**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 February 28, 2006**


**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**























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


******YES** þ      
      **NO**࿳





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





**Large
      accelerated filer**þ**Accelerated
      filer**࿳**Non-accelerated
      filer**࿳





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


******YES** ࿳     
      **NO** þ








**As
      of April 7, 2006,** **19,421,096****shares of
      the Company’s common stock, without par value, were
      outstanding.**


















**CHATTEM,
      INC.**





**INDEX**
















PAGE
                NO.**PART
              I.
              FINANCIAL INFORMATION**Item
                1.  Financial
                StatementsCondensed
                  Consolidated Balance Sheets as of February 28, 2006 andNovember
                  30, 2005
            3Condensed
                Consolidated Statements of Income for the ThreeMonths
                Ended February 28, 2006 and February 28, 2005
            5Condensed
                Consolidated Statements of Cash Flows for the Three
                MonthsEnded
                February 28, 2006 and February 28, 2005
            6Notes
                to Condensed Consolidated Financial Statements
            7Item
                2.  Management's
                Discussion and Analysis of Financial Conditionand
                Results of Operations
            28Item
                3.  Quantitative
                and Qualitative Disclosures About Market Risks
            37Item
                4.  Controls and
                Procedures
            37**PART
                II. OTHER INFORMATION**Item
                1.  Legal
                Proceedings
            38Item
                1A.          Risk
                Factors
            38Item
                2.  Unregistered
                Sales of Equity Securities and Use of Proceeds
            38Item
                3.  Defaults Upon
                Senior Securities
            38Item
                4.  Submission of
                Matters to a Vote of Security Holders
            38Item
                5.  Other
                Information
            38Item
                6.  Exhibits
            39**SIGNATURES**
            40









2





**PART
      1. FINANCIAL INFORMATION**




**Item
      1.       Financial
      Statements**




**CHATTEM,
      INC. AND SUBSIDIARIES**





**CONDENSED
      CONSOLIDATED BALANCE SHEETS**


(In
      thousands)





ASSETS
            
            FEBRUARY
                28,
              2006
            
            NOVEMBER
                30,
              2005(Unaudited)CURRENT
                ASSETS:Cash
                and cash equivalents
            
            $
            8,125
            
            $
            47,327Accounts
                receivable, less allowances of $3,083 atFebruary
                28, 2006 and $2,338 at November 30, 2005
            
            
            51,944
            
            
            33,672Other
                receivables
            
            
            9,103
            
            
            9,600Inventories
            
            
            25,427
            
            
            23,631Refundable
                income taxes
            
            
            —
            
            
            1,207Deferred
                income taxes
            
            
            2,478
            
            
            2,478Prepaid
                expenses and other current assets
            
            
            4,461
            
            
            5,106Total
                current assets
            
            
            101,538
            
            
            123,021PROPERTY,
                PLANT AND EQUIPMENT, NET
            
            
            30,126
            
            
            29,884OTHER
                NONCURRENT ASSETS:Patents,
                trademarks and other purchased product rights, net
            
            
            206,327
            
            
            206,387Debt
                issuance costs, net
            
            
            2,867
            
            
            4,297Other
            
            
            5,525
            
            
            4,704Total
                other noncurrent assets
            
            
            214,719
            
            
            215,388TOTAL
                ASSETS
            
            $
            346,383
            
            $
            368,293










The
      accompanying notes are an integral part of these condensed consolidated
      financial statements.




3


**CHATTEM,
      INC. AND SUBSIDIARIES**





**CONDENSED
      CONSOLIDATED BALANCE SHEETS**


(In
      thousands)








LIABILITIES
                AND SHAREHOLDERS’ EQUITY
            
            FEBRUARY
                28,
              2006
            
            NOVEMBER
                30,
              2005(Unaudited)CURRENT
                LIABILITIES:Current
                maturities of long-term debt
            
            $
            —
            
            $
            37,000Accounts
                payable and other
            
            
            11,931
            
            
            17,238Accrued
                liabilities
            
            
            23,485
            
            
            16,327Total
                current liabilities
            
            
            35,416
            
            
            70,565LONG-TERM
                DEBT, less current maturities
            
            
            150,500
            
            
            145,500DEFERRED
                INCOME TAXES
            
            
            27,872
            
            
            27,736OTHER
                NONCURRENT LIABILITIES
            
            
            1,890
            
            
            1,865COMMITMENTS
                AND CONTINGENCIES (Note 18)SHAREHOLDERS’
                EQUITY:Preferred
                shares, without par value, authorized 1,000,none
                issued
            
            
            —
            
            
            —Common
                shares, without par value, authorized 50,000,issued
                and outstanding 19,421 at February 28, 2006 and19,668
                at November 30, 2005
            
            
            56,590
            
            
            63,876Retained
                earnings
            
            
            75,626
            
            
            60,853132,216
            
            
            124,729Unamortized
                value of restricted common shares issued
              Cumulative
                other comprehensive income, net of tax:
            
            
            (1,522
            )
            
            (1,818
            )Interest
                rate cap adjustment
            
            
            (30
            )
            
            (83
            )Foreign
                currency translation adjustment
            
            
            41
            
            
            (201
            )Total
                shareholders’ equity
            
            
            130,705
            
            
            122,627TOTAL
                LIABILITIES AND SHAREHOLDERS’EQUITY
            
            $
            346,383
            
            $
            368,293







The
      accompanying notes are an integral part of these condensed consolidated
      financial statements.




4




**CHATTEM,
      INC. AND SUBSIDIARIES**





**CONDENSED
      CONSOLIDATED STATEMENTS OF INCOME**


(Unaudited
      and in thousands, except per share amounts)





FOR
                THE THREE MONTHS ENDEDFEBRUARY
                28,
            
            FEBRUARY
                28,2006
            
            2005TOTAL
                REVENUES:Net
                sales
            
            $
            83,977
            
            $
            71,480Royalties
            
            
            47
            
            
            51Total
                revenues
            
            
            84,024
            
            
            71,531COSTS
                AND EXPENSES:Cost
                of sales
            
            
            26,020
            
            
            20,260Advertising
                and promotion
            
            
            27,187
            
            
            20,351Selling,
                general and administrative
            
            
            11,591
            
            
            11,884Litigation
                settlement
            
            
            (8,613
            )
            
            2,755Total
                costs and expenses
            
            
            56,185
            
            
            55,250INCOME
                FROM OPERATIONS
            
            
            27,839
            
            
            16,281OTHER
                INCOME (EXPENSE):Interest
                expense
            
            
            (2,844
            )
            
            (3,495
            )Investment
                and other income, net
            
            
            194
            
            
            147Loss
                on early extinguishment of debt
            
            
            (2,805
            )
            
            —Total
                other income (expense)
            
            
            (5,455
            )
            
            (3,348
            )INCOME
                BEFORE INCOME TAXES
            
            
            22,384
            
            
            12,933PROVISION
                FOR INCOME TAXES
            
            
            7,611
            
            
            4,268NET
                INCOME
            
            $
            14,773
            
            $
            8,665NUMBER
                OF COMMON SHARES:
              Weighted
                average outstanding - basic
            
            
            19,553
            
            
            19,648Weighted
                average and potential dilutive outstanding
            
            
            19,577
            
            
            20,489NET
                INCOME PER COMMON SHARE:Basic
            
            $
            .76
            
            $
            .44Diluted
            
            $
            .75
            
            $
            .42





The
      accompanying notes are an integral part of these condensed consolidated
      financial statements.




5




**CHATTEM,
      INC. AND SUBSIDIARIES**





**CONDENSED
      CONSOLIDATED STATEMENTS OF CASH FLOWS**


(Unaudited
      and in thousands, except per share amount)






FOR
                THE THREE MONTHS ENDEDFEBRUARY
                28,
              2006
            
            FEBRUARY
                28,
              2005OPERATING
                ACTIVITIES:Net
                income
            
            $
            14,773
            
            $
            8,665Adjustments
                to reconcile net income to net cash provided byoperating
                activities:Depreciation
                and amortization
            
            
            1,425
            
            
            1,624Deferred
                income taxes
            
            
            239
            
            
            1,778Excess
                  tax benefit from stock-based compensation
            
            
            (309
            )
            
            186Stock-based
                compensation
            
            
            852
            
            
            —Loss
                on early extinguishment of debt
            
            
            2,805
            
            
            —Other,
                net
            
            
            66
            
            
            361Changes
                in operating assets and liabilities:Accounts
                receivable and other
            
            
            (17,775
            )
            
            (8,712
            )Inventories
            
            
            (1,644
            )
            
            (286
            )Refundable
                income taxes
            
            
            1,516
            
            
            2,172Prepaid
                expenses and other current assets
            
            
            652
            
            
            382Accounts
                payable and accrued liabilities
            
            
            3,126
            
            
            1,778Net
                cash provided by operating activities
            
            
            5,726
            
            
            7,948INVESTING
                ACTIVITIES:Purchases
                of property, plant and equipment
            
            
            (1,276
            )
            
            (599
            )Decrease
                (increase) in other assets, net
            
            
            (611
            )
            
            667Net
                cash (used in) provided by investing activities
            
            
            (1,887
            )
            
            68FINANCING
                ACTIVITIES:Repayment
                of long-term debt
            
            
            (75,000
            )
            
            —Proceeds
                from borrowings under revolving credit facility
            
            
            43,000
            
            
            —Repayment
                of policy loans
            
            
            —
            
            
            (1,031
            )Proceeds
                from exercise of stock options
            
            
            311
            
            
            187Repurchase
                of common shares
            
            
            (10,130
            )
            
            (3,514
            )Increase
                in debt issuance costs
            
            
            (15
            )
            
            —Retirement
                of debt issuance costs
            
            
            (1,501
            )
            
            —Excess
                tax benefit from stock-based compensation
            
            
            309
            
            
            —Net
                cash used in financing activities
            
            
            (43,026
            )
            
            (4,358
            )EFFECT
                OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS
            
            
            (15
            )
            
            (312
            )CASH
                AND CASH EQUIVALENTS:(Decrease)
                increase for the period
            
            
            (39,202
            )
            
            3,346At
                beginning of period
            
            
            47,327
            
            
            40,193At
                end of period
            
            $
            8,125
            
            $
            43,539SCHEDULE
                OF NON-CASH INVESTING AND FINANCING ACTIVITIES:Issuance
                of 50 shares of restricted common stock at a value of $35.37
                per share in 2005
            
            $
            —
            
            $
            1,768PAYMENTS
                FOR:Interest
            
            $
            1,793
            
            $
            1,003Taxes
            
            $
            1,045
            
            $
            85





The
      accompanying notes are an integral part of these condensed consolidated
      financial statements.




6




**CHATTEM,
      INC. AND SUBSIDIARIES**





**NOTES
      TO CONDENSED 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 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, 2005. 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.**
              **RECLASSIFICATIONS**


Certain
      prior year amounts have been reclassified to conform to the current period’s
      presentation.




**4.**
              **RECENT
                    ACCOUNTING
                    PRONOUNCEMENTS**


In
      December 2003, the Financial Accounting Standards Board (“FASB”) issued
      Interpretation No. 46R, “Consolidation of Variable Interest Entities” (“FIN
      46R”), which supersedes Interpretation No. 46, “Consolidation of Variable
      Interest Entities” issued in January 2003. FIN 46R requires a company to
      consolidate a variable interest entity (“VIE”), as defined, when the company
      will absorb a majority of the VIE’s expected losses, receives a majority of the
      VIE’s expected residual returns or both. FIN 46R also requires consolidation of
      existing, non-controlled affiliates if the VIE is unable to finance its
      operations without investor support, or where the other investors do not have
      exposure to the significant risks and rewards of ownership. FIN 46R applies
      immediately to a VIE created or acquired after January 31, 2003. For a VIE
      created before February 1, 2003, FIN 46R applies in the first fiscal year or
      interim period beginning after March 15, 2004, our third fiscal quarter
      beginning June 1, 2004. Application of FIN 46R is also required in financial
      statements that have interests in structures that are commonly referred to
      as
      special-purpose entities for periods ending after December 15, 2003. The
      adoption of FIN 46R did not have a material impact on our financial position,
      results of operations or cash flows.





In
      November 2004, the FASB issued Statement of Financial Accounting Standards
      (“SFAS”) No. 151, “Inventory Costs” (“SFAS 151”). SFAS 151 amends the guidance
      in Accounting Research Bulletin No. 43, Chapter 4, “Inventory Pricing”, to
      clarify that abnormal amounts of idle facility expense, freight, handling costs
      and wasted materials (spoilage) should be recognized as current-period charges
      and requires the allocation of fixed production overheads to inventory based
      on
      normal capacity of the production facilities. This statement is effective for
      inventory costs incurred during fiscal years beginning after June 15, 2005.
      The
      adoption of SFAS 151 on December 1, 2005 did not have an impact on our financial
      position, results of operations or cash flows.





In
      November 2004, the Emerging Issues Task Force (“EITF”) reached a consensus on
      Issue No. 03-13, “Applying the Conditions in Paragraph 42 of FASB Statement No.
      144, “Accounting for the Impairment or Disposal of Long-Lived Assets” in
      Determining Whether to Report Discontinued Operations” (“EITF 03-13”). Under the
      consensus, the approach for assessing whether cash flows of the component have
      been eliminated from the ongoing operations of the entity focuses on whether
      continuing cash flows are direct or indirect cash flows. Cash flows of the
      component would not be eliminated if the continuing cash flows to the entity
      are
      considered direct cash flows. The consensus should be applied to a component
      of
      an enterprise that is either disposed of or classified as held for sale in
      fiscal periods beginning after December 15, 2004. The adoption of EITF 03-13
      on
      December 1, 2005 did not have an impact on our financial position, results
      of
      operations or cash flows.





7


In
      December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No.
      123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), which is a revision of
      SFAS No. 123, “Accounting for Stock-Based Compensation”. SFAS 123R supersedes
      APB Opinion No. 25, “Accounting for Stock Issued to Employees” and amends SFAS
      No. 95, “Statement of Cash Flows”. SFAS 123R focuses primarily on accounting for
      transactions in which an entity obtains employee services in share-based payment
      transactions and requires all share-based payments to employees, including
      grants of employee stock options, to be recognized as additional compensation
      expense in the financial statements based on the calculated fair value of the
      awards. SFAS 123R also requires the benefits of tax deductions in excess of
      recognized compensation costs to be reported as a financing cash flow. This
      requirement will reduce net operating cash flows and increase net financing
      cash
      flows in periods after adoption. We adopted this statement effective for our
      fiscal year beginning December 1, 2005.  We
      have
      described the impact of adopting SFAS 123R in our condensed consolidated
      financial statements in Note 5, Stock-Based Compensation.





