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 May 31, 2008


Commission
file number 0-5905







CHATTEM,
INC.


A
TENNESSEE CORPORATION


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


1715
WEST 38TH STREET


CHATTANOOGA,
TENNESSEE 37409


TELEPHONE:  423-821-4571







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




YESþ      NO 





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




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




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




YESo      NO þ




As
of July 1, 2008,18,768,759shares of the Company’s common stock, without par value, were
outstanding.












CHATTEM,
INC.





INDEX










PART
I.  FINANCIAL INFORMATION


PAGE
      NO.Item
      1.  Financial StatementsConsolidated
      Balance Sheets as of May 31, 2008 and November 30, 2007
            3Consolidated
      Statements of Income for the Three and Six Months Ended May 31, 2008 and
      May 31, 2007
            5Consolidated
      Statements of Cash Flows for the Six Months Ended May 31, 2008 and May 31,
      2007
            6Notes
      to Consolidated Financial Statements
            7Item
      2.  Management’s Discussion
      and Analysis of Financial Condition and Results of
    Operations
            29Item
      3.  Quantitative and Qualitative Disclosures About Market
      Risk
            41Item
      4.  Controls and Procedures
            41PART
      II.  OTHER INFORMATIONItem
      1. Legal Proceedings
            42Item
      1A. Risk Factors
            42Item
      2. Unregistered Sales of Equity Securities and Use of
    Proceeds
            42Item
      3. Defaults Upon Senior Securities
            42Item
      4. Submission of Matters to a Vote of Security Holders
            42Item
      5. Other Information
            43Item
      6. Exhibits
            45SIGNATURES
            47





2


PART 1. FINANCIAL
INFORMATION








Item 1. Financial
Statements








CHATTEM, INC. AND
SUBSIDIARIES





CONSOLIDATED BALANCE
SHEETS


(In
thousands)





ASSETS
            
            MAY
      31,
              2008
            
            
            NOVEMBER
      30,
              2007(Unaudited)CURRENT
      ASSETS:Cash
      and cash equivalents
            
            $
            11,975
            
            
            $
            15,407Accounts
      receivable, less allowances of $14,296 at
              May
      31, 2008 and $13,810 at November 30, 2007
            
            
            55,445
            
            
            
            43,753Inventories
            
            
            42,384
            
            
            
            43,265Deferred
      income taxes
            
            
            7,050
            
            
            
            6,750Prepaid
      expenses and other current assets
            
            
            2,240
            
            
            
            2,065Total
      current assets
            
            
            119,094
            
            
            
            111,240PROPERTY,
      PLANT AND EQUIPMENT, NET
            
            
            32,556
            
            
            
            32,349OTHER
      NONCURRENT ASSETS:Patents,
      trademarks and other purchased product rights, net
            
            
            616,601
            
            
            
            616,810Debt
      issuance costs, net
            
            
            13,567
            
            
            
            15,430Other
            
            
            5,131
            
            
            
            4,731Total
      other noncurrent assets
            
            
            635,299
            
            
            
            636,971TOTAL
      ASSETS
            
            $
            786,949
            
            
            $
            780,560







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


3


CHATTEM, INC. AND
SUBSIDIARIES





CONSOLIDATED BALANCE
SHEETS


(In
thousands)








LIABILITIES AND
      SHAREHOLDERS’ EQUITY
            
            MAY
      31,
              2008
            
            
            NOVEMBER
      30,
              2007(Unaudited)CURRENT
      LIABILITIES:Current
      maturities of long-term debt
            
            $
            3,000
            
            
            $
            3,000Accounts
      payable and other
            
            
            12,402
            
            
            
            18,239Bank
      overdraft
            
            
            6,338
            
            
            
            7,584Accrued
      liabilities
            
            
            19,264
            
            
            
            21,537Total
      current liabilities
            
            
            41,004
            
            
            
            50,360LONG-TERM
      DEBT, less current maturities
            
            
            483,688
            
            
            
            505,000DEFERRED
      INCOME TAXES
            
            
            29,146
            
            
            
            21,056OTHER
      NONCURRENT LIABILITIES
            
            
            2,221
            
            
            
            2,436COMMITMENTS
      AND CONTINGENCIES (Note 19)SHAREHOLDERS’
      EQUITY:Preferred
      shares, without par value, authorized 1,000,none
      issued
            
            
            —
            
            
            
            —Common
      shares, without par value, authorized 100,000,issued
      and outstanding 18,997 at May 31, 2008 and19,092 
      at November 30, 2007
            
