes required the repayment at a price of 102% of the principal amount of the notes plus accrued interest. The $75.0 million of Floating Rate Senior Notes were fully redeemed on December 30, 2005. We utilized borrowings of $38.0 million under our Amended Revolving Credit Facility and $38.9 million of our cash on hand to fund the redemption of the Floating Rate Senior Notes (see Note 5 of the notes to consolidated financial statements in Item 8 “ Financial Statements and Supplementary Data ” ). As a result of the redemption, a loss on early extinguishment of debt of $2.8 million was recorded in the first quarter of fiscal 2006. Over the past two years, we have resolved all of the claims submitted in the Dexatrim PPA settlement. A total of $70.9 million was previously funded into a settlement trust by our insurers and Sidmak Laboratories, Inc., the manufacturer of Dexatrim products containing PPA, for the purpose of paying claims in the settlement. All claims in the settlement and expenses of the trust have now been paid. On June 14, 2006, we filed a motion to dissolve the settlement trust. The court granted this motion on July 14, 2006. On August 31, 2006, the settlement trust paid us $10.7 million which is included as a component of litigation settlement in our condensed consolidated statement of income. The settlement trust currently has a balance of approximately $2.8 million. We expect to use those funds to resolve the one pending Dexatrim PPA case which opted out of the settlement. Any funds remaining after we resolve the opt-out case will be returned to one of our insurance carriers. We currently do not expect to record any additional charges relative to the settlement of the PPA litigation, except for legal expenses that will be recorded in the period incurred. During the third quarter of fiscal 2005, we entered into a settlement agreement with the DELACO Company (“DELACO”), successor by merger to the Thompson Medical Company, Inc., which owned the Dexatrim brand prior to December 21, 1998 (the “DELACO Agreement”). The DELACO Agreement was approved by the DELACO bankruptcy court on July 28, 2005. Pursuant to the DELACO Agreement, we agreed to assume responsibility for all claims against DELACO and its predecessor, Thompson Medical Company, Inc., or us relating to Dexatrim products involving an injury date after December 21, 1998 and hold the DELACO bankruptcy estate harmless from any such claims. In exchange, a settlement trust to be established under DELACO’s bankruptcy plan agreed to pay us $8.8 million and assume responsibility for all claims related to Dexatrim products alleging injury dates on or before December 21, 1998. On February 17, 2006, the DELACO bankruptcy court entered an order confirming the DELACO bankruptcy plan which incorporated the terms of the DELACO Agreement. In accordance with the DELACO bankruptcy plan, the settlement trust established under the plan paid us $8.75 million on March 17, 2006, which is included as a component of litigation settlement in our consolidated statement of income. In addition, this order allowed us to dismiss all cases against us with injury dates prior to December 21, 1998. The confirmation of the DELACO bankruptcy plan effectively released us from liability for all PPA products liability cases with injury dates prior to December 21, 1998. On July 25, 2006, we successfully completed a consent solicitation from the holders of our 7% Subordinated Notes to an amendment to the indenture to increase our capacity to make restricted payments by an additional $85.0 million, including payments for the repurchase of our common stock, and adjust the fixed charge coverage ratio as defined in the indenture. In connection with the consent solicitation, our Board of Directors authorized the repurchase of up to an additional $100.0 million of our common stock under the terms of our existing stock repurchase program. As of February 1, 2007, the current amount available under the repurchase authorization from our Board of Directors was $88.1 million. On November 22, 2006, we completed a private offering of $125.0 million of 2.0% Convertible Senior Notes due 2013 (“Convertible Notes”), the proceeds of which were used to fund a convertible note hedge transaction designed to offset our exposure to dilution upon conversion of the Convertible Notes, repay existing indebtedness and fund in part the J&J Acquisition. The Convertible Notes bear interest at an annual rate of 2.0%, payable semi-annually on May 15 and November 15 of each year, with the first interest payment due on May 15, 2007. Concurrently