Chattem, Inc (CHTT) - Description of business


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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 through extensive and cost effective advertising strategies that emphasize the strengths of our products. We allocate a significant portion of our revenues to the advertising and promotion of our products. Expenditures for these purposes were approximately 32% of total revenues in fiscal 2006.

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 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 controlling 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 quickly and efficiently to launch and support new brands and product line extensions as well as increase market penetration of existing brands.

We work directly with retailers to develop promotional calendars and campaigns for each brand, customizing the promotion to the particular requirements of the individual retailer. These programs, which include cooperative advertising, temporary price reductions, in-store displays and special events, are designed to obtain or enhance distribution at the retail level

 

and to reach the ultimate consumers of the product. We also utilize consumer promotions such as coupons, samples and trial sizes to increase the trial and consumption of the products.

Customers

Our customers consist of mass merchandisers such as Wal-Mart Stores, Inc., drug retailers such as Walgreens Co. and food retailers such as The Kroger Co. In fiscal 2006, our ten largest customers represented approximately 73% of total revenues, and our 20 largest customers represented approximately 84% of total revenues, which allows us to target our selling efforts to our key customers and customize programs to meet their needs. Our fiscal 2006 sales to Wal-Mart Stores, Inc. accounted for approximately 36% of total revenues. No other customer accounts for more than 10% of our total revenues. Shoppers Drug Mart, a Canadian retailer, accounted for more than 10% of our international revenues in fiscal 2006. Consistent with industry practice, we do not operate under a long-term written supply contract with any of our customers.

Sales and Distribution

We have an established national sales and distribution sales organization that sells to mass merchandiser, drug and food retailers. We utilize our national sales network, consisting primarily of our own sales force, to sell and distribute newly acquired brands and product line extensions while maintaining tight controls over our selling expenses. Our experienced sales force of approximately 43 people serves all direct buying accounts on an individual basis. Our internal sales force accounts for more than 95% of domestic sales. For the more fragmented food channel and for the smaller individual stores, we rely on a national network of regional brokers to provide retail support. In excess of 90% of our domestic orders are received electronically through our electronic data interchange, or EDI, system, and accuracy for our order fulfillment has been consistently high. Our sales department performs significant analysis helping both our sales personnel and customers understand sales patterns and create appropriate promotions and merchandising aids for our products. Although not contractually obligated to do so, in certain circumstances, we allow our customers to return unsold merchandise, and for seasonal products, we provide extended payment terms to our customers.

Internationally, our products are sold by national brokers in Canada and the U.K. and by distributors in Europe and Latin America. We have entered into distribution agreements with third party distributors for Selsun in various international markets except Canada and the U.K.

Most of our products, including those manufactured by third party manufacturers, are shipped from a leased warehouse located in Chattanooga, Tennessee. We also use a third party logistics service located in California to warehouse and distribute our products to the west coast area of the United States. We use third party common carriers to transport our products. We do not generally experience wide variances in the amount of inventory we maintain. At present, we have no significant backlog of customer orders and are promptly meeting customer requirements.

Manufacturing and Quality Control

During fiscal 2006, we manufactured approximately 60% of the sales volume of our products at our two Chattanooga, Tennessee, facilities. The balance of our products are manufactured by third party contract manufacturers including our Gold Bond medicated powders, Icy Hot patches and sleeves, Herpecin-L, and our dietary supplements, including Dexatrim products. Newly acquired products that are similar to our currently manufactured products generally can be manufactured by us with the adaptation of existing equipment and facilities or the addition of new equipment at relatively small cost. We contract with third party manufacturers to manufacture products that are not compatible with our existing manufacturing facilities or which can be more cost-effectively manufactured by others. In many cases, third party manufacturers are not obligated under contracts that fix the term of their commitment. We believe we have adequate capacity to meet anticipated demand for our products through our own manufacturing facilities and third party manufacturers.

To monitor the quality of our products, we maintain an internal quality control system supported by onsite microbiology and analytical laboratories. We have trained quality control technicians who test our products and processes and guide the products through the manufacturing cycle. Consultants also are employed from time to time to test our quality control procedures and the compliance of our manufacturing operations with the United States Food and Drug Administration (“FDA”) regulations. We audit our third party manufacturers to monitor compliance with applicable current good manufacturing practices (“GMPs”) as defined by FDA regulations.

We purchase raw materials and packaging materials from a number of third party suppliers primarily on a purchase order basis. Except for pamabrom, pyrilamine maleate and compap, active ingredients used in our Pamprin and Prēmsyn PMS products, we are not limited to a single source of supply for the ingredients used in the manufacture of our products. Sales of our Pamprin and Prēmsyn PMS

 

products represented approximately 4% of our consolidated total revenues in fiscal 2006. In addition, we have a limited source of supply for selenium sulfide, the active ingredient in Selsun Blue . As a result of the limited supply and increase in worldwide demand for selenium metal, a major component in the manufacture of selenium sulfide, prices have been and are expected to be volatile. We believe that our current and potential alternative sources of supply will be adequate to meet future product demands.

Product Development

We strive to increase the value of our base brands and obtain an increased market presence through product line extensions. 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. Our growth strategy includes an emphasis on new product development as evidenced by our increased research and development spending, the expansion of our product development staff and our 10,000 square foot research and product development facility. We currently employ approximately 28 persons in our research and development department and also engage consultants from time to time to provide expertise or research in a particular product area. Our product development expenditures were $4.2 million in fiscal 2006 and $3.6 million in fiscal 2005.

Competition

We compete in the OTC health care, toiletries and dietary supplements markets. These markets are highly competitive and are characterized by the frequent introduction of new products, including the migration of prescription drugs to the OTC market, often accompanied by major advertising and promotional support. Our competitors include large pharmaceutical companies such as Pfizer Inc. and Johnson & Johnson, consumer products companies such as Procter & Gamble Co. and dietary supplements companies such as Nature’s Bounty, Inc. and Pharmaton Natural Health Products, many of which have considerably greater financial and other resources and are not as highly leveraged. Our competitors may be better positioned to spend more on research and development, employ more aggressive pricing strategies, utilize greater purchasing power, build stronger vendor relationships and develop broader distribution channels than us. In addition, our competitors have often been willing to use aggressive spending on trade promotions and advertising as a strategy for building market share at the expense of their competitors including us. The private label or generic category has also become increasingly more competitive in certain of our product markets. Our products continue to compete for shelf space among retailers who are increasingly consolidating.

Trademarks and Patents

Our trademarks are of material importance to our business and among our most important assets. We own all of our trademarks associated with brands that we currently market. In fiscal 2006, substantially all of our total revenues were from products bearing proprietary or licensed brand names. Accordingly, our future success may depend in part upon the goodwill associated with our brand names, particularly Gold Bond, Selsun Blue, Icy Hot and Aspercreme, and the newly acquired brands ACT,   Unisom and Cortizone .

