UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549






FORM
10-Q







QUARTERLY
REPORT


PURSUANT
TO SECTION 13 OR 15(d) OF


THE
SECURITIES EXCHANGE ACT OF 1934







For
the quarterly period ended August 31, 2008


Commission
file number 0-5905







CHATTEM,
INC.


A
TENNESSEE CORPORATION


I.R.S.
EMPLOYER IDENTIFICATION NO. 62-0156300


1715
WEST 38TH STREET


CHATTANOOGA,
TENNESSEE 37409


TELEPHONE:  423-821-4571













Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.




YESþ      NO 





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer or a smaller reporting
company.  See the definitions of “large accelerated filer”,
“accelerated filer” and “smaller reporting company” in Rule 12b-2 of the
Exchange Act.  (Check one):




Large accelerated filerþ
            Accelerated fileroNon-accelerated
      filero (Do not check if a smaller
      reporting company)
            Smaller reporting companyo




Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).




YESo      NO þ




As
of October 2, 2008,18,916,427 shares of the
Company’s common stock, without par value, were outstanding.










CHATTEM,
INC.





INDEX




PART
I.  FINANCIAL INFORMATION
 PAGE
      NO.Item
      1.  Financial StatementsConsolidated
      Balance Sheets as of August 31, 2008 andNovember
      30, 2007
              3Consolidated
      Statements of Income for the Three and NineMonths
      Ended August 31, 2008 and August 31, 2007
              5Consolidated
      Statements of Cash Flows for the Nine MonthsEnded
      August 31, 2008 and August 31, 2007
              6Notes
      to Consolidated Financial Statements
              7Item
      2.  Management’s Discussion
      and Analysis of Financial Conditionand Results of Operations
              29Item
      3.  Quantitative and Qualitative Disclosures About Market
      Risk
              41Item
      4.  Controls and Procedures
              42PART
      II.  OTHER INFORMATIONItem
      1. Legal Proceedings
              42Item
      1A. Risk Factors
              42Item
      2. Unregistered Sales of Equity Securities and Use of
    Proceeds
              43Item
      3. Defaults Upon Senior Securities
              43Item
      4. Submission of Matters to a Vote of Security Holders
              43Item
      5. Other Information
              43Item
      6. Exhibits
              43SIGNATURES
              44
 
 
 2
 PART 1. FINANCIAL
INFORMATION
 
 Item 1. Financial
Statements
 
 CHATTEM, INC. AND
SUBSIDIARIES
 
 CONSOLIDATED BALANCE
SHEETS
 (In
thousands)
 
 ASSETS
              
              AUGUST
      31,
                2008
              
              
              NOVEMBER
      30,
                2007(Unaudited)CURRENT
      ASSETS:Cash
      and cash equivalents
              
              $
              13,031
              
              
              $
              15,407Accounts
      receivable, less allowances of $11,578 at
                August
      31, 2008 and $13,810 at November 30, 2007
              
              
              51,320
              
              
              
              43,753Inventories
              
              
              40,655
              
              
              
              43,265Deferred
      income taxes
              
              
              7,435
              
              
              
              6,750Prepaid
      expenses and other current assets
              
              
              7,945
              
              
              
              2,065Total
      current assets
              
              
              120,386
              
              
              
              111,240PROPERTY,
      PLANT AND EQUIPMENT, NET
              
              
              32,419
              
              
              
              32,349OTHER
      NONCURRENT ASSETS:Patents,
      trademarks and other purchased product rights, net
              
              
              616,373
              
              
              
              616,810Debt
      issuance costs, net
              
              
              12,911
              
              
              
              15,430Other
              
              
              4,612
              
              
              
              4,731Total
      other noncurrent assets
              
              
              633,896
              
              
              
              636,971TOTAL
      ASSETS
              
              $
              786,701
              
              
              $
              780,560
 
 
 
 The
accompanying notes are an integral part of these consolidated financial
statements.
           
 3
 CHATTEM, INC. AND
SUBSIDIARIES
 
 CONSOLIDATED BALANCE
SHEETS
 (In
thousands)
 
 
 LIABILITIES AND
      SHAREHOLDERS’ EQUITY
              
              AUGUST
      31,
                2008
              
              
              NOVEMBER
      30,
                2007(Unaudited)CURRENT
      LIABILITIES:Current
      maturities of long-term debt
              
              $
              3,000
              
              
              $
              3,000Accounts
      payable and other
              
              
              18,795
              
              
              
              18,239Bank
      overdraft
              
              
              —
              
              
              
              7,584Accrued
      liabilities
              
              
              37,482
              
              
              
              21,537Total
      current liabilities
              
              
              59,277
              
              
              
              50,360LONG-TERM
      DEBT, less current maturities
              
              
              457,250
              
              
              
              505,000DEFERRED
      INCOME TAXES
              
              
              33,182
              
              
              
              21,056OTHER
      NONCURRENT LIABILITIES
              
              
              1,772
              
              
              
              2,436COMMITMENTS
      AND CONTINGENCIES (Note 19)SHAREHOLDERS’
      EQUITY:Preferred
      shares, without par value, authorized 1,000,
                none issued
              
              
              —
              
              
              
              —Common shares, without par value, authorized 100,000,
                issued and outstanding 18,828 at August 31, 2008
      and
                19,092 at November 30, 2007
              
              
              21,920
              
              
              
              36,800Retained
      earnings
              
              
              214,515
              
              
              
              165,655236,435
              
              
              
              202,455Cumulative other comprehensive income, net of tax:Interest rate hedge adjustment
              
              
              (1,724
              )
              
              
              (1,747
              )Foreign currency translation adjustment
              
              
              517
              
              
              
              1,008Unrealized actuarial gains and losses
              
              
              (8
              )
              
              
              (8
              )Total shareholders’ equity
              
              
              235,220
              
              
              
              201,708TOTAL
      LIABILITIES AND SHAREHOLDERS’
                EQUITY
              
              $
              786,701
              
              
              $
              780,560
 
  The
accompanying notes are an integral part of these consolidated financial
statements.
 
 
 4
 CHATTEM, INC. AND
SUBSIDIARIES
 
 CONSOLIDATED STATEMENTS OF
INCOME
 (Unaudited
and in thousands, except per share amounts)
   FOR
      THE THREE MONTHS
                ENDED AUGUST 31,
              
              
              FOR
      THE NINE MONTHS
                ENDED AUGUST 31,2008
              
              
              2007
              
              
              2008
              
              
              2007TOTAL
      REVENUES
              
              $
              111,929
              
              
              $
              108,965
              
              
              $
              349,418
              
              
              $
              322,760COSTS
      AND EXPENSES:Cost
      of sales
              
              
              31,753
              
              
              
              32,793
              
              
              
              99,127
              
              
              
              98,868Advertising and promotion
              
              
              26,789
              
              
              
              27,760
              
              
              
              91,532
              
              
              
              86,211Selling, general and administrative
              
              
              15,024
              
              
              
              15,626
              
              
              
              45,676
              
              
              
              42,348Litigation settlement
              
              
              11,196
              
              
              
              —
              
              
              
              11,196
              
              
              
              —Product recall (income) expenses
              
              
              (112
              )
              
              
              —
              
              
              
              5,931
              
              
              
              —Acquisition expenses
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              2,057Total costs and expenses
              
              
              84,650
              
              
              
              76,179
              
              
              
              253,462
              
              
              
              229,484INCOME
      FROM OPERATIONS
              
              
              27,279
              
              
              
              32,786
              
              
              
              95,956
              
              
              
              93,276OTHER
      INCOME (EXPENSE):Interest
      expense
              
              
              (6,176
              )
              
              
              (7,147
              )
              
              
              (19,293
              )
              
              
              (22,702
              )Investment and other income, net
              
              
              109
              
              
              
              206
              
              
              
              362
              
              
              
              1,090Loss on early extinguishment of debt
              
              
              —
              
              
              
              (414
              )
              
              
              (526
              )
              
              
              (2,633
              )Total other income (expense)
              
              
              (6,067
              )
              
              
              (7,355
              )
              
              
              (19,457
              )
              
              
              (24,245
              )INCOME
      BEFORE INCOME TAXES
              
              
              21,212
              
              
              
              25,431
              
              
              
              76,499
              
              
              
              69,031PROVISION
      FOR INCOME TAXES
              
              
              7,246
              
              
              
              9,119
              
              
              
              26,928
              
              
              
              24,161NET
      INCOME
              
              $
              13,966
              
              
              $
              16,312
              
              
              $
              49,571
              
              
              $
              44,870NUMBER
      OF COMMON SHARES:Weighted
      average outstanding-basic
              
              
              18,784
              
              
              
              19,026
              
              
              
              19,002
              
              
              
              18,903Weighted average and potential dilutive outstanding
              
              
              19,004
              
              
              
              19,409
              
              
              
              19,385
              
              
              
              19,273NET
      INCOME PER COMMON SHARE:Basic
              
              $
              .74
              
              
              $
              .86
              
              
              $
              2.61
              
              
              $
              2.37Diluted
              
              $
              .73
              
              
              $
              .84
              
              
              $
              2.56
              
              
              $
              2.33
 
 
 The
accompanying notes are an integral part of these consolidated financial
statements.
 
 5
 CHATTEM, INC. AND
SUBSIDIARIES
 
 CONSOLIDATED STATEMENTS OF
CASH FLOWS
 (Unaudited
and in thousands)
 
  FOR
      THE NINE MONTHS ENDEDAUGUST
      31,
                2008
              
              
              AUGUST
      31,
                2007OPERATING
      ACTIVITIES:Net
      income
              
              $
              49,571
              
              
              $
              44,870Adjustments
      to reconcile net income to net cash provided by
                operating activities:Depreciation
      and amortization
              
              
              6,316
              
              
              
              6,461Deferred
      income taxes
              
              
              12,404
              
              
              
              11,126Tax
      benefit realized from stock options exercised
              
              
              (2,342
              )
              
              
              (4,747
              )Stock-based
      compensation
              
              
              4,281
              
              
              
              4,122Loss
      on early extinguishment of debt
              
              
              526
              
              
              
              2,633Other,
      net
              
              
              137
              
              
              
              13Changes
      in operating assets and liabilities, net of effects from
      acquisitions:Accounts receivable and
      other
              
              
              (7,567
              )
              
              
              (12,903
              )Inventories
              
              
              2,611
              
              
              
              2,172Prepaid expenses and other current
      assets
              
              
              (5,885
              )
              
              
              833Accounts payable and accrued liabilities
              
              
              17,248
              
              
              
              18,741Net cash provided by operating
      activities
              
              
              77,300
              
              
              
              73,321INVESTING
      ACTIVITIES:Purchases
      of property, plant and equipment
              
              
              (3,567
              )
              
              
              (3,793
              )Acquisition of brands
              
              
              —
              
              
              
              (416,184
              )Decrease (increase) in other assets, net
              
              
              (1,255
              )
              
              
              1,796Net cash used in investing activities
              
              
              (4,822
              )
              
              
              (418,181
              )FINANCING
      ACTIVITIES:Repayment
      of long-term debt
              
              
              (37,250
              )
              
              
              (153,750
              )Proceeds from long-term debt
              
              
              —
              
              
              
              400,000Proceeds from borrowings under revolving credit facility
              
              
              148,000
              
              
              
              147,500Repayments of revolving credit facility
              
              
              (158,500
              )
              
              
              (102,500
              )Proceeds
      from exercise of stock options
              
              
              4,487
              
              
              
              11,130Change in bank overdraft
              
              
              (7,584
              )
              
              
              3,836Repurchase of common shares
              
              
              (26,327
              )
              
              
              (22,260
              )Purchase of note hedge
              
              
              —
              
              
              
              (29,500
              )Proceeds from issuance of warrant
              
              
              —
              
              
              
              17,430Increase in debt issuance costs
              
              
              —
              
              
              
              (9,374
              )Tax benefit realized from stock options exercised
              
              
              2,342
              
              
              
              4,747Net
      cash (used in) provided by financing activities
              
              
              (74,832
              )
              
              
              267,259EFFECT
      OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS
              
              
              (22
              )
              
              
              143CASH
      AND CASH EQUIVALENTS:Decrease
      for the period
              
              
              (2,376
              )
              
              
              (77,458
              )At beginning of period
              
              
              15,407
              
              
              
              90,527At end of period
              
              $
              13,031
              
              
              $
              13,069PAYMENTS
      FOR:Interest
              
              $
              14,129
              
              
              $
              16,678Taxes
              
              $
              10,733
              
              
              $
              6,680
 
 
 The
accompanying notes are an integral part of these consolidated financial
statements.
  6
 CHATTEM, INC.  AND
SUBSIDIARIES
 
 NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS
 (Unaudited)
 
 All
monetary and share amounts (other than per share amounts) in these Notes are
expressed in thousands.
 
 1.
              BASIS OF
      PRESENTATION
 
 The
accompanying unaudited consolidated financial statements have been prepared in
accordance with generally accepted accounting principles for interim financial
information and the instructions to Form 10-Q and Rule 10-01 of Regulation
S-X.  Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles in the United
States for complete financial statements.  These consolidated
financial statements should be read in conjunction with the audited consolidated
financial statements and related notes thereto included in our Annual Report on
Form 10-K for the year ended November 30, 2007.  The accompanying
unaudited consolidated financial statements, in the opinion of management,
include all adjustments necessary for a fair presentation.  All such
adjustments are of a normal recurring nature.
 
 2.
              CASH AND CASH
      EQUIVALENTS
 
 We
consider all short-term deposits and investments with original maturities of
three months or less to be cash equivalents.
 
 3.
              RECENT ACCOUNTING
      PRONOUNCEMENTS
 
 In July
2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation
No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), which clarifies
the accounting for uncertainty in income taxes recognized in the financial
statements in accordance with Statement of Financial Accounting Standard
(“SFAS”) No. 109, “Accounting for Income Taxes” (“SFAS 109”). FIN 48 provides
guidance on the financial statement recognition and measurement of a tax
position taken or expected to be taken in a tax return. FIN 48 also provides
guidance on de-recognition, classification, interest and penalties, accounting
in interim periods, disclosures and transition.  Additionally, in May
2007, the FASB issued FASB Staff Position (“FSP”) No. FIN 48-1, “Definition of
Settlement in FASB Interpretation No. 48” (“FSP FIN 48-1”), an amendment to FIN
48.  FSP FIN 48-1 clarifies how an enterprise is to determine whether
a tax position is effectively settled for the purpose of recognizing previously
unrecognized tax benefits.  The provisions of FIN 48 and FSP FIN 48-1
were effective for fiscal years beginning after December 15,
2006.   As described in Note 17, we adopted the provisions of FIN
48, as amended by FSP FIN 48-1, effective December 1, 2007.
  In
September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS
157”).  SFAS 157 provides guidance for using fair value to measure
assets and liabilities.  SFAS 157 applies when other standards require
(or permit) assets or liabilities to be measured at fair value but does not
expand the use of fair value in any new circumstances.  SFAS 157 also
requires expanded disclosure of the effect on earnings for items measured using
unobservable data (data not based on market observable information), establishes
a fair value hierarchy that prioritizes the information used to develop those
assumptions and requires separate disclosure by level within the fair value
hierarchy.  As described in Note 8, we adopted SFAS 157 effective
December 1, 2007.
  In
February 2008, the FASB issued FSP No. SFAS 157-2, “Effective
Date of FASB Statement No. 157” (“FSP 157-2”).  FSP 157-2
defers the effective date of SFAS 157 for nonfinancial assets and
nonfinancial liabilities, except those that are recognized or disclosed at fair
value in the financial statements on a recurring basis (at least annually), to
fiscal years and interim periods within those fiscal years, beginning after
November 15, 2008, or our fiscal 2009.  We are currently
evaluating the impact of adopting the provisions of FSP 157-2.
  In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
Financial Assets and Financial Liabilities” (“SFAS 159”).  SFAS 159
permits entities to choose to measure certain financial assets and liabilities
at fair value.  Unrealized gains and losses on items for which the
fair value option has been elected are reported in earnings. We adopted SFAS 159
effective December 1, 2007 without choosing to elect to measure certain
financial assets or liabilities at fair value that were not previously measured
at fair value.
  In
December 2007, the FASB issued SFAS No. 141R, “Business Combinations” (“SFAS
141R”).  SFAS 141R establishes principles and requirements for how the
acquirer in a business combination recognizes and measures the identifiable
assets acquired, liabilities assumed, and intangible assets acquired and
determines what information to disclose to enable users of the financial
statements to evaluate the nature and financial effects of the business
combination.  The provisions of SFAS
  7
 141R are
effective for acquisitions closing after the first annual reporting period
beginning after December 15, 2008.  Accordingly, we will apply the
provisions of SFAS 141R prospectively to business combinations consummated
beginning in the first quarter of our fiscal 2010.  We do not expect
SFAS 141R to have an effect on our previous acquisitions.
 
 In March
2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments
and Hedging Activities – An Amendment of FASB Statement No. 133” (“SFAS
161”).  SFAS 161 requires enhanced disclosures for derivative and
hedging activities.  SFAS 161 is effective for financial statements
issued for fiscal years and interim periods beginning after November 15, 2008,
or our fiscal 2009.  We are currently evaluating the impact, if any,
of SFAS 161.
 
 In
April 2008, the FASB issued FSP No. FAS 142-3, “Determination of the
Useful Life of Intangible Assets” (“FSP FAS 142-3”).  In determining the
useful life of intangible assets, FSP FAS 142-3 removes the requirement to
consider whether an intangible asset can be renewed without substantial cost of
material modifications to the existing terms and conditions and, instead,
requires an entity to consider its own historical experience in renewing similar
arrangements. FSP FAS 142-3 also requires expanded disclosure related to the
determination of intangible asset useful lives.  FSP FAS 142-3 is effective
for financial statements issued for fiscal years beginning after
December 15, 2008, or our fiscal 2010.  We are currently
evaluating the impact, if any, of FSP FAS 142-3.
  In May
2008, the FASB issued FSP Accounting Principles Board Opinion No. 14-1,
“Accounting for Convertible Debt Instruments That May Be Settled in Cash upon
Conversion (Including Partial Cash Settlement)” (“FSP 14-1”).  FSP
14-1 requires issuers of convertible debt instruments that may be settled in
cash to separately account for the liability and equity components in a manner
that will reflect the entity’s nonconvertible debt borrowing rate when interest
cost is recognized in periods subsequent to adoption.  Upon adoption
of FSP 14-1, we will allocate a portion of the proceeds received from the
issuance of our convertible notes between a liability and equity component by
determining the fair value of the liability component using our non-convertible
debt borrowing rate.  The difference between the proceeds of the notes
and the fair value of the liability component will be recorded as a discount on
the debt with a corresponding offset to paid-in-capital.  The
resulting discount will be accreted by recording additional non-cash interest
expense over the expected life of the convertible notes using the effective
interest rate method.  We are currently assessing the impact of
adopting FSP 14-1 on our consolidated financial statements, however we expect
there to be a dilutive effect on our earnings per share.  The
provisions of FSP 14-1 are to be applied retrospectively to all periods
presented upon adoption and are effective for fiscal years beginning after
December 15, 2008, or our fiscal 2010, and interim periods within those fiscal
years.
 
 4.
              STOCK-BASED
      COMPENSATION
 
 We
currently provide stock-based compensation under five stock incentive plans that
have been approved by our shareholders.  Our 1998 Non-Statutory Stock
Option Plan provides for the issuance of up to 1,400 shares of common stock to
key employees while the 1999 Non-Statutory Stock Option Plan for Non-Employee
Directors allows for the issuance of up to 200 shares of common
stock.  The 2000 Non-Statutory Stock Option Plan provides for the
issuance of up to 1,500 shares of common stock.  The 2003 and 2005
Stock Incentive Plans both provide for the issuance of up to 1,500 shares of
common stock.  Stock options granted under all of these plans
generally vest over four years from the date of grant as specified in the plans
or by the compensation committee of our board of directors and are exercisable
for a period of up to ten years from the date of grant.
 
 We
account for stock-based compensation under the provisions of SFAS No. 123
(revised 2004), “Share-Based Payment” (“SFAS 123R”), which requires the
recognition of the cost of employee services received in exchange for an award
of equity instruments in the financial statements and is measured based on the
grant date fair value of the award.  SFAS 123R also requires the stock
option compensation expense to be recognized over the period during which an
employee is required to provide service in exchange for the award (the vesting
period).
 