In
      December 2004, the FASB issued SFAS 153, “Exchanges of Nonmonetary Assets”
(“SFAS 153”). SFAS 153 amends the guidance in APB Opinion No. 29, “Accounting
      for Nonmonetary Transactions” to eliminate certain exceptions to the principle
      that exchanges of nonmonetary assets be measured based on the fair value of
      the
      assets exchanged. SFAS 153 eliminates the exception for nonmonetary exchanges
      of
      similar productive assets and replaces it with a general exception for exchanges
      of nonmonetary assets that do not have commercial substance. This statement
      is
      effective for nonmonetary asset exchanges in fiscal years beginning after June
      15, 2005. The adoption of SFAS 153 on December 1, 2005 did not have an impact
      on
      our financial position, results of operations or cash flows.





The
      American Jobs Creation Act of 2004 (the “AJCA”) was enacted on October 22, 2004.
      The AJCA repeals an export incentive, creates a new deduction for qualified
      domestic manufacturing activities and includes a special one-time deduction
      of
      85% of certain foreign earnings repatriated to the U.S.





In
      December 2004, the FASB issued FASB Staff Position No. 109-1, “Application
      of FASB Statement No. 109 (SFAS 109), Accounting for Income Taxes, to
      the Tax Deduction on Qualified Production Activities Provided by the American
      Jobs Creation Act of 2004” (FSP 109-1). FSP 109-1 clarifies that the
      manufacturer’s deduction provided for under the American Jobs Creation Act of
      2004 (AJCA) should be accounted for as a special deduction in accordance
      with SFAS 109 and not as a tax rate reduction. In
      accordance with FSP 109-1, we treat the deduction for qualified domestic
      manufacturing activities, which became effective beginning December 1, 2005,
      as
      a reduction of the income tax provision in future years when
      realized.





The
      FASB
      also issued FASB Staff Position No. 109-2, Accounting and Disclosure
      Guidance for the Foreign Earnings Repatriation Provision within the American
      Jobs Creation Act of 2004 (FSP 109-2). The AJCA introduces a special one-time
      dividends received deduction on the repatriation of certain foreign earnings
      to
      a U.S. taxpayer (repatriation provision), provided certain criteria are
      met. FSP 109-2 provides accounting and disclosure guidance for the repatriation
      provision. We have described the impact of FSP 109-2 in our condensed
      consolidated financial statements in Note 16, Income Taxes.





In
      May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error
      Corrections,” or (“SFAS No. 154”).  SFAS No. 154 replaces APB
      No. 20, “Accounting Changes” and SFAS No. 3, “Reporting Accounting
      Changes in Interim Financial Statements” and establishes retrospective
      application as the required method for reporting a change in accounting
      principle.  The reporting of a correction of an error by restating
      previously issued financial statements is also addressed. SFAS No. 154 is
      effective for accounting changes and corrections of errors made in fiscal years
      beginning after December 15, 2005.  The adoption of SFAS
      No. 154 is not expected to have an impact on our financial
      position, results of operations or cash flows.





In
      October 2005, the FASB issued FASB Staff Position (“FSP”) 123R-2, “Practical
      Accommodation to the Application of Grant Date as Defined in FASB Statement
      No.
      123(R) (“FSP 123R-2”)”. FSP 123R-2 provides companies with a “practical
      accommodation” when determining the grant date of an award that is subject to
      the accounting provisions in SFAS 123R. Specifically, assuming a company meets
      all of the other criteria in the definition of grant date in SFAS 123R, a mutual
      understanding (between the company and the recipient) of the key terms and
      conditions of an award is presumed to exist at the date the award is approved
      (in accordance with the company’s normal corporate governance policy) if (1) the
      award is unilateral grant meaning that the recipient does not have the ability
      to negotiate the key terms and conditions of the award, and (2) the key terms
      and conditions of the award are expected to be communicated to the recipient
      within a relatively short period of time (as defined in the FSP 123R-2) after
      the grant was approved. This FSP was effective upon initial adoption of SFAS
      123-R on December 1, 2005.





In
      November 2005, the FASB issued FSP 123R-3, “Transition Election Related to
      Accounting for the Tax Effects of Share-Based Payment Awards” (“FSP 123R-3”).
      FSP 123R-3 provides a practical exception when a company transitions to the
      accounting requirements in SFAS 123R. SFAS 123R requires a company to calculate
      the pool of excess tax benefits available to absorb tax deficiencies recognized
      subsequent to adopting SFAS 123R (“APIC Pool”), assuming the company




8




had
      been
      following the recognition provisions prescribed by SFAS 123. The FASB learned
      that several companies do not have the necessary historical information to
      calculate the APIC pool as envisioned by SFAS 123R and accordingly, the FASB
      decided to allow a practical exception as documented in FSP 123R-3. This FSP
      was
      effective on its issuance date.




**5.**
                **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.





Effective
      December 1, 2005, we adopted Statement of Financial Accounting Standards
      (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), using the
      modified prospective method. SFAS 123R 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). Prior to our adopting
      SFAS 123R, we accounted for our stock-based compensation plans under Accounting
      Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to
      Employees” (“APB 25”). Under APB 25, generally no compensation expense is
      recorded when the terms of the award are fixed and the exercise price of the
      employee stock option equals or exceeds the fair value of the underlying stock
      on the date of grant. We adopted the disclosure-only provision of SFAS No.
      123,
“Accounting for Stock-Based Compensation” (“SFAS 123”).





In
      the
      first quarter of fiscal 2006, we recorded compensation expense related to stock
      options that reduced income from operations by $852, provision for income taxes
      by $290, net income by $562 and basic and diluted net income per share by $.03.
      The stock option compensation expense was included partly in advertising and
      promotion expenses and partly in selling, general and administrative expenses
      in
      the accompanying condensed consolidated statement of income. We capitalized
      $152
      of stock option compensation cost as a component of the carrying cost of
      inventory on-hand as of February 28, 2006.





The
      weighted average fair value of stock options at the date of grant during the
      three months ended February 28, 2006 and 2005 was $13.03 and $8.53,
      respectively. For options granted subsequent to our adoption date of SFAS 123R
      on December 1, 2005, the fair value of each stock option grant was estimated
      on
      the date of grant using a Flex Lattice Model. For options granted prior to
      our
      adoption date of SFAS 123R, during the three-months ended February 28, 2005,
      we
      used the Black-Scholes option pricing model. We used the following assumptions
      to determine the fair value of stock option grants during the three months
      ended
      February 28, 2006 and 2005:








Three
                Months Ended
              February
                282006
            
            2005Expected
                life
            
            
            4.6
                years
            
            
            5.0
                yearsVolatility
            
            
            48
            %
            
            57
            %Risk-free
                interest rate
            
            
            4.55
            %
            
            4.38
            %Dividend
                yield
            
            
            0
            %
            
            0
            %Forfeitures
            
            
            0.9
            %
            
            0
            %





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 the historical 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. Subsequent to the adoption of SFAS 123R and 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). Prior to the adoption of SFAS 123R, forfeitures were not an input
      assumption for our fair value calculations of stock options under the
      Black-Scholes pricing model.





9




A
      summary
      of stock option activity for the three-months ended February 28, 2006 is
      presented below:




Shares
                Under
                Option
              
              
              Weighted
                Average
                Exercise
                Price
              
              
              Weighed
                Average
                Remaining
                Contractual
                Life
              
              
              Aggregate
                Intrinsic
                  ValueOutstanding
                  at December 1, 2005
              
              
              1,753
              
              $
              23.94Granted
              
              
              412
              
              
              38.05Exercised
              
              
              (30
              )
              
              11.64Cancelled
              
              
              (72
              )
              
              30.20Outstanding
                  at February 28, 2006
              
              
              2,063
              
              $
              26.73
              
              
              6.6
                  years
              
              $
              24,144Exercisable
                  at February 28, 2006
              
              
              937
              
              $
              25.99
              
              
              6.2
                  years
              
              $
              12,486






The
      total
      fair value of stock options that vested during the three months ended February
      28, 2006 and 2005 was $1,004 and $1,907, respectively. The total intrinsic
      value
      of stock options exercised during the three months ended February 28, 2006
      and
      2005 was $860 and $517, respectively.





As
      of
      February 28, 2006, we had $11,771 of unrecognized compensation cost related
      to
      stock options that will be recorded over a weighted average period of
      approximately 3 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 months ended February 28, 2006 and 2005
      was
      $190 and $319, respectively.





Restricted
      share activity under the plans is summarized as follows:





Number
                of
              Shares
            
            Weighted
                Average
              Grant
                Date Fair
              ValueNonvested
                at December 1, 2005
            
            
            75
            
            $
            24.27Granted
            
            
            —
            
            
            —Vested
            
            
            (9
            )
            
            21.13Forfeited
            
            
            (3
            )
            
            35.37Nonvested
                at February 28, 2006
            
            
            63
            
            
            24.28








10





Prior
      to
      December 1, 2005, we accounted for stock-based compensation plans under APB
      25.
      We adopted the disclosure-only provision of SFAS 123. Had compensation expense
      for stock option grants been determined based on the fair value at the grant
      dates consistent with the method prescribed by SFAS 123, our net income and
      net
      income per share would have been adjusted to the pro forma amounts for the
      three
      months ended February 28, 2005 as indicated below:








2005Net
                income:As
                reported
            
            $
            8,665Recognized
                stock-based compensation costs, net
            
            
            —Fair
                value method compensation costs, net
            
            
            (1,278
            )Pro
                forma
            
            $
            7,387Net
                income per share, basic:As
                reported
            
            $
            .44Pro
                forma
            
            $
            .38Net
                income per share, diluted:As
                reported
            
            $
            .42Pro
                forma
            
            $
            .36






**6.**
                **EARNINGS
                      PER SHARE**


The
      following table presents the computation of per share earnings for the three
      months ended February 28, 2006 and February 28, 2005, respectively:




2006
            
            2005NET
                INCOME
            
            $
            14,773
            
            $
            8,665NUMBER
                OF COMMON SHARES:Weighted
                average outstanding
            
            
            19,553
            
            
            19,648Issued
                upon assumed exercise of outstanding stock options
            
            
            —
            
            
            762Effect
                of issuance of restricted common shares
            
            
            24
            
            
            79Weighted
                average and potential dilutive outstanding (1)
            
            
            19,577
            
            
            20,489NET
                INCOME PER COMMON SHARE:Basic
            
            $
            .76
            
            $
            .44Diluted
            
            $
            .75
            
            $
            .42





(1)  
      Because their effects are anti-dilutive, excludes shares issuable under stock
      option plans and restricted stock issuance whose grant price was greater than
      the average market price of common shares outstanding as follows: 571 and 0
      shares for the three months ended February 28, 2006 and 2005,
      respectively.




**7.**
                **ADVERTISING
                      EXPENSES**


We
      incur
      significant expenditures on television, radio and print advertising to support
      our nationally branded over-the-counter (“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




11


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 Accounting Principles Board Opinion No. 28, “Interim Financial
      Reporting”) and adjusting that accrual to the actual expenses incurred at the
      end of the year.




8.
                **SHIPPING
                      AND HANDLING**


Shipping
      and handling costs of $2,264 and $1,857 are included in selling expenses for
      the
      three months ended February 28, 2006 and 2005, respectively.




**9.**
                **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 $205,983 as of February 28, 2006 and November 30, 2005, respectively. The
      gross carrying amount of intangible assets subject to amortization at February
      28, 2006 and November 30, 2005, which consist primarily of non-compete
      agreements, was $2,139, respectively. The related accumulated amortization
      of
      intangible assets at February 28, 2006 and November 30, 2005 was $1,795 and
      $1,735, respectively. Amortization of our intangible assets subject to
      amortization under the provisions of SFAS 142 for the three months ended
      February 28, 2006 and 2005 was $60 and $73, respectively. Estimated annual
      amortization expense for these assets for the years ended November 30, 2007,
      2008, 2009, 2010 and 2011 is $106, $40, $20, $0 and $0,
      respectively.





On
      February 28, 2005, we entered into an agreement to sell the trademark and
      product rights of our *Selsun* business
      in certain countries in Africa and Asia. As a result of the sale, $3,143 of
      indefinite-lived assets and $108 of intangible assets subject to amortization
      were retired, which resulted in an insignificant loss.




**10.**
                **INVENTORIES**


Inventories
      consisted of the following as of February 28, 2006 and November 30,
      2005:





2006
            
            2005Raw
                materials and work in process
            
            $
            12,358
            
            $
            12,388Finished
                goods
            
            
            13,069
            
            
            11,243Total
                inventories
            
            $
            25,427
            
            $
            23,631


**11.**
                **ACCRUED
                      LIABILITIES**


Accrued
      liabilities consisted of the following as of February 28, 2006 and November
      30,
      2005:





2006
            
            2005Interest
            
            $
            4,089
            
            $
            3,201Salaries,
                wages and commissions
            
            
            2,778
            
            
            5,991Product
                advertising and promotion
            
            
            9,095
            
            
            2,589Litigation
                settlement and legal fees
            
            
            1,617
            
            
            2,212Income
                taxes payable
            
            
            3,773
            
            
            —Other
            
            
            2,133
            
            
            2,334Total
                accrued liabilities
            
            $
            23,485
            
            $
            16,327


12
   **12.**
                **LONG-TERM
                      DEBT**


Long-term
      debt consisted of the following as of February 28, 2006 and November 30,
      2005:




2006
              
              2005Revolving
                  Credit Facility due 2010 at a variable rate of 5.93% and 7.00%
                  as of February 28, 2006 and November 30,
                  2005, respectively
              
              $
              43,000
              
              $
              —Floating
                    Rate Senior Notes due 2010at a variable rate of 7.41%
                    and 6.87% as of
                    December 30, 2005 (date redeemed) and November 30, 2005,
                    respectively
              
              
              —
              
              
              75,0007.0%
                  Senior Subordinated Notes due 2014
              
              
              107,500
              
              
              107,500Total
                  long-term debt
              
              
              150,500
              
              
              182,500Less:
                  current maturities
              
              
              —
              
              
              37,000Total
                  long-term debt, net of current maturities
              
              $
              150,500
              
              $
              145,500






On
      February 26, 2004, we entered into a new Senior Secured Revolving Credit
      Facility that matures February 26, 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. On March 9, 2004,
      we
      entered into a new 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. On November 29, 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 15, 2010. Borrowings under
      our Amended Revolving Credit Facility bear interest at LIBOR plus applicable
      percentages of 1.0% to 2.0% or a base rate (the higher of the federal funds
      rate
      plus 0.5% or the prime rate) plus applicable percentages of 0.0% to 0.5%.
      The applicable percentages are calculated based on our leverage ratio. As of
      February 28, 2006 and November 30, 2005, $43,000 and $0, respectively have
      been
      borrowed under the Amended Revolving Credit Facility, and the variable rate
      was
      5.93% and 7.0%, respectively. Borrowings under our Amended Revolving 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 Amended Revolving
      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, net worth and brand value calculations. On April 7, 2006, we
      had
      $38,000 of borrowings outstanding under our Amended Revolving Credit Facility.