Our principal brand names are registered trademarks in the United States and certain foreign countries. We maintain or have applied for patent and copyright protection in the United States relating to certain of our existing and proposed products and processes. We also license from third parties other intellectual property that is used in certain of our products. The sale of these products relies on our ability to maintain and extend our supply and licensing agreements with these third parties.

 

Government Regulation

 

The U.S. manufacturing, distribution, processing, formulation, packaging, labeling and advertising of our products are subject to regulation by federal agencies, including, but not limited to:

 

·
the Food & Drug Administration (the “FDA”);


·
the Federal Trade Commission (the “FTC”);


·
the Drug Enforcement Administration (the “DEA”);


·
the Consumer Product Safety Commission (the “CPSC”);


·
the United States Postal Service;


·
the Environmental Protection Agency (“EPA”); and


·
the Occupational Safety and Health Administration (“OSHA”).


 

These activities are also regulated by various agencies of the states, localities and foreign countries in which our products are sold. In particular, the FDA regulates the safety, manufacturing, labeling and distribution of dietary supplements including vitamins, minerals and herbs, as well as food additives, OTC and prescription drugs, medical devices and cosmetics. In addition, the FTC has primary jurisdiction to regulate the advertising of OTC drugs, medical devices, dietary supplements, functional toiletries and skin care products. In foreign countries these same activities may be regulated by Ministries of Health, or other local regulatory agencies; the manner in which they are registered, or how they are formulated, or what claims may be permitted may differ from similar products and practices in the U.S.

Under the Federal Food, Drug, and Cosmetic Act (“FDC Act”) all “new drugs”, including OTC products, are subject to pre-market approval by the FDA under the new drug application (“NDA”) process. The FDC Act defines a “new drug” as a drug that is not generally recognized among scientifically qualified experts as safe and effective for use under the conditions stated in its labeling. A drug might also be considered new if it has not been used, outside of clinical investigations, to a material extent or for a material time under conditions described for a product. A drug that is generally regarded as safe and effective is not a “new drug” and therefore does not require pre-market approval.

 

The FDA has adopted an administrative process, the OTC Drug Review, to determine which active ingredients and indications are safe and effective for use in OTC products. With the aid of independent expert advisory review panels, the FDA develops rules, referred to as “monographs”, that define categories of safe and effective OTC drugs. These monographs group drug ingredients into therapeutic classes such as OTC external analgesics. Products that comply with monograph conditions do not require pre-market approval from the FDA.

 

The FDA has finalized monographs for certain categories of OTC drugs such as drug products for the control of dandruff. If a product is marketed beyond the scope of a particular final monograph and without an approved NDA, such as if the manufacturer makes a label claim not covered by the monograph, the FDA will consider the product to be unapproved and misbranded and can take enforcement action against the drug company and product including, but not limited to, issuing a warning letter or initiating a product seizure. In order to market a product whose active ingredients are not permitted by a final monograph, a company must submit an NDA to the FDA.

 

There are several categories of OTC drugs, such as external analgesics, for which the FDA has not completed its review. In such cases, the FDA has established tentative final monographs. These tentative final monographs are similar to final monographs in that they establish conditions under which OTC drugs can be marketed for certain uses without FDA pre-marketing approval. The FDA generally does not take enforcement action against an OTC drug subject to a tentative final monograph unless there is a safety problem or a substantial effectiveness question.

 

The majority of our OTC drug products are regulated pursuant to the FDA monograph system with the exception of Pamprin All Day, the subject of an abbreviated NDA held by The Perrigo Company and the newly acquired Unisom SleepTabs, the subject of an approved NDA now held by Chattem. Many of our products are sold according to tentative final monographs. Therefore, we face the risk that the FDA could take action if there is a safety or efficacy issue with respect to one of our products or finalize these monographs with revised conditions as to which of our products do not comply. If any of our products were found not to be in compliance with the final monograph, we may be forced to reformulate or relabel such products, if possible, or submit an NDA or an abbreviated NDA to continue to market our existing formulation. The submission of a marketing application may require the preparation and submission of clinical tests, which would be time consuming and expensive. We may not receive FDA approval of any application in a timely manner or at all. If we were not able to reformulate or relabel our product or obtain FDA approval of an NDA, we would be required to discontinue selling the affected product. Changes in monographs could also require us to change our product formulation or dosage form, revise our labeling, modify our production process or provide additional scientific data, any of which would involve additional costs and may be prohibitive. For our OTC drug products that are sold according to final monographs, we cannot deviate from the conditions described in the final monograph, such as changes in approved active levels or labeling claims, unless we obtain pre-marketing approval from the FDA. In 2004, we launched Pamprin All Day containing the menstrual pain reliever naproxen sodium. The Perrigo Company (“Perrigo”) manufactures this product for us under its existing abbreviated NDA. Failure to comply with the conditions in a final monograph or NDA, where applicable, could result in an FDA enforcement action.

 

We have responded to certain questions received from the FDA with respect to efficacy of pyrilamine maleate, one of the active ingredients used in certain of the Pamprin Menstrual Pain Relief and   Prēmsyn PMS products. While we addressed all of the FDA questions in detail, the final monograph for menstrual drug products, which has not yet been issued, will determine if the FDA considers pyrilamine maleate safe and effective for menstrual relief products. If pyrilamine maleate is not included in the final monograph, we would be required to reformulate the products to continue to provide the consumer with multi-symptom relief benefits. We have been actively monitoring the process and do not believe that either Pamprin Menstrual Pain Relief or  

 

Prēmsyn PMS will be materially adversely affected by the FDA review. We believe that any adverse finding by the FDA would likewise affect our principal competitors in the menstrual product category and that finalization of the menstrual products monograph is not imminent. Moreover, we have formulated alternative Pamprin products that fully comply with both the internal analgesic and menstrual product monographs. Sales of our Pamprin Menstrual Pain Relief and Prēmsyn PMS products represented approximately 4% of our consolidated total revenues in fiscal 2006.

 

In early 2005, infrequent, but serious, adverse cardiovascular events were reported to the FDA associated with patients who were prescribed a subclass of COX-2 inhibitor non-steroidal anti-inflammatory drugs (“NSAID’s”) for long periods to relieve pain of chronic diseases such as arthritis. These products include Vioxx®, Bextra® and Celebrex®. In February 2005, the FDA held a joint advisory committee meeting to seek external counsel on the extent to which manufacturers might further warn patients of these cardiovascular risks on prescription product labeling, or prohibit sale of these prescription products. As part of its response on this issue, the FDA has recommended labeling changes for both the prescription and OTC NSAID’s. Well-known OTC NSAID’s such as ibuprofen and naproxen, which have been sold in vast quantities since the 1970s were affected by this regulatory action. Manufacturers of OTC NSAID’s were asked to revise their labeling to provide more specific information about the potential cardiovascular and gastrointestinal risks recognizing the limited dose and duration of treatment of these products. Our Pamprin All Day product, which contains naproxen sodium, is subject to these new labeling requirements. Pamprin All Day is manufactured for us by Perrigo, holder of an abbreviated NDA for naproxen sodium. As holder of the abbreviated NDA, Perrigo has made the mandated labeling changes within the time frame required by the FDA. Product with revised labeling compliant with new FDA regulations began shipping in February, 2006.