 The
following table represents the impact of compensation expense related to stock
options to our consolidated income statement during the three and nine months
ended August 31, 2008 and 2007, respectively:
 
 For
      the Three Months
                Ended
      August 31,
              
              
              For
      the Nine Months
                Ended
      August 31,2008
              
              
              2007
              
              
              2008
              
              
              2007Income
      from operations
              
              $
              1,701
              
              
              $
              1,490
              
              
              $
              4,281
              
              
              $
              4,122Provision
      for income taxes
              
              
              581
              
              
              
              534
              
              
              
              1,507
              
              
              
              1,443Net
      income
              
              $
              1,120
              
              
              $
              956
              
              
              $
              2,774
              
              
              $
              2,679Basic
      net income per share
              
              $
              0.06
              
              
              $
              0.05
              
              
              $
              0.15
              
              
              $
              0.14Diluted
      net income per share
              
              $
              0.06
              
              
              $
              0.05
              
              
              $
              0.14
              
              
              $
              0.14
  8
 The stock
option compensation expense was included partly in cost of sales, advertising
and promotion expenses and selling, general and administrative expenses in the
accompanying consolidated statements of income.  We capitalized $185
and $180 of stock option compensation cost as a component of the carrying cost
of inventory on-hand as of August 31, 2008 and 2007, respectively.
 
 The
weighted average grant-date fair value of stock options granted during the three
months ended August 31, 2008 and 2007 was $25.31 and $24.50, respectively, and
for the nine months ended August 31, 2008 and 2007 was $27.98 and $24.50,
respectively.   The fair value of each stock option grant was
estimated on the date of grant using a Flex Lattice Model.  The
following assumptions were used to determine the fair value of stock option
grants during the nine months ended August 31, 2008 and 2007:
 
 Nine
      Months Ended
                August 31,2008
              
              
              2007Expected
      life
              
              6.0
      years
              
              
              6.0
      yearsVolatility
              
              
              36%
              
              
              
              34%Risk-free
      interest rate
              
              
              3.84%
              
              
              
              4.47%Dividend
      yield
              
              
              0%
              
              
              
              0%Forfeitures
              
              
              0.3%
              
              
              
              1.2%
 
 The
expected life of stock options represents the period of time that the stock
options granted are expected to be outstanding based on historical exercise
trends.  The expected volatility is based on consideration of the
historical and implied price volatility of our common stock.  The
risk-free interest rate represents the U.S. Treasury bill rate for the expected
life of the related stock options.  The dividend yield represents our
anticipated cash dividend over the expected life of the stock
options.  In connection with using the Flex Lattice Model to determine
the fair value of stock option grants, the forfeiture rate was determined by
analyzing post vesting stock option activity for three separate groups
(non-employee directors, officers and other employees).
 
 A summary
of stock option activity for the nine months ended August 31, 2008 is presented
below:
 
 Shares
      Under Option
              
              
              Weighted
      Average  Exercise Price
              
              Weighted
                Average
                Remaining
                Contractual
                Life
              
              Aggregate
                Intrinsic
      ValueOutstanding
      at December 1, 2007
              
              
              1,458
              
              
              $
              40.43Granted
              
              
              364
              
              
              
              70.88Exercised
              
              
              (152
              )
              
              
              29.47Cancelled
              
              
              (13
              )
              
              
              58.82Outstanding
      at August 31, 2008
              
              
              1,657
              
              
              $
              47.99
              
              4.8
      years
              
              $
              35,774Exercisable
      at August 31, 2008
              
              
              800
              
              
              $
              35.71
              
              4.3
      years
              
              $
              26,802
 
 The total
fair value of stock options that vested during the three and nine months ended
August 31, 2008 and 2007 was $1,677 and $1,475 and $4,282 and $4,139,
respectively.  The total intrinsic value of stock options exercised
during the three and nine months ended August 31, 2008 and 2007 was $1,860 and
$6,580 and $6,563 and $24,485, respectively.
 
 As of
August 31, 2008, we had $17,573 of unrecognized compensation cost related to
stock options that will be recorded over a weighted average period of 2.8
years.
 
 We are
also authorized to grant restricted shares of common stock to employees under
our stock incentive plans that have been approved by
shareholders.  The restricted shares under these plans meet the
definition of “nonvested shares” in SFAS 123R.  The restricted shares
generally vest over a four year service period commencing upon the date of
grant.  The total fair market value of restricted shares on the date
of grant is amortized to expense on a straight line basis over the four-year
vesting period.  The amortization expense related to restricted shares
during the three and nine months ended August 31, 2008 and 2007 was $64 and $115
and $221 and $473, respectively.
 
 9
 Restricted share activity for the nine
months ended August 31, 2008 under the plans is summarized as
follows:
 
 Number
      of Shares
              
              
              Weighted
      Average Grant Date FairValueNonvested
      at December 1, 2007
              
              
              9
              
              
              $
              33.11Granted
              
              
              —
              
              
              
              —Vested
              
              
              6
              
              
              
              32.12Forfeited
              
              
              —
              
              
              
              —Nonvested
      at August 31, 2008
              
              
              3
              
              
              
              35.37
 
 
 As of August 31, 2008, we had $107 of
unrecognized compensation cost related to restricted shares that will be
recorded over a weighted average period of approximately 0.4 years.
 
 5.
              EARNINGS PER
      SHARE
 
 The
following table presents the computation of per share earnings for the three and
nine months ended August 31, 2008 and 2007, respectively:
 
 For
      the Three Months
                Ended August
      31,
              
              
              For
      the Nine Months
                Ended August 31,2008
              
              
              2007
              
              
              2008
              
              
              2007NET
      INCOME
              
              $
              13,966
              
              
              $
              16,312
              
              
              $
              49,571
              
              
              $
              44,870NUMBER
      OF COMMON SHARES:Weighted
      average outstanding
              
              
              18,784
              
              
              
              19,026
              
              
              
              19,002
              
              
              
              18,903Issued
      upon assumed exercise of outstanding stock options(1)
              
              
              50
              
              
              
              283
              
              
              
              70
              
              
              
              359Issued
      upon assumed conversion of convertible notes
              
              
              167
              
              
              
              87
              
              
              
              310
              
              
              
              —Effect
      of issuance of restricted common shares
              
              
              3
              
              
              
              13
              
              
              
              3
              
              
              
              11Weighted
      average and potential dilutive outstanding
              
              
              19,004
              
              
              
              19,409
              
              
              
              19,385
              
              
              
              19,273NET
      INCOME PER COMMON SHARE:Basic
              
              $
              .74
              
              
              $
              .86
              
              
              $
              2.61
              
              
              $
              2.37Diluted
              
              $
              .73
              
              
              $
              .84
              
              
              $
              2.56
              
              
              $
              2.33
 
 (1)  Because
their effects are anti-dilutive, excludes shares issuable under stock option
plans whose grant price was greater than the average market price of common
shares outstanding as follows: 756 and 412 shares for the three months ended
August 31, 2008 and 2007, respectively, and 562 and 195 shares for the nine
months ended August 31, 2008 and 2007, respectively.
   10
 6.
              LONG-TERM
      DEBT
 
 Long-term
debt consisted of the following as of August 31, 2008 and November 30,
2007:
 
 2008
              
              
              2007Revolving
      Credit Facility due 2010 at a variable rate of 4.05% and 6.19%
      as of August 31, 2008 and November
      30, 2007, respectively
              
              $
              19,500
              
              
              $
              30,0002.0%
      Convertible Senior Notes due 2013
              
              
              125,000
              
              
              
              125,0001.625%
      Convertible Senior Notes due 2014
              
              
              100,000
              
              
              
              100,000Term
      Loan due 2013 at a variable rate of 4.54% and 6.97% as of August 31,
      2008 and November 30, 2007, respectively
              
              
              108,250
              
              
              
              145,5007.0%
      Senior Subordinated Notes due 2014
              
              
              107,500
              
              
              
              107,500
 Total
      long-term debt
              
              
              460,250
              
              
              
              508,000Less:  current
      maturities
              
              
              (3,000
              )
              
              
              (3,000
              )Total
      long-term debt, net of current maturities
              
              $
              457,250
              
              
              $
              505,000
 
 In
February 2004, we entered into a Senior Secured Revolving Credit Facility with a
maturity date of February 2009 (the “Revolving Credit Facility”) with Bank of
America, N.A. that provided an initial borrowing capacity of $25,000 and an
additional $25,000, subject to successful syndication.  In March 2004,
we entered into a commitment agreement with a syndicate of commercial banks led
by Bank of America, N.A., as agent, that enabled us to borrow up to a total of
$50,000 under the Revolving Credit Facility and an additional $50,000, subject
to successful syndication.  In November 2005, we entered into an
amendment to our Revolving Credit Facility (the “Amended Revolving Credit
Facility”) that, among other things, increased our borrowing capacity under the
facility from $50,000 to $100,000, increased our flexibility to repurchase
shares of our stock, improved our borrowing rate under the facility and extended
the maturity date to November 2010.  Upon successful syndication, we
were able to increase the borrowing capacity under the Amended Revolving Credit
Facility by $50,000 to an aggregate of $150,000.  In November 2006, we
entered into an amendment to our Amended Revolving Credit Facility that, among
other things, permitted the sale of the 2.0% Convertible Senior Notes due 2013
(the “2.0% Convertible Notes”).  In January 2007, we completed an
amendment to the Amended Revolving Credit Facility providing for up to a
$100,000 revolving credit facility and a $300,000 term loan (the “Credit
Facility”).  The proceeds from the term loan under the Credit Facility
were used to finance in part the acquisition of the five consumer and OTC brands
from Johnson & Johnson.  The Credit Facility includes “accordion”
features that permit us under certain circumstances to increase our borrowings
under the revolving credit facility by $50,000 and to borrow an additional
$50,000 as a term loan, subject to successful syndication.  In April
2007, we entered into an amendment to our Credit Facility that, among other
things, permitted the sale of the 1.625% Convertible Senior Notes due
2014  (the “1.625% Convertible Notes”) and reduced the applicable
interest rates on the revolving credit facility portion of our Credit
Facility.
 
 Borrowings
under the revolving credit facility portion of our Credit Facility bear interest
at LIBOR plus applicable percentages of 0.875% to 1.500% or the higher of the
federal funds rate plus 0.50% or the prime rate (the “Base
Rate”).  The applicable percentages are calculated based on our
leverage ratio.  As of August 31, 2008 and November 30, 2007, we had
$19,500 and $30,000, respectively, of borrowings outstanding under the revolving
credit facility portion of our Credit Facility.  As of October 2,
2008, we had $19,500 of borrowings outstanding under the revolving credit
facility portion of our Credit Facility and our borrowing capacity was
$80,500.
 
 The term
loan under the Credit Facility bears interest at either LIBOR plus 1.75% or the
Base Rate plus 0.75%.  The term loan borrowings are to be repaid in
increments of $750 each calendar quarter, with the first principal payment paid
June 2007.  The principal outstanding after scheduled repayment and
any unscheduled prepayments matures and is payable January 2013.  In
April 2007, we utilized the net proceeds from the 1.625% Convertible Notes and
borrowings under the revolving credit facility portion of our Credit Facility to
repay $128,000 of the term loan under the Credit Facility.   In
July 2007, we utilized borrowings under the revolving credit facility portion of
our Credit Facility to repay an additional $25,000 of the term loan under the
Credit Facility.  In connection with the term loan repayments during
April 2007 and July 2007, we retired a proportional share of the term loan debt
issuance costs and recorded the resulting loss on early extinguishment of debt
of $2,633 in fiscal 2007.  In January 2008, we utilized borrowings
under the revolving credit facility portion of our Credit Facility to repay an
additional $35,000 of the term loan under the Credit Facility.  In
connection with the term loan repayment in January 2008, we retired a
proportional share of the term loan debt issuance costs and recorded the
resulting loss on early extinguishment of debt of $526 in the first quarter of
fiscal 2008.
 
 Borrowings
under the Credit Facility are secured by substantially all of our assets, except
real property, and shares of capital stock of our domestic subsidiaries held by
us and by the assets of the guarantors (our domestic
subsidiaries).  The Credit Facility contains covenants,
representations, warranties and other agreements by us that are customary in
credit agreements and security instruments relating to financings of this
type.  The significant financial covenants include fixed charge
coverage ratio, leverage ratio, senior secured leverage ratio and brand value
calculations.
 11
 In
February 2004, we issued and sold $125,000 of 7.0% Senior Subordinated Notes due
2014 (the “7.0% Subordinated Notes”).  During fiscal 2005, we
repurchased $17,500 of our 7.0% Subordinated Notes in the open market at an
average premium of 1.6% over the principal amount of the notes.  The
outstanding balance of the remaining 7.0% Subordinated Notes was reduced to
$107,500.
 
 Interest
payments on the 7.0% Subordinated Notes are due semi-annually in arrears in
March and September.  Our domestic subsidiaries are guarantors of the
7.0% Subordinated Notes.  The guarantees of the 7.0% Subordinated
Notes are unsecured senior subordinated obligations of the
guarantors.  At any time after March 1, 2009, we may redeem any of the
7.0% Subordinated Notes upon not less than 30 nor more than 60 days’ notice at
redemption prices (expressed in percentages of principal amount), plus accrued
and unpaid interest, if any, and liquidation damages, if any, to the applicable
redemption rate, if redeemed during the twelve-month periods beginning March
2009 at 103.500%, March 2010 at 102.333%, March 2011 at 101.167% and March 2012
and thereafter at 100.000%.
 
 The
indenture governing the 7.0% Subordinated Notes, among other things, limits our
ability and the ability of our restricted subsidiaries to: (i) borrow money or
sell preferred stock, (ii) create liens, (iii) pay dividends on or redeem or
repurchase stock, (iv) make certain types of investments, (v) sell stock in our
restricted subsidiaries, (vi) restrict dividends or other payments from
restricted subsidiaries, (vii) enter into transactions with affiliates, (viii)
issue guarantees of debt and (ix) sell assets or merge with other
companies.  In addition, if we experience specific kinds of changes in
control, we must offer to purchase the 7.0% Subordinated Notes at 101.0% of
their principal amount plus accrued and unpaid interest.
 
 In July
2006, we successfully completed a consent solicitation from the holders of the
7.0% Subordinated Notes to an amendment to the indenture to increase our
capacity to make restricted payments by an additional $85,000, including
payments for the repurchase of our common stock, and adjust the fixed charge
coverage ratio (as defined in the indenture).
 
 In
November 2006, we completed a private offering of $125,000 of the 2.0%
Convertible Notes to qualified institutional purchasers pursuant to Section 4(2)
of the Securities Act of 1933.  The 2.0% Convertible Notes bear
interest at an annual rate of 2.0%, payable semi-annually in May and November of
each year.  The 2.0% Convertible Notes are convertible into our common
stock at an initial conversion price of $58.92 per share, upon the occurrence of
certain events, including the closing price of our common stock exceeding 130%
of the initial conversion price per share, or $76.59 per share, for 20 of the
last 30 consecutive trading days of the fiscal quarter (the “prescribed
measurement period”).  The evaluation of the classification of the
2.0% Convertible Notes occurs each fiscal quarter.
 
 Upon
conversion, a holder will receive, in lieu of common stock, an amount of cash
equal to the lesser of (i) the principal amount of the 2.0% Convertible
Notes, or (ii) the conversion value, determined in the manner set forth in
the indenture governing the 2.0% Convertible Notes, of a number of shares equal
to the conversion rate. If the conversion value exceeds the principal amount of
the 2.0% Convertible Notes on the conversion date, we will also deliver, at our
election, cash or common stock or a combination of cash and common stock with
respect to the conversion value upon conversion. If conversion occurs in
connection with a change of control, we may be required to deliver additional
shares of our common stock by increasing the conversion rate with respect to
such notes. The maximum aggregate number of shares that we would be obligated to
issue upon conversion of the 2.0% Convertible Notes is 2,673.
 
 Concurrently
with the sale of the 2.0% Convertible Notes, we purchased a note hedge from an
affiliate of Merrill Lynch (the “Counterparty”), which is designed to mitigate
potential dilution from the conversion of the 2.0% Convertible Notes. Under the
note hedge, the Counterparty is required to deliver to us the number of shares
of our common stock that we are obligated to deliver to the holders of the 2.0%
Convertible Notes with respect to the conversion, calculated exclusive of shares
deliverable by us by reason of any additional premium relating to the 2.0%
Convertible Notes or by reason of any election by us to unilaterally increase
the conversion rate pursuant to the indenture governing the 2.0% Convertible
Notes. The note hedge expires at the close of trading on November 15, 2013,
which is the maturity date of the 2.0% Convertible Notes, although the
Counterparty will have ongoing obligations with respect to 2.0% Convertible
Notes properly converted on or prior to that date of which the Counterparty has
been timely notified.
 
 In
addition, we issued warrants to the Counterparty that could require us to issue
up to approximately 2,122 shares of our common stock on November 15, 2013
upon notice of exercise by the Counterparty. The exercise price is $74.82 per
share, which represented a 60.0% premium over the closing price of our shares of
common stock on November 16, 2006. If the Counterparty exercises the
warrant, we will have the option to settle in cash or shares the excess of the
price of our shares on that date over the initially established exercise
price.
 
 12
 The note
hedge and warrant are separate and legally distinct instruments that bind us and
the Counterparty and have no binding effect on the holders of the 2.0%
Convertible Notes.
 
 In
November 2006, we entered into an interest rate swap (“swap”) agreement
effective January 2007.  The swap has decreasing notional principal
amounts beginning October 2007 and a swap rate of 4.98% over the life of the
agreement.  During the second quarter of fiscal 2008, we retired a
portion of the swap for approximately $270, which was recorded as additional
interest expense in the accompanying consolidated statement of
income.  As of August 31, 2008, we had $126,588 of LIBOR based
borrowings hedged under the provisions of the swap.  During the nine
months ended August 31, 2008, the decrease in fair value of the swap of $272,
net of tax, was recorded to other comprehensive income.  The current
portion of the fair value of the swap of $2,388 is included in accrued
liabilities, and the long-term portion of $760 is included in noncurrent
liabilities.  As of August 31, 2008, the swap was deemed to be an
effective cash flow hedge.  The fair value of the swap agreement is
valued by a third party.  The swap agreement expires in January
2010.
 
 In April
2007, we entered into an interest rate cap agreement.  The cap has
decreasing notional principal amounts beginning May 2007 and a cap rate of 5.0%
over the life of the agreement.  We paid a $114 premium to enter into
the cap agreement.  The cap agreement expired in September
2008.
 
 In April
2007, we completed a private offering of $100,000 of the 1.625% Convertible
Notes to qualified institutional investors pursuant to Rule 144A under the
Securities Act of 1933.  The 1.625% Convertible Notes bear interest at
an annual rate of 1.625%, payable semi-annually in May and November of each
year.  The 1.625% Convertible Notes are convertible into our common
stock at an initial conversion price of $73.20 per share, upon the occurrence of
certain events, including the closing price of our common stock exceeding 130%
of the initial conversion price per share, or $95.16 per share, for the
prescribed measurement period.  The evaluation of the classification
of the 1.625% Convertible Notes occurs each fiscal quarter.
 
 Upon
conversion, a holder will receive, in lieu of common stock, an amount of cash
equal to the lesser of (i) the principal amount of the 1.625% Convertible
Notes, or (ii) the conversion value, determined in the manner set forth in
the indenture governing the 1.625%  Convertible Notes, of a number of
shares equal to the conversion rate. If the conversion value exceeds the
principal amount of the 1.625% Convertible Note on the conversion date, we will
also deliver, at our election, cash or common stock or a combination of cash and
common stock with respect to the conversion value upon conversion. If conversion
occurs in connection with a change of control, we may be required to deliver
additional shares of our common stock by increasing the conversion rate with
respect to such notes. The maximum aggregate number of shares that we would be
obligated to issue upon conversion of the 1.625% Convertible Notes is
1,694.
 
 Concurrently
with the sale of the 1.625% Convertible Notes, we purchased a note hedge from
the Counterparty, which is designed to mitigate potential dilution from the
conversion of the 1.625% Convertible Notes. Under the note hedge, the
Counterparty is required to deliver to us the number of shares of our common
stock that we are obligated to deliver to the holders of the 1.625% Convertible
Notes with respect to the conversion, calculated exclusive of shares deliverable
by us by reason of any additional premium relating to the 1.625% Convertible
Notes or by reason of any election by us to unilaterally increase the conversion
rate pursuant to the indenture governing the 1.625% Convertible Notes. The note
hedge expires at the close of trading on May 1, 2014, which is the maturity date
of the 1.625% Convertible Notes, although the Counterparty will have ongoing
obligations with respect to 1.625% Convertible Notes properly converted on or
prior to that date of which the Counterparty has been timely
notified.
 