On
      February 26, 2004, we issued and sold $75,000 of Floating Rate Senior Notes
      due
      March 1, 2010 (the “Floating Rate Senior Notes”) and $125,000 of the 7.0%
      Subordinated Notes, the proceeds of which were used to purchase $204,538 of
      our
      8.875% Senior Subordinated Notes due 2008 on February 26, 2004 and April 1,
      2004
      and refinance our then existing credit facility.





On
      March
      8, 2004, we entered into an interest rate cap agreement effective June 1, 2004
      with decreasing annual notional principal amounts of $15,000 beginning March
      1,
      2006 and cap rates ranging from 4.0% to 5.0% over the life of the agreement.
      We
      paid a $1,375 premium to enter into the interest rate cap agreement, which
      will
      be amortized over the life of the agreement. The current portion of the premium
      on the interest rate cap agreement of $213 is included in prepaid expenses
      and other current assets, and the long-term portion of $942 is included in
      other
      noncurrent assets. During the first quarter of fiscal 2006, the amortized value
      of the premium on the interest rate cap was compared to the fair value of the
      interest rate cap and the change in the market value of the premium of $98,
      net
      of tax, was recorded to other comprehensive income. Also as of November 30,
      2005, a portion of the interest rate cap was deemed to be an ineffective cash
      flow hedge due to the reduction of variable rate debt upon the subsequent
      redemption of the Floating Rate Senior Notes, resulting in a loss of $60, net
      of
      tax, reflected in the income statement as interest expense. The balance of
      the
      cash flow hedge was deemed to be effective as of November 30, 2005. As of
      February 28, 2006, a portion of the interest rate cap continued to be deemed
      an
      ineffective cash flow hedge due to the reduction of variable rate debt due
      to
      the redemption of the Floating Rate Senior Notes, resulting in a gain of $24,
      net of tax, reflected in the income statement. The balance of the cash flow
      hedge was deemed to be effective as of February 28, 2006. The fair value of
      the
      interest rate cap agreement is valued by a third party. The interest rate cap
      agreement terminates on March 1, 2010. Our domestic subsidiaries were




13




guarantors
      of the Floating Rate Senior Notes. The guarantees of the Floating Rate Senior
      Notes were unsecured senior obligations of the guarantors and ranked equally
      with all of the current and future unsecured senior debt of the guarantors.
      The
      guarantees of the Floating Rate Senior Notes effectively ranked junior to any
      secured debt of the guarantors, including the guarantors’ guarantee of our
      indebtedness under the Amended Revolving Credit Facility.





Interest
      payments on the 7.0% Subordinated Notes are due semi-annually in arrears on
      March 1 and September 1, commencing on September 1, 2004. 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
      1,
      2009 at 103.500%, March 1, 2010 at 102.333%, March 1, 2011 at 101.167% and
      March
      1, 2012 and thereafter at 100.000%. At any time prior to March 1, 2007, we
      may
      redeem up to 35% of the aggregate principal amount of the 7.0% Subordinated
      Notes (including any additional 7.0% Subordinated Notes) at a redemption price
      of 107.0% of the principal amount thereof, plus accrued and unpaid interest
      and
      liquidated damages, if any, thereon to the applicable redemption rate, with
      the
      net cash proceeds of one or more qualified equity offerings; provided, that
      (i)
      at least 65.0% of the aggregate principal amount of the 7.0% Subordinated Notes
      remains outstanding immediately after the occurrence of such redemption
      (excluding the 7.0% Subordinated Notes held by us and our subsidiaries); and
      (ii) the redemption must occur within 90 days of the date of the closing of
      such
      qualified equity offering.





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.





During
      the second quarter of 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 repurchases resulted in a loss on early
      extinguishment of debt, including related expenses of $744. The outstanding
      balance of the remaining 7.0% Subordinated Notes was reduced to
      $107,500.





On
      November 30, 2005, we called our $75,000 of Floating Rate Senior Notes for
      full
      redemption on December 30, 2005. On December 30, 2005, we fully redeemed our
      $75,000 of Floating Rate Senior Notes at a price of 102% of par plus accrued
      interest to December 30, 2005. We utilized borrowings of $38,000 under our
      Amended Revolving Credit Facility and $38,948 of our cash on hand to fund the
      redemption of the Floating Rate Senior Notes. As a result of the redemption,
      we
      paid a 2% premium over par or $1,500, retired associated debt issuance costs
      of
      $1,303 and incurred other related call fees, which resulted in a loss on early
      extinguishment of debt of $2,805 during the first quarter of fiscal 2006. As
      of
      April 7, 2006, our borrowing capacity under the Amended Revolving Credit
      Facility was $62,000.








The
      future maturities of long-term debt outstanding as of February 28, 2006 are
      as
      follows:


2007
            
            $
            —


2008
            
            —2009
            
            —2010
            
            43,0002011
            
            
            —Thereafter
            
            
            107,500$
            150,500








14




13.
              **COMPREHENSIVE
                    INCOME**


Comprehensive
      income consisted of the following components for the three months ended February
      28, 2006 and 2005, respectively:





2006
            
            2005Net
                income
            
            $
            14,773
            
            $
            8,665Other
                - interest rate cap adjustment
            
            
            53
            
            
            (31
            )Other
                - foreign currency translation adjustment
            
            
            242
            
            
            6Total
            
            $
            15,068
            
            $
            8,640






**14.**
              **STOCK
                    BUYBACK**


In
      the
      first quarter of fiscal 2006, we repurchased 275 shares for $10,130. All
      repurchased shares were retired and returned to unissued. We, however, are
      limited in our ability to repurchase shares due to restrictions under the terms
      of our Amended Revolving Credit Facility and the indenture pursuant to which
      the
      7.0% Subordinated Notes were issued. Subsequent to February 28, 2006 to the
      date
      of this filing, we have not repurchased any shares.






**15.**
              **RETIREMENT
                    PLANS AND POSTRETIREMENT HEALTH CARE
                    BENEFITS**


RETIREMENT
      PLANS





We
      have a
      noncontributory defined benefit pension plan (“the Plan”), which covers
      substantially all employees as of December 31, 2000. The Plan provides benefits
      based upon years of service and the employee's compensation. Our contributions
      are based on computations by independent actuaries. Plan assets at February
      28,
      2006 and November 30, 2005 were invested primarily in United States government
      and agency securities and corporate debt and equity securities. In October
      2000,
      our board of directors adopted an amendment to the Plan that freezes benefits
      of
      the Plan and prohibits new entrants to the Plan effective December 31, 2000.





Net
      periodic pension cost for the three months ended February 28, 2006 and 2005
      comprised the following components:





2006
            
            2005Service
                cost
            
            $
            --
            
            $
            --Interest
                cost on projected benefit obligation
            
            
            156
            
            
            152Actual
                return on plan assets
            
            
            (226
            )
            
            (212
            )Net
                amortization and deferral
            
            
            0
            
            
            5Net
                pension cost (benefit)
            
            $
            (70
            )
            $
            (55
            )





No
      employer contributions were made for the three months ended February 28, 2006
      and 2005, and no employer contributions are expected to be made in fiscal
      2006.





POSTRETIREMENT
      HEALTH CARE BENEFITS





We
      maintain certain postretirement health care benefits for eligible employees.
      Employees become eligible for these benefits if they meet certain age and
      service requirements. We pay a portion of the cost of medical benefits for
      certain retired employees over the age of 65. Effective January 1, 1993, our
      contribution is a service-based percentage of the full premium. We pay these
      benefits as claims are incurred. Employer contributions expected for fiscal
      2006
      are approximately $73.





15





Net
      periodic postretirement health care benefits cost for the three months ended
      February 28, 2006 and 2005, included the following components:





2006
            
            2005Service
                cost
            
            $
            20
            
            $
            18Interest
                cost on accumulated postretirementbenefit
                obligation
            
            
            22
            
            
            21Amortization
                of prior service cost
            
            
            4
            
            
            4Amortization
                of net gain
            
            
            (4
            )
            
            (4
            )Net
                periodic postretirement benefits cost
            
            $
            42
            
            $
            39







**16.**
              **INCOME
                    TAXES**


We
      account for income taxes using the asset and liability approach as prescribed
      by
      SFAS No. 109, “Accounting for Income Taxes”. This approach requires recognition
      of deferred tax assets and liabilities for the expected future tax consequences
      of events that have been included in the 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
      tax rate for the three months ended February 28, 2006 was 34%, as compared
      to
      33% in the three months ended February 28, 2005.





Undistributed
      earnings of Chattem Canada amounted to approximately $98 for the three months
      ended February 28, 2006. 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 those 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).





During
      fiscal 2005, pursuant to the provisions of the American Jobs Creation Act of
      2004 (the “Act”), we adopted a domestic reinvestment plan for purposes of
      facilitating the repatriation of dividends from our Canadian affiliates. Upon
      distribution of fiscal 2004 and 2005 earnings, we were subject to U.S. income
      taxes of $213. The majority of the cash distribution was treated as an
      extraordinary dividend and qualified for the 85 percent dividend received
      deduction allowed under the Act.






**17.**
              **PRODUCT
                    SEGMENT
                    INFORMATION**


Net
      sales
      of our domestic product categories within our single healthcare business segment
      for the three months ended February 28, 2006 and 2005 are as
      follows:





2006
            
            2005Topical
                pain care products
            
            $
            32,441
            
            $
            21,407Medicated
                skin care products
            
            
            16,892
            
            
            17,624Dietary
                supplements
            
            
            8,853
            
            
            8,660Medicated
                dandruff shampoos and conditioner
            
            
            11,816
            
            
            9,800Other
                OTC and toiletry products
            
            
            8,441
            
            
            8,078Total
            
            $
            78,443
            
            $
            65,569






**18.**
              **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




16


District
      of Washington before United States District Judge Barbara Jacobs 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. After the final judgment was entered, two parties who had objected
      to the settlement filed appeals challenging and seeking to set aside the final
      judgment. Both of these appeals have now been dismissed.




The *Dexatrim* PPA
      settlement includes 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.
      In accordance with the terms of the class action settlement agreement, we
      previously published notice of the settlement and details as to the manner
      in
      which claims could be submitted. The deadline for submission of claims was
      July
      7, 2004. A total of 391 claims were certified by the court as timely submitted.
      Of these 391 claims, 173 alleged stroke as an injury and 218 alleged other
      non-stroke injuries. Of the 391 total claims, only 371 claimants actually had
      alleged injuries that occurred after December 21, 1998 and continued to pursue
      their claims in the settlement. The remaining claimants have either withdrawn
      their claims or cannot be located. 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 nine of the opt out claims. The five
      remaining opt out claimants may pursue claims for damages against us in separate
      lawsuits. As of April 7, 2006, three of the five remaining opt out claimants
      have filed lawsuits against us that we are continuing to defend.




We
      previously reached an agreement with Kemper Indemnity Insurance Company
      ("Kemper") to settle its lawsuit that sought to rescind our policy for $50,000
      of excess coverage for product liability claims. After giving effect to the
      settlement with Kemper, we have available for the claims against us related
      to
      the PPA litigation, through our first three layers of insurance coverage,
      approximately $60,885 of the $77,000 of product liability coverage provided
      by
      these insurance policies. The $60,885 of available coverage consists of $37,500
      of insurance under the Kemper policy and approximately $23,385 under policies
      with two other insurance companies. In accordance with the terms of the class
      action settlement agreement, this $60,885 of coverage has been funded into
      a
      settlement trust. In addition, on July 14, 2004, we entered into a settlement
      agreement with Sidmak Laboratories, Inc. (“Sidmak”), the manufacturer of *Dexatrim* products
      containing PPA, pursuant to which Sidmak has contributed $10,000 into the
      settlement trust. We have also entered into a settlement agreement with
      Interstate Fire & Casualty Company (“Interstate”) with regard to its $25,000
      of coverage in excess of the insurance funds available in the settlement trust.




During
      the fourth quarter of fiscal 2005, we resolved substantially all of the claims
      submitted in the *Dexatrim* PPA
      settlement and now estimate that the total cost of the *Dexatrim* settlement will be approximately $56,000. As indicated above, a total of $70,885
      was previously funded into a settlement trust by our insurers and Sidmak for
      the
      purpose of paying claims in the settlement. Any funds remaining in the
      settlement trust after all claims and expenses of the trust have been paid
      will
      be distributed as approved by the court in accordance with the class action
      settlement agreement and our settlement agreements with each of Kemper and
      Sidmak. Payment of claims through the settlement trust is now substantially
      complete and we currently expect that we could recover up to approximately
      $8,500 from the settlement trust after all claims and expenses of the settlement
      trust have been paid. If realized, this potential recovery is estimated to
      occur
      during mid 2006. We currently do not expect to record any additional charges
      relative to the settlement of the PPA litigation, except for legal expenses
      that
      will be recorded in the period incurred. During the first quarter of fiscal
      2006, we incurred and recorded $137 of legal expenses related to the *Dexatrim* litigation.




We
      have
      also been named as a defendant in approximately 206 lawsuits relating to *Dexatrim* containing PPA which involve alleged injuries by *Dexatrim* products
      containing PPA manufactured and sold prior to our acquisition of *Dexatrim* on
      December 21, 1998. In these lawsuits, we have been defended on the basis of
      indemnification obligations assumed by The DELACO Company (“DELACO”), successor
      by merger to the Thompson Medical Company, Inc., which owned the brand prior
      to
      December 21, 1998. 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 in DELACO’s bankruptcy case in order to preserve our
      claims for indemnification against DELACO.