We are also aware of the FDA’s concern about the potential toxicity due to concomitant use of OTC and prescription products that contain the analgesic ingredient acetaminophen, an ingredient also found in Pamprin and   Prēmsyn PMS . We are participating in an industry-wide effort to reassure the FDA that the current recommended dosing regimen is safe and effective and that proper labeling and public education by both OTC and prescription drug companies are the best policies to abate the FDA’s concern. The FDA will address this issue in its effort to finalize the monograph on internal analgesic products. We believe the FDA may issue revised labeling requirements within the next year, perhaps prior to monograph closure, that will cause the industry to relabel its analgesic products to better inform consumers of concomitant use.

 

We were notified in October, 2000 that the FDA denied a citizen petition submitted by Thompson Medical Company, Inc., the previous owner of Sportscreme and Aspercreme. The petition sought a determination that 10% trolamine salicylate, the active ingredient in Sportscreme and Aspercreme , was clinically proven to be an effective active ingredient in external analgesic OTC drug products and should be included in the FDA’s yet-to-be finalized monograph for external analgesics. We have met with the FDA and submitted a proposed protocol study to evaluate the efficacy of 10% trolamine salicylate as an active ingredient in OTC external analgesic drug products. We are working to develop alternate formulations for Sportscreme and Aspercreme in the event that the FDA does not consider the available clinical data to conclusively demonstrate the efficacy of trolamine salicylate when the OTC external analgesic monograph is finalized. If 10% trolamine salicylate is not included in the final monograph, we would likely be required to discontinue these products as currently formulated and remove them from the market after expiration of an anticipated grace period. If this occurred, we believe we could market related products as homeopathic products and could also reformulate them using ingredients included in the FDA monograph. We are uncertain as to when the monograph is likely to become final. Sales of our Sportscreme and Aspercreme products represented approximately 8% of our consolidated total revenues in fiscal 2006.

 

Certain of our topical analgesic products are currently marketed under an FDA tentative final monograph. The FDA has recently proposed that the final monograph exclude external analgesic products in patch, plaster or poultice form, unless the FDA receives additional data supporting the safety and efficacy of these products. On October 14, 2003, we submitted to the FDA information regarding the safety of our Icy Hot patches and arguments to support our product’s inclusion in the final monograph. We have also participated in an industry-wide effort coordinated by Consumer Healthcare Products Association (“CHPA”) to establish with the FDA a protocol of additional research that will allow the patches to be marketed under the final monograph even if the final monograph does not explicitly allow them. The CHPA submission to the FDA was made on October 15, 2003. Thereafter, in April 2004, we launched the Icy Hot Sleeve, a flexible, non-occlusive fabric patch with 16% menthol. In February 2006, we launched the Icy Hot Pro-Therapy Medicated Foam Pad with Knee Wrap containing 5% menthol, and the Capzasin Back & Body Patch containing 0.025% capsaicin. All of these drug products contain levels of active ingredients consistent with the levels permitted in the OTC monograph. If additional research is required either as a preliminary to final FDA monograph approval and/or as a requirement of future individual product sale, we may need to invest in a considerable amount of expensive testing and data analysis. Any preliminary cost may be shared with other patch manufacturers. Because the submissions made into the FDA docket have been forwarded from its OTC Division to its Dermatological Division within the Center for Drug Evaluation and Research (“CDER”), we believe that the monograph is unlikely to become final and take effect before mid-2008 and perhaps thereafter. If neither action described above is successful and the final monograph summarily excludes such products, we will have to file an NDA in order to continue to market the Icy Hot and Aspercreme patches, Icy

 

Hot Sleeve, Icy Hot Pro-Therapy Medicated Pad with Knee Wrap, Capzasin Back & Body Patch, and/or similar delivery systems under our other topical analgesic brands. In such case, we would have to remove the existing products from the market likely one year from the effective date of the final monograph, or pending FDA review and approval of an NDA. The preparation of an NDA would likely take us six to 18 months and would be expensive. It typically takes the FDA at least 12 months to rule on an NDA once it is submitted. Sales of our Icy Hot and Aspercreme patches and Icy Hot Sleeve products represented approximately 12% of our consolidated total revenues in fiscal 2006.

 

During the finalization of the monograph on sunscreen products, the FDA chose to hold in abeyance specific requirements relating to the characterization of a product’s ability to reduce UVA radiation. A final ruling on this matter would be expected to result in new UVA testing requirements and subsequent labeling changes related to sun protection factor, or SPF, ratings, and other labeling claims. We expect that the FDA may take action on this matter within the next six months. If implemented, the final rules would likely result in new testing requirements and revised labeling of our Bullfrog product line, and all of our competitors’ products in the suncare category, within one year after issuance of the final rules.

 

The FDA also regulates the research, testing, manufacturing, safety, labeling, storage, recordkeeping, pre-market clearance or approval, promotion, distribution and production of medical devices in the United States to ensure that medical products distributed domestically are safe and effective for their intended uses. Under the FDC Act, medical devices are classified into one of three classes (Class I, Class II or Class III) depending on the degree of risk associated with each medical device and the extent of control needed to ensure safety and effectiveness. Our Icy Hot Heat Therapy , Icy Hot Pro-Therapy Knee and Back Brace and the Icy Hot Pro-Therapy Disposable Cold and Hot Packs are Class I devices.

 

Class I devices are subject to the lowest level of regulatory scrutiny because they are considered low risk devices. FDA requires Class I devices to comply with its General Controls, which include compliance with the applicable portions of the FDA’s Quality System Regulation, or QSR, facility registration and product listing, reporting of adverse medical events, and use of appropriate truthful and non-misleading labeling, advertising, and promotional materials. Most Class I devices are not required to submit 510(k) pre-market notifications (so-called “Class I Exempt”), but all are subject to FDA’s general misbranding and adulteration prohibitions. Both the Icy Hot Pro-Therapy Back and Knee Brace and the Icy Hot Pro-Therapy Disposable Cold and Hot Packs, and Icy Hot Heat Therapy are subject to regulations which exempt them from the 510(k) pre-market notification requirements. The FDA may disagree with our conclusion that clearances or approvals for such devices were not required or may require clearance or approval for future modifications of these or other devices. Such submissions may be time consuming and costly and may not ultimately be cleared or approved by FDA. If the FDA determines that we have failed to comply with applicable regulatory requirements, it can impose a variety of enforcement actions which could include public warning letters, fines, injunctions, consent decrees, civil penalties, suspension or delayed issuance of approvals or seizure or recall of our products. The FDA could also require us to repair, replace, or refund the cost of devices that we manufactured or distributed.