 In
addition, we issued warrants to the Counterparty that could require us to issue
up to approximately 1,366 shares of our common stock on May 1, 2014 upon notice
of exercise by the Counterparty. The exercise price is $94.45 per share, which
represented a 60% premium over the closing price of our shares of common stock
on April 4, 2007. If the Counterparty exercises the warrant, we will have the
option to settle in cash or shares the excess of the price of our shares on that
date over the initially established exercise price.
 
 Pursuant
to EITF 90-19,“Convertible Bonds with Issuer Option to Settle for Cash upon Conversion”
(“EITF 90-19”), EITF 00-19, “Accounting for Derivative Financial Instruments
Indexed to, and Potentially Settled in, a Company’s Own Stock”  (“EITF
00-19”) and EITF 01-6,  “The Meaning of Indexed to a Company’s Own
Stock”  (“EITF 01-6”), the 2.0% Convertible Notes and the 1.625%
Convertible Notes are accounted for as convertible debt in the accompanying
consolidated balance sheet and the embedded conversion option in the 2.0%
Convertible Notes and the 1.625% Convertible Notes have not been accounted for
as separate derivatives. Additionally, pursuant to EITF 00-19 and EITF 01-6, the
note hedges and warrants are accounted for as equity transactions, and
therefore, the payments associated with the issuance of the note hedges and the
proceeds received from the issuance of the warrants were recorded as a charge
and an increase, respectively, in common shares in shareholders’ equity as
separate equity transactions.
 
 For
income tax reporting purposes, we have elected to integrate the 2.0% Convertible
Notes and the 1.625% Convertible Notes and the respective note hedge
transaction. Integration of the respective note hedge with the 2.0% Convertible
 13
 Notes and
the 1.625% Convertible Notes creates an in-substance original issue debt
discount for income tax reporting purposes and therefore, the cost of the note
hedge transactions will be accounted for as interest expense over the term of
the 2.0% Convertible Notes and the 1.625% Convertible Notes, respectively, for
income tax reporting purposes. The income tax benefit related to each respective
convertible note issuance was recognized as a deferred tax asset.
 
 The
future maturities of long-term debt to be funded for the next five successive
fiscal years and those thereafter as of August 31, 2008 are as
follows:
 
 2008
              
              $
              7502009
              
              
              3,0002010
              
              
              22,5002011
              
              
              3,0002012
              
              
              3,000Thereafter
              
              
              428,000$
              460,250
 
 7.
              ACQUISITION OF
      BRANDS
 
 In
January 2007, we acquired the U.S. rights to five leading consumer and OTC
brands from Johnson & Johnson (“J&J Acquisition”).  The
acquired brands were: ACT, an anti-cavity
mouthwash/mouth rinse; Unisom, an OTC sleep-aid;
Cortizone-10, a
hydrocortisone anti-itch product; Kaopectate, an anti-diarrhea
product; and Balmex, a
diaper rash product.  The J&J Acquisition was funded with the
proceeds from a $300,000 term loan provided under our Credit Facility,
borrowings under the revolving credit facility portion of our Credit Facility
and through the use of a portion of the proceeds derived from the issuance of
the 2.0% Convertible Notes.  The purchase price of the J&J
Acquisition was $410,000 plus $1,573 of costs directly related to the
acquisition.  The purchase price included $5,916 of inventory, $1,781
of assumed liabilities, $463 of equipment, $403,061 of trademarks, which were
assigned an indefinite life, and $3,914 of distribution rights, which was
assigned a useful life of five years.  The value assigned each of the
acquired brands was as follows:  ACT, $163,167; Unisom, $95,181; Cortizone-10, $124,318; Kaopectate, $11,653; and
Balmex,
$8,742.  Certain of the products are manufactured and supplied under
assumed agreements with third party manufacturers.  During fiscal 2007
and 2008, the manufacturing of certain products was transferred to our
facilities.  For a period of up to six months from the close of the
acquisition, Johnson & Johnson was to provide transition services consisting
of consumer affairs, distribution and collection services (including related
financial, accounting and reporting services).  We terminated the
distribution and collections services effective April 2, 2007 and the consumer
affairs services effective June 21, 2007.  The costs charged for these
transition services approximated the actual costs incurred by Johnson &
Johnson.  During the nine months ended August 31, 2007, we incurred
$2,057, of expenses related to these transition services, which are recorded as
acquisition expenses in the accompanying consolidated statements of
income.
  The
following unaudited consolidated pro forma information assumes the J&J
Acquisition had occurred at the beginning of the period presented:
 
 PRO FORMA
CONSOLIDATED RESULTS OF OPERATIONS (Unaudited)
 
 Nine
      Months Ended
                August 31, 2007Total
      revenue
              
              $
              331,942Net
      income
              
              
              45,653Earnings
      per share – basic:
              
              
              2.42Earnings
      per share – diluted:
              
              
              2.37
 
 The pro
forma consolidated results of operations include adjustments to give effect to
interest expense on debt to finance the J&J Acquisition, increased
advertising expense to raise brand awareness, incremental selling, general and
administrative expenses, amortization of certain intangible assets and decreased
interest income on cash used in the J&J Acquisition, together with related
income tax effects. The pro forma information is for comparative purposes only
and does not purport to be indicative of the results that would have occurred
had the J&J Acquisition and borrowings occurred at the beginning of the
periods presented, or indicative of the results that may occur in the
future.
 
 In May
2007, we acquired the worldwide trademark and rights to sell and market ACT in Western Europe from
Johnson & Johnson (“ACTAcquisition”) for $4,100 in cash plus certain assumed
liabilities.  The ACT Acquisition was funded
with existing cash.
 
 14
 8.
              FAIR VALUE
      MEASUREMENTS
 
 We
currently measure and record in the accompanying consolidated financial
statements an interest rate cap and an interest rate swap at fair
value.  SFAS 157, which we adopted effective December 1, 2007,
establishes a fair value hierarchy for those instruments measured at fair value
that distinguishes between assumptions based on market data (observable inputs)
and our own assumptions (unobservable inputs).  The hierarchy consists
of three levels:
 
 Level 1 -
Quoted market prices in active markets for identical assets or
liabilities;
  Level 2 -
Inputs other than Level 1 inputs that are either directly or indirectly
observable; and
  Level 3 -
Unobservable inputs developed using estimates and assumptions developed by us,
which reflect those that a market participant would use.
 
 Determining
which category an asset or liability falls within the hierarchy requires
significant judgment.  We evaluate our hierarchy disclosures each
quarter.
 
 The
following table summarizes the financial instruments measured at fair value in
the accompanying consolidated balance sheet as of August 31, 2008:
 
 Fair
      Value Measurements as of
                August 31, 2008Level 1
              
              
              Level 2
              
              
              Level 3
              
              
              TotalAssetsInterest
      rate cap (1)
              
              $
              —
              
              
              $
              —
              
              
              $
              —
              
              
              $
              —LiabilitiesInterest
      rate swap (2)
              
              $
              —
              
              
              $
              3,148
              
              
              $
              —
              
              
              $
              3,148
  (1)
              The
      interest rate cap is valued at an insignificant amount in the accompanying
      consolidated balance sheet as of August 31, 2008 and matured in September
      2008.  We value this financial instrument using the “Income
      Approach” valuation technique.  This method uses valuation
      techniques to convert future amounts to a single present value
      amount.  The measurement is based on the value indicated by
      current market expectations about those future
  amounts.
 (2)
              The
      total fair value of the interest rate swap is partially classified as a
      current and a noncurrent liability as of August 31, 2008 and matures in
      January 2010.  This financial instrument is valued using the
      “Income Approach” valuation technique as described directly above in
      (1).
 
 SFAS 157 requires separate disclosure
of assets and liabilities measured at fair value on a recurring basis, as
documented above, from those measured at fair value on a nonrecurring
basis.  As of August 31, 2008, no assets or liabilities are measured
at fair value on a nonrecurring basis.
 
 9.
              ADVERTISING
      EXPENSES
 
 We incur
significant expenditures on television, radio and print advertising to support
our nationally branded OTC health care products and
toiletries.  Customers purchase products from us with the
understanding that the brands will be supported by our extensive media
advertising.  This advertising supports the retailers’ sales effort
and maintains the important brand franchise with the consuming
public.  Accordingly, we consider our advertising program to be
clearly implicit in our sales arrangements with our
customers.  Therefore, we believe it is appropriate to allocate a
percentage of the necessary supporting advertising expenses to each dollar of
sales by charging a percentage of sales on an interim basis based upon
anticipated annual sales and advertising expenditures (in accordance with APB
Opinion No. 28, “Interim Financial Reporting”) and adjusting that accrual to the
actual expenses incurred at the end of the year.
 
 10.
              SHIPPING AND
      HANDLING
 
 Shipping
and handling costs of $3,823 and $3,358 were included in selling expenses
for the three months ended August 31, 2008 and 2007, respectively, and $11,806
and $8,923 for the nine months ended August 31, 2008 and 2007,
respectively.
 
 15
 11.
              PATENT, TRADEMARKS AND
      OTHER PURCHASED PRODUCT
RIGHTS
 
 The
carrying value of trademarks, which are not subject to amortization under the
provisions of SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”),
was $613,328 as of August 31, 2008 and November 30, 2007,
respectively.  The gross carrying amount of intangible assets subject
to amortization at August 31, 2008 and November 30, 2007, which consist
primarily of non-compete agreements and distribution rights, was $6,503 and
$6,053, respectively.  The related accumulated amortization of
intangible assets at August 31, 2008 and November 30, 2007 was $3,458 and
$2,797, respectively.  Amortization of our intangible assets subject
to amortization under the provisions of SFAS 142 for the three months ended
August 31, 2008 and 2007 was $228 and $206, respectively, and for the nine
months ended August 31, 2008 and 2007 was $661 and $618,
respectively.   Estimated annual amortization expense for these
assets for the years ending November 30, 2009, 2010, 2011, 2012 and 2013 is
$893, $873, $873, $155 and $23, respectively.
 
 12.
              INVENTORIES
 
 Inventories
consisted of the following as of August 31, 2008 and November 30,
2007:
 
 2008
              
              
              2007Raw
      materials and work in process
              
              $
              16,426
              
              
              $
              17,892Finished
      goods
              
              
              24,229
              
              
              
              25,373Total
      inventories
              
              $
              40,655
              
              
              $
              43,265
 
 13.
              ACCRUED
      LIABILITIES
 
 Accrued
liabilities consisted of the following as of August 31, 2008 and November 30,
2007:
 
 2008
              
              
              2007Interest
              
              $
              5,890
              
              
              $
              3,510Salaries,
      wages and commissions
              
              
              3,541
              
              
              
              6,209Product
      advertising and promotion
              
              
              2,619
              
              
              
              3,051Litigation
      settlement and legal fees
              
              
              13,988
              
              
              
              2,084Income
      taxes payable
              
              
              6,404
              
              
              
              3,643Interest
      rate swap
              
              
              2,388
              
              
              
              1,274Other
              
              
              2,652
              
              
              
              1,766Total
      accrued liabilities
              
              $
              37,482
              
              
              $
              21,537
 
 14.
              COMPREHENSIVE
      INCOME
 
 Comprehensive
income consisted of the following components for the three and nine months ended
August 31, 2008 and 2007, respectively:
 
 For
      the Three Months Ended
                August 31,
              
              
              For
      the Nine Months Ended
                August 31,2008
              
              
              2007
              
              
              2008
              
              
              2007Net
      income
              
              $
              13,966
              
              
              $
              16,312
              
              
              $
              49,571
              
              
              $
              44,870Other
      – interest rate hedge adjustment
              
              
              235
              
              
              
              (832
              )
              
              
              23
              
              
              
              250Other
      – foreign currency translation adjustment
              
              
              (651
              )
              
              
              347
              
              
              
              (491
              )
              
              
              558Total
              
              $
              13,550
              
              
              $
              15,827
              
              
              $
              49,103
              
              
              $
              45,678
 
 15.
              STOCK
      REPURCHASE
 
 On April
30, 2008, our Board of Directors increased the repurchase authorization to a
total of $100,000 of our common stock under the terms of our existing stock
repurchase program.  In the three and nine months ended August 31,
2008, we repurchased 231 and 418 shares of our common stock, respectively, for
$13,773 and $26,327, respectively, at an average price per share of $59.65 and
$62.94, respectively.  The repurchased shares were retired and
returned to unissued.  As of October 2, 2008, the current amount
available under the authorization from the Board of Directors was
$73,913.
 
 16
 16.
              RETIREMENT PLANS AND
      POSTRETIREMENT HEALTH CARE
BENEFITS
 
 DEFINED BENEFIT PENSION
PLAN
 
 We have a
noncontributory defined benefit pension plan (the “Pension Plan”), which covers
substantially all employees as of December 31, 2000.  The Pension Plan
provides benefits based upon years of service and employee compensation to
employees who had completed one year of service prior to December 31,
2000.  On December 31, 2000, benefits and participation in the Pension
Plan were frozen.  Contributions to the Pension Plan are calculated by
an independent actuary and have been sufficient to provide benefits to
participants and meet the funding requirements of the Employee Retirement Income
Security Act of 1974.  Plan assets as of August 31, 2008 and November
30, 2007 were invested primarily in United States government and agency
securities and corporate debt and equity securities.
 
 Net
periodic pension benefit for the three and nine months ended August 31, 2008 and
2007 was comprised of the following components:
 
 For
      the Three MonthsEnded
                August 31,
              
              
              For
      the Nine MonthsEnded
                August 31,2008
              
              
              2007
              
              
              2008
              
              
              2007Interest
      cost
              
              $
              152
              
              
              $
              153
              
              
              $
              457
              
              
              $
              459Expected
      return on plan assets
              
              
              (234
              )
              
              
              (220
              )
              
              
              (703
              )
              
              
              (660
              )Net
      periodic pension benefit
              
              $
              (82
              )
              
              $
              (67
              )
              
              $
              (246
              )
              
              $
              (201
              )
 
 No
employer contributions were made for the nine months ended August 31, 2008 and
2007, and no employer contributions are expected to be made for the Pension Plan
in fiscal 2008.
 
 DEFINED
CONTRIBUTION PLAN
 
 We
sponsor a defined contribution plan that covers substantially all
employees.  Eligible employees are allowed to contribute up to 15% of
their eligible annual compensation.  We make matching contributions of
25% on the first 6% of contributed compensation.  The cost of the
matching contribution totaled $75 and $72 for the three months ended August 31,
2008 and 2007, respectively, and $225 and $209 for the nine months ended August
31, 2008 and 2007, respectively.  In addition to matching
contributions, safe harbor contributions equaling 3% of eligible annual
compensation are made on behalf of eligible participants.  Safe harbor
contributions totaled $218 and $204 for the three months ended August 31, 2008
and 2007, respectively, and $675 and $607 for the nine months ended August 31,
2008 and 2007, respectively.  Total matching and safe harbor
contributions for fiscal 2008 are expected to approximate amounts funded in
fiscal 2007.  Total matching and safe harbor contributions in fiscal
2007 were $1,061.
 
 POSTRETIREMENT
HEALTH CARE BENEFITS PLAN
 
 We
maintain a postretirement health care benefits plan (the “Retiree Health Plan”)
for certain eligible employees over the age of 65.  On May 31, 2006,
Retiree Health Plan eligibility was restricted to current retirees and those
active employees that were retirement eligible as of that date (age 55 and 10
years of service or age 65). Contributions to the Retiree Health Plan are
limited to approximately $2 per participant per year and are paid monthly on a
fully insured basis.  Participants are required to pay any insurance
premium amount in excess of the $2 employer
contribution.   Employer contributions expected for fiscal 2008
are approximately $78.
 
 Net periodic postretirement health care
benefits cost (benefit) for the three and nine months ended August 31, 2008 and
2007 included the following components:
 
 For
      the Three Months Ended
                August 31,
              
              
              For
      the Nine MonthsEnded
                August 31,2008
              
              
              2007
              
              
              2008
              
              
              2007Service
      cost
              
              $
              5
              
              
              $
              14
              
              
              $
              16
              
              
              $
              42Interest
      cost
              
              
              14
              
              
              
              18
              
              
              
              42
              
              
              
              54Amortization
      of prior service cost
              
              
              —
              
              
              
              4
              
              
              
              —
              
              
              
              12Amortization
      of net actuarial (gain) loss
              
              
              (24
              )
              
              
              (4
              )
              
              
              (72
              )
              
              
              (12
              )Net
      periodic postretirement cost (benefit)
              
              $
              (5
              )
              
              $
              32
              
              
              $
              (14
              )
              
              $
              96
  17
 17.
              INCOME
      TAXES
 
 We
account for income taxes using the asset and liability approach as prescribed by
SFAS 109, FIN 48, FSP FIN 48-1 and other applicable FSP’s and FASB
Interpretations.  This approach requires recognition of deferred tax
assets and liabilities for the expected future tax consequences of events that
have been included in our consolidated financial statements or tax
returns.  Using the enacted tax rates in effect for the year in which
the differences are expected to reverse, deferred tax assets and liabilities are
determined based on the differences between the financial reporting and the tax
basis of an asset or liability.  We record income tax expense in our
consolidated financial statements based on an estimated annual effective income
tax rate.  Our estimated tax rate for the nine months ended August 31,
2008 and 2007 was 35.2% and 35.0%, respectively.
 
 Undistributed
earnings of Chattem Canada, our Canadian subsidiary, amounted to approximately
$537 and $1,118 for the three and nine months ended August 31, 2008,
respectively.  These earnings are considered to be reinvested
indefinitely and, accordingly, no provision for U.S. federal and state income
taxes has been provided thereon.  Upon distribution of accumulated
earnings in the form of dividends or otherwise, we would be subject to U.S.
income taxes (subject to an adjustment for foreign tax credits).
 
 We
adopted FIN 48, as amended by FSP FIN 48-1, on December 1, 2007. The difference
between the tax benefit recognized in the financial statements for a position in
accordance with FIN 48 and the tax benefit claimed in the tax return is referred
to as an unrecognized tax benefit.  In connection with the adoption of FIN
48, we recognized an increase in the liability for unrecognized tax benefits of
$1,595, which is included in the accompanying consolidated financial statements
as a reduction to retained earnings of $711 and an increase to deferred tax
assets of $884.  We have a total unrecognized tax benefit of $2,180 as of
December 1, 2007, which includes an estimate of related interest and penalties
of $312.  The total amount of unrecognized tax benefits that, if
recognized, would affect the effective tax rate is $1,205.  We recognize
interest and penalties related to income tax matters as a component of the
provision for income taxes.
 
 The total
unrecognized tax benefit increased $2,414 during the third quarter to $7,794 as
of August 31, 2008.  This increase consists primarily of the deduction
of certain elements of compensation in our 2007 federal and state tax returns.
It is reasonably possible that the amount of unrecognized tax benefit could
increase by approximately $1,000 during the next twelve months if certain
elements of compensation are deducted in our 2008 federal and state tax
returns.
 
 We file
income tax returns in the U.S. federal jurisdiction and various state and
foreign jurisdictions. We are no longer subject to examinations by tax
authorities related to U.S. federal income taxes for fiscal years before 2004,
state income taxes for fiscal years before 2003 or non-U.S. income taxes for
fiscal years before 2002.
 