with the sale of the Convertible Notes, we purchased a note hedge for $32.0 million and issued warrants for proceeds of $18.6 million with an affiliate of Merrill Lynch (the “Counterparty”). The note hedge and warrants are separate and legally distinct instruments that bind us and the Counterparty and have no binding effect on the holders of the Convertible Notes. Based on Icy Hot Pro-Therapy performing below expectations, a review of point of sales data throughout fiscal 2006, an estimate of inventory on hand at customers and a review of our on hand inventory and purchase commitments outstanding as of November 30, 2006, during the fourth fiscal quarter we provided for an estimate of returns of $3.3 million and an estimate of obsolete inventory of $2.0 million, which reduced net sales and increased cost of sales, respectively, in our consolidated financial statements as of November 30, 2006. During fiscal 2006, we repurchased 1.2 million shares of our common stock under our stock repurchase program for $39.3 million at an average price per share of $33.57. On January 2, 2007, we completed the J&J Acquisition, which added the following five brands: ACT , an anti-cavity mouthwash/mouth rinse; Unisom , an OTC sleep aid; Cortizone , a hydrocortisone anti-itch product; Kaopectate, an anti-diarrhea product; and Balmex , a diaper rash product. On January 2, 2007, we also completed an amended credit facility providing for up to a $100.0 million revolving credit facility and a $300.0 million term loan (the “ Credit Facility ” ). The proceeds from the term loan under the Credit Facility were used to finance in part the J&J Acquisition.  Products We currently market a diverse and broad portfolio of branded OTC healthcare products, toiletries and dietary supplements in such categories as topical pain care, medicated skin care products, medicated dandruff shampoos, dietary supplements and other OTC and toiletry products. Our branded products by category consist of: Category and Brands   Product Description     Topical Pain Care     Icy Hot Dual action muscular and arthritis pain reliever Icy Hot Pro-Therapy Elastic support braces and pain relieving inserts Aspercreme Odor-free arthritis pain reliever Flexall Aloe-vera based pain reliever Capzasin Deep penetrating, odor-free arthritis pain reliever Sportscreme Odor-free muscular pain reliever Arthritis Hot Value-priced arthritis pain reliever   Medicated Skin Care Products   Gold Bond Medicated powder, cream, lotion, first aid and foot care products Cortizone Hydrocortisone anti-itch Balmex Diaper rash       Medicated Dandruff Shampoos   Selsun Blue Medicated dandruff shampoos Selsun Salon Medicated dandruff shampoos with enhanced moisturizers and nutrients     Dietary Supplements   Dexatrim Diet pills Garlique Cholesterol health supplement Melatonex Sleep aid New Phase Menopausal supplement Omnigest EZ Digestive aid Other OTC and Toiletry Products       Internal Analgesics   Pamprin Menstrual pain reliever Prēmsyn PMS Premenstrual pain reliever   Seasonal   Bullfrog Waterproof sunscreens Sun-In Spray-on hair lightener UltraSwim Chlorine-removing shampoo and conditioner     Oral Care   ACT Anti-cavity mouthwash/mouth rinse Herpecin-L Cold sore lip treatment Benzodent Denture pain relief cream       Other   Unisom OTC sleep-aid Kaopectate Anti-diarrhea Mudd Facial masque     Topical Pain Care Our topical pain care portfolio features six distinctly positioned brands. Our flagship brand, Icy Hot , is a leader in the external analgesic category and receives heavy media support and strong advertising featuring NBA super-star Shaquille O ’ Neal. In fiscal 2006, we introduced Icy Hot Pro-Therapy , a product line which combines strong knee or back support with therapeutic pain relieving inserts. In the first quarter of fiscal 2007, we extended the Icy Hot brand into the air activated portable heat category with Icy Hot Heat Therapy. Icy Hot will also be introducing new patch and cream line extensions in fiscal 2007 that are intended to capitalize on consumer trends. Aspercreme provides odor-free pain relief for sufferers of arthritis and other joint and muscle pain. Capzasin is an arthritis pain reliever that contains capsaicin, the active ingredient that doctors and pharmacists recommend for arthritis sufferers. In the first quarter of 2007, we will launch a new no-mess applicator under the Capzasin brand. Sportscreme is targeted at serious athletes as well as “weekend warriors”. Flexall is marketed toward those who seek a menthol and aloe vera based pain reliever for conditions such as chronic back pain or muscle strain. Arthritis Hot rounds out the portfolio and competes against private label products at a value price. Medicated Skin Care Products The Gold Bond brand competes in numerous product categories with specially formulated products for both adults and babies, including body powder, therapeutic hand and body lotions, foot care and first aid. Gold Bond has long been the number one selling brand of medicated body powder domestically, and its strong brand equity among consumers has allowed us to successfully launch new line extensions, most recently under the Gold Bond Ultimate line.  