 

The Dietary Supplement Health and Education Act of 1994 (“DSHEA”) was enacted on October 25, 1994. DSHEA amends the FDC Act by defining dietary supplements, which include vitamins, minerals, amino acids, nutritional supplements, herbs and botanicals, as a new category of food separate from conventional food. DSHEA provides a regulatory framework to ensure safe, quality dietary supplements and to foster the dissemination of accurate information about such products. Under DSHEA, the FDA is generally prohibited from regulating dietary supplements as food additives or as drugs unless product claims, such as claims that a product may diagnose, mitigate, cure or prevent an illness, disease or malady, permit the FDA to attach drug status to a product. In such case, the FDA could require pre-market approval to sell the product. Manufacturers are not required to obtain prior FDA approval before producing or selling a dietary supplement unless the ingredient is considered “new” or was not on the market as of October 15, 1994.

Dietary supplement products may include truthful, non-misleading and substantiated statements of nutritional support.  Examples of such claims are statements describing general well-being resulting from consumption of a dietary ingredient or the role of a nutrient or dietary ingredient in affecting or maintaining a structure or function of the body.  These claims are also known as “ structure/function ” claims.  FDA requires companies which include structure/function claims on their labeling to notify the agency of the claim within 30 days of first marketing the dietary supplement with the identified claims.  FDA does not typically respond to these notifications, but could issue a “courtesy letter” should the agency question some aspect of the submission.  A dietary supplement that includes a structure/function claim on its labeling is also required to include a disclaimer stating that the FDA has not evaluated the claim.  FDA distinguishes between structure/function claims which do not require FDA pre-approval and disease-related health claims which require FDA prior approval or the issuance of an authorizing regulation.

 

A product marketed as a dietary supplement and subsequently approved for use as a drug or biologic may continue to be sold and regulated as a dietary supplement unless the FDA specifically finds that it is unsafe for use as a dietary supplement. A substance that has not been marketed as a dietary supplement prior to its approval as a drug or biologic, or prior to initiation of

 

substantial clinical investigations for such uses, may be sold as a dietary supplement only pursuant to an FDA regulation authorizing its use as a dietary supplement.

 

The FDA may take enforcement action against a dietary supplement if the FDA believes the supplement presents a significant or unreasonable risk of illness or injury under conditions of use suggested in the labeling or under ordinary conditions of use. Under DSHEA, the FDA bears the burden of proof to show that a dietary supplement presents a significant or unreasonable risk of illness or injury. The FDA may also take enforcement action for unlawful promotion of a dietary supplement.

 

The FDA has finalized some of its regulations to implement DSHEA including those relating to nutritional labeling requirements and nutritional support claims. The FDA also has under development additional regulations and guidelines to implement DSHEA. Newly adopted and future regulations may require expanded or different labeling for our dietary supplements. We cannot determine what effect these regulations, when fully implemented, will have on our business in the future. These regulations could require the reformulation or discontinuance of certain products, additional recordkeeping, warnings, notification procedures and expanded documentation of the properties of certain products and scientific substantiation regarding ingredients, product claims and safety. Failure to comply with applicable FDA requirements can result in sanctions being imposed on us or the manufacture of our products including, but not limited to, warning letters, product recalls and seizures, injunctions or criminal prosecution.

 

The FDA has promulgated regulations relating to the manufacturing process for drugs, which are known as current GMP’s. We anticipate that the FDA will promulgate GMP’s, which are specific to dietary supplements and require at least some of the quality control provisions contained in the GMP’s for drugs, which are more rigorous than the GMP’s for foods. We source all of our dietary supplement products from outside suppliers, including Dexatrim, New Phase, Garlique, Melatonex, CardioAssist, and Omnigest . As part of its regulatory authority, the FDA may periodically conduct audits of the physical facilities, machinery, processes and procedures that we, or our suppliers, use to manufacture products. The FDA may perform these audits at any time without advanced notice. As a result of these audits, the FDA may order us, or our suppliers, to make certain changes in manufacturing facilities and processes. We may be required to make additional expenditures to comply with these orders or new GMP requirements, or possibly discontinue selling certain products until we, or our suppliers, comply with these orders and requirements. As a result, our business could be adversely affected.

   

In 1997, the FDA published a proposed rule on the use of dietary supplements containing ephedrine alkaloids. In June 2002, the United States Department of Health and Human Services (“HHS”) proposed an expanded scientific evaluation of Ephedra which led to the issuance of a report by the RAND-based Southern California Evidence-Based Practice Center (the “RAND Report”). The RAND Report concluded that ephedrine, ephedrine plus caffeine and Ephedra-containing dietary supplements with or without herbs containing caffeine all promote modest amounts of weight loss over the short term and use of Ephedra, or ephedrine plus caffeine, is associated with an increased risk of gastrointestinal, psychiatric and autonomic symptoms. The adverse event reports contained a smaller number of more serious adverse events. Given the small number of such events, the RAND Report concluded that further study would be necessary to determine whether consumption of Ephedra, or ephedrine, may be causally related to these serious adverse events. In connection with the RAND Report, HHS sought public comment on whether additional measures are required concerning the sale and distribution of dietary supplements containing ephedrine alkaloids.

 

On December 30, 2003, the FDA issued a consumer alert on the safety of dietary supplements containing ephedrine alkaloids and on February 6, 2004 published a final rule with respect to these products. The final rule prohibits the sale of dietary supplements containing ephedrine alkaloids because such supplements present an unreasonable risk of illness or injury. The final rule became effective on April 11, 2004. Although we discontinued the manufacturing and shipment of Dexatrim containing ephedrine in September 2002, the FDA’s final rule may result in lawsuits in addition to those we currently have being filed against us alleging damages related to the use or purchase of Dexatrim containing ephedrine. See “Legal Proceedings”. In April 2005, a Utah federal court called into question the 2004 final rule. The court decision is being appealed and may have an effect on the FDA’s enforcement of the ephedrine alkaloid final rule.

 

The FDA also regulates some of our products as cosmetics or drug-cosmetics. There are fewer regulatory requirements for cosmetics than for drugs or dietary supplements. Cosmetics marketed in the United States must comply with the FDC Act, the Fair Packaging and Labeling Act and the FDA’s implementing regulations. Cosmetics must also comply with quality and labeling requirements proscribed by the FDA. In addition, several of our products are subject to product packaging regulation by the CPSC and the FDA.

 

Combination products can be regulated via a memorandum of understanding between federal agencies. In February 2006, we launched Bullfrog   Mosquito Coast , a combination of sunscreen and insect repellent. The sunscreen labeling is regulated by the FDA in its sunscreen monograph, but the insect repellent, IR-3535, and its labeling, require pre-market safety and

 

efficacy testing and approval by the EPA and all 50 states (and U.S. Territories). Bullfrog   Mosquito Coast received approval from all states and the EPA prior to launch. Further, the FDA has announced its intention in its November, 2005 Unified Agenda to regulate, under the monograph system, the combination of sunscreens and insect repellents in a notice of proposed rulemaking yet to be published. Any final rule making is years in the future and the FDA might grandfather existing products or otherwise allow time for their compliance.