 18.
              PRODUCT SEGMENT
      INFORMATION
 
 Net sales
of our domestic product categories within our single healthcare business segment
for the three and nine months ended August 31, 2008 and 2007 are as
follows:
 
 For
      the Three Months
                Ended August 31,
              
              
              For
      the Nine Months
                Ended August 31,2008
              
              
              2007
              
              
              2008
              
              
              2007Medicated
      skin care
              
              $
              35,806
              
              
              $
              32,678
              
              
              $
              107,931
              
              
              $
              92,105Topical
      pain care
              
              
              24,192
              
              
              
              23,548
              
              
              
              74,279
              
              
              
              75,700Oral
      care
              
              
              15,859
              
              
              
              13,042
              
              
              
              47,045
              
              
              
              35,260Internal
      OTC
              
              
              12,149
              
              
              
              12,967
              
              
              
              36,633
              
              
              
              33,430Medicated
      dandruff shampoos
              
              
              7,654
              
              
              
              8,770
              
              
              
              26,940
              
              
              
              27,406Dietary
      supplements
              
              
              4,939
              
              
              
              6,710
              
              
              
              15,446
              
              
              
              21,564Other
      OTC and toiletry products
              
              
              4,364
              
              
              
              3,046
              
              
              
              16,695
              
              
              
              16,136Total
      domestic sales
              
              
              104,963
              
              
              
              100,761
              
              
              
              324,969
              
              
              
              301,601International
      revenues
              
              
              6,966
              
              
              
              8,204
              
              
              
              24,449
              
              
              
              21,159Total
      revenues
              
              $
              111,929
              
              
              $
              108,965
              
              
              $
              349,418
              
              
              $
              322,760
 
 
 19.
                COMMITMENTS AND
      CONTINGENCIES
 
 GENERAL
LITIGATION
  We were
named as a defendant in a number of lawsuits alleging that the plaintiffs were
injured as a result of ingestion of products containing phenylpropanolamine
(“PPA”), which was an active ingredient in most of our Dexatrim products until
November 2000.  The lawsuits filed in federal court were transferred
to the United States District Court for the Western District of
  18
 Washington
before United States District Judge Barbara J. Rothstein (In Re Phenylpropanolamine (“PPA”)
Products Liability Litigation, MDL No. 1407).  The remaining
lawsuits were filed in state court in a number of different states.
  On April
13, 2004, we entered into a class action settlement agreement with
representatives of the plaintiffs’ settlement class, which provided for a
national class action settlement of all Dexatrim PPA
claims.  On November 12, 2004, Judge Barbara J. Rothstein of the
United States District Court for the Western District of Washington entered a
final order and judgment certifying the class and granting approval of the Dexatrim PPA
settlement.  The Dexatrim PPA settlement
included claims against us involving alleged injuries by Dexatrim products containing
PPA in which the alleged injury occurred after December 21, 1998, the date we
acquired the Dexatrim
brand.  A total of 14 claimants with alleged injuries that occurred
after December 21, 1998 elected to opt-out of the class
settlement.  Subsequently, we have settled twelve of the opt-out
claims. The other two opt-outs have not filed lawsuits against us, and we
believe the applicable statutes of limitation have run against their
claims.
  In
accordance with the terms of the class action settlement, approximately $70,885
was initially funded into a settlement trust.  We have resolved all
claims in the settlement and paid all trust expenses.  On June 14,
2006, we filed a motion to dissolve the settlement trust.  The court
granted this motion on July 14, 2006.  We dissolved the settlement
trust in a letter to the trustee dated September 24, 2008.
  We were
also named as a defendant in approximately 206 lawsuits relating to Dexatrim containing PPA which
involved alleged injuries by Dexatrim products containing
PPA manufactured and sold prior to our acquisition of Dexatrim on December 21,
1998.  The DELACO Company (“DELACO”), successor by merger to the
Thompson Medical Company, Inc., which owned the brand prior to December 21,
1998, owed us an indemnity obligation for any liabilities arising from these
lawsuits.  On February 12, 2004, DELACO filed a Chapter 11 bankruptcy
petition in the United States Bankruptcy Court for the Southern District of New
York.  We filed a claim for indemnification in DELACO’s
bankruptcy.  We entered into a settlement agreement with DELACO dated
June 30, 2005 that resolved DELACO’s indemnity obligations to us (“the DELACO
Agreement”).  The DELACO Agreement was approved by the DELACO
bankruptcy court on July 28, 2005.  In accordance with the DELACO
bankruptcy plan, a settlement trust established under the plan paid us $8,750 on
March 17, 2006, which was included in our consolidated statement of income,
net of legal expenses, as litigation settlement for 2006.  The payment
to us by the DELACO settlement trust of $8,750 has conclusively compromised and
settled our indemnity claim filed in the DELACO bankruptcy. 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
December 30, 2003, the United States Food and Drug Administration (“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.  We discontinued the manufacturing and shipment of Dexatrim containing ephedrine
in September 2002 and have resolved all of the prior lawsuits filed against us
alleging injuries related to the ingestion of Dexatrim containing
ephedrine.  However, during April to June of 2008, we received
notification of 26 individual claims, all from the same attorney,
alleging the development of pulmonary arterial hypertension as a
result of ingesting Dexatrim containing ephedrine
and/or PPA in 1998 through 2003.  We resolved all of these claims for
$13,250, of which approximately $2,545 will be funded from the proceeds of the
Dexatrim settlement
trust.  We are not currently aware of any additional product liability
claims relating to Dexatrim.
 
 We were
named as a defendant in a putative class action lawsuit filed in the United
States District Court for the Southern District of California relating to the
labeling, advertising, promotion and sale of our Garliqueproduct.  We were served with this lawsuit on July 5,
2007.  The plaintiff has voluntarily dismissed his claim for class
certification but still seeks injunctive relief and attorney fees.  We
plan to vigorously defend this case.
 
 On
December 20, 2007, Avon Products, Inc. filed a patent infringement lawsuit
against us in the U.S. District Court for the Southern District of New York
alleging that our BullfrogMosquito Coast product infringes an Avon patent.  We are in the
process of negotiations with Avon to resolve this litigation and obtain a
fully paid license of the disputed patent.  The contemplated
license would permit us to continue manufacturing and selling Bullfrog Mosquito Coast without further
litigation.
  On July
25, 2008, LecTec Corporation filed a complaint against us in the U.S. District
Court for the Eastern District of Texas, that alleges our Capzasinand Icy Hot products infringe
LecTec’s patent.  In the same lawsuit, LecTec has asserted patent
infringement claims against Endo Pharmaceuticals, Inc.; Johnson & Johnson
Consumer Company, Inc.; The Mentholatum Company, Inc.; and Prince of Peace
Enterprises, Inc.  LecTec seeks injunctive relief, compensatory and
enhanced damages for the alleged infringement, and attorneys’ fees and
expenses.  We filed an answer and counterclaim on September 30,
2008.  This matter has not been set for trial.  We plan to
vigorously defend this lawsuit.
 
 19
 On
February 8, 2008, we initiated a voluntary nationwide recall of our Icy HotHeat Therapy
products, including consumer “samples” that were included on a limited
promotional basis in cartons of our 3 oz. Aspercreme product, and are
no longer marketing these products.  The recall is being conducted to
the consumer level.  We recalled these products because we received
some consumer reports of first, second and third degree burns, as well as skin
irritation resulting from consumer use or possible misuse of the
products.  As of October 2, 2008, there were approximately
132 consumers with pending claims against us and three products
liability lawsuits have been filed against us alleging burns and skin irritation
from the use of the Icy HotHeat Therapy products.  We may receive additional claims and/or
lawsuits in the future alleging burns and/or skin irritation from use of our
Heat Therapy products.  The outcome of any such potential litigation
cannot be predicted.
 
 Other
claims, suits and complaints arise in the ordinary course of our business
involving such matters as patents and trademarks, product liability,
environmental matters, employment law issues and other alleged injuries or
damage. The outcome of such litigation cannot be predicted, but, in the opinion
of management, based in part upon assessments from counsel, all such other
pending matters are without merit or are of such kind or involve such other
amounts that are not reasonably estimable or would not have a material adverse
effect on our financial position, results of operations or cash flows if
disposed of unfavorably.
 
 We
maintain insurance coverage for product liability claims relating to our
products under claims-made policies which are subject to annual
renewal.   For the current annual policy period beginning
September 1, 2008, we maintain product liability insurance coverage in the
amount of $30,000 through our captive insurance subsidiary, of which
approximately $6,268 has been funded as of October 2, 2008.  We
also have $25,000 of excess coverage through a third party reinsurance
policy.
 
 REGULATORY
  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 still market
these products as homeopathic products or reformulate them using ingredients
included in the FDA monograph.  We are uncertain as to when the
monograph is likely to become final.
 
 Certain
of our topical analgesic products are currently marketed under a FDA tentative
final external analgesic monograph. The FDA has 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 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 containing 16% menthol.  In February 2006,
we launched the Capzasin Back & Body
patch containing 0.025% capsaicin. In December 2007, we launched the Icy Hot PM Patch containing
0.025% capsaicin and 5% menthol.  All of these drug products contain
levels of active ingredients consistent with 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 costly testing
and data analysis. Any preliminary expenditures 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 are uncertain as to when this
matter is likely to become final.  For example, the FDA could choose
to hold in abeyance a final ruling on alternative dose forms even if the
monograph is otherwise finalized.  If the final monograph excludes
such products, we will have to file a new drug application (“NDA”) for
previously marketed drugs in order to continue to market the Icy Hot and AspercremePatches, the Icy Hot Sleeve, the Capzasin Back & Body
Patch and/or similar delivery systems under our other topical analgesic brands.
In such case, we would likely have to remove the existing products from the
market one year from the effective date of the final monograph, pending FDA
review and approval of an NDA. The preparation of an NDA would likely take us
six to 18 months and would be a significant cost. It typically takes the FDA at
least twelve months to rule on an NDA once it is submitted and there is no
assurance that the NDA will be approved or that the FDA will not ask for more
data or information.
 
 20
 We have responded to certain questions
with respect to efficacy received from the FDA in connection with clinical
studies for pyrilamine maleate, one of the active ingredients used in certain of
the Pamprin 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 were 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 or Prēmsyn
PMS, as brands, will be materially 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.
 
 We are
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 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 both issues 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.
 
 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.  In September 2007, the FDA published a new proposed
rule amending the previously stayed final monograph on sunscreens to include new
formulation options, labeling requirements and testing standards for measuring
UVA protection and revised testing for UVB protection.  When
implemented, the final rule will require all sunscreen manufacturers to conduct
new testing and revise the labeling of their products within eighteen months
after issuance of the final rule.  We will be required to take such
actions for our BullFrog product
line.
 
 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 the CHPA, presenting evidence that titanium dioxide presents
“no significant risk” to consumers.
 
 On
February 8, 2008, we initiated a voluntary nationwide recall of all lots of the
medical device, Icy Hot
Heat Therapy Air Activated Heat patch (Back and Arm, Neck and Leg), including
consumer “samples” that were included on a limited promotional basis in cartons
of our 3 oz. Aspercreme
product.  The recall was due to adverse events reports which
associated the use of the products with temporary or medically reversible health
consequences, skin irritation and burns.  The recall was voluntary and
conducted with the full knowledge of the FDA. On February 5-8, 2008, the FDA
conducted a medical device inspection of our manufacturing plant, manufacturing
records, and consumer complaint handling system related to the manufacture and
distribution of the Heat Therapy device.  On February 8, 2008, the FDA
issued a Form FDA-483 noting three inspectional observations pertaining to
medical device reporting, device correction reports, and corrective and
preventive action procedures.  We responded to the Form FDA-483 on
February 14 and February 20, 2008 committing to correct the cited observations.
On June 10, 2008, we received a warning letter from the FDA asserting the Heat
Therapy devices are misbranded and adulterated based on the inspectional
observations and requesting additional information to correct the
observations.  On June 24, 2008, we responded to the warning letter
addressing the noted violations and providing the requested
documentation.  On September 22, 2008, the FDA responded stating that
our response to the warning letter was thorough and appeared to adequately
address the FDA’s concerns.  We are no longer marketing the Icy Hot Heat Therapy
products.
 
 In June
2007, the FDA published a final rule establishing regulations requiring current
good manufacturing practices for dietary supplements.  This final
rule, which became effective June 2008, implements new rules covering supplement
production and process controls, packaging, labeling and consumer complaints, to
ensure the quality and safety of finished dietary supplements.
  21
 20.
                CONSOLIDATING
      FINANCIAL STATEMENTS
 
 The
consolidating financial statements, for the dates or periods indicated, of
Chattem, Inc.  (“Chattem”), Signal Investment & Management Co.
(“Signal”), SunDex, LLC (“SunDex”) and Chattem (Canada) Holdings, Inc.
(“Canada”), the guarantors of the long-term debt of Chattem, and the
non-guarantor direct and indirect wholly-owned subsidiaries of Chattem are
presented below.  Signal is 89% owned by Chattem and 11% owned by
Canada.  SunDex and Canada are wholly-owned subsidiaries of
Chattem.  The guarantees of Signal, SunDex and Canada are full and
unconditional and joint and several.  The guarantees of Signal, SunDex
and Canada as of August 31, 2008 arose in conjunction with Chattem’s Credit
Facility and Chattem’s issuance of the 7.0% Subordinated Notes (See Note
6).  The maximum amount of future payments the guarantors would be
required to make under the guarantees as of August 31, 2008 is
$235,250.
                                 22
 Note 20
 CHATTEM,
INC. AND SUBSIDIARIES
 CONSOLIDATING
BALANCE SHEETS
 
 AUGUST
      31, 2008
 (Unaudited
      and in thousands)
  CHATTEM
              
              
              GUARANTOR
      SUBSIDIARY COMPANIES
              
              
              NON-GUARANTOR
      SUBSIDIARY
                COMPANIES
              
              
              ELIMINATIONS
              
              
              CONSOLIDATEDASSETSCURRENT
      ASSETS:Cash
      and cash equivalents
              
              $
              601
              
              
              $
              348
              
              
              $
              12,082
              
              
              $
              —
              
              
              $
              13,031Accounts
      receivable, less allowances of $11,578
              
              
              42,936
              
              
              
              17,135
              
              
              
              8,384
              
              
              
              (17,135
              )
              
              
              51,320Interest
      receivable
              
              
              102
              
              
              
              641
              
              
              
              (85
              )
              
              
              (658
              )
              
              
              —Inventories
              
              
              35,213
              
              
              
              1,864
              
              
              
              3,578
              
              
              
              —
              
              
              
              40,655Deferred
      income taxes
              
              
              7,395
              
              
              
              —
              
              
              
              40
              
              
              
              —
              
              
              
              7,435Prepaid
      expenses and other current assets
              
              
              7,751
              
              
              
              —
              
              
              
              194
              
              
              
              —
              
              
              
              7,945Total
      current assets
              
              
              93,998
              
              
              
              19,988
              
              
              
              24,193
              
              
              
              (17,793
              )
              
              
              120,386PROPERTY,
      PLANT AND EQUIPMENT, NET
              
              
              30,848
              
              
              
              775
              
              
              
              796
              
              
              
              —
              
              
              
              32,419OTHER
      NONCURRENT ASSETS:Patents,
      trademarks and other purchased productrights, net
              
              
              3,045
              
              
              
              674,057
              
              
              
              1,561
              
              
              
              (62,290
              )
              
              
              616,373Debt
      issuance costs, net
              
              
              12,911
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              12,911Investment
      in subsidiaries
              
              
              316,314
              
              
              
              33,000
              
              
              
              66,860
              
              
              
              (416,174
              )
              
              
              —Note
      receivable
              
              
              —
              
              
              
              33,000
              
              
              
              —
              
              
              
              (33,000
              )
              
              
              —Other
              
              
              4,612
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              4,612Total
      other noncurrent assets
              
              
              336,882
              
              
              
              740,057
              
              
              
              68,421
              
              
              
              (511,464
              )
              
              
              633,896TOTAL
      ASSETS
              
              $
              461,728
              
              
              $
              760,820
              
              
              $
              93,410
              
              
              $
              (529,257
              )
              
              $
              786,701LIABILITIES AND
      SHAREHOLDERS’ EQUITYCURRENT
      LIABILITIES:Current
      maturities of long-term debt
              
              $
              3,000
              
              
              $
              —
              
              
              $
              —
              
              
              $
              —
              
              
              $
              3,000Accounts
      payable and other
              
              
              16,721
              
              
              
              —
              
              
              
              2,074
              
              
              
              —
              
              
              
              18,795Accrued
      liabilities
              
              
              38,028
              
              
              
              792
              
              
              
              16,454
              
              
              
              (17,792
              )
              
              
              37,482Total
      current liabilities
              
              
              57,749
              
              
              
              792
              
              
              
              18,528
              
              
              
              (17,792
              )
              
              
              59,277LONG-TERM
      DEBT, less current maturities
              
              
              456,650
              
              
              
              (1,200
              )
              
              
              34,800
              
              
              
              (33,000
              )
              
              
              457,250DEFERRED
      INCOME TAXES
              
              
              (23,651
              )
              
              
              56,833
              
              
              
              —
              
              
              
              —
              
              
              
              33,182OTHER
      NONCURRENT LIABILITIES
              
              
              1,772
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              1,772INTERCOMPANY
      ACCOUNTS
              
              
              (266,002
              )
              
              
              260,986
              
              
              
              5,016
              
              
              
              —
              
              
              
              —SHAREHOLDERS’
      EQUITY:Preferred
      shares, without par value, authorized 1,000, none
    issued
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —Common
      shares, without par value, authorized 100,000, issued and outstanding
      18,828
              
              
              21,920
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              21,920Shares
      of subsidiaries
              
              
              —
              
              
              
              329,704
              
              
              
              39,804
              
              
              
              (369,508
              )
              
              
              —Dividends
              
              
              —
              
              
              
              (52,498
              )
              
              
              —
              
              
              
              52,498
              
              
              
              —Retained
      earnings
              
              
              214,515
              
              
              
              166,203
              
              
              
              (5,726
              )
              
              
              (160,477
              )
              
              
              214,515236,435
              
              
              
              443,409
              
              
              
              34,078
              
              
              
              (477,487
              )
              
              
              236,435Cumulative
      other comprehensive income, net of tax:Interest
      rate hedge adjustment
              
              
              (1,724
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (1,724
              )Foreign
      currency translation adjustment
              
              
              507
              
              
              
              —
              
              
              
              988
              
              
              
              (978
              )
              
              
              517Unrealized
      actuarial gains and losses
              
              
              (8
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (8
              )Total
      shareholders’ equity
              
              
              235,210
              
              
              
              443,409
              
              
              
              35,066
              
              
              
              (478,465
              )
              
              
              235,220TOTAL
      LIABILITIES AND SHAREHOLDERS’ EQUITY
              
              $
              461,728
              
              
              $
              760,820
              
              
              $
              93,410
              
              
              $
              (529,257
              )
              
              $
              786,701
  23
 Note 20
 CHATTEM,
INC. AND SUBSIDIARIES
 CONSOLIDATING
BALANCE SHEETS
 
 NOVEMBER
      30, 2007
 (In
      thousands)
   CHATTEM
              
              
              GUARANTOR
                SUBSIDIARY
                COMPANIES
              
              
              NON-GUARANTOR
                SUBSIDIARY
                COMPANIES
              
              
              ELIMINATIONS
              
              
              CONSOLIDATEDASSETSCURRENT
      ASSETS:Cash
      and cash equivalents
              
              $
              4,685
              
              
              $
              590
              
              
              $
              10,132
              
              
              $
              —
              
              
              $
              15,407Accounts
      receivable, less allowances of $13,810
              
              
              37,492
              
              
              
              16,693
              
              
              
              6,261
              
              
              
              (16,693
              )
              
              
              43,753Interest
      receivable
              
              
              101
              
              
              
              625
              
              
              
              (84
              )
              
              
              (642
              )
              
              
              —Inventories
              
              
              36,220
              
              
              
              3,242
              
              
              
              3,803
              
              
              
              —
              
              
              
              43,265Deferred
      income taxes
              
              
              6,709
              
              
              
              —
              
              
              
              41
              
              
              
              —
              
              
              
              6,750Prepaid
      expenses and other current assets
              
              
              1,913
              
              
              
              —
              
              
              
              302
              
              
              
              (150
              )
              
              
              2,065Total
      current assets
              
              
              87,120
              
              
              
              21,150
              
              
              
              20,455
              
              
              
              (17,485
              )
              
              
              111,240PROPERTY,
      PLANT AND EQUIPMENT, NET
              
              
              30,902
              
              
              
              775
              
              
              
              672
              
              
              
              —
              
              
              
              32,349OTHER
      NONCURRENT ASSETS:Patents,
      trademarks and other purchased product rights, net
              
              
              3,482
              
              
              
              674,058
              
              
              
              1,560
              
              
              
              (62,290
              )
              
              
              616,810Debt
      issuance costs, net
              
              
              15,430
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              15,430Investment
      in subsidiaries
              
              
              336,936
              
              
              
              33,000
              
              
              