In
      order
      to resolve DELACO’s indemnity obligations to us, we entered into a settlement
      agreement with DELACO dated June 30, 2005 (“the DELACO Agreement”). The DELACO
      Agreement was approved by the DELACO bankruptcy court on July 28, 2005. Pursuant
      to the DELACO Agreement, we agreed to assume responsibility for all claims
      against DELACO and its predecessor, Thompson Medical Company, Inc., or us
      relating to *Dexatrim* products
      involving an injury date after






17


December
      21, 1998, and hold the DELACO bankruptcy estate harmless from any such claims.
      In exchange, a settlement trust to be established under DELACO’s bankruptcy plan
      agreed to pay us $8,750 and assume responsibility for all claims related to *Dexatrim* products
      alleging injury dates on or before December 21, 1998. On February 17, 2006,
      the
      DELACO bankruptcy court entered an order confirming the DELACO bankruptcy plan
      which incorporated the terms of the DELACO Agreement. In accordance with the
      DELACO bankruptcy plan, the settlement trust established under the plan paid
      us
      $8,750 on March 17, 2006. In addition, this order will allow us to dismiss
      all
      cases against us with injury dates prior to December 21, 1998, and channel
      these
      cases to the DELACO settlement trust whether brought by an injured party or
      a
      co-defendant to a *Dexatrim* products
      liability case. We expect all claims with injury dates prior to December 21,
      1998 to be channeled to the DELACO settlement trust.





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. The payment to us by the DELACO settlement trust of $8,750
      and the channeling of cases to the DELACO settlement trust as described above
      has conclusively compromised and settled our indemnity claim filed in the DELACO
      bankruptcy. As of February 28, 2006, we recorded a settlement receivable of
      $8,750, which is reflected, net of legal expenses, as a litigation settlement
      item on our consolidated statements of income.





We
      maintain a significantly lower level of insurance coverage for all other
      potential claims relating to our products including *Dexatrim* products
      containing ephedrine. For the current policy period, we are insured for product
      liability insurance for all of our other products, including *Dexatrim* products
      containing ephedrine, for up to $20,000 through our captive insurance
      subsidiary, of which approximately $6,481 is funded as of April 7, 2006. We
      also
      have $30,000 of excess coverage through third party insurers. There are
      currently two *Dexatrim* with
      ephedrine products liability lawsuits pending against us.




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. Although
      we discontinued the manufacturing and shipment of *Dexatrim* containing ephedrine in September 2002, the FDA's final rule may result in
      additional lawsuits being filed against us alleging damages related to the
      use
      or purchase of *Dexatrim* containing ephedrine.




We
      were
      named as a defendant in a putative class action lawsuit filed in the Superior
      Court of the State of California for the County of Los Angeles on February
      11,
      2004, relating to the labeling, advertising, promotion and sale of our *Bullfrog* suncare
      products. We filed an answer to this lawsuit on June 28, 2004. An amended
      complaint was filed March 29, 2006, pursuant to a court order formally
      consolidating this lawsuit with eight existing lawsuits involving other
      manufacturers of sunscreen products into a coordinated proceeding in California
      state court. The amended lawsuit seeks class certification of all persons who
      purchased our *Bullfrog* sun care
      products in California during a four-year period prior to February 11, 2004.
      The
      amended lawsuit seeks restitution and/or disgorgement of profits, actual
      damages, injunctive relief, punitive damages and attorneys fees and costs
      arising out of alleged deceptive, untrue or misleading advertising and breach
      of
      warranty, fraudulent or negligent misrepresentations, in connection with the
      manufacturing, labeling, advertising, promotion and sale of *Bullfrog* products
      in California. An answer to this amended complaint is due mid April, 2006,
      and
      we are vigorously defending this lawsuit.




We
      have
      been named as a defendant in a putative class action suit filed in the Superior
      Court of the State of California, County of Los Angeles, on January 13, 2005.
      The lawsuit seeks injunctive relief, compensatory damages and attorneys fees
      against us under the California Business and Professions Code, arising out
      of
      alleged deceptive, untrue or misleading advertising and breach of express
      warranty in connection with the manufacturing, labeling, advertising, promotion
      and sale of certain *Dexatrim* Natural
      products. The lawsuit seeks certification of a class consisting of all persons
      who purchased *Dexatrim* Natural
      in California during the four-year period prior to the filing of the lawsuit
      up
      to the date of any judgment obtained. The plaintiff has stipulated that the
      amount in controversy with respect to each individual claim and each member
      of
      the proposed class in the action does not exceed $75. We filed an answer on
      March 1, 2005, and are vigorously defending the lawsuit.




On
      March
      9, 2006, we were named in a lawsuit filed in the Southern District of New York
      by Novogen, Inc. Novogen alleges that our product*New
      Phase*infringes upon Novogen patents by containing certain phytoestrogens from clover
      or equivalent sources. Novogen seeks to force us to reformulate our product
      and
      to recover damages. We have not filed an answer as of April 7, 2006, but we
      plan
      to vigorously defend Novogen’s allegations.





18


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 as would not have a material adverse effect on our financial position,
      results of operations or cash flows if disposed of unfavorably.





**REGULATORY**





The
      FDA,
      the Drug Enforcement Administration and a number of state and local governments
      have enacted or proposed restrictions or prohibitions on the sale of products
      that contain ephedrine. Ephedrine can refer to the herbal substance derived
      from
      the plant ephedra or the plant heart leaf, which, until September 2002, was
      used
      in the manufacturing of some forms of *Dexatrim* Natural
      and *Dexatrim* Results,
      or synthetic ephedrine, a FDA regulated ingredient used in some OTC drug
      products, which has not been used in our products. These restrictions include
      the prohibition of OTC sales, required warnings or labeling statements, record
      keeping and reporting requirements, the prohibition of sales to minors, per
      transaction limits on the quantity of product that may be purchased and
      limitations on advertising and promotion. The enactment of further restrictions
      or prohibitions on sales, the perceived safety concerns related to ephedrine
      and
      the possibility of further regulatory action could result in an increase in
      the
      number of ephedrine related lawsuits filed including ones in which we are named
      as a defendant.





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





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





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




19


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 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 *Icy
      Hot Pro-Therapy* Medicated Foam Pad with Knee Wrap containing 5% menthol, and the *Capzasin* Back
& Body patch containing 0.025% capsaicin. All of these drug products contain
      levels of active ingredients consistent with levels permitted in the OTC
      monograph. If additional research is required either as a preliminary to final
      FDA monograph approval and/or as a requirement of future individual product
      sale, we may need to invest in a considerable amount of expensive testing and
      data analysis. Any preliminary cost may be shared with other patch
      manufacturers. Because the submissions made into the FDA docket have been
      forwarded from its OTC Division to its Dermatological Division within the Center
      for Drug Evaluation and Research (“CDER”), we 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 neither action described above is successful and 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 *Aspercreme* Patches,
      the *Icy
      Hot* Sleeve,
      the *Icy
      Hot Pro-Therapy* Medicated Foam Pad with Knee Wrap, *Capzasin* Back
& Body Patch and/or similar delivery systems under our other topical
      analgesic brands. In such case, we would have to remove the existing products
      from the market 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 expensive. It typically takes the FDA at least
      12 months to rule on an NDA once it is submitted.





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.





In
      early
      2005, infrequent, but serious, adverse cardiovascular events were reported
      to
      the FDA associated with patients who were prescribed a subclass of COX-2
      inhibitor non-steroidal anti-inflammatory drugs (“NSAID’s”) for long periods to
      relieve pain of chronic diseases such as arthritis. These products include
      Vioxx®, Bextra®, and Celebrex®. In February 2005, the FDA held a joint advisory
      committee meeting to seek external counsel on the extent to which manufacturers
      might further warn patients of these cardiovascular risks on prescription
      product labeling, or prohibit sale of these prescription products. As part
      of
      its response on this issue, the FDA has recommended labeling changes for both
      the prescription and OTC NSAID’s. Well-known OTC NSAID’s such as ibuprofen and
      naproxen, which have been sold in vast quantities since the 1970s, were affected
      by this regulatory action. Manufacturers of OTC NSAID’s were asked to revise
      their labeling to provide more specific information about the potential
      cardiovascular and gastrointestinal risks recognizing the limited dose and
      duration of treatment of these products. Our *Pamprin
      All Day* product,
      which contains naproxen sodium, is subject to these new labeling requirements. *Pamprin
      All Day* is
      manufactured for us by The Perrigo Company (“Perrigo”), holder of an abbreviated
      NDA for naproxen sodium. As holder of the abbreviated NDA, Perrigo has made
      the
      mandated labeling changes within the time frame required by the FDA. Product
      with revised labeling compliant with new FDA regulations is being shipped in
      February, 2006. We are also aware of the FDA's concern about the potential
      toxicity due to concomitant use of OTC and prescription products that contain
      the analgesic ingredient acetaminophen, an ingredient also found in *Pamprin* and *Prēmsyn
      PMS* .
      We are
      participating in an industry-wide effort to reassure the FDA that the current
      recommended dosing regimen is safe and effective and that proper labeling and
      public education by both OTC and prescription drug companies are the best
      policies to abate the FDA's concern. The FDA will address this issue in its
      effort to finalize the monograph on internal analgesic products. We believe
      the
      FDA may issue revised labeling requirements within the next year, perhaps prior
      to monograph closure, that will cause the industry to relabel its analgesic
      products to better inform consumers of concomitant use.





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





20


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.





In
      March,
      2006, the FDA conducted a routine site audit of our manufacturing plants and
      laboratories. There were no material adverse findings resulting from the
      audit.







**19.**
            **CONDENSED
                CONSOLIDATING FINANCIAL
                STATEMENTS**





The
      condensed 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 February 28, 2006 arose in
      conjunction with Chattem’s Amended Revolving Credit Facility and Chattem’s
      issuance of the 7.0% Subordinated Notes (See Note 12). The maximum amount of
      future payments the guarantors would be required to make under the guarantees
      as
      of February 28, 2006 is $150,500.

























21




Note
      19


CHATTEM,
      INC. AND SUBSIDIARIES


CONDENSED
      CONSOLIDATING BALANCE SHEETS





FEBRUARY
      28, 2006


(Unaudited
      and in thousands)


CHATTEM
            
            GUARANTOR
              SUBSIDIARY
              COMPANIES
            
            NON-GUARANTOR
              SUBSIDIARY
              COMPANIES
            
            ELIMINATIONS
            
            CONSOLIDATEDASSETSCURRENT
                ASSETS:Cash
                and cash equivalents
            
            $
            (1,116
            )
            $
            1,986
            
            $
            7,255
            
            $
            —
            
            $
            8,125Accounts
                receivable, less allowances of $3,083
            
            
            47,147
            
            
            23,686
            
            
            4,797
            
            
            (23,686
            )
            
            51,944Other
                receivable
            
            
            9,103
            
            
            —
            
            
            —
            
            
            —
            
            
            9,103Interest
                receivable
            
            
            17
            
            
            1,244
            
            
            —
            
            
            (1,261
            )
            
            —Inventories
            
            
            19,774
            
            
            2,969
            
            
            2,684
            
            
            —
            
            
            25,427Refundable
                income taxes
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —Deferred
                income taxes
            
            
            2,478
            
            
            —
            
            
            —
            
            
            —
            
            
            2,478Prepaid
                expenses and other current assets
            
            
            3,402
            
            
            —
            
            
            1,284
            
            
            (225
            )
            
            4,461Total
                current assets
            
            
            80,805
            
            
            29,885
            
            
            16,020
            
            
            (25,172
            )
            
            101,538PROPERTY,
                PLANT AND EQUIPMENT, NET
            
            
            28,818
            
            
            775
            
            
            533
            
            
            —
            
            
            30,126OTHER
                NONCURRENT ASSETS:Patents,
                trademarks and other purchased product rights, net
            
            
            344
            
            
            268,273
            
            
            —
            
            
            (62,290
            )
            
            206,327Debt
                issuance costs, net
            
            
            2,867
            
            
            —
            
            
            —
            
            
            —
            
            
            2,867Investment
                in subsidiaries
            
            
            287,091
            
            
            33,000
            
            
            66,860
            
            
            (386,951
            )
            
            —Note
                receivable
            
            
            —
            
            
            33,000
            
            
            —
            
            
            (33,000
            )
            
            —Other
            
            
            5,001
            
            
            —
            
            
            524
            
            
            —
            
            
            5,525Total
                other noncurrent assets
            
            
            295,303
            
            
            334,273
            
            
            67,384
            
            
            (482,241
            )
            
            214,719TOTAL
                ASSETS
            
            $
            404,926
            
            $
            364,933
            
            $
            83,937
            
            $
            (507,413
            )
            $
            346,383LIABILITIES
                AND SHAREHOLDERS’ EQUITYCURRENT
                LIABILITIES:Current
                maturities of long-term debt
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            —Accounts
                payable and other
            
            
            9,750
            
            
            —
            
            
            2,181
            
            
            —
            
            
            11,931Accrued
                liabilities
            
            
            39,698
            
            
            2,376
            
            
            6,583
            
            
            (25,172
            )
            
            23,485Total
                current liabilities
            
            
            49,448
            
            
            2,376
            
            
            8,764
            
            
            (25,172
            )
            
            35,416LONG-TERM
                DEBT, less current maturities
            
            
            150,500
            
            
            —
            
            
            33,000
            
            
            (33,000
            )
            
            150,500DEFERRED
                INCOME TAXES
            
            
            (659
            )
            
            28,531
            
            
            —
            
            
            —
            
            
            27,872OTHER
                NONCURRENT LIABILITIES
            
            
            1,890
            
            
            —
            
            
            —
            
            
            —
            
            
            1,890INTERCOMPANY
                ACCOUNTS
            
            
            73,039
            
            
            (72,944
            )
            
            (95
            )
            
            —
            
            
            —SHAREHOLDERS’
                EQUITY:Preferred
                shares, without par value, authorized 1,000, none
                issued
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —Common
                shares, without par value, authorized 50,000, issued and outstanding
                19,421
            
            
            56,590
            
            
            —
            
            
            —
            
            
            —
            
            
            56,590Shares
                of subsidiaries
            
            
            —
            
            
            329,705
            
            
            39,803
            
            
            (369,508
            )
            
            —Retained
                earnings
            
            
            75,626
            
            
            77,265
            
            
            2,233
            
            
            (79,498
            )
            