            
            31,140
            
            
            
            36,800Retained
      earnings
            
            
            200,549
            
            
            
            165,655231,689
            
            
            
            202,455Cumulative
      other comprehensive income, net of tax:Interest
      rate hedge adjustment
            
            
            (1,959
            )
            
            
            (1,747
            )Foreign
      currency translation adjustment
            
            
            1,168
            
            
            
            1,008Unrealized
      actuarial gains and losses
            
            
            (8
            )
            
            
            (8
            )Total
      shareholders’ equity
            
            
            230,890
            
            
            
            201,708TOTAL
      LIABILITIES AND SHAREHOLDERS’EQUITY
            
            $
            786,949
            
            
            $
            780,560







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




4


CHATTEM, INC. AND
SUBSIDIARIES





CONSOLIDATED
STATEMENTS OF INCOME


(Unaudited
and in thousands, except per share amounts)





FOR
      THE THREE MONTHS
              ENDED MAY 31,
            
            
            FOR
      THE SIX MONTHS
              ENDED MAY 31,2008
            
            
            2007
            
            
            2008
            
            
            2007TOTAL
      REVENUES
            
            $
            116,716
            
            
            $
            112,964
            
            
            $
            237,489
            
            
            $
            213,795COSTS
      AND EXPENSES:Cost
      of sales
            
            
            32,641
            
            
            
            35,095
            
            
            
            67,374
            
            
            
            66,075Advertising
      and promotion
            
            
            30,247
            
            
            
            29,664
            
            
            
            64,743
            
            
            
            58,451Selling,
      general and administrative
            
            
            15,186
            
            
            
            14,311
            
            
            
            30,652
            
            
            
            26,722Product
      recall expenses
            
            
            —
            
            
            
            —
            
            
            
            6,043
            
            
            
            —Acquisition expenses
            
            
            —
            
            
            
            886
            
            
            
            —
            
            
            
            2,057Total
      costs and expenses
            
            
            78,074
            
            
            
            79,956
            
            
            
            168,812
            
            
            
            153,305INCOME
      FROM OPERATIONS
            
            
            38,642
            
            
            
            33,008
            
            
            
            68,677
            
            
            
            60,490OTHER
      INCOME (EXPENSE):Interest
      expense
            
            
            (6,565
            )
            
            
            (8,319
            )
            
            
            (13,117
            )
            
            
            (15,555
            )Investment
      and other income, net
            
            
            116
            
            
            
            291
            
            
            
            253
            
            
            
            884Loss
      on early extinguishment of debt
            
            
            —
            
            
            
            (2,219
            )
            
            
            (526
            )
            
            
            (2,219
            )Total
      other income (expense)
            
            
            (6,449
            )
            
            
            (10,247
            )
            
            
            (13,390
            )
            
            
            (16,890
            )INCOME
      BEFORE INCOME TAXES
            
            
            32,193
            
            
            
            22,761
            
            
            
            55,287
            
            
            
            43,600PROVISION
      FOR INCOME TAXES
            
            
            11,461
            
            
            
            7,853
            
            
            
            19,682
            
            
            
            15,042NET
      INCOME
            
            $
            20,732
            
            
            $
            14,908
            
            
            $
            35,605
            
            
            $
            28,558NUMBER
      OF COMMON SHARES:Weighted
      average outstanding-basic
            
            
            19,118
            
            
            
            19,021
            
            
            
            19,112
            
            
            
            18,841Weighted
      average and potential dilutive outstanding
            
            
            19,518
            
            
            
            19,359
            
            
            
            19,592
            
            
            
            19,237NET
      INCOME PER COMMON SHARE:Basic
            
            $
            1.08
            
            
            $
            .78
            
            
            $
            1.86
            
            
            $
            1.52Diluted
            
            $
            1.06
            
            
            $
            .77
            
            
            $
            1.82
            
            
            $
            1.48





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




5


CHATTEM, INC. AND
SUBSIDIARIES





CONSOLIDATED STATEMENTS OF
CASH FLOWS


(Unaudited
and in thousands)




FOR
      THE SIX MONTHS ENDEDMAY
      31, 2008
            
            
            MAY
      31,2007OPERATING
      ACTIVITIES:Net
      income
            
            $
            35,605
            
            
            $
            28,558Adjustments
      to reconcile net income to net cash provided by
              operating
      activities:Depreciation
      and amortization
            
            
            4,216
            
            
            
            4,278Deferred
      income taxes
            
            
            8,898
            
            
            