              66,860
              
              
              
              (436,796
              )
              
              
              —Note
      receivable
              
              
              —
              
              
              
              33,000
              
              
              
              —
              
              
              
              (33,000
              )
              
              
              —Other
              
              
              4,218
              
              
              
              —
              
              
              
              513
              
              
              
              —
              
              
              
              4,731Total
      other noncurrent assets
              
              
              360,066
              
              
              
              740,058
              
              
              
              68,933
              
              
              
              (532,086
              )
              
              
              636,971TOTAL
      ASSETS
              
              $
              478,088
              
              
              $
              761,983
              
              
              $
              90,060
              
              
              $
              (549,571
              )
              
              $
              780,560LIABILITIES AND
      SHAREHOLDERS’ EQUITYCURRENT
      LIABILITIES:Current
      maturities of long-term debt
              
              $
              3,000
              
              
              $
              —
              
              
              $
              —
              
              
              $
              —
              
              
              $
              3,000Accounts
      payable and other
              
              
              16,439
              
              
              
              —
              
              
              
              1,800
              
              
              
              —
              
              
              
              18,239Bank
      overdraft
              
              
              7,584
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              7,584Accrued
      liabilities
              
              
              33,561
              
              
              
              691
              
              
              
              4,770
              
              
              
              (17,485
              )
              
              
              21,537Total
      current liabilities
              
              
              60,584
              
              
              
              691
              
              
              
              6,570
              
              
              
              (17,485
              )
              
              
              50,360LONG-TERM
      DEBT, less current maturities
              
              
              504,400
              
              
              
              (1,200
              )
              
              
              34,800
              
              
              
              (33,000
              )
              
              
              505,000DEFERRED
      INCOME TAXES
              
              
              (23,976
              )
              
              
              45,032
              
              
              
              —
              
              
              
              —
              
              
              
              21,056OTHER
      NONCURRENT LIABILITIES
              
              
              2,436
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              2,436INTERCOMPANY
      ACCOUNTS
              
              
              (267,058
              )
              
              
              259,083
              
              
              
              7,975
              
              
              
              —
              
              
              
              —SHAREHOLDERS’
      EQUITYPreferred
      shares, without par value, authorized 1,000, none
    issued
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —Common
      shares, without par value, authorized 100,000, issued and
      outstanding, 19,092
              
              
              36,800
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              36,800Shares
      of subsidiaries
              
              
              —
              
              
              
              329,704
              
              
              
              39,804
              
              
              
              (369,508
              )
              
              
              —Dividends
              
              
              —
              
              
              
              (18,046
              )
              
              
              (9,000
              )
              
              
              27,046
              
              
              
              —Retained
      earnings
              
              
              165,655
              
              
              
              146,719
              
              
              
              8,430
              
              
              
              (155,149
              )
              
              
              165,655202,455
              
              
              
              458,377
              
              
              
              39,234
              
              
              
              (497,611
              )
              
              
              202,455Cumulative
      other comprehensive income, net of tax:Interest
      rate hedge adjustment
              
              
              (1,747
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (1,747
              )Foreign
      currency translation adjustment
              
              
              1,002
              
              
              
              —
              
              
              
              1,481
              
              
              
              (1,475
              )
              
              
              1,008Unrealized
      actuarial gains and losses
              
              
              (8
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (8
              )Total
      shareholders’ equity
              
              
              201,702
              
              
              
              458,377
              
              
              
              40,715
              
              
              
              (499,086
              )
              
              
              201,708TOTAL
      LIABILITIES AND SHAREHOLDERS’ EQUITY
              
              $
              478,088
              
              
              $
              761,983
              
              
              $
              90,060
              
              
              $
              (549,571
              )
              
              $
              780,560
 
 
 24
 Note 20
 
 CHATTEM,
INC. AND SUBSIDIARIES
 CONSOLIDATING
STATEMENTS OF INCOME
 
 FOR THE
NINE MONTHS ENDED AUGUST 31, 2008
 (Unaudited
and in thousands)
 
 CHATTEM
              
              
              GUARANTOR
      SUBSIDIARY COMPANIES
              
              
              NON-GUARANTOR
                SUBSIDIARY
                COMPANIES
              
              
              ELIMINATIONS
              
              
              CONSOLIDATEDTOTAL
      REVENUES
              
              $
              317,818
              
              
              $
              68,598
              
              
              $
              18,342
              
              
              $
              (55,340
              )
              
              $
              349,418COSTS
      AND EXPENSES:Cost
      of sales
              
              
              89,316
              
              
              
              3,745
              
              
              
              8,369
              
              
              
              (2,303
              )
              
              
              99,127Advertising
      and promotion
              
              
              82,308
              
              
              
              4,560
              
              
              
              4,664
              
              
              
              —
              
              
              
              91,532Selling,
      general and administrative
              
              
              43,392
              
              
              
              430
              
              
              
              1,854
              
              
              
              —
              
              
              
              45,676Litigation
      settlement
              
              
              491
              
              
              
              —
              
              
              
              10,705
              
              
              
              —
              
              
              
              11,196Product
      recall expenses
              
              
              5,129
              
              
              
              —
              
              
              
              802
              
              
              
              —
              
              
              
              5,931Equity
      in subsidiary income
              
              
              (30,498
              )
              
              
              —
              
              
              
              —
              
              
              
              30,498
              
              
              
              —Total
      costs and expenses
              
              
              190,138
              
              
              
              8,735
              
              
              
              26,394
              
              
              
              28,195
              
              
              
              253,462INCOME
      FROM OPERATIONS
              
              
              127,680
              
              
              
              59,863
              
              
              
              (8,052
              )
              
              
              (83,535
              )
              
              
              95,956OTHER
      INCOME (EXPENSE):Interest
      expense
              
              
              (19,279
              )
              
              
              —
              
              
              
              (1,927
              )
              
              
              1,913
              
              
              
              (19,293
              )Investment
      and other income, net
              
              
              87
              
              
              
              1,922
              
              
              
              2,141
              
              
              
              (3,788
              )
              
              
              362Loss
      on early extinguishment of debt
              
              
              (526
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (526
              )Royalties
              
              
              (50,592
              )
              
              
              (2,444
              )
              
              
              —
              
              
              
              53,036
              
              
              
              —Corporate
      allocations
              
              
              1,543
              
              
              
              (1,423
              )
              
              
              (120
              )
              
              
              —
              
              
              
              —Total
      other income (expense)
              
              
              (68,767
              )
              
              
              (1,945
              )
              
              
              94
              
              
              
              51,161
              
              
              
              (19,457
              )INCOME
      BEFORE INCOME TAXES
              
              
              58,913
              
              
              
              57,918
              
              
              
              (7,958
              )
              
              
              (32,374
              )
              
              
              76,499PROVISION
      FOR INCOME TAXES
              
              
              9,342
              
              
              
              20,388
              
              
              
              (2,802
              )
              
              
              —
              
              
              
              26,928NET
      INCOME
              
              $
              49,571
              
              
              $
              37,530
              
              
              $
              (5,156
              )
              
              $
              (32,374
              )
              
              $
              49,571
 
     
 25
 Note 20
 
 CHATTEM,
INC. AND SUBSIDIARIES
 CONSOLIDATING
STATEMENTS OF INCOME
 
 FOR THE
NINE MONTHS ENDED AUGUST 31, 2007
 (Unaudited
and in thousands)
 
 CHATTEM
              
              
              GUARANTOR
      SUBSIDIARY COMPANIES
              
              
              NON-GUARANTOR
                SUBSIDIARY
                COMPANIES
              
              
              ELIMINATIONS
              
              
              CONSOLIDATEDTOTAL
      REVENUES
              
              $
              286,359
              
              
              $
              70,374
              
              
              $
              16,727
              
              
              $
              (50,700
              )
              
              $
              322,760COSTS
      AND EXPENSES:Cost
      of sales
              
              
              87,617
              
              
              
              5,724
              
              
              
              7,758
              
              
              
              (2,231
              )
              
              
              98,868Advertising
      and promotion
              
              
              73,748
              
              
              
              8,194
              
              
              
              4,269
              
              
              
              —
              
              
              
              86,211Selling,
      general and administrative
              
              
              41,535
              
              
              
              (220
              )
              
              
              1,201
              
              
              
              —
              
              
              
              42,516Acquisition
      expenses
              
              
              2,057
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              2,057Equity
      in subsidiary income
              
              
              (35,319
              )
              
              
              —
              
              
              
              —
              
              
              
              35,319
              
              
              
              —Total
      costs and expenses
              
              
              169,638
              
              
              
              13,698
              
              
              
              13,228
              
              
              
              33,088
              
              
              
              229,652INCOME
      FROM OPERATIONS
              
              
              116,721
              
              
              
              56,676
              
              
              
              3,499
              
              
              
              (83,788
              )
              
              
              93,108OTHER
      INCOME (EXPENSE):Interest
      expense
              
              
              (22,923
              )
              
              
              —
              
              
              
              (1,989
              )
              
              
              2,210
              
              
              
              (22,702
              )Investment
      and other income, net
              
              
              795
              
              
              
              1,923
              
              
              
              2,626
              
              
              
              (4,086
              )
              
              
              1,258Loss
      on early extinguishment of debt
              
              
              (2,633
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (2,633
              )Royalties
              
              
              (44,983
              )
              
              
              (3,486
              )
              
              
              —
              
              
              
              48,469
              
              
              
              —Corporate
      allocations
              
              
              2,026
              
              
              
              (1,978
              )
              
              
              (48
              )
              
              
              —
              
              
              
              —Total
      other income (expense)
              
              
              (67,718
              )
              
              
              (3,541
              )
              
              
              589
              
              
              
              46,593
              
              
              
              (24,077
              )INCOME
      BEFORE INCOME TAXES
              
              
              49,003
              
              
              
              53,135
              
              
              
              4,088
              
              
              
              (37,195
              )
              
              
              69,031PROVISION
      FOR INCOME TAXES
              
              
              4,133
              
              
              
              18,597
              
              
              
              1,431
              
              
              
              —
              
              
              
              24,161NET
      INCOME
              
              $
              44,870
              
              
              $
              34,538
              
              
              $
              2,657
              
              
              $
              (37,195
              )
              
              $
              44,870
     
 26
 Note 20
 CHATTEM,
INC. AND SUBSIDIARIES
 CONSOLIDATING
STATEMENTS OF CASH FLOWS
 
 FOR THE
NINE MONTHS ENDED AUGUST 31, 2008
 (Unaudited
and in thousands)
 CHATTEM
              
              
              GUARANTOR
                SUBSIDIARY
                COMPANIES
              
              
              NON-GUARANTOR
                SUBSIDIARY
                COMPANIES
              
              
              ELIMINATIONS
              
              
              CONSOLIDATEDOPERATING
      ACTIVITIES:Net
      income
              
              $
              49,571
              
              
              $
              37,530
              
              
              $
              (5,156
              )
              
              $
              (32,374
              )
              
              $
              49,571Adjustments
      to reconcile net income to net cashprovided
      by operating activities:Depreciation
      and amortization
              
              
              6,208
              
              
              
              —
              
              
              
              108
              
              
              
              —
              
              
              
              6,316Deferred
      income taxes
              
              
              603
              
              
              
              11,801
              
              
              
              —
              
              
              
              —
              
              
              
              12,404Tax
      benefit realized from stock options exercised
              
              
              (2,342
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (2,342
              )Stock-based
      compensation
              
              
              4,281
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              4,281Loss
      on early extinguishment of debt
              
              
              526
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              526Other,
      net
              
              
              115
              
              
              
              —
              
              
              
              22
              
              
              
              —
              
              
              
              137Equity
      in subsidiary income
              
              
              (32,374
              )
              
              
              —
              
              
              
              —
              
              
              
              32,374
              
              
              
              —Changes
      in operating assets and liabilities, net of effects from
      acquisitions:Accounts
      receivable and other
              
              
              (5,444
              )
              
              
              (442
              )
              
              
              (2,123
              )
              
              
              442
              
              
              
              (7,567
              )Interest
      receivable
              
              
              —
              
              
              
              (15
              )
              
              
              —
              
              
              
              15
              
              
              
              —Inventories
              
              
              1,009
              
              
              
              1,378
              
              
              
              224
              
              
              
              —
              
              
              
              2,611Prepaid
      expenses and other current assets
              
              
              (5,843
              )
              
              
              —
              
              
              
              108
              
              
              
              (150
              )
              
              
              (5,885
              )Accounts
      payable and accrued liabilities
              
              
              5,497
              
              
              
              101
              
              
              
              11,957
              
              
              
              (307
              )
              
              
              17,248Net
      cash provided by operating activities
              
              
              21,807
              
              
              
              50,353
              
              
              
              5,140
              
              
              
              —
              
              
              
              77,300INVESTING
      ACTIVITIES:Purchases
      of property, plant and equipment
              
              
              (3,326
              )
              
              
              —
              
              
              
              (241
              )
              
              
              —
              
              
              
              (3,567
              )Decrease
      in other assets, net
              
              
              (1,333
              )
              
              
              —
              
              
              
              78
              
              
              
              —
              
              
              
              (1,255
              )Net
      cash used in investing activities
              
              
              (4,659
              )
              
              
              —
              
              
              
              (163
              )
              
              
              —
              
              
              
              (4,822
              )FINANCING
      ACTIVITIES:Repayment
      of long-term debt
              
              
              (37,250
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (37,250
              )Proceeds
      from borrowings under revolving credit facility
              
              
              148,000
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              148,000Repayments
      of revolving credit facility
              
              
              (158,500
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (158,500
              )Proceeds
      from exercise of stock options
              
              
              4,487
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              4,487Change
      in bank overdraft
              
              
              (7,584
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (7,584
              )Repurchase
      of common shares
              
              
              (26,327
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (26,327
              )Tax
      benefit realized from stock options exercised
              
              
              2,342
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              2,342Changes
      in intercompany accounts
              
              
              2,977
              
              
              
              1,903
              
              
              
              (4,880
              )
              
              
              —
              
              
              
              —Dividends
      paid
              
              
              50,623
              
              
              
              (52,498
              )
              
              
              1,875
              
              
              
              —
              
              
              
              —Net
      cash used in financing activities
              
              
              (21,232
              )
              
              
              (50,595
              )
              
              
              (3,005
              )
              
              
              —
              
              
              
              (74,832
              )EFFECT
      OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS
              
              
              —
              
              
              
              —
              
              
              
              (22
              )
              
              
              —
              
              
              
              (22
              )CASH
      AND CASH EQUIVALENTS:(Decrease)
      increase for the period
              
              
              (4,084
              )
              
              
              (242
              )
              
              
              1,950
              
              
              
              —
              
              
              
              (2,376
              )At
      beginning of period
              
              
              4,685
              
              
              
              590
              
              
              
              10,132
              
              
              
              —
              
              
              
              15,407At
      end of period
              
              $
              601
              
              
              $
              348
              
              
              $
              12,082
              
              
              $
              —
              
              
              $
              13,031
 27
 Note
20
 
 CHATTEM,
INC. AND SUBSIDIARIES
 CONSOLIDATING
STATEMENTS OF CASH FLOWS
 
 FOR THE
NINE MONTHS ENDED AUGUST 31, 2007
 (Unaudited
and in thousands)
  CHATTEM
              
              
              GUARANTOR
                SUBSIDIARY
                COMPANIES
              
              
              NON-GUARANTOR
                SUBSIDIARY
                COMPANIES
              
              
              ELIMINATIONS
              
              
              CONSOLIDATEDOPERATING
      ACTIVITIES:Net
      income
              
              $
              44,870
              
              
              $
              34,538
              
              
              $
              2,657
              
              
              $
              (37,195
              )
              
              $
              44,870Adjustments
      to reconcile net income to net cashprovided
      by operating activities:Depreciation
      and amortization
              
              
              6,307
              
              
              
              —
              
              
              
              154
              
              
              
              —
              
              
              
              6,461Deferred
      income taxes
              
              
              5,524
              
              
              
              5,603
              
              
              
              (1
              )
              
              
              —
              
              
              
              11,126Tax
      benefit realized from stock options exercised
              
              
              (4,747
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (4,747
              )Stock-based
      compensation
              
              
              4,122
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              4,122Loss
      on early extinguishment of debt
              
              
              2,633
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              2,633Other,
      net
              
              
              156
              
              
              
              —
              
              
              
              (143
              )
              
              
              —
              
              
              
              13Equity
      in subsidiary income
              
              
              (37,195
              )
              
              
              —
              
              
              
              —
              
              
              
              37,195
              
              
              
              —Changes
      in operating assets and liabilities, net of effects from
      acquisitions:Accounts
      receivable and other
              
              
              (11,528
              )
              
              
              (6,770
              )
              
              
              (1,375
              )
              
              
              6,770
              
              
              
              (12,903
              )Interest
      receivable
              
              
              (33
              )
              
              
              (27
              )
              
              
              (295
              )
              
              
              355
              
              
              
              —Inventories
              
              
              1,912
              
              
              
              275
              
              
              
              (15
              )
              
              
              —
              
              
              
              2,172Prepaid
      expenses and other current assets
              
              
              825
              
              
              
              —
              
              
              
              (232
              )
              
              
              240
              
              
              
              833Accounts
      payable and accrued liabilities
              
              
              23,644
              
              
              
              (85
              )
              
              
              2,547
              
              
              
              (7,365
              )
              
              
              18,741Net
      cash provided by operating activities
              
              
              36,490
              
              
              
              33,534
              
              
              
              3,297
              
              
              
              —
              
              
              
              73,321INVESTING
      ACTIVITIES:Purchases
      of property, plant and equipment
              
              
              (3,590
              )
              
              
              —
              
              
              
              (203
              )
              
              
              —
              
              
              
              (3,793
              )Acquisition
      of brands
              
              
              (8,091
              )
              
              
              (406,531
              )
              
              
              (1,562
              )
              
              
              —
              
              
              
              (416,184
              )Decrease
      in other assets, net
              
              
              229
              
              
              
              467
              
              
              
              1,100
              
              
              
              —
              
              
              
              1,796Net
      cash used in investing activities
              
              
              (11,452
              )
              
              
              (406,064
              )
              
              
              (665
              )
              
              
              —
              
              
              
              (418,181
              )FINANCING
      ACTIVITIES:Repayment
      of long-term debt
              
              
              (153,750
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (153,750
              )Intercompany
      debt proceeds (payments)
              
              
              6,400
              
              
              
              (1,200
              )
              
              
              (5,200
              )
              
              
              —
              
              
              
              —Proceeds
      from long-term debt
              
              
              400,000
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              400,000Proceeds
      from borrowings under revolving credit facility
              
              
              147,500
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              147,500Repayments
      of revolving credit facility
              
              
              (102,500
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (102,500
              )Proceeds
      from exercise of stock options
              
              
              11,130
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              11,130Change
      in bank overdraft
              
              
              3,836
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              3,836Repurchase
      of common shares
              
              
              (22,260
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (22,260
              )Purchase
      of note hedge
              
              
              (29,500
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (29,500
              )Proceeds
      from issuance of warrant
              
              
              17,430
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              17,430Increase
      in debt issuance costs
              
              
              (9,374
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (9,374
              )Tax
      benefit realized from stock options exercised
              
              
              4,747
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              4,747Changes
      in intercompany accounts
              
              
              (375,541
              )
              
              
              374,157
              
              
              
              1,384
              
              
              
              —
              
              
              
              —Dividends
      paid
              
              
              —
              
              
              
              (1,875
              )
              
              
              1,875
              
              
              
              —
              
              
              
              —Net
      cash (used in) provided by financing activities
              
              
              (101,882
              )
              
              
              371,082
              
              
              
              (1,941
              )
              
              
              —
              
              
              
              267,259EFFECT
      OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS
              
              
              —
              
              
              
              —
              
              
              
              143
              
              
              
              —
              
              
              
              143CASH
      AND CASH EQUIVALENTS:(Decrease)
      increase for the period
              
              
              (76,844
              )
              
              
              (1,448
              )
              
              
              834
              
              
              
              —
              
              
              
              (77,458
              )At
      beginning of period
              
              
              80,198
              
              
              
              1,967
              
              
              
              8,362
              
              
              
              —
              
              
              
              90,527At
      end of period
              
              $
              3,354
              
              
              $
              519
              
              
              $
              9,196
              
              
              $
              —
              
              
              $
              13,069
 
 28
 Item
2.   Management’s Discussion and Analysis of Financial Condition
and Results of
Operations
  The
following discussion and analysis of our financial condition and results of
operations should be read in conjunction with the audited consolidated financial
statements and related notes thereto included in our 2007 Annual Report on Form
10-K filed with the Securities and Exchange Commission (“SEC”).  This
discussion and analysis contains forward-looking statements that involve risks,
uncertainties and assumptions.  The actual results may differ
materially from those anticipated in these forward-looking statements as a
result of a number of factors, including, but not limited to, those described in
our filings with the SEC.
 