 

Our business is also regulated by the California Safe Drinking Water and Toxic Enforcement Act of 1986, known as Proposition 65. Proposition 65 prohibits businesses from exposing consumers to chemicals that the state has determined cause cancer or reproduction toxicity without first giving fair and reasonable warning unless the level of exposure to the carcinogen or reproductive toxicant falls below prescribed levels. From time to time, one or more ingredients in our products could become subject to an inquiry under Proposition 65. If an ingredient is on the state’s list as a carcinogen, it is possible that a claim could be brought, in which case we would be required to demonstrate that exposure is below a “no significant risk” level for consumers. Any such claims may cause us to incur significant expense, and we may face monetary penalties or injunctive relief, or both, or be required to reformulate our product to acceptable levels. The State of California under Proposition 65 is also considering the inclusion of titanium dioxide on the state’s list of suspected carcinogens. Titanium dioxide has a long history of widespread use as an excipient in prescription and OTC pharmaceuticals, cosmetics, dietary supplements and skin care products and is an active ingredient in our Bullfrog Superblock products. We have participated in an industry-wide submission to the State of California, facilitated through CHPA, presenting evidence that titanium dioxide presents “no significant risk” to consumers.

 

Finally, the FDA regulates the quality of all finished drug, medical device, and food products under GMP’s. As part of its regulatory authority, the FDA may periodically conduct audits of the physical facilities, machinery, processes and procedures that we, or our suppliers, use to manufacture products. The FDA may perform these audits at any time without advanced notice. In February 2006, we registered as a medical device manufacturer with the FDA in connection with our sale of Pro-Therapy products. It might be expected that we could be audited as a new device manufacturer under medical device GMP’s. Working with consultants we have instituted medical device GMP’s pursuant to applicable portions of the medical device Quality System Regulation, or QSR. As a result of any audits, the FDA may order us, or our suppliers, to make certain changes in manufacturing facilities and processes. We may be required to make additional expenditures to comply with these orders, or possibly discontinue selling certain products until we, or our suppliers, comply with these orders. As a result, our business could be adversely affected. In the future, manufacturers of dietary supplements may be mandated by the FDA to comply with more rigorous GMP’s as well as post-marketing responsibilities similar to those applied to OTC drugs or medical devices. Such regulations may include mandatory adverse event reporting requirements as part of new GMP’s regulations.

 

The FDA has broad regulatory and enforcement powers. If the FDA determines that we have failed to comply with applicable regulatory requirements, it can impose a variety of enforcement actions from public warning letters, fines, injunctions, consent decrees and civil penalties to suspension or delayed issuance of approvals, seizure or recall of our products, total or partial shutdown of production, withdrawal of approvals or clearances already granted, and criminal prosecution. The FDA can also require us to repair, replace or refund the cost of devices that we manufactured or distributed. If any of these events were to occur, it could materially adversely affect us.

 

Environmental Matters

We continually assess the compliance of our operations with applicable federal, state and local environmental laws and regulations. Our policy is to record liabilities for environmental matters when loss amounts are probable and reasonably determinable. Our manufacturing site utilizes chemicals and other potentially hazardous materials and generates both hazardous and non-hazardous waste, the transportation, treatment, storage and disposal of which are regulated by various governmental agencies. We have engaged environmental consultants on a regular basis to assist with our compliance efforts. We believe we are currently in compliance with all applicable environmental permits and are aware of our responsibilities under applicable environmental laws. Any expenditure necessitated by changes in law and permitting requirements cannot be predicted at this time, although such costs are not expected to be material to our financial position, results of operations or cash flows.

In late 2005, we began the manufacture of Bullfrog Mosquito Coast at our Chattanooga, Tennessee plant. Bullfrog Mosquito Coast is a combination of sunscreen and insect repellent. The EPA has primary jurisdiction over insect repellants and combination insect repellant products containing sunscreens, such as BullFrog Mosquito Coast . Both products and manufacturing establishments must be registered with EPA. The FDA has published notice that a monograph regulating combination insect repellants and sunscreens will be issued during 2007. This new monograph may change the regulatory enforcement jurisdiction from the EPA to the FDA.

The handling, disposal, and environmental exposure of the insect repellent, IR-3535, is strictly regulated by the EPA under the Clean Waters Act. Any failure to comply with applicable regulations with respect to the use of IR-3535 might result in EPA action against us, including fines or injunctive action.

 

Employees

We employ approximately 423 persons on a full-time basis and eight persons on a part-time basis in the United States. In addition, we employ approximately 24 persons at our foreign subsidiaries’ offices. Our employees are not represented by any organized labor union, and we consider our labor relations to be good.

Financial Information on Products and Geographical Areas

For financial information on our product categories and geographical areas, see note 12 to our consolidated financial statements.

Additional Information

Our internet website address is www.chattem.com . We make available free of charge on or through our website our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, reports filed pursuant to Section 16, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission.

Item 1A. Risk Factors

Our business is subject to a number of risks. Some of the risks associated with our operations are described in the “Competition,” “Government Regulation,” “Environmental,” and “Manufacturing and Quality Control” portions of this Form 10-K. In addition to the other information contained in this Form 10-K, the following risk factors should be carefully considered.

We may not be able to successfully integrate the five brands acquired in the J&J Acquisition into our portfolio of consumer brands or achieve other synergies associated with the acquisition.

 

In connection with the completion of the J&J Acquisition, we acquired the U.S. rights to the following five brands: ACT , Unisom, Cortizone, Kaopectate and Balmex. The integration of these acquired brands into our existing business involves a number of risks and presents significant financial, operational and managerial challenges. Failure to successfully integrate the new brands into our business may have a material adverse effect on our business, results of operation, financial condition, cash flow or the trading price for our common stock or the trading price and liquidity of the Convertible Notes.

We have a significant amount of debt that could adversely affect our business and growth prospects.

As of November 30, 2006, our total long-term debt was $232.5 million. Additionally, on January 2, 2007, we completed an amended credit facility providing for up to a $100.0 million revolving credit facility and a $300.0 million term loan. The proceeds from the term loan were used to finance in part the J&J Acquisition. In the future, we may incur significant additional debt. Our debt could have significant adverse effects on our business including:


requiring us to dedicate a substantial portion of our available cash for interest payments and the repayment of principal;



limiting our ability to capitalize on significant business opportunities;



making us more vulnerable to economic downturns;



limiting our ability to withstand competitive pressures; and



making it more difficult for us to obtain additional financing on favorable terms.


If we are unable to generate sufficient cash flow from operations in the future, we may not be able to service our debt and may have to refinance all or a portion of our debt, obtain additional financing or sell assets to repay such debt. We cannot assure you that we will be able to obtain such refinancing, additional financing or asset sale on favorable terms or at all.

We face significant competition in the OTC health care, toiletries and dietary supplements markets.