            75,626Total
            
            
            132,216
            
            
            406,970
            
            
            42,036
            
            
            (449,006
            )
            
            132,216Unamortized
                value of restricted common shares issued
            
            
            (1,522
            )
            
            —
            
            
            —
            
            
            —
            
            
            (1,522
            )Cumulative
                other comprehensive income:Interest
                rate cap adjustment
            
            
            (30
            )
            
            —
            
            
            —
            
            
            —
            
            
            (30
            )Foreign
                currency translation adjustment
            
            
            44
            
            
            —
            
            
            232
            
            
            (235
            )
            
            41Total
                shareholders’ equity
            
            
            130,708
            
            
            406,970
            
            
            42,268
            
            
            (449,241
            )
            
            130,705TOTAL
                LIABILITIES AND SHAREHOLDERS’ EQUITY
            
            $
            404,926
            
            $
            364,933
            
            $
            83,937
            
            $
            (507,413
            )
            $
            346,383





22


Note
      19


CHATTEM,
      INC. AND SUBSIDIARIES


CONSOLIDATING
      BALANCE SHEETS





NOVEMBER
      30, 2005


(In
      thousands)


CHATTEM
            
            GUARANTOR
                SUBSIDIARY
                COMPANIES
            
            NON-GUARANTOR
                SUBSIDIARY
                COMPANIES
            
            ELIMINATIONS
            
            CONSOLIDATEDASSETSCURRENT
                ASSETS:Cash
                and cash equivalents
            
            $
            36,647
            
            $
            1,982
            
            $
            8,698
            
            $
            —
            
            $
            47,327Accounts
                receivable, less allowances of $2,338
            
            
            29,220
            
            
            11,181
            
            
            4,452
            
            
            (11,181
            )
            
            33,672Other
                receivables
            
            
            9,600
            
            
            —
            
            
            —
            
            
            —
            
            
            9,600Interest
                receivable
            
            
            17
            
            
            625
            
            
            —
            
            
            (642
            )
            
            —Inventories
            
            
            18,192
            
            
            2,429
            
            
            3,010
            
            
            —
            
            
            23,631Refundable
                income taxes
            
            
            1,207
            
            
            —
            
            
            —
            
            
            —
            
            
            1,207Deferred
                income taxes
            
            
            2,478
            
            
            —
            
            
            —
            
            
            —
            
            
            2,478Prepaid
                expenses and other current assets
            
            
            4,241
            
            
            —
            
            
            1,285
            
            
            (420
            )
            
            5,106Total
                current assets
            
            
            101,602
            
            
            16,217
            
            
            17,445
            
            
            (12,243
            )
            
            123,021PROPERTY,
                PLANT AND EQUIPMENT, NET
            
            
            28,567
            
            
            775
            
            
            542
            
            
            —
            
            
            29,884OTHER
                NONCURRENT ASSETS:Patents,
                trademarks and other purchased product rights, net
            
            
            404
            
            
            268,273
            
            
            —
            
            
            (62,290
            )
            
            206,387Debt
                issuance costs, net
            
            
            4,297
            
            
            —
            
            
            —
            
            
            —
            
            
            4,297Investment
                in subsidiaries
            
            
            276,987
            
            
            33,000
            
            
            66,860
            
            
            (376,847
            )
            
            —Note
                receivable
            
            
            —
            
            
            33,000
            
            
            —
            
            
            (33,000
            )
            
            —Other
            
            
            4,704
            
            
            —
            
            
            —
            
            
            —
            
            
            4,704Total
                other noncurrent assets
            
            
            286,392
            
            
            334,273
            
            
            66,860
            
            
            (472,137
            )
            
            215,388TOTAL
                ASSETS
            
            $
            416,561
            
            $
            351,265
            
            $
            84,847
            
            $
            (484,380
            )
            $
            368,293LIABILITIES
                AND SHAREHOLDERS’ EQUITYCURRENT
                LIABILITIES:Current
                maturities of long-term debt
            
            $
            37,000
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            37,000Accounts
                payable and other
            
            
            14,841
            
            
            —
            
            
            2,397
            
            
            —
            
            
            17,238Accrued
                liabilities
            
            
            21,432
            
            
            969
            
            
            6,169
            
            
            (12,243
            )
            
            16,327Total
                current liabilities
            
            
            73,273
            
            
            969
            
            
            8,566
            
            
            (12,243
            )
            
            70,565LONG-TERM
                DEBT, less current maturities
            
            
            145,500
            
            
            —
            
            
            33,000
            
            
            (33,000
            )
            
            145,500DEFERRED
                INCOME TAXES
            
            
            (795
            )
            
            28,531
            
            
            —
            
            
            —
            
            
            27,736OTHER
                NONCURRENT LIABILITIES
            
            
            1,865
            
            
            —
            
            
            —
            
            
            —
            
            
            1,865INTERCOMPANY
                ACCOUNTS
            
            
            74,088
            
            
            (75,941
            )
            
            1,853
            
            
            —
            
            
            —SHAREHOLDERS’
                EQUITY:Preferred
                shares, without par value, authorized 1,000, none issued
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —Common
                shares, without par value, authorized 50,000, issued
                19,668
            
            
            63,876
            
            
            —
            
            
            —
            
            
            —
            
            
            63,876Share
                capital of subsidiaries
            
            
            —
            
            
            329,705
            
            
            39,803
            
            
            (369,508
            )
            
            —Retained
                earnings
            
            
            60,853
            
            
            68,001
            
            
            1,582
            
            
            (69,583
            )
            
            60,853Total
            
            
            124,729
            
            
            397,706
            
            
            41,385
            
            
            (439,091
            )
            
            124,729Unamortized
                value of restricted common shares issued
            
            
            (1,818
            )
            
            —
            
            
            —
            
            
            —
            
            
            (1,818
            )Cumulative
                other comprehensive income, net oftaxes:Interest
                rate cap adjustment
            
            
            (83
            )
            
            —
            
            
            —
            
            
            —
            
            
            (83
            )Foreign
                currency translation adjustment
            
            
            (198
            )
            
            —
            
            
            43
            
            
            (46
            )
            
            (201
            )Total
                shareholders’ equity
            
            
            122,630
            
            
            397,706
            
            
            41,428
            
            
            (439,137
            )
            
            122,627TOTAL
                LIABILITIES AND SHAREHOLDERS’ EQUITY
            
            $
            416,561
            
            $
            351,265
            
            $
            84,847
            
            $
            (484,380
            )
            $
            368,293







23


Note
      19





CHATTEM,
      INC. AND SUBSIDIARIES


CONDENSED
      CONSOLIDATING STATEMENTS OF INCOME





FOR
      THE
      THREE MONTHS ENDED FEBRUARY 28, 2006


(Unaudited
      and in thousands)


CHATTEM
            
            GUARANTOR
              SUBSIDIARY
              COMPANIES
            
            NON-GUARANTOR
              SUBSIDIARY
              COMPANIES
            
            ELIMINATIONS
            
            CONSOLIDATEDTOTAL
                REVENUES
            
            $
            71,077
            
            $
            21,432
            
            $
            4,625
            
            $
            (13,110
            )
            $
            84,024COSTS
                AND EXPENSES:Cost
                of sales
            
            
            22,567
            
            
            2,121
            
            
            1,938
            
            
            (606
            )
            
            26,020Advertising
                and promotion
            
            
            22,773
            
            
            2,829
            
            
            1,585
            
            
            —
            
            
            27,187Selling,
                general and administrative
            
            
            11,529
            
            
            (102
            )
            
            164
            
            
            —
            
            
            11,591Litigation
                settlement
            
            
            (8,613
            )
            
            —
            
            
            —
            
            
            —
            
            
            (8,613
            )Equity
                in subsidiary income
            
            
            (9,915
            )
            
            —
            
            
            —
            
            
            9,915
            
            
            —Total
                costs and expenses
            
            
            38,341
            
            
            4,848
            
            
            3,687
            
            
            9,309
            
            
            56,185INCOME
                FROM OPERATIONS
            
            
            32,736
            
            
            16,584
            
            
            938
            
            
            (22,419
            )
            
            27,839OTHER
                INCOME (EXPENSE):Interest
                expense
            
            
            (2,844
            )
            
            —
            
            
            (619
            )
            
            619
            
            
            (2,844
            )Investment
                and other income, net
            
            
            124
            
            
            630
            
            
            684
            
            
            (1,244
            )
            
            194Loss
                on early extinguishment of debt
            
            
            (2,805
            )
            
            —
            
            
            —
            
            
            —
            
            
            (2,805
            )Royalties
            
            
            (11,099
            )
            
            (1,406
            )
            
            —
            
            
            12,505
            
            
            —Corporate
                allocations
            
            
            841
            
            
            (825
            )
            
            (16
            )
            
            —
            
            
            —Total
                other income (expense)
            
            
            (15,783
            )
            
            (1,601
            )
            
            49
            
            
            11,880
            
            
            (5,455
            )INCOME
                BEFORE INCOME TAXES
            
            
            16,953
            
            
            14,983
            
            
            987
            
            
            (10,539
            )
            
            22,384PROVISION
                FOR INCOME TAXES
            
            
            2,180
            
            
            5,095
            
            
            336
            
            
            —
            
            
            7,611NET
                INCOME
            
            $
            14,773
            
            $
            9,888
            
            $
            651
            
            $
            (10,539
            )
            $
            14,773









24


Note
      19





CHATTEM,
      INC. AND SUBSIDIARIES


CONDENSED
      CONSOLIDATING STATEMENTS OF INCOME





FOR
      THE
      THREE MONTHS ENDED FEBRUARY 28, 2005


(Unaudited
      and in thousands)


CHATTEM
            
            GUARANTOR
              SUBSIDIARY
              COMPANIES
            
            NON-GUARANTOR
              SUBSIDIARY
              COMPANIES
            
            ELIMINATIONS
            
            CONSOLIDATEDTOTAL
                REVENUES
            
            $
            58,790
            
            $
            19,062
            
            $
            4,873
            
            $
            (11,194
            )
            $
            71,531COSTS
                AND EXPENSES:Cost
                of sales
            
            
            16,614
            
            
            2,323
            
            
            2,139
            
            
            (816
            )
            
            20,260Advertising
                and promotion
            
            
            15,459
            
            
            3,803
            
            
            1,089
            
            
            —
            
            
            20,351Selling,
                general and administrative
            
            
            11,521
            
            
            73
            
            
            290
            
            
            —
            
            
            11,884Litigation
                settlement
            
            
            1,070
            
            
            —
            
            
            1,685
            
            
            —
            
            
            2,755Equity
                in subsidiary income
            
            
            (6,831
            )
            
            —
            
            
            —
            
            
            6,831
            
            
            —Total
                costs and expenses
            
            
            37,833
            
            
            6,199
            
            
            5,203
            
            
            6,015
            
            
            55,250INCOME
                (LOSS) FROM OPERATIONS
            
            
            20,957
            
            
            12,863
            
            
            (330
            )
            
            (17,209
            )
            
            16,281OTHER
                INCOME (EXPENSE):Interest
                expense
            
            
            (3,489
            )
            
            —
            
            
            (623
            )
            
            617
            
            
            (3,495
            )Investment
                and other income, net
            
            
            95
            
            
            623
            
            
            671
            
            
            (1,242
            )
            
            147Royalties
            
            
            (9,017
            )
            
            (1,362
            )
            
            —
            
            
            10,379
            
            
            —Corporate
                allocations
            
            
            715
            
            
            (699
            )
            
            (16
            )
            
            —
            
            
            —Total
                other income (expense)
            
            
            (11,696
            )
            
            (1,438
            )
            
            32
            
            
            9,754
            
            
            (3,348
            )INCOME
                (LOSS) BEFORE INCOME TAXES
            
            
            9,261
            
            
            11,425
            
            
            (298
            )
            
            (7,455
            )
            
            12,933PROVISION
                FOR (BENEFIT FROM) INCOME TAXES
            
            
            596
            
            
            3,770
            
            
            (98
            )
            
            —
            
            
            4,268NET
                INCOME (LOSS)
            
            $
            8,665
            
            $
            7,655
            
            $
            (200
            )
            $
            (7,455
            )
            $
            8,665










25


Note
      19





CHATTEM,
      INC. AND SUBSIDIARIES


CONDENSED
      CONSOLIDATING STATEMENTS OF CASH FLOWS





FOR
      THE
      THREE MONTHS ENDED FEBRUARY 28, 2006


(Unaudited
      and in thousands)


CHATTEM
            
            GUARANTOR
              SUBSIDIARY
              COMPANIES
            
            NON-GUARANTOR
              SUBSIDIARY
              COMPANIES
            
            ELIMINATIONS
            
            CONSOLIDATEDOPERATING
                ACTIVITIES:Net
                income
            
            $
            14,773
            
            $
            9,888
            
            $
            651
            
            $
            (10,539
            )
            $
            14,773Adjustments
                to reconcile net income to net cashprovided
                by (used in) operating activities:Depreciation
                and amortization
            
            
            1,379
            
            
            —
            
            
            46
            
            
            —
            
            
            1,425Deferred
                income taxes
            
            
            233
            
            
            —
            
            
            6
            
            
            —
            
            
            239Excess
                  tax benefit from stock-based compensation
            
            
            (309
            )
            
            —
            
            
            —
            
            
            —
            
            
            (309
            )Stock-based
                compensation
            
            
            852
            
            
            —
            
            
            —
            
            
            —
            
            
            852Loss
                on early extinguishment of debt
            
            
            2,805
            
            
            —
            
            
            —
            
            
            —
            
            
            2,805Other,
                net
            
            
            51
            
            
            —
            
            
            15
            
            
            —
            
            
            66Equity
                in subsidiary income
            
            
            (10,539
            )
            
            —
            
            
            —
            
            
            10,539
            
            
            —Changes
                in operating assets and liabilities:Accounts
                receivable and other
            
            
            (17,430
            )
            
            (12,505
            )
            
            (345
            )
            
            12,505
            
            
            (17,775
            )Interest
                receivable
            
            
            —
            
            
            (619
            )
            
            —
            
            
            619
            
            
            —Inventories
            
            
            (1,430
            )
            
            (539
            )
            
            325
            
            
            —
            
            
            (1,644
            )Refundable
                income taxes
            
            
            1,516
            
            
            —
            
            
            —
            
            
            —
            
            
            1,516Prepaid
                expenses and other current assets
            
            
            838
            
            
            —
            
            
            9
            
            
            (195
            )
            