Initially launched in fiscal 2003, Gold Bond Ultimate Healing Skin Therapy Lotion helps to heal and nurture extremely dry, cracked and irritated skin with seven intensive moisturizers plus vitamins A, C and E. The Gold Bond Ultimate line expanded into the everyday bath powder category with the introduction of Gold Bond Ultimate Comfort Body Powder during the first quarter of fiscal 2005. Gold Bond Ultimate Comfort Body Powder is a talc-free powder that provides freshness, odor protection and moisture control and features the signature   Ultimate fragrance. In the fourth quarter of fiscal 2006, we introduced Gold Bond Ultimate Softening Lotion. The new Ultimate Softening lotion is specially formulated to soften rough dry skin. As part of the J&J Acquisition on January 2, 2007, we have added two new brands to the medicated skin care category: Cortizone-10, a hydrocortisone anti-itch product, and Balmex, a diaper rash product. Medicated Dandruff Shampoos Selsun Blue offers four domestic shampoo formulations: medicated, with a unique cooling clean feel; moisturizing, with aloe and moisturizers; 2-in-1, with a patented conditioning system; and pH balanced for color treated hair. Each formula blends the active medication (selenium sulfide) with extra hair care properties to provide alternative formulas for individuals who need a medicated dandruff shampoo. In the fourth quarter of fiscal 2005, we began shipping Selsun Salon , a maximum dandruff control shampoo with enhanced moisturizers and nutrients. All Selsun   Salon products are formulated with a unique blend of salon quality moisturizers, vitamins and nutrients to provide great looking hair and the proven dandruff ingredient pyrithione zinc 1% for effective dandruff control.   Dietary Supplements Dexatrim is a leading brand in the diet pill category. Dexatrim experienced strong growth in fiscal 2006 behind Dexatrim Max and the newly   introduced Dexatrim Max 2 O . Dexatrim Max was introduced in fiscal 2005 and contains Vitamin B complex, ginseng, chromium and ECGC from green tea. In fiscal 2007, we plan to launch Dexatrim Max Evening Appetite Control, a caffeine-free diet pill intended for night time use. Dexatrim Natural, a drug free, all-natural dietary supplement, is available in green tea, caffeine-free and extra energy versions. In fiscal 2006, we launched a unique new diet product, Dexatrim Max 2 O. Dexatrim Max 2 O, an effervescent tablet that dissolves in water, contains a Vitamin B complex and ECGC from green tea and is now available in four flavors.  We compete in the dietary supplements category with our Sunsource line of products. We focus the marketing of our Sunsource dietary supplements in two key areas: cardiovascular and menopausal health. Known for its support of cardiovascular health, Garlique leads the garlic supplement category and is positioned as an odor-free, one-per-day supplement that will help maintain cholesterol levels within a healthy range. In fiscal 2006, we launched a new cardiovascular health supplement called Garlique   CardioAssist.   Garlique CardioAssist is a clinically tested, odor-free dietary supplement containing an ingredient clinically proven to help lower total and LDL cholesterol. The proprietary formula also helps support normal levels of HDL cholesterol, triglycerides and homosysteines for more complete heart health. New Phase is a menopausal supplement that helps relieve the common discomforts of menopause, as well as providing support for strong bones and a healthy heart. All Sunsource products are specially formulated to provide consumers with an all-natural, drug-free way to support their specific health care goals. Other OTC and Toiletry Products Internal Analgesics We compete in the menstrual analgesic category with two brands, Pamprin and Prēmsyn PMS . Pamprin , featuring three distinct formulas, seeks to provide complete relief of a woman’s menstrual symptoms, while Prēmsyn PMS has one formula designed to address specific