 Overview
 
 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 including such categories as medicated skin care, topical pain care,
oral care, internal OTC, medicated dandruff shampoos, dietary supplements, and
other OTC and toiletry products. Our portfolio of products includes
well-recognized brands such as:
 
 •
              Gold Bond, Balmexand
      Cortizone-10–
      medicated skin care;
 
 •
              Icy Hot, Capzasin and
      Aspercreme–
      topical pain care;
 
 •
              ACT and Herpecin-L– oral
      care;
 
 •
              Unisom, Pamprin and Kaopectate–
      internal OTC;
 
 •
              Selsun Blue and Selsun Natural – medicated
      dandruff shampoos;
 
 •
              Dexatrim, Garlique and New Phase–
      dietary supplements; and
 
 •
              Bullfrog, Ultraswim and Sun-In – other OTC and
      toiletry products.
 
 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 product 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, our Cortizone-10 anti-itch
ointment 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
26.2% of our total revenues for the nine months ended August 31, 2008. 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 acquiring brands,
developing product line extensions and increasing market penetration of our
existing products.
 
 Developments
During Fiscal 2008
 
 Products
 
 In the
first nine months of fiscal 2008, we introduced the following product line
extensions: Unisom
Sleep Melts, Cortizone-10 Intensive
Healing, Gold Bond
Ultimate Restoring Lotion, Gold Bond Ultimate Foot
Cream, Gold Bond
Soothing Lotion, Icy
Hot PM Lotion, Icy
Hot PM Patch, Aspercreme Heat Pain
Relieving Gel, Aspercreme Nighttime Lotion,
Dexatrim Max Daytime
Control and Dexatrim
Max Complex 7.
 
 Product Recall
 
 On
February 8, 2008, we initiated a voluntary nationwide recall of our Icy Hot Heat Therapy product.
Icy HotHeat Therapy is
an air-activated, self-heating disposable device for temporary relief of
muscular and joint pain.  We recalled these products because we
received some consumer reports of first, second and third degree burns and skin
irritation resulting from the use or possible misuse of the
product.  Based in part on consideration of on-hand factory inventory
and retail point of sales data, during the first quarter of fiscal 2008 we
recorded an estimate of approximately $6.0 million of recall expenses related to
product returns, inventory obsolescence, destruction costs, consumer refunds,
legal fees and other estimated expenses.  During the third quarter of
fiscal 2008, we recorded a reduction of the estimated expenses from our original
estimate of approximately
  29
 $0.6
million, offset by legal fees and settlement payments of approximately $0.5
million.  The remaining accrued liability for product recall expenses
was $0.7 million as of August 31, 2008.
 
 Stock
Repurchase
 
 During
the first nine months of fiscal 2008, we repurchased 418,281 shares of our
common stock under our stock repurchase program for $26.3 million at an average
price per share of $62.94.
 
 Litigation
Settlement
 
 During
the third quarter of fiscal 2008, we reached a settlement on all 26 known claims
alleging pulmonary arterial hypertension as a result of the ingestion of Dexatrim products in 1998
through 2003. Included as litigation settlement in the consolidated
statements of income is the settlement of the 26 claims totaling $13.3 million
and $0.5 million of legal expenses, which were partially offset by $2.6 million
to be funded with proceeds from the Dexatrim litigation settlement
trust.
  Results
of Operations
 
 The following table sets forth, for the
periods indicated, certain items from our Consolidated Statements of Income
expressed as a percentage of total revenues:
  For
      the Three Months
                Ended August 31,
              
              
              For
      the Nine Months
                Ended August 31,2008
              
              
              2007
              
              
              2008
              
              
              2007TOTAL
      REVENUES
              
              
              100.0
              %
              
              
              100.0
              %
              
              
              100.0
              %
              
              
              100.0
              %COSTS
      AND EXPENSES:Cost
      of sales
              
              
              28.4
              
              
              
              30.1
              
              
              
              28.4
              
              
              
              30.6Advertising
      and promotion
              
              
              23.9
              
              
              
              25.5
              
              
              
              26.2
              
              
              
              26.7Selling,
      general and administrative
              
              
              13.4
              
              
              
              14.3
              
              
              
              13.0
              
              
              
              13.2Litigation
      settlement
              
              
              10.0
              
              
              
              —
              
              
              
              3.2
              
              
              
              —Product
      recall (income) expenses
              
              
              (0.1
              )
              
              
              —
              
              
              
              1.7
              
              
              
              —Acquisition
      expenses
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              0.6Total
      costs and expenses
              
              
              75.6
              
              
              
              69.9
              
              
              
              72.5
              
              
              
              71.1INCOME
      FROM OPERATIONS
              
              
              24.4
              
              
              
              30.1
              
              
              
              27.5
              
              
              
              28.9OTHER
      INCOME (EXPENSE):Interest
      expense
              
              
              (5.5
              )
              
              
              (6.6
              )
              
              
              (5.5
              )
              
              
              (7.0
              )Investment
      and other income, net
              
              
              0.1
              
              
              
              0.2
              
              
              
              0.1
              
              
              
              0.3Loss
      on early extinguishment of debt
              
              
              —
              
              
              
              (0.4
              )
              
              
              (0.2
              )
              
              
              (0.8
              )Total
      other income (expense)
              
              
              (5.4
              )
              
              
              (6.8
              )
              
              
              (5.6
              )
              
              
              (7.5
              )INCOME
      BEFORE INCOME TAXES
              
              
              19.0
              
              
              
              23.3
              
              
              
              21.9
              
              
              
              21.4PROVISION
      FOR INCOME TAXES
              
              
              6.5
              
              
              
              8.4
              
              
              
              7.7
              
              
              
              7.5NET
      INCOME
              
              
              12.5
              %
              
              
              14.9
              %
              
              
              14.2
              %
              
              
              13.9
              %
 
  Critical
Accounting Policies
 
 The
preparation of financial statements in accordance with U.S. generally accepted
accounting principles requires management to use estimates.  Several
different estimates or methods can be used by management that might yield
different results.  The following are the significant estimates used
by management in the preparation of the consolidated financial statements for
the three and nine months ended August 31, 2008.
 
 For a
summary of our significant accounting policies, see Note 2 of Notes to
Consolidated Financial Statements included in our Annual Report on Form 10-K for
the year ended November 30, 2007 filed with the SEC.
 
 30
 Allowance
for Doubtful Accounts
 
 As of
August 31, 2008, an estimate was made of the collectibility of the outstanding
accounts receivable balances.   This estimate requires the
utilization of outside credit services, knowledge about the customer and the
customer’s industry, new developments in the customer’s industry and operating
results of the customer as well as general economic conditions and historical
trends.  When all these facts are compiled, a judgment as to the
collectibility of the individual account is made.   Many factors
can impact this estimate, including those noted in this
paragraph.  The adequacy of the estimated allowance may be impacted by
the deterioration in the financial condition of a large customer, weakness in
the economic environment resulting in a higher level of customer bankruptcy
filings or delinquencies and the competitive environment in which the customer
operates.  During the third quarter of fiscal 2008, we performed a
detailed assessment of the collectibility of trade accounts receivable and did
not make any significant adjustments to our estimate of allowance for doubtful
accounts.  The balance of allowance for doubtful accounts was $0.4
million at August 31, 2008 and November 30, 2007.
 
 Revenue
Recognition
 
 Revenue
is recognized when our products are shipped to our customers.  It is
generally our policy across all classes of customers that all sales are
final.  As is common in the consumer products industry, customers
return products for a variety of reasons including products damaged in transit,
discontinuance of a particular size or form of product and shipping
errors.  As sales are recorded, we accrue an estimated amount for
product returns, as a reduction of these sales, based upon our historical
experience and consideration of discontinued products, product divestitures,
estimated inventory levels held by our customers and retail point of sale data
on existing and newly introduced products.  The level of returns may
fluctuate from our estimates due to several factors including weather
conditions, customer inventory levels and competitive conditions.  We
charge the allowance account for product returns when the customer provides
appropriate supporting documentation that the product is properly destroyed or
upon receipt of the product.
 
 We
separate returns into the two categories of seasonal and non-seasonal
products.  We use the historical return detail of seasonal and
non-seasonal products for at least the most recent three fiscal years on
generally all products, which is normalized for any specific occurrence that is
not reasonably likely to recur, to determine the amount of product return as a
percentage of sales, and estimate an allowance for potential returns based on
product sold in the current period.  To consider product sold in
current and prior periods, an estimate of inventory held by our retail customers
is calculated based on customer inventory detail.  This estimate of
inventory held by our customers, along with historical returns as a percentage
of sales, is used to determine an estimate of potential product
returns.  This estimate of the allowance for seasonal and non-seasonal
returns is further analyzed by considering retail customer point of sale
data.  We also consider specific events, such as discontinued product
or product divestitures, when determining the adequacy of the
allowance.  Based on consideration of the sales of Icy Hot Pro Therapy
performing below expectations, review of retail point of sales data and an
estimate of inventory held by customers, an allowance for returns of $4.5
million was recorded as of November 30, 2007.  During the third
quarter of fiscal 2008, based on a revised estimate of inventory held by
customers, we reduced the estimated remaining liability for returns by $1.5
million, which resulted in an increase to net sales in our consolidated
financial statements.  As of August 31, 2008, the allowance remaining
for Icy Hot Pro Therapyreturns is $1.0 million.
 
 Our
estimate of product returns for seasonal and non-seasonal products as of August
31, 2008 was $3.1 million and $1.0 million, respectively, and $1.2 million and
$1.3 million, respectively, as of November 30, 2007.  For the nine
months ended August 31, 2008, we increased our estimate of returns for seasonal
products by approximately $1.9 million, which resulted in a decrease to net
sales in our consolidated financial statements and decreased our estimate for
non-seasonal returns by approximately $0.3 million which resulted in an increase
to net sales in our consolidated financial statements.  During the
nine months ended August 31, 2007, we increased our estimate of returns for
seasonal products and non-seasonal returns by approximately $1.3 million and
$0.1 million, respectively, which resulted in a decrease to net sales in our
consolidated financial statements.  Each percentage point change in
the seasonal and non-seasonal return rate would impact net sales by
approximately $0.2 million and $0.5 million, respectively.
 
 We
routinely enter into agreements with customers to participate in promotional
programs.  The cost of these programs is recorded as either
advertising and promotion expense or as a reduction of sales as prescribed by
Emerging Issues Task Force 01-9, “Accounting for Consideration Given by a Vendor
to a Customer (Including a Reseller of the Vendor’s Products)”.  A
significant portion of the programs are recorded as a reduction of sales and
generally take the form of coupons and vendor allowances, which are normally
taken via temporary price reductions, scan downs, display activity and
participations in in-store programs provided uniquely by the
customer.  We also enter into cooperative advertising programs with
certain customers, the cost of which is recorded as advertising and promotion
expense.  In order for retailers to receive reimbursement under such
programs, the retailer must meet specified advertising guidelines and provide
appropriate documentation of the advertisement being run.
 
 31
 We
analyze promotional programs in two primary categories — coupons and vendor
allowances.  Customers normally utilize vendor allowances in the form
of temporary price reductions, scan downs, display activity and participations
in in-store programs provided uniquely by the customer.  We estimate
the accrual for outstanding coupons by utilizing a third-party clearinghouse to
track coupons issued, coupon value, distribution and expiration dates, quantity
distributed and estimated redemption rates that are provided by
us.  We estimate the redemption rates based on internal analysis of
historical coupon redemption rates and expected future retail sales by
considering recent point of sale data.  The estimate for vendor
allowances is based on estimated unit sales of a product under a program and
amounts committed for such programs in each fiscal year.  Estimated
unit sales are determined by considering customer forecasted sales, point of
sale data and the nature of the program being offered.  The three most
recent years of expected program payments versus actual payments made and
current year retail point of sale trends are analyzed to determine future
expected payments.  Customer delays in requesting promotional program
payments due to their audit of program participation and resulting request for
reimbursement is also considered to evaluate the accrual for vendor
allowances.  The costs of these programs is often variable based on
the number of units actually sold.  As of August 31, 2008, the coupon
and vendor allowances accruals were $1.8 million and $5.1 million,
respectively, and $1.9 million and $5.5 million, respectively, as of November
30, 2007.  Each percentage point change in promotional program
participation and advertising and promotion expense would impact net sales by
$0.2 million and an insignificant amount, respectively, for the nine months
ended August 31, 2008.
 
 Income
Taxes
 
 We
account for income taxes using the asset and liability approach as prescribed by
SFAS 109, FIN 48, FSP FIN 48-1 and other applicable FSP’s and FASB
Interpretations.  This approach requires recognition of deferred tax
assets and liabilities for the expected future tax consequences of events that
have been included in our consolidated financial statements or tax
returns.  Using the enacted tax rates in effect for the year in which
the differences are expected to reverse, deferred tax assets and liabilities are
determined based on the differences between the financial reporting and the tax
basis of an asset or liability.  We adopted FIN 48, as amended by FSP
FIN 48-1, on December 1, 2007.  FIN 48 clarifies the accounting for
uncertainty in income taxes recognized in the financial statements in accordance
with SFAS 109. We record income tax expense in our consolidated financial
statements based on an estimated annual effective income tax
rate.  Our effective tax rate for the nine months ended August 31,
2008 and 2007 was 35.2% and 35.0%, respectively.
 
 Accounting
for Acquisitions and Intangible Assets
 
 We
account for our acquisitions under the purchase method of accounting for
business combinations as prescribed by SFAS No. 141, “Business Combinations”
(“SFAS 141”).  Under SFAS 141, the cost, including transaction costs,
are allocated to the underlying net assets, based on their respective estimated
fair values.  Business combinations consummated beginning in the first
quarter of our fiscal 2010 will be accounted for under SFAS 141R.
 
 We
account for our intangible assets in accordance with SFAS 142.  Under
SFAS 142, intangible assets with indefinite useful lives are not amortized but
are reviewed for impairment at least annually. Intangible assets with finite
lives are amortized over their estimated useful lives using the straight-line
method.
 
 The
judgments made in determining the estimated fair value and expected useful lives
assigned to each class of assets and liabilities acquired can significantly
affect net income.  For example, the useful life of property, plant,
and equipment acquired will differ substantially from the useful life of brand
licenses and trademarks.  Consequently, to the extent a longer-lived
asset is ascribed greater value under the purchase method than a shorter-lived
asset or a value is assigned to an indefinite-lived asset, net income in a given
period may be higher.
 
 Determining
the fair value of certain assets and liabilities acquired is judgmental in
nature and often involves the use of significant estimates and
assumptions.  An area that requires significant judgment is the fair
value and useful lives of intangible assets.  In this process, we
often obtain the assistance of a third party valuation firm for certain
intangible assets.
 
 Our
intangible assets consist of exclusive brand licenses, trademarks and other
intellectual property, customer relationships and non-compete
agreements.  We have determined that our trademarks have indefinite
useful lives, as cash flows from the use of the trademarks are expected to be
generated indefinitely. The useful lives of our intangible assets are reviewed
as circumstances dictate using the guidance of applicable accounting
literature.
 
 The value
of our intangible assets is exposed to future adverse changes if we experience
declines in operating results or experience significant negative industry or
economic trends.  We review our indefinite-lived intangible assets for
impairment at least annually by comparing the carrying value of the intangible
assets to its estimated fair value.  The estimate of fair value is
determined by discounting the estimate of future cash flows of the intangible
assets.  Consistent with our policy, we perform the annual impairment
testing of our indefinite-lived intangible assets during the quarter ended
November 30, with the most recent test performed in the quarter ended November
30, 2007.  No impairment or adjustment to the carrying value of our
indefinite-lived intangible assets was required as a result of this
testing.
 
 32
 In
January 2007, we completed the acquisition of the U.S. rights to five consumer
and OTC brands from Johnson & Johnson (“J&J
Acquisition”).  The acquired brands were: ACT, Unisom, Cortizone-10, Kaopectate, and Balmex.  In May
2007, we acquired the worldwide trademark and rights to sell and market ACT in Western Europe from
Johnson & Johnson (“ACT
Acquisition”).
 
 Fair
Value Measurements
  On
December 1, 2007, we adopted SFAS 157, which provides guidance for using fair
value to measure assets and liabilities.  SFAS 157 applies both to
items recognized and reported at fair value in the financial statements and to
items disclosed at fair value in the notes to the financial
statements.  SFAS 157 does not change existing accounting rules
governing what can or must be recognized and reported at fair value and
clarifies that fair value is defined as the price received to sell an asset, or
paid to transfer a liability, in an orderly transaction between market
participants at the measurement date.  Additionally, SFAS 157 does not
eliminate practicability exceptions that exist in accounting pronouncements
amended by SFAS 157 when measuring fair value.  As a result, we are
not required to recognize any new assets or liabilities at fair
value.  SFAS 157-2 defers the date of SFAS 157 for nonfinancial assets
and liabilities and is effective in our fiscal 2009.
  SFAS 157
also establishes a framework for measuring fair value.  Fair value is
generally determined based on quoted market prices in active markets for
identical assets or liabilities.  If quoted market prices are not
available, SFAS 157 provides guidance on alternative valuation techniques that
place greater reliance on observable inputs and less reliance on unobservable
inputs.
  Stock-Based
Compensation
 
 We
account for stock-based compensation under the provisions of SFAS 123R, which
requires the recognition of the cost of employee services received in exchange
for an award of equity instruments in the financial statements and is measured
based on the grant date fair value of the award.  The fair value of
each stock option grant is estimated using a Flex Lattice Model.  The
input assumptions used in determining fair value are the expected life of the
stock options, the expected volatility of our common stock, the risk-free
interest rate over the expected life of the option and the expected forfeiture
rate of the options granted.  We recognize stock option compensation
expense over the period during which an employee provides service in exchange
for the award (the vesting period).
 
 Comparison
of Three Months Ended August 31, 2008 and 2007
 
 To
facilitate discussion of our operating results for the three months ended August
31, 2008 and 2007, we have included the following selected data from our
unaudited Consolidated Statements of Income:
 
 Increase (Decrease)2008
              
              
              2007
              
              
              Amount
              
              
              Percentage(dollars
      in thousands)Domestic
      net sales
              
              $
              104,963
              
              
              $
              100,761
              
              
              $
              4,202
              
              
              
              4.2
              %International
      revenues (including royalties)
              
              
              6,966
              
              
              
              8,204
              
              
              
              (1,238
              )
              
              
              (15.1
              )Total
      revenues
              
              
              111,929
              
              
              
              108,965
              
              
              
              2,964
              
              
              
              2.7Cost
      of sales
              
              
              31,753
              
              
              
              32,793
              
              
              
              (1,040
              )
              
              
              (3.2
              )Advertising
      and promotion expense
              
              
              26,789
              
              
              
              27,760
              
              
              
              (971
              )
              
              
              (3.5
              )Selling,
      general and administrative expense
              
              
              15,024
              
              
              
              15,626
              
              
              
              (602
              )
              
              
              (3.9
              )Litigation
      settlement
              
              
              11,196
              
              
              
              —
              
              
              
              11,196
              
              
              
              100.0Product
      recall income
              
              
              (112
              )
              
              
              —
              
              
              
              (112
              )
              
              
              (100.0
              )Interest
      expense
              
              
              6,176
              
              
              
              7,147
              
              
              
              (971
              )
              
              
              (13.6
              )Loss
      on early extinguishment of debt
              
              
              —
              
              
              
              414
              
              
              
              (414
              )
              
              
              (100.0
              )Net  income
              
              
              13,966
              
              
              
              16,312
              
              
              
              (2,346
              )
              
              
              (14.4
              )
 
 33
 Domestic
Net Sales
 
 Domestic
net sales for the three months ended August 31, 2008 increased $4.2 million,
or 4.2%, to $105.0 million from $100.8 million in the prior year
quarter.   A comparison of domestic net sales for the categories
of products included in our portfolio of OTC healthcare products is as
follows:
 Increase (Decrease)2008
              
              
              2007
              
              
              Amount
              
              
              Percentage(dollars
      in thousands)Medicated
      skin care
              
              $
              35,806
              
              
              $
              32,678
              
              
              $
              3,128
              
              
              
              9.6
              %Topical
      pain care
              
              
              24,192
              
              
              
              23,548
              
              
              
              644
              
              
              
              2.7Oral
      care
              
              
              15,859
              
              
              
              13,042
              
              
              
              2,817
              
              
              
              21.6Internal
      OTC
              
              
              12,149
              
              
              
              12,967
              
              
              
              (818
              )
              
              
              (6.3
              )Medicated
      dandruff shampoos
              
              
              7,654
              
              
              
              8,770
              
              
              
              (1,116
              )
              
              
              (12.7
              )Dietary
      supplements
              
              
              4,939
              
              
              
              6,710
              
              
              
              (1,771
              )
              
              
              (26.4
              )Other
      OTC and toiletry products
              
              
              4,364
              
              
              
              3,046
              
              
              
              1,318
              
              
              
              43.3Total
              
              $
              104,963
              
              
              $
              100,761
              
              
              $
              4,202
              
              
              
              4.2
 
 Net sales
in the medicated skin care category increased $3.1 million, or 9.6%, in the
third quarter of fiscal 2008 compared to the prior year quarter.  Net
sales of Gold Bond
increased 14.7% compared to the prior year quarter, led by sales of Gold Bond Ultimate Restoring
Lotion, launched in the first quarter of fiscal 2008, and increased sales of
Gold Bond Ultimate
Softening Lotion.  Continued growth of the Cortizone-10 brand due to the
launch ofCortizone-10
Intensive Healing in the first quarter of fiscal 2008 also contributed to the
increase in net sales in this category.
 