            652Accounts
                payable and accrued liabilities
            
            
            14,451
            
            
            1,406
            
            
            198
            
            
            (12,929
            )
            
            3,126Net
                cash provided by (used in) operating activities
            
            
            7,190
            
            
            (2,369
            )
            
            905
            
            
            —
            
            
            5,726INVESTING
                ACTIVITIES:Purchases
                of property, plant and equipment
            
            
            (1,276
            )
            
            —
            
            
            —
            
            
            —
            
            
            (1,276
            )Increase in
                other assets, net
            
            
            (271
            )
            
            —
            
            
            (340
            )
            
            —
            
            
            (611
            )Net
                cash used in investing activities
            
            
            (1,547
            )
            
            —
            
            
            (340
            )
            
            —
            
            
            (1,887
            )FINANCING
                ACTIVITIES:Repayment
                of long-term debt
            
            
            (75,000
            )
            
            —
            
            
            —
            
            
            —
            
            
            (75,000
            )Proceeds
                from borrowings under revolving credit facility
            
            
            43,000
            
            
            —
            
            
            —
            
            
            —
            
            
            43,000Proceeds
                from exercise of stock options
            
            
            311
            
            
            —
            
            
            —
            
            
            —
            
            
            311Repurchase
                of common shares
            
            
            (10,130
            )
            
            —
            
            
            —
            
            
            —
            
            
            (10,130
            )Increase
                in debt issuance costs
            
            
            (15
            )
            
            —
            
            
            —
            
            
            —
            
            
            (15
            )Retirement
                of debt issuance costs
            
            
            (1,501
            )
            
            —
            
            
            —
            
            
            —
            
            
            (1,501
            )Excess
                  tax benefit from stock-based compensation
            
            
            309
            
            
            —
            
            
            —
            
            
            —
            
            
            309Changes
                in intercompany accounts
            
            
            (380
            )
            
            2,998
            
            
            (2,618
            )
            
            —
            
            
            —Dividends
                paid
            
            
            —
            
            
            (625
            )
            
            625
            
            
            —
            
            
            —Net
                cash (used in) provided by financing activities
            
            
            (43,406
            )
            
            2,373
            
            
            (1,993
            )
            
            —
            
            
            (43,026
            )EFFECT
                OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS
            
            
            —
            
            
            —
            
            
            (15
            )
            
            —
            
            
            (15
            )CASH
                AND CASH EQUIVALENTS:Decrease
                for the period
            
            
            (37,763
            )
            
            4
            
            
            (1,443
            )
            
            —
            
            
            (39,202
            )At
                beginning of period
            
            
            36,647
            
            
            1,982
            
            
            8,698
            
            
            —
            
            
            47,327At
                end of period
            
            $
            (1,116
            )
            $
            1,986
            
            $
            7,255
            
            $
            —
            
            $
            8,125













26


Note
      19


CHATTEM,
      INC. AND SUBSIDIARIES


CONDENSED
      CONSOLIDATING STATEMENTS OF CASH FLOWS





FOR
      THE
      THREE MONTHS ENDED FEBRUARY 28, 2005


(Unaudited
      and in thousands)


CHATTEM
            
            GUARANTOR
              SUBSIDIARY
              COMPANIES
            
            NON-GUARANTOR
              SUBSIDIARY
              COMPANIES
            
            ELIMINATIONS
            
            CONSOLIDATEDOPERATING
                ACTIVITIES:Net
                income (loss)
            
            $
            8,665
            
            $
            7,655
            
            $
            (200
            )
            $
            (7,455
            )
            $
            8,665Adjustments
                to reconcile net income (loss) to net cash (used in) provided by
                operating activities:Depreciation
                and amortization
            
            
            1,585
            
            
            —
            
            
            39
            
            
            —
            
            
            1,624Deferred
                income taxes
            
            
            487
            
            
            1,291
            
            
            —
            
            
            —
            
            
            1,778Tax
                benefit realized from stock option plans
            
            
            186
            
            
            —
            
            
            —
            
            
            —
            
            
            186Other,
                net
            
            
            49
            
            
            —
            
            
            312
            
            
            —
            
            
            361Equity
                in subsidiary income
            
            
            (7,455
            )
            
            —
            
            
            —
            
            
            7,455
            
            
            —Changes
                in operating assets and liabilities:Accounts
                receivable
            
            
            (11,307
            )
            
            1,498
            
            
            (547
            )
            
            1,644
            
            
            (8,712
            )Inventories
            
            
            (462
            )
            
            628
            
            
            (452
            )
            
            —
            
            
            (286
            )Refundable
                income taxes
            
            
            2,172
            
            
            —
            
            
            —
            
            
            —
            
            
            2,172Prepaid
                expenses and other current assets
            
            
            1,072
            
            
            —
            
            
            (690
            )
            
            —
            
            
            382Accounts
                payable and accrued liabilities
            
            
            (70
            )
            
            255
            
            
            3,237
            
            
            (1,644
            )
            
            1,778Net
                cash (used in) provided by operating activities
            
            
            (5,078
            )
            
            11,327
            
            
            1,699
            
            
            —
            
            
            7,948INVESTING
                ACTIVITIES:Purchases
                of property, plant and equipment
            
            
            (566
            )
            
            —
            
            
            (33
            )
            
            —
            
            
            (599
            )Decrease
                in other assets, net
            
            
            155
            
            
            —
            
            
            512
            
            
            —
            
            
            667Net
                cash (used in) provided by investing activities
            
            
            (411
            )
            
            —
            
            
            479
            
            
            —
            
            
            68FINANCING
                ACTIVITIES:Repayment
                of policy loans
            
            
            (1,031
            )
            
            —
            
            
            —
            
            
            —
            
            
            (1,031
            )Proceeds
                from exercise of stock options
            
            
            187
            
            
            —
            
            
            —
            
            
            —
            
            
            187Repurchase
                of common shares
            
            
            (3,514
            )
            
            —
            
            
            —
            
            
            —
            
            
            (3,514
            )Changes
                in intercompany accounts
            
            
            10,529
            
            
            (10,700
            )
            
            171
            
            
            —
            
            
            —Dividends
                paid
            
            
            —
            
            
            (625
            )
            
            625
            
            
            —
            
            
            —Net
                cash provided by (used in) financing activities
            
            
            6,171
            
            
            (11,325
            )
            
            796
            
            
            —
            
            
            (4,358
            )EFFECT
                OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS
            
            
            —
            
            
            —
            
            
            (312
            )
            
            —
            
            
            (312
            )CASH
                AND CASH EQUIVALENTS:Increase
                for the period
            
            
            682
            
            
            2
            
            
            2,662
            
            
            —
            
            
            3,346At
                beginning of period
            
            
            28,344
            
            
            1,967
            
            
            9,882
            
            
            —
            
            
            40,193At
                end of period
            
            $
            29,026
            
            $
            1,969
            
            $
            12,544
            
            $
            —
            
            $
            43,539













27





**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 2005 Annual Report on
      Form
      10-K filed with the Securities and Exchange Commission. 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
      Securities and Exchange Commission.





***Overview***





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 topical pain care products, medicated skin care
      products, medicated dandruff shampoos and conditioner, dietary supplements,
      and
      other OTC and toiletry products. Our portfolio of products includes
      well-recognized brands such as:





•  Topical
      pain care products such as *Icy
      Hot, Icy Hot Pro-Therapy* and *Aspercreme* ;





•  Medicated
      skin care products such as *Gold
      Bond* medicated skin care powder, cream, lotion, first aid, and foot care
      products;





•  *Selsun
      Blue* and *Selsun
      Salon* medicated dandruff shampoos;





•  Dietary
      supplements including *Dexatrim* , *Garlique* and *New
      Phase* ;
      and





•  Other
      OTC
      and toiletry products such as *Pamprin* ,
      a
      menstrual analgesic; *Herpecin-L* ,
      a lip
      care product; *Benzodent* ,
      a
      dental analgesic cream; *Bullfrog* ,
      a line
      of suncare products; and toiletries such as *Ultraswim* ,
      a
      chlorine-removing shampoo; and *Sun-In* ,
      a hair
      lightener.





Our
      products typically target niche markets that are often outside the core product
      areas of larger companies where we believe we can achieve and sustain
      significant market penetration through innovation and strong advertising and
      promotion support. Many of our products are among the U.S. market leaders in
      their respective categories. For example, our portfolio of topical pain care
      brands and our *Gold
      Bond* medicated body powders have the leading U.S. market share in these categories.
      We support our brands through extensive and cost-effective advertising and
      promotion, the expenditures for which represented approximately 32.4% of our
      total revenues in the first quarter of fiscal 2006. We sell our products
      nationally through mass merchandiser, drug and food channels principally
      utilizing our own sales force.





***Developments
      During Fiscal 2006***





***Products***





In
      the
      first quarter of fiscal 2006, we introduced the following product line
      extensions: *Icy
      Hot Pro-Therapy* , *Bullfrog*  *Mosquito
      Coast* , *Garlique
      CardioAssist* , *Capzasin* Back
& Body Patch and *Pamprin* Max.





***Debt***





On
      November 30, 2005, we called our $75.0 million of Floating Rate Senior Notes
      for
      full redemption on December 30, 2005. The terms of the indenture for the
      Floating Rate Senior Notes required the repayment at a price of 102% of the
      principal amount of the notes plus accrued interest. The $75.0 million of
      Floating Rate Senior Notes were fully redeemed on December 30, 2005. We utilized
      borrowings of $38.0 million under our Amended Revolving Credit Facility and
      $38.9 million of our cash on hand to fund the redemption of the Floating Rate
      Senior Notes. As a result of the redemption, a loss on early extinguishment
      of
      debt of $2.8 million was recorded in the first quarter of fiscal
      2006.





***Litigation***





During
      the fourth quarter of fiscal 2005, we resolved substantially all of the claims
      submitted in the *Dexatrim* PPA
      settlement and now estimate that the total cost of the *Dexatrim* settlement will be approximately $56.0 million. A total of $70.9 million was
      previously funded into a settlement trust by our insurers and Sidmak
      Laboratories, Inc., the manufacturer of *Dexatrim*




28


products
      containing PPA, for the purpose of paying claims in the settlement. Any funds
      remaining in the settlement trust after all claims and expenses of the trust
      have been paid will be distributed as approved by the court in accordance with
      the class action settlement agreement and our settlement agreements with each
      of
      Kemper Indemnity Insurance Company and the product manufacturer. Payment of
      claims through the settlement trust is now substantially complete and we
      currently expect that we could recover up to approximately $8.5 million from
      the
      settlement trust after all claims and expenses of the settlement trust have
      been
      paid. If realized, this potential recovery is estimated to occur during mid
      2006. We currently do not expect to record any additional charges relative
      to
      the settlement of the PPA litigation, except for legal expenses that will be
      recorded in the period incurred. During the first quarter of fiscal 2006, we
      incurred and recorded $0.1 million of legal expenses related to the *Dexatrim* litigation.




During
      the third quarter of fiscal 2005, we entered into a settlement agreement with
      the DELACO Company (“DELACO”), successor by merger to the Thompson Medical
      Company, Inc., which owned the *Dexatrim* brand
      prior to December 21, 1998 (the “DELACO Agreement”). The DELACO Agreement was
      approved by the DELACO bankruptcy court on July 28, 2005. Pursuant to the DELACO
      Agreement, we agreed to assume responsibility for all claims against DELACO
      and
      its predecessor, Thompson Medical Company, Inc., or us relating to *Dexatrim* products
      involving an injury date after December 21, 1998 and hold the DELACO bankruptcy
      estate harmless from any such claims. In exchange, a settlement trust to be
      established under DELACO’s bankruptcy plan agreed to pay us $8.75 million and
      assume responsibility for all claims related to *Dexatrim* products
      alleging injury dates on or before December 21, 1998. On February 17, 2006,
      the
      DELACO bankruptcy court entered an order confirming the DELACO bankruptcy plan
      which incorporated the terms of the DELACO Agreement. In accordance with the
      DELACO bankruptcy plan, the settlement trust established under the plan paid
      us
      $8.75 million on March 17, 2006. In addition, this order will allow us to
      dismiss all cases against us with injury dates prior to December 21, 1998,
      and
      channel these cases to the DELACO settlement trust whether brought by an injured
      party or a co-defendant to a *Dexatrim* products
      liability case. We expect all claims with injury dates prior to December 21,
      1998 to be channeled to the DELACO settlement trust.




The
      confirmation of the DELACO bankruptcy plan effectively releases us from
      liability for all PPA products liability cases with injury dates prior to
      December 21, 1998. The payment to us by the DELACO settlement trust of $8.75
      million and the channeling of cases to the DELACO settlement trust as described
      above has conclusively compromised and settled our indemnity claim filed in
      the
      DELACO bankruptcy. As of February 28, 2006, we recorded a settlement receivable
      of $8.75 million, which is reflected, net of legal expenses, as a litigation
      settlement item on our consolidated statements of income.

























29




***Results
      of Operations***





The
      following table sets forth, for the periods indicated, certain items from our
      Condensed Consolidated Statements of Income expressed as a percentage of total
      revenues:




For
                the Three Months EndedFebruary
                28, 2006
            
            February
                28, 2005TOTAL
                REVENUES
            
            
            100.0
            %
            
            100.0
            %COSTS
                AND EXPENSES:Cost
                of sales
            
            
            31.0
            
            
            28.3Advertising
                and promotion
            
            
            32.4
            
            
            28.5Selling,
                general and administrative
            
            
            13.8
            
            
            16.6Litigation
                settlement
            
            
            (10.3
            )
            
            3.8Total
                costs and expenses
            
            
            66.9
            
            
            77.2INCOME
                FROM OPERATIONS
            
            
            33.1
            
            
            22.8OTHER
                INCOME (EXPENSE):Interest
                expense
            
            
            (3.4
            )
            
            (4.9
            )Investment
                and other income, net
            
            
            0.2
            
            
            0.2Loss
                on early extinguishment of debt
            
            
            (3.3
            )
            
            --Total
                other income (expense)
            
            
            (6.5
            )
            
            (4.7
            )INCOME
                BEFORE INCOME TAXES
            
            
            26.6
            
            
            18.1PROVISION
                FOR INCOME TAXES
            
            
            9.1
            
            
            6.0NET
                INCOME
            
            
            17.5
            %
            
            12.1
            %





***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 February 28, 2006 condensed consolidated financial
      statements:





***Allowance
      for Doubtful Accounts***





As
      of
      February 28, 2006, 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 first quarter of fiscal 2006, 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 $0.3 million at February 28, 2006 and
      November 30, 2005, respectively.