The OTC health care, toiletries and dietary supplements markets are highly competitive and are characterized by the frequent introduction of new products, including the migration of prescription drugs to the OTC market, often accompanied by major advertising and promotional support. These introductions may adversely affect our business especially because we compete in categories in which product sales are highly influenced by advertising and promotions. Our competitors include large pharmaceutical companies such as Pfizer Inc. and Johnson & Johnson, consumer products companies such as Procter & Gamble Co. and dietary supplements companies such as Nature’s Bounty, Inc. and Pharmaton Natural Health Products, many of which have considerably greater financial and other resources than we do and are not as highly leveraged as we are. These competitors are thus better positioned to spend more on research and development, employ more aggressive pricing strategies, utilize greater purchasing power, build stronger vendor relationships and develop broader distribution channels than us. In addition, our competitors have often been willing to use aggressive spending on trade promotions and advertising as a strategy for building market share at the expense of their competitors including us. The private label or generic category has also become increasingly more competitive in certain of our product markets. If we are unable to continue to introduce new and innovative products that are attractive to consumers or are unable to allocate sufficient resources to effectively advertise and promote our products so that they achieve wide spread market acceptance, we may not be able to compete effectively, and our operating results and financial condition may be adversely affected.

 

We may face additional lawsuits alleging injury from the use of Dexatrim products containing ephedrine, which we discontinued manufacturing and shipping in September 2002, or from other products that we currently produce or may produce in the future.

We are currently named as a defendant in two lawsuits alleging that the plaintiffs were injured as a result of the ingestion of Dexatrim containing ephedrine. On December 30, 2003, the FDA issued a consumer alert on the safety of dietary supplements containing ephedrine alkaloids and on February 6, 2004 published a final rule with respect to these products. The final rule prohibits the sale of dietary supplements containing ephedrine alkaloids because such supplements present an unreasonable risk of illness or injury. The final rule became effective on April 11, 2004. Although we discontinued the manufacture and shipment of Dexatrim containing ephedrine in September 2002, the FDA’s final rule may result in additional lawsuits being filed against us alleging damages related to the use or purchase of Dexatrim containing ephedrine.

Our available product liability coverage for the defense of lawsuits alleging injury from the use of Dexatrim products containing ephedrine, or from other products that we currently produce or may produce in the future, consists of $25.0 million of coverage through our captive insurance subsidiary, of which approximately $6.6 million is funded as of February 1, 2007. We also have an additional $20.0 million of excess coverage through a third party reinsurance policy, which excludes coverage for any future claims involving Dexatrim products containing ephedrine. In the future, if we face significant liabilities relating to the Dexatrim products which included ephedrine, our product liability insurance may be insufficient, and we may not have sufficient resources to satisfy these liabilities in excess of our insurance coverage.

An inherent risk of our business is exposure to product liability claims by users of our products. We may also experience significant product liability exposure related to our other products (including the five brands acquired in the J&J Acquisition) in the future.

Our product liability insurance coverage may be insufficient to cover existing or future product liability claims.

Our business inherently makes us the potential target of product liability claims. We have product liability insurance through our captive insurance subsidiary and a third party reinsurance policy that provides coverage for product liability claims. Our product liability insurance coverage for all of our products, including Dexatrim products containing ephedrine, consists of $25.0 million of coverage through our captive insurance subsidiary, of which approximately $6.6 million is funded as of February 1, 2007, and an additional $20.0 million of excess coverage through a third party reinsurance policy, which excludes coverage for any future claims involving Dexatrim products containing ephedrine.

All of our insurance policies are subject to certain limitations that are generally customary for policies of this type such as deductibles and exclusions for exemplary and punitive damages. Since plaintiffs in product liability claims may seek exemplary and punitive damages, if these damages were awarded, some of our insurance coverage would not cover these amounts, and we may not have sufficient resources to pay these damages. Any amounts paid by our insurance to satisfy product liabilities would decrease product liability insurance coverage available for any other claims. If our liability for product liability claims is significant, our existing insurance is likely to be insufficient to cover these claims, and we may not have sufficient resources to pay the liabilities in excess of our insurance coverage. Furthermore, our product liability insurance

 

provided by third parties will expire at the end of each annual policy period, currently in May of each year. We may incur significant additional costs to obtain insurance coverage upon the expiration of our current policies and may not be able to obtain coverage in the future in amounts equal to that which we currently have or in amounts sufficient to satisfy future claims. Also, the addition of five new brands to our consumer products portfolio following the completion of the J&J Acquisition may result in increased insurance costs.

Our acquisition strategy is subject to risk and may not be successful.

A component of our growth strategy depends on our ability to successfully execute acquisitions, which involves numerous risks including:


not accurately identifying suitable products or brands for acquisition;



difficulties in integrating the operations, technologies and manufacturing processes of the acquired products;



the diversion of management’s attention from other business concerns; and



incurring substantial additional indebtedness.


 

Any future acquisitions, or potential acquisitions, may result in substantial costs, disrupt our operations or materially adversely affect our operating results.

Our business is regulated by numerous federal, state and foreign governmental authorities, which subjects us to elevated compliance costs and risks of non-compliance.

The manufacturing, distributing, processing, formulating, packaging and advertising of our products are subject to numerous and complicated federal, state and foreign governmental regulations. Compliance with these regulations is difficult and expensive. In particular, the FDA regulates the safety, manufacturing, labeling and distributing of our OTC products, medical devices, and dietary supplements. In addition, the FTC may regulate the promotion and advertising of our drug products, particularly OTC versions and dietary supplements. The EPA regulates our Bullfrog Mosquito Coast insect repellent products. We are also regulated by various state statutes, including the California Safe Drinking Water and Toxic Enforcement Act of 1986. If we fail to adhere to the standards required by these federal and state regulations, or are alleged to have failed to adhere such regulations, our operating results and financial condition may be adversely affected.

 

Our success depends on our ability to anticipate and respond in a timely manner to changing consumer preferences.

Our success depends on our products’ appeal to a broad range of consumers whose preferences cannot be predicted with certainty and are subject to change. If our current products do not conform to consumer preferences, our sales may decline. In addition, our growth depends upon our ability to develop new products through product line extensions and product modifications, which involve numerous risks. We may not be able to accurately identify consumer preferences and translate our knowledge into customer-accepted products or successfully integrate these products with our existing product platform or operations. We may also experience increased expenses incurred in connection with product development, marketing and advertising that are not subsequently supported by a sufficient level of sales, which would negatively affect our margins. Furthermore, product development may divert management’s attention from other business concerns, which could cause sales of our existing products to suffer. We cannot assure you that newly developed products will contribute favorably to our operating results.

We rely on a few large customers, particularly Wal-Mart Stores, Inc., for a significant portion of our sales.

In fiscal 2006, Wal-Mart Stores, Inc. represented approximately 36% of our total revenues, our ten largest customers represented approximately 73% of our total revenues and our 20 largest customers represented approximately 84% of our total revenues. Consistent with industry practice, we do not operate under a long-term written supply contract with Wal-Mart Stores, Inc. or any of our other customers. Our business would materially suffer if we lost Wal-Mart Stores, Inc. as a continuing major customer or if our business with Wal-Mart Stores, Inc. significantly decreases. The loss of sales to any other large customer could also materially and adversely affect our financial results.

We may be adversely affected by fluctuations in buying decisions of mass merchandiser, drug and food trade buyers and the trend toward retail trade consolidation.