symptoms of premenstrual syndrome. Pamprin is available in three formulas: Multi-Symptom, Cramp and All Day. In fiscal 2006, Pamprin   Max was added to the line. Pamprin   Max is formulated with three active ingredients to provide maximum relief from menstrual symptoms. Seasonal The majority of sales of our seasonal brands, Bullfrog , Sun-In and UltraSwim , typically occur during the first three quarters of our fiscal year. Bullfrog is a line of high quality, high SPF waterproof sunblocks targeted to outdoor active children and adults. In fiscal 2006, we launched Bullfrog Mosquito Coast , which combines SPF 30 sunblock with a DEET-free insect repellent in a convenient spray form. In the first quarter of fiscal 2007, we will launch Bullfrog Marathon Mist. This new product available in an adult and children’s version combines quick-drying SPF 30 sunblock in a continuous spray format.   Sun-In , a hair lightener, is available in two varieties of spray-on and a highlighting gel. In 2007, Sun-In will introduce an updated package design for its spray-on products. UltraSwim is our niche line of swimmers’ shampoos and conditioner. Oral Care Our oral care brands include Herpecin-L , a lip care product that treats cold sores and protects lips from the harmful rays of the sun, and Benzodent , a dental analgesic cream for pain related to dentures. Herpecin-L is available in a stick and a jar format. With the J&J Acquisition completed January 2, 2007, we have added ACT , a line of anti-cavity mouthwash and mouth rinses. Other Our other brands include Mudd, a line of specialty masque products, and a variety of other smaller brands. In connection with the J&J Acquisition on January 2, 2007, we also added the Unisom and Kaopectate brands . Unisom is the leading single ingredient brand in the OTC sleep aid category. Kaopectate is a well established anti-diarrheal remedy. International Business Our international business, which represented approximately 8% of our total revenues in fiscal 2006, has been concentrated in Canada, an export market driven from our operations in Ireland and the U.K. and in international countries in which Selsun and certain of our other products are sold. Selsun International We plan to focus our efforts on expanding Selsun ’s international presence in existing key markets, such as Canada, Mexico, Brazil, the U.K. and Australia. In certain international markets, we sell Selsun through distributors and receive a royalty based on a percentage of distributor sales. We have entered into distributor agreements with third party distributors for Selsun in various international markets other than Canada and the U.K., where we engage national brokers. Europe Our European business is conducted through Chattem Global Consumer Products Limited (“Chattem Global”), our Irish subsidiary, located in Limerick, Ireland, and Chattem (U.K.) Limited (“Chattem (U.K.)”), a wholly-owned subsidiary located in Basingstoke, Hampshire, England. This unit also services distributors in various other worldwide locations. Packaging and distribution operations are conducted principally in Ireland with certain products sourced from our U.S. operations. Chattem uses a national broker in the U.K., while distributors are used to market and sell our products on the European continent and elsewhere. Our products sold in Europe include Selsun , Sun-In , Mudd and UltraSwim . Cornsilk ® is sold by Chattem (U.K.) under a licensing arrangement with the owner of its registered trademark, Del Laboratories, Inc. Spray Blond Spray-In Hair lightener is marketed only on the European continent. Certain of our OTC health care products are sold by Chattem Global to customers in parts of Central Europe and the Middle East. Canada Chattem Canada, a wholly-owned subsidiary based in Mississauga, Ontario, Canada, markets and distributes certain of our consumer products throughout Canada. The manufacturing of these products is principally done in our facilities in Chattanooga, Tennessee, while some packaging is done in Mississauga. Chattem Canada utilizes a national broker for its sales efforts. Brands marketed and sold in Canada include Icy Hot , Selsun, Gold Bond, Pamprin, Sun-In, UltraSwim and Aspercreme. United States Export Our United States export division services various distributors primarily located in the Caribbean and Latin America. We distribute Selsun, Gold Bond, Dexatrim, Icy Hot, Aspercreme, Capzasin and Sportscreme into these markets. Marketing, Sales and Distribution Advertising and Promotion We aggressively seek to build brand awareness and product usage throug