***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




30


sales
      are
      recorded, we accrue an estimated amount for product returns, as a reduction
      of
      these sales, based upon our historical experience and any known specific events
      that affect the accrual. We charge the allowance account resulting from this
      accrual with any authorized deduction from remittance by the customer or product
      returns upon receipt of the product.





In
      accordance with industry practice, we allow our customers to return unsold
      sun
      care products (i.e. *Bullfrog* and *Sun
      In* lines of
      products) at the end of the sun care season. We record the sales at the time
      the
      products are shipped and title transfers. At the time of shipment, we also
      record a reduction in sales and an allowance on our balance sheet for
      anticipated returns based upon an estimated return level. The level of returns
      may fluctuate from our estimates due to several factors including weather
      conditions, customer inventory levels and competitive conditions. Each
      percentage point change in our return rate would impact our net sales by
      approximately $0.2 million. As a result of higher sales volumes in the first
      quarter of fiscal 2006 and 2005, we increased our estimate of seasonal returns
      by approximately $0.4 million and $0.1 million, respectively, which resulted
      in
      a decrease to net sales in our condensed consolidated financial statements.
      During the first quarter of fiscal 2006 and 2005, as a result of our estimate
      of
      customer inventory levels and based on historical non-seasonal product returns,
      we increased our estimate of non-seasonal returns by approximately $0.3 and
      $0.6
      million, which resulted in a decrease to net sales in our condensed consolidated
      financial statements. At November 30, 2005, we recorded an allowance for returns
      of pHisoderm of $0.7 million as a result of the sale of pHisoderm. At February
      28, 2006 the allowance for pHisoderm returns is $0.4 million.





We
      routinely enter into agreements with our customers to participate in promotional
      programs. These programs generally take the form of coupons, temporary price
      reductions, scan downs, display activity and participations in advertising
      vehicles provided uniquely by the customer. The ultimate cost of these programs
      is often variable based on the number of units actually sold. Estimated unit
      sales of a product under a promotional program are used to estimate the total
      cost of the program, which is recorded as a reduction of sales. Actual results
      can differ from the original estimate. In addition, increases and decreases
      in
      total program commitments each year impact the accrual. We also consider
      customer delays in requesting promotional program payments when evaluating
      the
      required accrual. Some customers audit programs significantly after the date
      of
      performance to determine the actual amount due and make a claim for
      reimbursement at that time. As a result, changes in the unit sales trends under
      promotional programs as well as the timing of payments could result in changes
      in the accrual. During the first quarter of fiscal 2006 and 2005, primarily
      as a
      result of sales volume related promotional programs, we increased our estimate
      of promotional accruals by approximately $2.5 million and $0.5 million,
      respectively, which resulted in an increase in advertising and promotion expense
      in our condensed consolidated financial statements.





***Income
      Taxes***





We
      account for income taxes using the asset and liability approach as prescribed
      by
      Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for
      Income Taxes”. This approach requires recognition of deferred tax assets and
      liabilities for the expected future tax consequences of events that have been
      included in our condensed 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 condensed consolidated financial
      statements based on an estimated annual effective income tax rate. Our tax
      rate
      for the three months ended February 28, 2006 was 34%, as compared to 33% in
      the
      three months ended February 28, 2005, respectively.





For
      a
      summary of our significant accounting policies, see Note 2 of Notes to Condensed
      Consolidated Financial Statements included in our Annual Report on Form 10-K
      for
      the year ended November 30, 2005 filed with the Securities and Exchange
      Commission.












31





***Comparison
      of Three Months Ended February 28, 2006 and 2005***





To
      facilitate discussion of our operating results for the three months ended
      February 28, 2006 and 2005, we have included the following selected data from
      our Condensed Consolidated Statements of Income:





Increase
                (Decrease)2006
            
            2005
            
            Amount
            
            Percentage(dollars
                in thousands)Domestic
                net sales
            
            $
            78,443
            
            $
            65,569
            
            $
            12,874
            
            
            19.6
            %International
                revenues (including royalties)
            
            
            5,581
            
            
            5,962
            
            
            (381
            )
            
            (6.4
            )Total
                revenues
            
            
            84,024
            
            
            71,531
            
            
            12,493
            
            
            17.5Cost
                of sales
            
            
            26,020
            
            
            20,260
            
            
            5,760
            
            
            28.4Advertising
                and promotion expense
            
            
            27,187
            
            
            20,351
            
            
            6,836
            
            
            33.6Selling,
                general and administrative expense
            
            
            11,591
            
            
            11,884
            
            
            (293
            )
            
            (2.5
            )Litigation
                settlement
            
            
            (8,613
            )
            
            2,755
            
            
            (11,368
            )
            
            (412.6
            )Interest
                expense
            
            
            2,844
            
            
            3,495
            
            
            (651
            )
            
            (18.6
            )Loss
                on early extinguishment of debt
            
            
            2,805
            
            
            —
            
            
            nm
            
            
            nmNet
                income
            
            
            14,773
            
            
            8,665
            
            
            6,108
            
            
            70.5





**Domestic
      Net Sales**





Domestic
      net sales for the three months ended February 28, 2006 increased $12.9 million,
      or 19.6%, to $78.4 million from $65.6 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)2006
            
            2005
            
            Amount
            
            Percentage(dollars
                in thousands)Topical
                pain care products
            
            $
            32,441
            
            $
            21,407
            
            $
            11,034
            
            
            51.5
            %Medicated
                skin care products
            
            
            16,892
            
            
            17,624
            
            
            (732
            )
            
            (4.2
            )Dietary
                supplements
            
            
            8,853
            
            
            8,660
            
            
            193
            
            
            2.2Medicated
                dandruff shampoos andconditioner
            
            
            11,816
            
            
            9,800
            
            
            2,016
            
            
            20.6Other
                OTC and toiletry products
            
            
            8,441
            
            
            8,078
            
            
            363
            
            
            4.5Total
            
            $
            78,443
            
            $
            65,569
            
            $
            12,874
            
            
            19.6





Net
      sales
      in the topical pain care category increased 52% for the first quarter of fiscal
      2006 compared to the prior year quarter, due primarily to the initial sell-in
      of
      the new *Icy
      Hot*  *Pro-Therapy* line of
      elastic support braces and pain relieving insert products. Excluding sales
      of *Icy
      Hot Pro-Therapy,* the
      category declined 3% compared to the prior year quarter.





Net
      sales
      in the medicated skin care products category decreased 4% in the first quarter
      of fiscal 2006 compared to the prior year quarter which included pHisoderm
      sales
      of $2.9 million. Net sales of *Gold
      Bond* increased 13% behind strong sales of *Gold
      Bond* Medicated Body Lotion and *Gold
      Bond Ultimate* Healing
      Lotion. Sampling and enhanced media support behind the *Gold
      Bond* lotion
      products resulted in record first quarter sales for both the lotion line and
      the
      brand as a whole. Net sales of *Gold
      Bond* powder
      products declined 15% for the first quarter of fiscal 2006 compared to the
      prior
      year quarter due in part to the pipeline volume of *Gold
      Bond Ultimate* Comfort
      Body Powder during the first quarter of fiscal 2005.





Net
      sales
      in the dietary supplements category increased 2% for the first quarter of fiscal
      2006 compared to the prior year quarter driven primarily by a 15% increase
      in
      sales of *Dexatrim* due to
      the continued strong performance of the *Dexatrim* Max diet
      pill. Net sales of *Garlique* increased 10% for the first quarter, reflecting renewed advertising support
      and
      the initial sell-in of the new *Garlique
      CardioAssist* dietary
      supplement. These strong increases were offset by the discontinuance of the *Dexatrim* All In
      One Bar, which accounted for approximately $1.0 million of net sales in the
      first quarter of fiscal 2005.





Net
      sales
      in the medicated dandruff shampoos and conditioner category increased 21% in
      the
      first quarter of fiscal 2006 compared to the prior year quarter as a result
      of
      strong distribution of *Selsun*  *Salon.* Sales of *Selsun
      Blue* declined
      for the quarter primarily due to increased media support and in-store
      promotional activity among competitive brands.





32


Net
      sales
      in the other OTC and toiletry products category increased 5% due primarily
      to
      increased sales of *Pamprin* ,
      which
      were driven by media support and the initial sell-in of *Pamprin* Max.
      The
      balance of this category was essentially flat compared to the prior year
      quarter.





Domestic
      sales variances were principally the result of changes in unit sales volumes
      with the exception of certain selected products for which we implemented a
      unit
      sales price increase.





**International
      Revenues**





For
      the
      first quarter of fiscal 2006, international revenues decreased $0.4 million,
      or
      6.4%, compared to the first quarter of fiscal 2005, primarily due to the
      reduction of sales as a result of the divestiture of pHisoderm at the end of
      fiscal 2005 and the suspension of distribution in a single European market
      in
      mid-2005, partially offset by the successful introductions of *Icy
      Hot* in
      Canada and Mexico. Sales variances for our international operations were
      principally the result of changes in unit sales volume.





**Cost
      of Sales**





Cost
      of
      sales as a percentage of total revenues was 31.0% for the first quarter of
      fiscal 2006 as compared to 28.3% in the prior year quarter. Gross margin
      for the first quarter of fiscal 2006 was 69.0% compared to 71.7% in the prior
      year quarter. The gross margin decline was largely attributable to the launch
      of *Icy
      Hot* Pro-Therapy which has lower gross margins than our other products.





**Advertising
      and Promotion Expense**





Advertising
      and promotion expenses in the first quarter of fiscal 2006 increased $6.8
      million, or 33.6%, as compared to the same quarter of fiscal 2005 and were
      32.4% of total revenues for the three months ended February 28, 2006 compared
      to
      28.5% for the prior year quarter. Support for new product introductions drove
      an
      increase in advertising and promotion expense in the current period.





**Selling,
      General and Administrative Expense**





Selling,
      general and administrative expenses decreased $0.3 million, or 2.5%, compared
      to
      the prior year quarter. Selling, general and administrative expenses were 13.8%
      and 16.6% of total revenues for the first quarter of fiscal 2006 and 2005,
      respectively. The decrease was attributable to lower compensation expense in
      the
      current period reflecting restricted stock grants in the prior year quarter,
      offset in part by share-based payment expense under SFAS 123R (as defined below
      in Recent Accounting Pronouncements) and higher freight costs in the current
      period.





**Litigation
      Settlement**




Litigation
      settlement items decreased $11.4 million as compared to the same quarter of
      fiscal 2005 due to the $8.75 million recovery from the DELACO settlement trust
      ($8.6 million net of legal expense) in the *Dexatrim* litigation settlement in the current period compared to *Dexatrim* litigation costs of $2.8 million in the prior year quarter.





**Interest
      Expense**





Interest
      expense decreased $0.7 million, or 18.6%, in the first quarter of fiscal 2006
      as
      compared to the prior year quarter, reflecting the impact of the previously
      announced refinancing transactions. Until our indebtedness is reduced
      substantially, interest expense will continue to represent a significant
      percentage of our total revenues.





**Loss
      on Early Extinguishment of Debt**





Our
      $75.0
      million of Floating Rate Senior Notes were fully redeemed in the first quarter
      of fiscal 2006. As a result of the redemption, a loss on early extinguishment
      of
      debt of $2.8 million was recorded in the first quarter of fiscal 2006. No
      corresponding charge was incurred in first quarter of fiscal 2005.





***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.





33


Cash
      of
      $5.7 million and $7.9 million was provided by operations for the three
      months ended February 28, 2006 and 2005, respectively. The decreases in cash
      flows from operations over the prior year quarter was primarily attributable
      to
      the increase in accounts receivable and other, which includes the $8.75 million
      DELACO settlement receivable and trade receivables related to new product
      launches such as *Icy
      Hot* Pro-Therapy, offset by a loss on early extinguishment of debt of $2.8 million
      related to the redemption of our $75.0 million of Floating Rate Senior
      Notes.





Investing
      activities used cash of $1.9 million and provided cash of $0.1 million in the
      three months ended February 28, 2006 and 2005, respectively. The increase in
      cash used is primarily related to an increase in capital expenditures as
      compared to the prior year quarter.





Financing
      activities used cash of $43.0 million and $4.4 million in the three months
      ended
      February 28, 2006 and 2005, respectively. The increase in cash used in the
      current period was primarily attributable to the redemption of our $75.0 million
      of Floating Rate Senior Notes offset by borrowings under our Amended Revolving
      Credit Facility of $43.0 million and $10.1 million of common stock repurchases
      as compared to prior period cash used for the $3.5 million repurchase of common
      stock and the repayment of loans related to executive and director life
      insurance policies.





***Foreign
      Operations***





Historically,
      our primary foreign operations have been conducted through our Canadian and
      United Kingdom (“U.K.”) subsidiaries. Effective November 1, 2004, we
      transitioned our European business to Chattem Global Consumer Products Limited,
      a wholly-owned subsidiary located in Limerick, Ireland. The functional
      currencies of these subsidiaries are Canadian dollars 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
      three months ended February 28, 2006 and 2005, these subsidiaries accounted
      for
      6% and 7% of total revenues, respectively, and 3% and 4% of total assets,
      respectively. It has not been our practice to hedge our assets and liabilities
      in Canada, the U.K. 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. Following our
      acquisition of *Selsun
      Blue* ,
      which
      is sold in approximately 70 foreign countries, our international business
      operations have expanded significantly, which will increase our exposure to
      fluctuations in foreign exchange rates. During fiscal 2005, a portion of these
      foreign sales was reflected as royalties, which have been paid to us in U.S.
      dollars. In addition, until July 2005 Abbott Laboratories (“Abbott”), from whom
      we acquired *Selsun
      Blue* ,
      continued to supply a portion of our international product and billed us in
      U.
      S. dollars in certain instances. Beginning April 1, 2004, a portion of our
      international supply of *Selsun* was
      billed to us in local currencies. Historically, gains or losses from foreign
      currency transactions have not had a material impact on our operating results.
      Losses of $800 and $10,000 for the three months ended February 28, 2006 and
      2005, respectively, resulted from foreign currency transactions and are included
      in selling, general and administrative expenses in the Condensed Consolidated
      Statements of Income. ****





***Recent
      Accounting Pronouncements***





In
      December 2003, the Financial Accounting Standards Board (“FASB”) issued
      Interpretation No. 46R, “Consolidation of Variable Interest Entities” (“FIN
      46R”), which supersedes Interpretation No. 46, “Consolidation of Variable
      Interest Entities” issued in January 2003. FIN 46R requires a company to
      consolidate a variable interest entity (“VIE”), as defined, when the company
      will absorb a majority of the VIE’s expected losses, receives a majority of the
      VIE’s expected residual returns or both. FIN 46R also requires consolidation of
      existing, non-controlled affiliates if the VIE is unable to finance its
      operations without investor support, or where the other investors do not have
      exposure to the significant risks and rewards of ownership. FIN 46R applies
      immediately to a VIE created or acquired after January 31, 2003. For a VIE
      created before February 1, 2003, FIN 46R applies in the first fiscal year or
      interim period beginning after March 15, 2004, our third fiscal quarter
      beginning June 1, 2004. Application of FIN 46R is also required in financial
      statements that have interests in structures that are commonly referred to
      as
      special-purpose entities for periods ending after December 15, 2003. The
      adoption of FIN 46R did not have a material impact on our financial position,
      results of operations or cash flows.