We sell our products to mass merchandiser and food and drug retailers in the United States. Consequently, our total revenues are affected by fluctuations in the buying patterns of these customers. These fluctuations may result from wholesale buying decisions, economic conditions and other factors. In addition, with the growing trend towards retail consolidation, we are increasingly dependent upon a few leading retailers, such as Wal-Mart Stores, Inc., whose bargaining strength continues to grow due to their size. Such retailers have demanded, and may continue to demand, increased service and order accommodations as well as price and incremental promotional investment concessions. As a result, we may face downward pressure on our prices and increased promotional expenses to meet these demands, which would reduce our margins. We also may be negatively affected by changes in the policies of our retail trade customers such as inventory destocking, limitations on access to shelf space and other conditions.

We rely on third party manufacturers for a portion of our product portfolio, including products under our Gold Bond, Icy Hot , Selsu n and Dexatrim brands and the brands acquired in the J&J Acquisition.

We use third party manufacturers to make products representing approximately 40% of our fiscal 2006 sales volume, including our Gold Bond medicated powders and foot spray, the Icy Hot patches and sleeves, Herpecin-L, and our line of dietary supplements including Dexatrim Max and, internationally, our line of Selsun medicated dandruff shampoos.  Pfizer Inc. will manufacture the Cortizone , Unisom and  Kaopectate products for us during a transition period of up to 18 months.  In the near term, we will also rely on third party manufacturers to manufacture the Act and Balmex product lines. In many cases, third party manufacturers are not bound by fixed term commitments in our contracts with them, and they may discontinue production with little or no advance notice. Manufacturers also may experience problems with product quality or timeliness of product delivery. We rely on these manufacturers to comply with applicable current GMPs. The loss of a contract manufacturer may force us to shift production to in-house facilities and possibly cause manufacturing delays, disrupt our ability to fill orders or require us to suspend production until we find another third party manufacturer. We are not able to control the manufacturing efforts of these third party manufacturers as closely as we control our business. Should any of these manufacturers fail to meet our standards, we may face regulatory sanctions, additional product liability claims or customer complaints, any of which could harm our reputation and our business.

Our dietary supplement business could suffer as a result of injuries caused by dietary supplements in general, unfavorable scientific studies or negative press.

Our dietary supplements consist of Dexatrim and our Sunsource product line. We are highly dependent upon consumers’ perceptions of the benefit and integrity of the dietary supplements business as well as the safety and quality of products in that industry. Injuries caused by dietary supplements or unfavorable scientific studies or news relating to products in this category, such as the December 30, 2003 consumer alert on the safety of dietary supplements containing ephedrine alkaloids issued by the FDA and the subsequent FDA rule banning the sale of supplements containing ephedrine alkaloids that became effective on April 11, 2004, may negatively affect consumers’ overall perceptions of products in this category, including our products, which could harm the goodwill of these brands and cause our sales to decline.

Our business could be adversely affected if we are unable to successfully protect our intellectual property.

Our trademarks are of material importance to our business and are among our most important assets. In fiscal 2006, substantially all of our total revenues were from products bearing proprietary or licensed brand names. Accordingly, our future success may depend in part upon the goodwill associated with our brand names, particularly Gold Bond, Selsun Blue, Icy Hot and Aspercreme as well as the brands acquired in the J&J Acquisition in January 2007. Although our principal brand names are registered trademarks in the United States and certain foreign countries, we cannot assure you that the steps we take to protect our proprietary rights in our brand names will be adequate to prevent the misappropriation of these registered brand names in the United States or abroad. In addition, the laws of some foreign countries do not protect proprietary rights in brand names to the same extent as do the laws of the United States. Also, we did not acquire any material intellectual property or trademark rights outside of the United States for the five brands acquired in the J&J Acquisition. We cannot assure you that we will be able to successfully protect our trademarks from infringement or otherwise. The loss or infringement of our trademarks could impair the goodwill associated with our brands, harm our reputation and materially adversely affect our financial results.

We license additional intellectual property from third parties that is used in certain of our products, and we cannot assure you that these third parties can successfully maintain their intellectual property rights. In addition, the sale of these products relies on our ability to maintain and extend our licensing agreements with third parties, and we cannot assure you that we will be successful in maintaining these licensing agreements. Any significant impairment of the intellectual property covered by these licenses, or in our rights to use this intellectual property, may cause our sales to decline.

In addition, our product line extensions are often based on new or unique delivery methods for those products like our Icy Hot patches and sleeves. These delivery methods may not be protected by intellectual property rights that we own or license on an exclusive basis or by exclusive manufacturing agreements. As a result, we may be unable to prevent any competitor or customer from duplicating our delivery methods to compete directly with these product line extensions, which could cause sales to suffer.

We may face litigation in the future, either to protect our intellectual property rights or to defend against claims that we have infringed the intellectual property rights of others. Intellectual property litigation can be extremely expensive, and such expense could materially adversely affect our business.

Because most of our operations are located in Chattanooga, Tennessee, we are subject to regional and local risks.

Approximately 60% of our sales volume in fiscal 2006 was from products manufactured in two plants located in Chattanooga, Tennessee. We store the raw materials used in our manufacturing activities in two warehouses that are also located in Chattanooga. We package and ship most of our products from Chattanooga. Additionally, our corporate headquarters are also located in Chattanooga, and most of our employees live in the area. Because of this, we are subject to regional and local risks, such as:


changes in state and local government regulations;



severe weather conditions, such as floods, ice storms and tornadoes;



natural disasters, such as fires and earthquakes;



power outages;



nuclear facility incidents;



spread of infectious diseases;



hazardous material incidents; or



any other catastrophic events in our area.


If our region, city or facilities were to suffer a significant disaster, our operations are likely to be disrupted and our business would suffer.

We depend on sole source suppliers for three active ingredients used in our Pamprin and Prēmsyn   PMS products and a limited source of supply for selenium sulfide, the active ingredient in Selsun Blue , and if we are unable to buy these ingredients, we will not be able to manufacture these products.

Pamabrom, pyrilamine maleate and compap, active ingredients used in our Pamprin and Prēmsyn PMS products, are purchased from single sources of supply. Pamabrom is sold only by Chattem Chemicals, Inc. (an unrelated company), pyrilamine maleate is produced only in India and sold only by Lonza, Inc. and compap is sold only by Mallinckrodt, Inc. In addition, we have a limited source of supply for selenium sulfide, the active ingredient in Selsun Blue . Financial, regulatory or other difficulties faced by these source suppliers or significant changes in demand for these active ingredients could limit the availability and increase the price of these active ingredients. We may not be able to obtain necessary supplies in a timely manner, and we may be required to pay higher than expected prices for these active ingredients, which could adversely affect our gross margin from these products. Any interruption or significant delay in the supply of these active ingredients would impede our ability to manufacture these products, which would cause our sales to decline. We would not be able to find an alternative supplier and would either need to reformulate these products or discontinue their production. We cannot assure you that we will be able to continue to purchase adequate quantities of these active ingredients at acceptable prices in the future.