 Net sales
in the topical pain care category increased $0.6 million, or 2.7%, for the third
quarter of fiscal 2008 compared to the prior year quarter.  Excluding
sales of Icy Hot Heat
Therapy (voluntarily recalled on February 8, 2008), the category increased 11.4%
compared to the prior year quarter, led by the new products introduced in the
first quarter of fiscal 2008, Icy Hot PM Lotion, Icy Hot PM Patch, Aspercreme Heat Pain Gel and
Aspercreme Nighttime
Lotion.
 
 Net sales
in the oral care category increased $2.8 million, or 21.6%, in the third quarter
of fiscal 2008 compared to the prior year quarter.  This increase was
led by the continued growth of ACT resulting from additional
product distribution and continued advertising support.
 
 Net sales
in the internal OTC category decreased $0.8 million, or 6.3%, in the third
quarter of fiscal 2008 compared to the prior year quarter primarily due to
higher sales of Unisom
to one customer in the third quarter of fiscal 2007 as a result of an inventory
shortage of another product in the sleep aid category that did not occur again
in the third quarter of fiscal 2008, which was offset in part by sales from the
launch of Unisom
SleepMelts in the second quarter of fiscal 2008.
 
 Net sales
in the medicated dandruff shampoos category decreased $1.1 million, or 12.7%, in
the third quarter of fiscal 2008 compared to the prior year quarter primarily
due to declining sales of SelsunSalon and partially
offset by sales of Selsun BlueNaturals, which began shipping in the second quarter of fiscal
2007.
 
 Net sales
in the dietary supplements category decreased $1.8 million, or 26.4%, for the
third quarter of fiscal 2008 compared to the prior year quarter.  Net
sales of Dexatrim
decreased 32.3% primarily resulting from increased competitive pressures in the
category and a decline in sales of Dexatrim Max2O, partially offset by the
launch of Dexatrim Max
Daytime Control in the first quarter of fiscal 2008 and Dexatrim Max Complex 7 which
began shipping in the third quarter of fiscal 2008.
 
 Net sales
in the other OTC and toiletry products category increased $1.3 million, or
43.3%, in the third quarter of fiscal 2008 compared to the prior year quarter
primarily due to the timing of shipments of Bullfrog from the second
quarter of fiscal 2008 to the third quarter of fiscal 2008 to certain of our
customers.
 
 Domestic
sales variances were principally the result of changes in unit sales volume with
the exception of certain selected products for which we implemented a unit sales
price increase effective April 2008.
 
 International
Revenues
 
 For the
third quarter of fiscal 2008, international revenues decreased $1.2 million, or
15.1%, compared to the third quarter of fiscal 2007 due principally to the
timing of sales to certain customers in Latin America in the third quarter of
fiscal 2008 compared to the prior year quarter.
 
 34
 Cost
of Sales
 
 Cost of
sales in the third quarter of fiscal 2008 was $31.8 million, or 28.4% as a
percentage of total revenues for the third quarter of fiscal 2008 compared to
30.1% in the prior year quarter, resulting in gross margin for the third quarter
of fiscal 2008 of 71.6% compared to 69.9% in the prior year
quarter.  The increase in gross margin was largely attributable to the
integration of manufacturing of certain of the acquired brands from the J&J
Acquisition in the fourth quarter of fiscal 2007.
 
 Advertising
and Promotion Expense
 
 Advertising
and promotion expenses in the third quarter of fiscal 2008 were 23.9% of total
revenues in the third quarter of fiscal 2008 compared to 25.5% for the prior
year quarter.  The decrease in advertising and promotion expense as a
percentage of total revenues for the current period reflects the fixed cost
component of our advertising and promotion expenditures not increasing
commensurate with the percentage increase in domestic net sales and the
reduction of planned promotion expenditures as a percentage of revenue in the
third quarter of fiscal 2008 as compared to the prior year quarter.
 
 Selling,
General and Administrative Expense
 
 Selling,
general and administrative expenses in the third quarter of fiscal 2008
decreased $0.6 million, or 3.9%, compared to the prior year
quarter.  Selling, general and administrative expenses were 13.4% and
14.3% of total revenues for the third quarter of fiscal 2008 and 2007,
respectively.  The decrease in selling, general and administrative
expenses as a percentage of total revenues was largely attributable to our
general and administrative expenses not increasing commensurate with the
percentage increase in domestic net sales partially offset by higher
transportation costs.
 
 Litigation
Settlement
 
 During
the third quarter of fiscal 2008, we reached a settlement on all 26 known claims
alleging pulmonary arterial hypertension as a result of the ingestion of Dexatrim products in 1998
through 2003.  Included as litigation settlement in the consolidated
statements of income is the settlement of the 26 claims totaling $13.3 million
and $0.5 million of legal expenses, which were partially offset by $2.6
million to be funded with proceeds of the Dexatrim litigation
settlement trust.
 
 Product
Recall Income
 
 Product recall income in the third
quarter of fiscal 2008 represents a $0.6 million adjustment to reduce the
estimated charges that were initially recorded related to the voluntary recall
of Icy Hot Heat Therapy
initiated in February 2008, offset by legal fees and settlement payments of
approximately $0.5 million incurred during the quarter.
 
 Interest
Expense
 
 Interest
expense decreased $1.0 million, or 13.6%, in the third quarter of fiscal 2008
compared to the prior year quarter reflecting a reduction in the principal
portion of debt since the third quarter of fiscal 2007.  Until our
indebtedness is reduced substantially, interest expense will continue to
represent a significant percentage of our income from operations.
 
 Loss
on Early Extinguishment of Debt
 
 During
the third quarter of fiscal 2007, we utilized borrowings under the revolving
credit facility portion of our Credit Facility to repay $25.0 million of the
term loan under the Credit Facility.  In connection with the
repayment, we retired a proportional share of the term loan debt issuance costs,
which resulted in a loss on early extinguishment of debt of $0.4
million.  We did not have a similar loss during the third quarter of
fiscal 2008.
 
 35
 Comparison of
Nine Months Ended August 31, 2008 and 2007
 
 To
facilitate discussion of our operating results for the nine months ended August
31, 2008 and 2007, we have included the following selected data from our
unaudited Consolidated Statements of Income:
 
 Increase (Decrease)2008
              
              
              2007
              
              
              Amount
              
              
              Percentage(dollars
      in thousands)Domestic
      net sales
              
              $
              324,969
              
              
              $
              301,601
              
              
              $
              23,368
              
              
              
              7.7
              %International
      revenues (including royalties)
              
              
              24,449
              
              
              
              21,159
              
              
              
              3,290
              
              
              
              15.5Total
      revenues
              
              
              349,418
              
              
              
              322,760
              
              
              
              26,658
              
              
              
              8.3Cost
      of sales
              
              
              99,127
              
              
              
              98,868
              
              
              
              259
              
              
              
              0.3Advertising
      and promotion expense
              
              
              91,532
              
              
              
              86,211
              
              
              
              5,321
              
              
              
              6.2Selling,
      general and administrative expense
              
              
              45,676
              
              
              
              42,348
              
              
              
              3,328
              
              
              
              7.9Litigation
      settlement
              
              
              11,196
              
              
              
              —
              
              
              
              11,196
              
              
              
              100.0Product
      recall expenses
              
              
              5,931
              
              
              
              —
              
              
              
              5,931
              
              
              
              100.0Acquisition
      expenses
              
              
              —
              
              
              
              2,057
              
              
              
              (2,057
              )
              
              
              (100.0
              )Interest
      expense
              
              
              19,293
              
              
              
              22,702
              
              
              
              (3,409
              )
              
              
              (15.0
              )Loss
      on early extinguishment of debt
              
              
              526
              
              
              
              2,633
              
              
              
              (2,107
              )
              
              
              (80.0
              )Net
      income
              
              
              49,571
              
              
              
              44,870
              
              
              
              4,701
              
              
              
              10.5
 
 Domestic
Net Sales
 
 Domestic
net sales for the nine months ended August 31, 2008 increased $23.4 million,
or 7.7%, as compared to the corresponding period of
2007.   A comparison of domestic net sales for the categories of
products included in our portfolio of OTC healthcare products is as
follows:
 Increase (Decrease)2008
              
              
              2007
              
              
              Amount
              
              
              Percentage(dollars
      in thousands)Medicated
      skin care
              
              $
              107,931
              
              
              $
              92,105
              
              
              $
              15,826
              
              
              
              17.2
              %Topical
      pain care
              
              
              74,279
              
              
              
              75,700
              
              
              
              (1,421
              )
              
              
              (1.9
              )Oral
      care
              
              
              47,045
              
              
              
              35,260
              
              
              
              11,785
              
              
              
              33.4Internal
      OTC
              
              
              36,633
              
              
              
              33,430
              
              
              
              3,203
              
              
              
              9.6Medicated
      dandruff shampoos
              
              
              26,940
              
              
              
              27,406
              
              
              
              (466
              )
              
              
              (1.7
              )Dietary
      supplements
              
              
              15,446
              
              
              
              21,564
              
              
              
              (6,118
              )
              
              
              (28.4
              )Other
      OTC and toiletry products
              
              
              16,695
              
              
              
              16,136
              
              
              
              559
              
              
              
              3.5Total
              
              $
              324,969
              
              
              $
              301,601
              
              
              $
              23,368
              
              
              
              7.7
 
 Net sales
in the medicated skin care category increased $15.8 million, or 17.2%, for the
first nine months of fiscal 2008 compared to the same period in fiscal 2007 as a
result of the launch of Gold
Bond Ultimate Restoring Lotion and Cortizone-10 Intensive
Healing in the first quarter of fiscal 2008, the continued success of Gold Bond Ultimate Softening
Lotion and our ownership of the Cortizone-10 and Balmex brands for the entire
nine month period of fiscal 2008 compared to only eight months of ownership in
the same period of fiscal 2007.
 
 Net sales
in the topical pain care products category decreased $1.4 million, or 1.9%, for
the first nine months of fiscal 2008 compared to the same period in fiscal 2007,
principally as a result of the discontinuance of shipments of Icy HotHeat Therapy
following our February 8, 2008 voluntary recall of the product, and the
continued decline of Icy Hot
Pro Therapy sales. Excluding sales of Icy Hot Heat Therapy andIcy Hot Pro Therapy, sales in the
category increased 6.9% compared to the prior year period, led by the new
products introduced in the first quarter of fiscal 2008, Icy Hot PM Lotion, Icy Hot PM Patch, Aspercreme Heat Pain Gel and
Aspercreme Nighttime
Lotion.
 
 Net sales
in the oral care category increased $11.8 million, or 33.4%, for the first nine
months of fiscal 2008 compared to the same period in 2007.  The
increase results from our ownership of the ACT brand for the entire nine
month period of fiscal 2008 compared to only eight months of ownership in the
same period of fiscal 2007 and growing sales of the ACT brand resulting from
additional product distribution and advertising support.
 
 Net sales
in the internal OTC category increased $3.2 million, or 9.6%, for the first nine
months of fiscal 2008 compared to the same period in 2007 as a result of our
ownership of the Unisom
and Kaopectate brands
for the entire nine month period of fiscal 2008 compared to only eight months of
ownership in the same period of fiscal 2007 and the introduction of UnisomSleepMelts in the
second quarter of fiscal 2008.
 
 36
 Net sales
in the medicated dandruff shampoos category decreased $0.5 million, or 1.7%, for
the first nine months of fiscal 2008 compared to the same period in 2007
primarily due to declining sales of SelsunSalon, which were
partially offset by sales of Selsun Blue Naturals, which
began shipping in the second quarter of fiscal 2007.
 
 Net sales
in the dietary supplements category decreased $6.1 million, or 28.4%, for the
first nine months of fiscal 2008 compared to the same period in
2007.  Net sales of Dexatrim decreased 41.5%
primarily resulting from increased competitive pressures in the diet-aid
category and a decline in sales of Dexatrim Max2O, partially offset by the
launch of Dexatrim Max
Daytime Control in the first quarter of fiscal 2008 and Dexatrim Max Complex 7, which
began shipping in the third quarter of fiscal 2008.
 
 Net sales
in the other OTC and toiletry products category increased $0.6 million, or 3.5%,
for the first nine months of fiscal 2008 compared to the same period in fiscal
2007 as a result of unit volume changes to the brands within the category and an
adjustment for estimated product returns in the prior year period and no
corresponding charge in the fiscal 2008 period.
 
 Domestic
sales variances were principally the result of changes in unit sales volume with
the exception of certainselected products for
which we implemented a unit sales price increase effective April
2008.
 
 International
Revenues
 
 For the
nine months ended August 31, 2008, international revenues increased $3.3
million, or 15.5%, compared to the same period in fiscal 2007 primarily due to
increased sales in the Latin American market from the brands acquired in the
J&J Acquisition in January 2007, the ACT Acquisition in May 2007
and the fluctuation of currency exchange rates in the first nine months of
fiscal 2008 compared to the currency exchange rates in the comparable prior year
period.
 
 Cost
of Sales
 
 Cost of
sales for the nine months ended August 31, 2008 was 28.4% as a percentage of
total revenues compared to 30.6% in the prior year period and gross margin for
the same period of fiscal 2008 was 71.6% compared to 69.4% in the prior year
period.  The increase in gross margin was largely attributable to the
integration of manufacturing of certain of the acquired brands from the J&J
Acquisition in the fourth quarter of fiscal 2007.
 
 Advertising
and Promotion Expense
 
 Advertising
and promotion expenses for the nine months ended August 31, 2008 increased $5.3
million, or 6.2%, compared to the same period in fiscal 2007 and were 26.2% and
26.7% of total revenues for the nine months ended August 31, 2008 and 2007,
respectively.  The increase in advertising and promotion expenses
results from higher expected expenditures for advertising and promotion in
fiscal 2008 and the ownership and resulting advertising and promotion support of
the brands acquired in the J&J Acquisition for the entire nine month period
ended August 31, 2008 as compared to only eight months of ownership in the same
period in 2007.
 
 Selling,
General and Administrative Expense
 
 Selling,
general and administrative expenses for the nine months ended August 31, 2008
increased $3.3 million, or 7.9%, compared to the same period of fiscal 2007
and were 13.0% and 13.2% of total revenues for the nine months ended August
31, 2008 and 2007, respectively.  The increase in selling, general and
administrative expenses as a percentage of total revenues was largely
attributable to the absorption of transition service costs similar to those paid
to Johnson & Johnson related to freight and administrative costs that were
recorded as acquisition expenses in the comparable period of fiscal 2007 and
higher transportation costs.
 
 Litigation
Settlement
 
 During
the third quarter of fiscal 2008, we reached a settlement on all 26 known claims
alleging pulmonary arterial hypertension as a result of the ingestion of Dexatrim products in 1998
through 2003.  Included as litigation settlement in the consolidated
statements of income is the settlement of the 26 claims totaling $13.3 million
and $0.5 million of legal expenses, which were partially offset by $2.6 million
to be funded with proceeds from the Dexatrim litigation
settlement trust.
 
 37
 Product
Recall Expenses
 
 The $5.9 million of product recall
expenses in the first nine months of fiscal 2008 relates to the voluntary recall
of our Icy Hot Heat
Therapy product initiated in February 2008.  The product recall
expenses include product returns, inventory obsolescence, destruction costs,
consumer refunds, legal fees, settlement payments and other estimated
expenses.  The estimate was made by management based on consideration
of on-hand inventory and retail point of sales data at the time of the initial
recall and was adjusted during the third quarter of fiscal 2008.  As
of August 31, 2008, the remaining liability estimated for the product recall is
$0.7 million.
 
 Acquisition
Expenses
 
 Acquisition
expenses of $2.1 million were recorded in the first half of fiscal 2007 related
to transition services provided by Johnson & Johnson under a transition
services agreement entered into in connection with the J&J
Acquisition.  The transition services provided by Johnson &
Johnson included consumer affairs, distribution and collection services, which
included related financial accounting and reporting services.  The
distribution and collection services were terminated in April 2007 and the
consumer affairs services were terminated in June 2007.
 
 Interest
Expense
 
 Interest
expense decreased $3.4 million, or 15.0%, for the nine months ended August 31,
2008 compared to the same period in fiscal 2007 reflecting a reduction in the
principal portion of debt since August 31, 2007.  Until our
indebtedness is reduced substantially, interest expense will continue to
represent a significant percentage of our income from operations.
 
 Loss
on Early Extinguishment of Debt
 
 During the first quarter of fiscal
2008, we utilized borrowings under the revolving credit facility portion of our
Credit Facility to repay $35.0 million of the term loan under the Credit
Facility.  In connection with the term loan repayment, we retired a
proportional share of the term loan debt issuance costs and recorded the
resulting loss on extinguishment of debt of $0.5 million.  In April
2007, we utilized the net proceeds from the 1.625% Convertible Notes and
borrowings under the revolving credit facility portion of our Credit Facility to
repay $128.0 million of the term loan under the Credit
Facility.   In July 2007, we utilized borrowings under the
revolving credit facility portion of our Credit Facility to repay an additional
$25.0 million of the term loan under the Credit Facility.  In
connection with the term loan repayments, we retired a proportional share of the
term loan debt issuance costs and recorded the resulting loss on early
extinguishment of debt of $2.6 million during the nine months ended August 31,
2007.
 
 Liquidity
and Capital Resources
 
 We have
historically financed our operations with a combination of internally generated
funds and borrowings.  Our principal uses of cash are for operating
expenses, servicing long-term debt, acquisitions, working capital, repurchases
of our common stock, payment of income taxes and capital
expenditures.
 
 Cash of
$77.3 million and $73.3 million was provided by operating activities for
the nine months ended August 31, 2008 and 2007, respectively.  The
increase in cash flows from operating activities over the prior year period was
primarily attributable to increased net income and a smaller increase in
accounts receivable from November 30, 2007 to August 31, 2008 as compared to the
increase from November 30, 2006 to August 31, 2007, offset by an increase in
prepaid expenses.
 
 Investing activities used cash of $4.8
million and $418.2 million in the nine months ended August 31, 2008 and 2007,
respectively.  The cash used in the first nine months of fiscal 2007
was primarily related to amounts used to fund the J&J Acquisition and the
ACT
Acquisition.
 
 Financing
activities used cash of $74.8 million and provided cash of $267.3 million in the
nine months ended August 31, 2008 and 2007, respectively.  In the
first nine months of fiscal 2008, the financing activities cash flow was used to
reduce borrowings outstanding under our Credit Facility and repurchase shares of
our common stock.  In the first nine months of fiscal 2007, the
financing activities cash flow was used to fund the J&J Acquisition and
repurchase shares of our common stock.
 