In
      November 2004, the FASB issued Statement of Financial Accounting Standards
      (“SFAS”) No. 151, “Inventory Costs” (“SFAS 151”). SFAS 151 amends the guidance
      in Accounting Research Bulletin No. 43, Chapter 4, “Inventory Pricing”, to
      clarify that abnormal amounts of idle facility expense, freight, handling costs
      and wasted materials (spoilage) should be recognized as current-period charges
      and requires the allocation of fixed production overheads to inventory based
      on
      normal capacity of the production facilities. This statement is effective for
      inventory costs incurred during fiscal years beginning after June 15, 2005.
      The
      adoption of SFAS 151 on December 1, 2005 did not have an impact on our financial
      position, results of operations or cash flows.





34


In
      November 2004, the Emerging Issues Task Force (“EITF”) reached a consensus on
      Issue No. 03-13, “Applying the Conditions in Paragraph 42 of FASB Statement No.
      144, “Accounting for the Impairment or Disposal of Long-Lived Assets” in
      Determining Whether to Report Discontinued Operations” (“EITF 03-13”). Under the
      consensus, the approach for assessing whether cash flows of the component have
      been eliminated from the ongoing operations of the entity focuses on whether
      continuing cash flows are direct or indirect cash flows. Cash flows of the
      component would not be eliminated if the continuing cash flows to the entity
      are
      considered direct cash flows. The consensus should be applied to a component
      of
      an enterprise that is either disposed of or classified as held for sale in
      fiscal periods beginning after December 15, 2004. The adoption of EITF 03-13
      on
      December 1, 2005 did not have an impact on our financial position, results
      of
      operations or cash flows.





In
      December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No.
      123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), which is a revision of
      SFAS No. 123, “Accounting for Stock-Based Compensation”. SFAS 123R supersedes
      APB Opinion No. 25, “Accounting for Stock Issued to Employees” and amends SFAS
      No. 95, “Statement of Cash Flows”. SFAS 123R focuses primarily on accounting for
      transactions in which an entity obtains employee services in share-based payment
      transactions and requires all share-based payments to employees, including
      grants of employee stock options, to be recognized as additional compensation
      expense in the financial statements based on the calculated fair value of the
      awards. SFAS 123R also requires the benefits of tax deductions in excess of
      recognized compensation costs to be reported as a financing cash flow. This
      requirement will reduce net operating cash flows and increase net financing
      cash
      flows in periods after adoption. We adopted this statement effective for our
      fiscal year beginning December 1, 2005.  We
      have
      described the impact of adopting SFAS 123R in our condensed consolidated
      financial statements in Note 5, Stock-Based Compensation.





In
      December 2004, the FASB issued SFAS 153, “Exchanges of Nonmonetary Assets”
(“SFAS 153”). SFAS 153 amends the guidance in APB Opinion No. 29, “Accounting
      for Nonmonetary Transactions” to eliminate certain exceptions to the principle
      that exchanges of nonmonetary assets be measured based on the fair value of
      the
      assets exchanged. SFAS 153 eliminates the exception for nonmonetary exchanges
      of
      similar productive assets and replaces it with a general exception for exchanges
      of nonmonetary assets that do not have commercial substance. This statement
      is
      effective for nonmonetary asset exchanges in fiscal years beginning after June
      15, 2005. The adoption of SFAS 153 on December 1, 2005 did not have an
      impact on our financial position, results of operations or cash
      flows.





The
      American Jobs Creation Act of 2004 (the “AJCA”) was enacted on October 22, 2004.
      The AJCA repeals an export incentive, creates a new deduction for qualified
      domestic manufacturing activities and includes a special one-time deduction
      of
      85% of certain foreign earnings repatriated to the U.S.




In
        December 2004, the FASB issued FASB Staff Position No. 109-1, “Application
        of FASB Statement No. 109 (SFAS 109), Accounting for Income Taxes, to
        the Tax Deduction on Qualified Production Activities Provided by the American
        Jobs Creation Act of 2004” (FSP 109-1). FSP 109-1 clarifies that the
        manufacturer’s deduction provided for under the American Jobs Creation Act of
        2004 (AJCA) should be accounted for as a special deduction in accordance
        with SFAS 109 and not as a tax rate reduction. In accordance with FSP
        109-1, we treat the deduction for qualified domestic manufacturing activities,
        which became effective beginning December 1, 2005, as a reduction of the
        income
        tax provision in future years when realized.


The
      FASB
      also issued FASB Staff Position No. 109-2, Accounting and Disclosure
      Guidance for the Foreign Earnings Repatriation Provision within the American
      Jobs Creation Act of 2004 (FSP 109-2). The AJCA introduces a special one-time
      dividends received deduction on the repatriation of certain foreign earnings
      to
      a U.S. taxpayer (repatriation provision), provided certain criteria are
      met. FSP 109-2 provides accounting and disclosure guidance for the repatriation
      provision. We have described the impact of FSP 109-2 in our condensed
      consolidated financial statements in Note 16, Income Taxes.





In
      May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error
      Corrections,” or (“SFAS No. 154.”)  SFAS No. 154 replaces APB
      No. 20, “Accounting Changes” and SFAS No. 3, “Reporting Accounting
      Changes in Interim Financial Statements” and establishes retrospective
      application as the required method for reporting a change in accounting
      principle.  The reporting of a correction of an error by restating
      previously issued financial statements is also addressed. SFAS No. 154 is
      effective for accounting changes and corrections of errors made in fiscal years
      beginning after December 15, 2005.  The adoption of SFAS No. 154
      is not expected to have an impact on our financial position, results of
      operations or cash flows.





In
      October 2005, the FASB issued FASB Staff Position (“FSP”) 123R-2, “Practical
      Accommodation to the Application of Grant Date as Defined in FASB Statement
      No.
      123(R) (“FSP 123R-2”)”. FSP 123R-2 provides companies with a “practical
      accommodation” when determining the grant date of an award that is subject to
      the accounting provisions in SFAS 123R. Specifically, assuming a company meets
      all of the other criteria in the definition of grant date in SFAS 123R, a mutual
      understanding (between the company and the recipient) of the key terms and
      conditions of an award is presumed to exist at the date the award is approved
      (in accordance with the company’s normal corporate governance policy) if (1) the
      award is unilateral grant meaning that the recipient does not have the ability
      to negotiate the key terms and conditions of the award, and (2) the key terms
      and conditions of the award are expected to be communicated to the recipient
      within a relatively short period of time (as defined in the FSP 123R-2) after
      the grant was approved. This FSP was effective upon initial adoption of SFAS
      123R on December 1, 2005.





35


In
      November 2005, the FASB issued FSP 123R-3, “Transition Election Related to
      Accounting for the Tax Effects of Share-Based Payment Awards” (“FSP 123R-3”).
      FSP 123R-3 provides a practical exception when a company transitions to the
      accounting requirements in SFAS 123R. SFAS 123R requires a company to calculate
      the pool of excess tax benefits available to absorb tax deficiencies recognized
      subsequent to adopting SFAS 123R (“APIC Pool”), assuming the company had been
      following the recognition provisions prescribed by SFAS 123. The FASB learned
      that several companies do not have the necessary historical information to
      calculate the APIC pool as envisioned by SFAS 123R and accordingly, the FASB
      decided to allow a practical exception as documented in FSP 123R-3. This FSP
      was
      effective on its issuance date.








***Forward
      Looking Statements***





We
      may
      from time to time make written and oral forward-looking statements. Written
      forward-looking statements may appear 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. 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. The risks, uncertainties and
      assumptions of the forward-looking statements include, but are not limited
      to,
      the lack of availability, limits of coverage and expense related to product
      liability insurance, the reduction of available insurance coverage as proceeds
      are used to fund any product liability settlements or awards; the possibility
      of
      other product liability claims, including claims relating to the prior existence
      of ephedrine in *Dexatrim* products
      or arising from the FDA’s rule banning the sale of dietary supplements
      containing ephedrine; our ability to fund liabilities from product liability
      claims greater than our insurance coverage or outside the scope of insurance
      coverage; the possible effect of the negative public perception resulting from
      product liability claims on sales of *Dexatrim* products
      without PPA or ephedrine; the impact of brand acquisitions and divestures;
      the
      impact of gains or losses resulting from product acquisitions or divestures;
      product demand and market acceptance risks; product development risks, such
      as
      delays or difficulties in developing, producing and marketing new products
      or
      line extensions; the impact of competitive products, pricing and advertising;
      our ability to sell and market *Selsun* internationally where we have only limited experience and infrastructure;
      constraints resulting from our financial condition, including the degree to
      which we are leveraged, debt service requirements and restrictions under
      indentures and loan agreements; government regulations; risks of loss of
      material customers; public perception regarding our products; dependence on
      third party manufacturers; environmental matters; and other risks described
      in
      our Securities and Exchange Commission filings.












































36





**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 consists of our Amended Revolving
      Credit Facility. Loans under our Amended Revolving Credit Facility bear interest
      at LIBOR plus applicable percentages of 1.00% to 2.00% or a base rate (the
      higher of the federal funds rate plus 0.5% or the prime rate) plus applicable
      percentages of 0.0% to 0.5%. The applicable percentages are calculated based
      on
      our leverage ratio. As of February 28, 2006, $43,000 was outstanding under
      the Amended Revolving Credit Facility, and the variable rate on the Amended
      Revolving Credit Facility was LIBOR plus 1.25%, or 5.93%. The 7.0% Subordinated
      Notes are fixed interest rate obligations. On March 8, 2004, we entered into
      an
      interest rate cap agreement effective June 1, 2004 with decreasing annual
      notional principal amounts of $15.0 million beginning March 1, 2006 and cap
      rates ranging from 4.0% to 5.0% over the life of the agreement. The amortized
      value of the premium on the interest rate cap was compared to its fair value
      as
      of February 28, 2006, and a gain of $98,000, net of tax, was recorded to other
      comprehensive income. The interest rate cap agreement terminates on March 1,
      2010. The impact on our results of operations of a one-point rate change on
      the
      April 7, 2006 outstanding balance of $38.0 million of our Amended Revolving
      Credit Facility for the next twelve months would be approximately $0.3 million,
      net of tax.





We
      are
      subject to risk from changes in the foreign exchange rates relating to our
      Canadian, U.K. and Irish subsidiaries. Assets and liabilities of these
      subsidiaries are translated to U.S. dollars at year-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 in the Condensed Consolidated Statements of Income.
      Until July 2005, Abbott continued to supply us with a portion of our
      international supply of *Selsun* and
      billed us in U.S. dollars in certain instances. Beginning April 1, 2004, a
      portion of our international supply of *Selsun* was
      billed to us in local currencies. The potential loss resulting from a
      hypothetical 10.0% adverse change in the quoted foreign currency exchange rate
      amounts to approximately $0.4 million as of February 28, 2006.





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 February 28, 2006 (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. During the quarter ended February
      28,
      2006, we implemented a quarterly inventory control process that management
      believes will ensure that inventory balances will include the appropriate
      amounts of overhead costs each quarter. Except for this change, there has been
      no change in our internal control over financial reporting during the quarter
      ended February 28, 2006 that has materially affected, or is reasonably likely
      to
      materially affect, such internal control over financial reporting.
















37


**PART
      II.   OTHER INFORMATION**




**Item
      1.       Legal
      Proceedings**





See
      Note
      18 of Notes to Condensed 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, 2005.





**Item
      2.       Unregistered Sales of Equity Securities
      and Use of Proceeds**





A
      summary
      of the common stock repurchase activity for our first quarter of fiscal 2006
      is
      as follows:





Period
            
            Total
                Number of SharesPurchased
            
            Average
                PricePaid
                Per Share (1)
            
            Total
                Number of Shares Purchased as Part of Publicly Announced Plans orPrograms
                (2)
            
            Approximate
                Dollar Value that may yet be Purchased under the Plans orPrograms (2)December
                1- December 31
            
            
            —
            
            $
            —
            
            
            —
            
            
            30,000,000January
                1 - January 31
            
            
            —
            
            
            —
            
            
            —
            
            
            30,000,000February
                1 - February 28
            
            
            275,000
            
            
            36.84
            
            
            275,000
            
            
            19,869,517Total
                First Quarter
            
            
            275,000
            
            $
            36.84
            
            
            275,000
            
            
            19,869,517





(1)
            Average
                price paid per share includes broker commissions.




(2)
            In
                January 2005, our board of directors increased the total authorization
                to
                repurchase our common stock under our stock buyback program to $30.0
                million. A total of $17.3 million remained available under the stock
                buyback authority prior to July 29, 2005, when our board of directors
                increased the total buyback authorization back to $30.0 million.
                Subsequent to share purchases made in the fourth quarter of fiscal
                2005,
                our board of directors again increased the total buyback authorization
                back to $30.0 million, effective November 29, 2005. 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.
















38








**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




















































39








**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: April
              10, 2006
            
            /s/ Zan
              GuerryZan
              GuerryChairman
              and Chief Executive Officer  CHATTEM,
                  INC.
                (Registrant)Dated: April
                10, 2006
              
              /s/ Robert
                E.
                BosworthRobert
                E. BosworthPresident
                and
                Chief Operating Officer




















































40










**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
















































































41