We are subject to the risk of doing business internationally.

In fiscal 2006, approximately 8% of our total revenues were attributable to our international business. Our acquisition of Selsun Blue in 2002 expanded our international business. We operate in regions and countries where we have little or no

 

experience, and we may not be able to market our products in, or develop new products successfully for, these markets. We may also encounter other risks of doing business internationally including:


unexpected changes in, or impositions of, legislative or regulatory requirements;



fluctuations in foreign exchange rates, which could cause fluctuations in the price of our products in foreign markets or cause fluctuations in the cost of certain raw materials purchased by us;



delays resulting from difficulty in obtaining export licenses, tariffs and other barriers and restrictions, potentially longer payment cycles, greater difficulty in accounts receivable collection and potentially adverse tax treatment;



potential trade restrictions and exchange controls;



differences in protection of our intellectual property rights; and



the burden of complying with a variety of foreign laws.


In addition, we will be increasingly subject to general geopolitical risks in foreign countries where we operate such as political and economic instability and changes in diplomatic and trade relationships, which could affect, among other things, customers’ inventory levels and consumer purchasing, which could cause our results to fluctuate and our sales to decline. It has not been our practice to engage in foreign exchange hedging transactions to manage the risk of fluctuations in foreign exchange rates because of the limited nature of our past international operations. Due to the significant expansion of our international operations as a result of the Selsun Blue acquisition, our exposure to fluctuations in foreign exchange rates has increased.

The terms of our outstanding debt obligations limit certain of our activities.

The terms of the indenture under which our 7.0% Subordinated Notes are issued and our Credit Facility impose operating and financial restrictions on us including restrictions on:


incurrence of additional indebtedness;



dividends and restricted payments;



investments;



loans and guarantees;



creation of liens;



transactions with affiliates;



use of proceeds from sales of assets and subsidiary stock; and



certain mergers, consolidations and transfers of assets.


The terms of our Credit Facility also require us to comply with financial maintenance covenants. In the future, we may have other indebtedness with similar or even more restrictive covenants. These restrictions may impair our ability to respond to changing business and economic conditions or to grow our business. In the event that we fail to comply with these covenants, there could be an event of default under the applicable debt instrument, which in turn could cause a cross default to other debt instruments. As a result, all amounts outstanding under our various debt instruments may become immediately due and payable.

Our operations are subject to significant environmental laws and regulations.

Our manufacturing sites use chemicals and other potentially hazardous materials and generate both hazardous and non-hazardous waste, the transportation, treatment, storage and disposal of which are regulated by various governmental agencies and federal, state and local laws and regulations. Under these laws and regulations, we are exposed to liability primarily as an owner or operator of real property, and as such, we may be responsible for the clean-up or other remediation of

 

contaminated property. Environmental laws and regulations can change rapidly, and we may become subject to more stringent environmental laws and regulations in the future, which may be retroactively applied to earlier events. Product line extensions, such as Bullfrog Mosquito Coast , or acquisitions of new products, such as those acquired in the J&J Acquisition, may also subject our business to new or additional environmental laws and regulations. In addition, compliance with new or more stringent environmental laws and regulations could involve significant costs.

We are dependent on certain key executives, the loss of whom could have a material adverse effect on our business.

Our future performance depends significantly upon the efforts and abilities of certain members of senior management, in particular those of Zan Guerry, our chairman and chief executive officer, and Robert E. Bosworth, our president and chief operating officer. If we were to lose any key senior executive, our business could be materially adversely affected.

Our shareholder rights plan and restated charter contain provisions that may delay or prevent a merger, tender offer or other change of control of us.

Provisions of our shareholder rights plan and our restated charter, as well as certain provisions of Tennessee corporation law, may deter unfriendly offers or other efforts to obtain control over us and could deprive shareholders (including holders of the Convertible Notes which may convert into common stock) of their ability to receive a premium on their common stock.

Generally, if any person attempts to acquire 15% or more of our common stock then outstanding without the approval of our independent directors, pursuant to our shareholder rights plan, our shareholders may purchase a significant amount of additional shares of our common stock at 50% of the then applicable market price. This threat of substantial dilution will discourage takeover attempts not approved by our board despite significant potential benefits to our shareholders.

Our restated charter contains the following additional provisions, which may have the effect of discouraging takeover attempts:


our directors are divided into three classes, with only one class of directors elected at each annual meeting for a term of three years, making it difficult for new shareholders to quickly gain control of our board of directors;



directors may be removed only for cause prior to the expiration of their terms; and



we are prohibited from engaging in certain business combination transactions with any interested shareholder unless such transaction is approved by the affirmative vote of at least 80% of the outstanding shares of our common stock held by disinterested shareholders, unless disinterested members of our board of directors approve the transaction or certain fairness conditions are satisfied, in which case such transaction may be approved by either the affirmative vote of the holders of not less than 75% of our outstanding shares of common stock and the affirmative vote of the holders of not less than 66% of the outstanding shares of our common stock which are not owned by the interested shareholder, or by a majority of disinterested members of our board of directors, provided that certain quorum requirements are met.


The Tennessee Business Combination Act prevents an interested shareholder, which is defined generally as a person owning 10% or more of our voting stock, from engaging in a business combination with us for five years following the date such person became an interested shareholder unless before such person became an interested shareholder, our board of directors approved the transaction in which the interested shareholder became an interested shareholder or approved the business combination, and the proposed business combination satisfied any additional applicable requirements imposed by law and by our restated charter or bylaws. If the requisite approval for the business combination or share acquisition has not been obtained, any business combination is prohibited until the expiration of five years following the date such person became an interested shareholder.

The trading price of our common stock may be volatile.

The trading price of our common stock could be subject to significant fluctuations in response to several factors, some of which are beyond our control, including variations in our quarterly operating results, our leveraged financial position, potential sales of additional shares of our common stock, general trends in the consumer products industry, changes by securities analysts in their estimates or investment ratings, the relative illiquidity of our common stock, news regarding potential product liability litigation and stock market conditions generally.

We have no current intention of paying dividends to holders of our common stock.

We presently intend to retain our earnings, if any, for use in our operations, to repurchase our common stock and to repay our outstanding indebtedness and have no current intention of paying dividends to holders of our common stock.

Market Data

We use market and industry data throughout this Annual Report on Form 10-K and the documents incorporated by reference herein, which we have obtained from market research, publicly available information and industry publications. These sources generally state that the information that they provide has been obtained from sources believed to be reliable, but that the accuracy and completeness of such information are not guaranteed. The market and industry data is often based on industry surveys and the preparers’ experience in the industry. Similarly, although we believe that the surveys and market research that others have performed are reliable, we have not independently verified this information. In particular, market share information has been coordinated and prepared for us by A.C. Nielsen at our request based on market segments that we defined and for which we have paid customary fees. Therefore, such data, including the market category delineations that form the basis for such data, are not necessarily representative of results that would have been obtained from an independent source.

Item 1B. Unresolved Staff Comments

None


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