 We
believe that cash provided by operating activities, our cash and cash
equivalents balance and funds available under the revolving credit facility
portion of our Credit Facility will be sufficient to fund our capital
expenditures, debt service and working capital requirements for the foreseeable
future as our business is currently conducted.  It is likely that any
acquisitions we make in the future will require us to obtain additional
financing.  If additional financing is required, there are no
assurances that it will be available, or, if available, that it can be obtained
on terms favorable to us or not dilutive to our future earnings.
  38
 As of
August 31, 2008, we had $19.5 million of borrowings outstanding under the
revolving credit facility portion of our Credit Facility.  As of
October 2, 2008, we had $19.5 million of borrowings outstanding under the
revolving credit facility portion of our Credit Facility and our borrowing
capacity was $80.5 million.
 
 Foreign
Operations
 
 Historically,
our primary foreign operations have been conducted through our Canadian and
United Kingdom (“U.K.”) subsidiaries.  Since November 1, 2004, our
European business has been conducted through Chattem Global Consumer Products
Limited, a wholly-owned subsidiary located in Limerick, Ireland.  In
connection with the ACT
Acquisition, we have been conducting business in Greece through our newly
created subsidiary Chattem Greece, a wholly-owned subsidiary located in Alimos
Attica, Greece.  The functional currencies of these subsidiaries are
Canadian dollars, British pounds and Euros,
respectively.  Fluctuations in exchange rates can impact operating
results, including total revenues and expenses, when translations of the
subsidiary financial statements are made in accordance with SFAS No. 52,
“Foreign Currency Translation”.  For the nine months ended August 31,
2008 and 2007, these subsidiaries accounted for 5% of total revenues in each
period, and 2% of total assets in each period.  It has not been our
practice to hedge our assets and liabilities in Canada, the U.K., Greece and
Ireland or our intercompany transactions due to the inherent risks associated
with foreign currency hedging transactions and the timing of payments between us
and our foreign subsidiaries.  Historically, gains or losses from
foreign currency transactions have not had a material impact on our operating
results.  Gains and losses from foreign currency transactions for the
nine months ended August 31, 2008 and 2007 were $0.3 million and an
insignificant amount, respectively, and are included in selling, general and
administrative expenses in the consolidated statements of income.
 
 Recent
Accounting Pronouncements
 
 In July
2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation
No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), which clarifies
the accounting for uncertainty in income taxes recognized in the financial
statements in accordance with Statement of Financial Accounting Standard
(“SFAS”) No. 109, “Accounting for Income Taxes” (“SFAS 109”). FIN 48 provides
guidance on the financial statement recognition and measurement of a tax
position taken or expected to be taken in a tax return. FIN 48 also provides
guidance on de-recognition, classification, interest and penalties, accounting
in interim periods, disclosures and transition.  Additionally, in May
2007, the FASB issued FASB Staff Position (“FSP”) No. FIN 48-1, “Definition of
Settlement in FASB Interpretation No. 48” (“FSP FIN 48-1”), an amendment to FIN
48.  FSP FIN 48-1 clarifies how an enterprise is to determine whether
a tax position is effectively settled for the purpose of recognizing previously
unrecognized tax benefits.  The provisions of FIN 48 and FSP FIN 48-1
were effective for fiscal years beginning after December 15,
2006.   As described in Note 17, we adopted the provisions of FIN
48, as amended by FSP FIN 48-1, effective December 1, 2007.
  In
September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS
157”).  SFAS 157 provides guidance for using fair value to measure
assets and liabilities.  SFAS 157 applies when other standards require
(or permit) assets or liabilities to be measured at fair value but does not
expand the use of fair value in any new circumstances.  SFAS 157 also
requires expanded disclosure of the effect on earnings for items measured using
unobservable data (data not based on market observable information), establishes
a fair value hierarchy that prioritizes the information used to develop those
assumptions and requires separate disclosure by level within the fair value
hierarchy.  As described in Note 8, we adopted SFAS 157 effective
December 1, 2007.
  In
February 2008, the FASB issued FSP No. SFAS 157-2, “Effective
Date of FASB Statement No. 157” (“FSP 157-2”).  FSP 157-2
defers the effective date of SFAS 157 for nonfinancial assets and
nonfinancial liabilities, except those that are recognized or disclosed at fair
value in the financial statements on a recurring basis (at least annually), to
fiscal years and interim periods within those fiscal years, beginning after
November 15, 2008, or our fiscal 2009.  We are currently
evaluating the impact of adopting the provisions of FSP 157-2.
  In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
Financial Assets and Financial Liabilities” (“SFAS 159”).  SFAS 159
permits entities to choose to measure certain financial assets and liabilities
at fair value.  Unrealized gains and losses on items for which the
fair value option has been elected are reported in earnings. We adopted SFAS 159
effective December 1, 2007 without choosing to elect to measure certain
financial assets or liabilities at fair value that were not previously measured
at fair value.
  In
December 2007, the FASB issued SFAS No. 141R, “Business Combinations” (“SFAS
141R”).  SFAS 141R establishes principles and requirements for how the
acquirer in a business combination recognizes and measures the identifiable
assets acquired, liabilities assumed, and intangible assets acquired and
determines what information to disclose to enable users of the financial
statements to evaluate the nature and financial effects of the business
combination.  The provisions of SFAS 141R are effective for
acquisitions closing after the first annual reporting period beginning after
December 15, 2008.  Accordingly, we will apply the provisions of SFAS
141R prospectively to business combinations consummated beginning in the first
quarter of our fiscal 2010.  We do not expect SFAS 141R to have an
effect on our previous acquisitions.
 
 39
 In March
2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments
and Hedging Activities – An Amendment of FASB Statement No. 133” (“SFAS
161”).  SFAS 161 requires enhanced disclosures for derivative and
hedging activities.  SFAS 161 is effective for financial statements
issued for fiscal years and interim periods beginning after November 15, 2008,
or our fiscal 2009.  We are currently evaluating the impact, if any,
of SFAS 161.
 
 In
April 2008, the FASB issued FSP No. FAS 142-3, “Determination of the
Useful Life of Intangible Assets” (“FSP FAS 142-3”).  In determining the
useful life of intangible assets, FSP FAS 142-3 removes the requirement to
consider whether an intangible asset can be renewed without substantial cost of
material modifications to the existing terms and conditions and, instead,
requires an entity to consider its own historical experience in renewing similar
arrangements. FSP FAS 142-3 also requires expanded disclosure related to the
determination of intangible asset useful lives.  FSP FAS 142-3 is effective
for financial statements issued for fiscal years beginning after
December 15, 2008, or our fiscal 2010.  We are currently
evaluating the impact, if any, of FSP FAS 142-3.
  In May
2008, the FASB issued FSP Accounting Principles Board Opinion No. 14-1,
“Accounting for Convertible Debt Instruments That May Be Settled in Cash upon
Conversion (Including Partial Cash Settlement)” (“FSP 14-1”).  FSP
14-1 requires issuers of convertible debt instruments that may be settled in
cash to separately account for the liability and equity components in a manner
that will reflect the entity’s nonconvertible debt borrowing rate when interest
cost is recognized in periods subsequent to adoption.  Upon adoption
of FSP 14-1, we will allocate a portion of the proceeds received from the
issuance of our convertible notes between a liability and equity component by
determining the fair value of the liability component using our non-convertible
debt borrowing rate.  The difference between the proceeds of the notes
and the fair value of the liability component will be recorded as a discount on
the debt with a corresponding offset to paid-in-capital.  The
resulting discount will be accreted by recording additional non-cash interest
expense over the expected life of the convertible notes using the effective
interest rate method.  We are currently assessing the impact of
adopting FSP 14-1 on our consolidated financial statements, however we expect
there to be a dilutive effect on our earnings per share.  The
provisions of FSP 14-1 are to be applied retrospectively to all periods
presented upon adoption and are effective for fiscal years beginning after
December 15, 2008, or our fiscal 2010, and interim periods within those fiscal
years.
 
 Forward
Looking Statements
 
 We may
from time to time make written and oral forward-looking statements.
Forward-looking statements may appear in writing in documents filed with the
Securities and Exchange Commission, in press releases and in reports to
shareholders or be made orally in publicly accessible conferences or conference
calls. The Private Securities Litigation Reform Act of 1995 contains a safe
harbor for forward-looking statements. We rely on this safe harbor in making
such disclosures. These forward-looking statements generally can be identified
by use of phrases such as “believe,” “plan,” “expect,” “anticipate,” “intend,”
“forecast” or other similar words or phrases.  These forward-looking
statements relate to, among other things, our strategic and business initiatives
and plans for growth or operating changes; our financial condition and results
of operation; future events, developments or performance; and management’s
expectations, beliefs, plans, estimates and projections.  The
forward-looking statements are based on management’s current beliefs and
assumptions about expectations, estimates, strategies and projections. These
statements are not guarantees of future performance and involve risks,
uncertainties and assumptions that are difficult to predict. Therefore, actual
outcomes and results may differ materially from what is expressed or forecasted
in such forward-looking statements. We undertake no obligation to update
publicly any forward-looking statements whether as a result of new information,
future events or otherwise. Factors that could cause our actual results to
differ materially from those anticipated in the forward-looking statements in
this Form 10-Q and the documents incorporated herein by reference include the
following:
 
 •
              we
      face significant competition in the OTC healthcare, toiletries and dietary
      supplements markets;
 •
              our
      acquisition strategy is subject to risk and may not be
      successful;
 •
              our
      initiation of a voluntary recall of our Icy HotHeat Therapy
      products could expose us to product liability
  claims;
 •
              we
      may receive additional claims that allege personal injury from ingestion
      of Dexatrim;
 •
              we
      rely on a few large customers, particularly Wal-Mart Stores, Inc., for a
      significant portion of our sales;
 •
              litigation
      may adversely affect our business, financial condition and results of
      operations;
 •
              we
      have a significant amount of debt that could adversely affect our business
      and growth prospects;
 •
              our
      product liability insurance coverage may be insufficient to cover existing
      or future liability claims;
 •
              our
      business is regulated by numerous federal, state and foreign governmental
      authorities, which subjects us to elevated compliance costs and risks of
      non-compliance;
  40
  •
              our
      success depends on our ability to anticipate and respond in a timely
      manner to changing consumer
preferences;
 •
              we
      may be adversely affected by fluctuations in buying decisions of mass
      merchandise, drug and food trade buyers and the trend toward retail trade
      consolidation;
 •
              we
      rely on third party manufacturers for a portion of our product portfolio,
      including products under our Gold Bond, Icy Hot, Selsun, Dexatrim, ACT, Unisom and Kaopectatebrands;
 •
              our
      dietary supplement business could suffer as a result of injuries caused by
      dietary supplements in general, unfavorable scientific studies or negative
      press;
 •
              our
      business could be adversely affected if we are unable to successfully
      protect our intellectual property;
 •
              because
      most of our operations are located in Chattanooga, Tennessee, we are
      subject to regional and local
risks;
 •
              we
      depend on sole or limited source suppliers for ingredients in certain of
      our products, and our inability to buy these ingredients would prevent us
      from manufacturing these products;
 •
              we
      are subject to the risk of doing business
  internationally;
 •
              the
      terms of our outstanding debt obligations limit certain of our
      activities;
 •
              to
      service our indebtedness, we will require a significant amount of
      cash;
 •
              our
      operations are subject to significant environmental laws and
      regulations;
 •
              we
      are dependent on certain key executives, the loss of whom could have a
      material adverse effect on our
business;
 •
              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;
 •
              the
      trading price of our common stock may be
  volatile;
 •
              we
      have no current intentions of paying dividends to holders of our common
      stock;
 •
              we
      can be affected adversely and unexpectedly by the implementation of new,
      or changes in the interpretation of existing, accounting principles
      generally accepted in the United States of America
    (“GAAP”);
 •
              identification
      of material weakness in internal controls over financial reporting may
      adversely affect our financial
results;
 •
              the
      convertible note hedge and warrant transactions may affect the value of
      our common stock and our convertible
notes;
 •
              conversion
      of our convertible notes may dilute the ownership interest of existing
      shareholders, including holders who had previously converted their
      convertible notes;
 •
              virtually
      all of our assets consists of intangibles;
and
 •
              other
      risks described in our Securities and Exchange Commission
      filings.
  
 Item 3.  
Quantitative and Qualitative Disclosures About Market Risks
 
 We are
exposed to market risk from changes in interest rates and foreign currency
exchange rates, which may adversely affect our results of operations and
financial condition.  We seek to minimize the risks from these
interest rates and foreign currency exchange rate fluctuations through our
regular operating and financing activities.
 
 Our
exposure to interest rate risk currently relates to amounts outstanding under
our Credit Facility.  Loans under the revolving credit facility
portion of our Credit Facility bear interest at LIBOR plus applicable
percentages of 0.875% to 1.50% or the higher of the federal funds rate plus
0.50% or the prime rate (the “Base Rate”).  The applicable percentages
are calculated based on our leverage ratio.  The term loan under our
Credit Facility bears interest at either LIBOR plus 1.75% or the Base Rate plus
0.75%.  As of August 31, 2008, $19.5 million was outstanding under the
revolving credit facility and $108.3 million was outstanding under the term loan
portion of our Credit Facility.  The variable rate for the revolving
credit facility was LIBOR plus 1.25%, or 4.05% as of August 31, 2008, and the
variable rate for the term loan portion was LIBOR plus 1.75%, or 4.54%, as of
August 31, 2008.  The 7.0% Subordinated Notes, the 1.625% Convertible
Notes and the 2.0% Convertible Notes are fixed interest rate
obligations.
 
 In
November 2006, we entered into an interest rate swap (“swap”) agreement
effective January 2007.  The swap has decreasing notional principal
amounts beginning October 2007 and a swap rate of 4.98% over the life of the
agreement.  As of August 31, 2008, the notional amount of the swap was
$126.6 million and the decrease in fair value for the nine months ended August
31, 2008 of $0.3 million, net of tax, was recorded to other comprehensive
income.  The swap was deemed to be an effective cash flow hedge as of
August 31, 2008 and expires in January 2010.
 
 In April
2007, we entered into an interest rate cap (“cap”) agreement.  The cap
has decreasing notional principal amounts beginning May 2007 and a rate of 5.0%
over the life of the agreement.  The cap expired in September
2008.
 
 The
impact on our results of operations of a one-point rate change on the October 2,
2008 outstanding revolving credit facility balance of $19.5 million and $107.5
million term loan balance of our Credit Facility for the next twelve months
would be approximately $0.8 million, net of tax.
 
 41
 We are subject to risk from changes in
the foreign exchange rates relating to our Canadian, U.K., Irish and Greek
subsidiaries. Assets and liabilities of these subsidiaries are translated to
U.S. dollars at quarter-end exchange rates. Income and expense items are
translated at average rates of exchange prevailing during the
year.  Translation adjustments are accumulated as a separate component
of shareholders’ equity. Gains and losses, which result from foreign currency
transactions, are included as a component of investment and other income in the
accompanying consolidated statements of income.  The potential loss
resulting from a hypothetical 10.0% adverse change in the quoted foreign
currency exchange rate amounts to approximately $1.3 million as of August 31,
2008.
 
 This market risk discussion contains
forward-looking statements.  Actual results may differ materially from
this discussion based upon general market conditions and changes in financial
markets.
 
 Item 4.   Controls
and Procedures
 
 Under the
supervision and with the participation of our management, including our Chief
Executive Officer and Chief Financial Officer, we have evaluated the
effectiveness of our disclosure controls and procedures (as such terms are
defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of
1934, as amended (the “Exchange Act”)), as of August 31, 2008 (the “Evaluation
Date”).  Based on such evaluation, such officers have concluded that,
as of the Evaluation Date, our disclosure controls and procedures were effective
in alerting them on a timely basis to material information relating to us
(including our consolidated subsidiaries) required to be included in our reports
filed or submitted under the Exchange Act.
 
 PART II.  OTHER
INFORMATION
 Item 1.   Legal
Proceedings
 
 See Note 19 of Notes to Consolidated
Financial Statements included in Part 1, Item 1 of this Report.
 
 Item 1A.  Risk
Factors
 
 There have been no material changes
from the risk factors previously disclosed in our Annual Report on Form 10-K for
the year ended November 30, 2007, other than the addition of the following risk
factors.
 
 Our initiation of a voluntary recall of
our Icy Hot Heat
Therapy products could expose us to additional product liability
claims.
 
 On February 8, 2008, we initiated a
voluntary nationwide recall of our Icy Hot Heat Therapy
products.  The recall is being conducted to the consumer
level.  We recalled these products because we received some consumer
reports of first, second and third degree burns, as well as skin irritation
resulting from consumer use or possible misuse of the products.  Two
product liability lawsuits have been filed against us and we may receive
additional lawsuits in the future alleging skin irritation and/or burns from use
of our Heat Therapy products.  See our current Report on Form 8-K,
filed on February 14, 2008, for additional information.
 
 We may receive additional claims that
allege personal injury from ingestion of Dexatrim.
 
 During the third quarter of fiscal
2008, we reached a settlement on all 26 known claims alleging pulmonary arterial
hypertension as a result of the ingestion of Dexatrim products in 1998
through 2003.  However, we may receive additional claims and some or
all of these potential claimants may file lawsuits against us.  If the
lawsuits are filed, we plan to vigorously defend these claims.  If
notwithstanding our defenses these or other product liability claims are
resolved in favor of the claimants, it could have a material adverse effect on
our results of operation and financial condition.
   42
 Item 2.  
Unregistered Sales of Equity Securities and Use of Proceeds
 
 (a) Not applicable.
 
 (b) Not applicable.
 
 (c) A summary of the common stock
repurchase activity for our third quarter of fiscal 2008 is as
follows:
 
 Period
              
              Total
      Number
                of
      Shares
                Purchased
              
              
              Average
      Price
                Paid Per Share (1)
              
              
              Total
      Number of
                Shares
      Purchased
                as
      Part of Publicly
                Announced
      Plans or
                Programs (2)
              
              
              Approximate
      Dollar
                Value
      that may yet
                be
      Purchased under
                the
      Plans or
                Programs (2)June
      1– June 30
              
              
              230,900
              
              
              $
              59.65
              
              
              
              230,900
              
              
              $
              73,913,336July
      1 – July 31
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              73,913,336August
      1 – August 31
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              73,913,336Total Third Quarter
              
              
              230,900
              
              
              $
              59.65
              
              
              
              230,900
              
              
              $
              73,913,336
 
 (1)
              Average
      price paid per share includes broker
  commissions.
  (2)
              On
      April 30, 2008, our Board of Directors increased the authorization to a
      total of $100.0 million of our common stock under the terms of our
      existing stock repurchase program.  There is no expiration date
      specified for our stock buyback
program.
 
 Item 3.   Defaults
Upon Senior Securities
  None.
 
 Item 4.  
Submission of Matters to a Vote of Security Holders
  None.
 
 Item 5.   Other
Information
  None.
 
 Item 6. 
Exhibits
  Exhibits
(numbered in accordance with Item 601 of Regulation S-K):
 
 Exhibit
      Number
              
              Description31.1
              
              Certification
      required by Rule 13a-14(a) under the Securities Exchange Act of
      193431.2
              
              Certification
      required by Rule 13a-14(a) under the Securities Exchange Act of
      193432
              
              Certification
      required by Rule 13a-14(b) under the Securities Exchange Act of 1934 and
      18 U.S.C. Section 1350
 
  
 43
 CHATTEM,
INC.
 SIGNATURES
 
 
 Pursuant
to the requirements of the Securities Exchange Act of 1934, the Registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.
 
 
 CHATTEM,
      INC.(Registrant)Dated:   
      October 10, 2008
                By:
                /s/ Zan
      GuerryZan
      GuerryChairman
      and Chief Executive Officer
 
 Dated:   
      October 10, 2008
                  By:
                  /s/ Robert
      B. LongRobert
      B. LongVice
      President and Chief Financial Officer
   44
 
 Chattem, Inc. and
Subsidiaries
 Exhibit
Index
 
   
 
 Exhibit
      Number
              
              Description
      of Exhibit31.1
              
              Certification
      required by Rule 13a-14(a) under the Securities Exchange Act of
      193431.2
              
              Certification
      required by Rule 13a-14(a) under the Securities Exchange Act of
      193432
              
              Certification
      required by Rule 13a-14(b) under the Securities Exchange Act of 1934 and
      18 U.S.C. Section 1350




















































45