            6,647Tax
      benefit realized from stock options exercised
            
            
            (1,855
            )
            
            
            (3,966
            )Stock-based
      compensation
            
            
            2,580
            
            
            
            2,632Loss
      on early extinguishment of debt
            
            
            526
            
            
            
            2,219Other,
      net
            
            
            135
            
            
            
            117Changes
      in operating assets and liabilities, net of effects from
      acquisitions:Accounts
      receivable and other
            
            
            (11,692
            )
            
            
            (21,976
            )Inventories
            
            
            906
            
            
            
            3,255Refundable
      income taxes
            
            
            —
            
            
            
            2,475Prepaid
      expenses and other current assets
            
            
            (180
            )
            
            
            1,130Accounts
      payable and accrued liabilities
            
            
            (7,850
            )
            
            
            18,006Net
      cash provided by operating activities
            
            
            31,289
            
            
            
            43,375INVESTING
      ACTIVITIES:Purchases
      of property, plant and equipment
            
            
            (2,466
            )
            
            
            (1,580
            )Acquisition
      of brands
            
            
            —
            
            
            
            (415,980
            )(Increase)
      decrease in other assets, net
            
            
            (1,140
            )
            
            
            2,458Net
      cash used in investing activities
            
            
            (3,606
            )
            
            
            (415,102
            )FINANCING
      ACTIVITIES:Repayment
      of long-term debt
            
            
            (36,500
            )
            
            
            (128,000
            )Proceeds
      from long-term debt
            
            
            —
            
            
            
            400,000Proceeds
      from borrowings under revolving credit facility
            
            
            109,500
            
            
            
            89,000Repayments
      of revolving credit facility
            
            
            (94,312
            )
            
            
            (57,000
            )Proceeds
      from exercise of stock options
            
            
            2,165
            
            
            
            8,434Change
      in bank overdraft
            
            
            (1,246
            )
            
            
            (1,392
            )Repurchase
      of common shares
            
            
            (12,554
            )
            
            
            —Purchase
      of note hedge
            
            
            —
            
            
            
            (29,500
            )Proceeds
      from issuance of warrant
            
            
            —
            
            
            
            17,430Increase
      in debt issuance costs
            
            
            —
            
            
            
            (9,110
            )Tax
      benefit realized from stock options exercised
            
            
            1,855
            
            
            
            3,966Net
      cash provided by (used in) financing activities
            
            
            (31,092
            )
            
            
            293,828EFFECT
      OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS
            
            
            (23
            )
            
            
            29CASH
      AND CASH EQUIVALENTS:Decrease
      for the period
            
            
            (3,432
            )
            
            
            (77,870
            )At
      beginning of period
            
            
            15,407
            
            
            
            90,527At
      end of period
            
            $
            11,975
            
            
            $
            12,657PAYMENTS
      FOR:Interest
            
            $
            11,489
            
            
            $
            13,025Taxes
            
            $
            9,931
            
            
            $
            6,434





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


6


CHATTEM, INC.  AND
SUBSIDIARIES





NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS


(Unaudited)





All
monetary and share amounts (other than per share amounts) in these Notes are
expressed in thousands.





1.
            BASIS OF
      PRESENTATION





The
accompanying unaudited consolidated financial statements have been prepared in
accordance with generally accepted accounting principles for interim financial
information and the instructions to Form 10-Q and Rule 10-01 of Regulation
S-X.  Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles in the United
States for complete financial statements.  These consolidated
financial statements should be read in conjunction with the audited consolidated
financial statements and related notes thereto included in our Annual Report on
Form 10-K for the year ended November 30, 2007.  The accompanying
unaudited consolidated financial statements, in the opinion of management,
include all adjustments necessary for a fair presentation.  All such
adjustments are of a normal recurring nature.





2.
            CASH AND CASH
      EQUIVALENTS





We
consider all short-term deposits and investments with original maturities of
three months or less to be cash equivalents.





3.
            RECENT ACCOUNTING
      PRONOUNCEMENTS





In July
2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation
No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), which clarifies
the accounting for uncertainty in income taxes recognized in the financial
statements in accordance with Statement of Financial Accounting Standard
(“SFAS”) No. 109, “Accounting for Income Taxes” (“SFAS 109”). FIN 48 provides
guidance on the financial statement recognition and measurement of a tax
position taken or expected to be taken in a tax return. FIN 48 also provides
guidance on de-recognition, classification, interest and penalties, accounting
in interim periods, disclosures and transition.  Additionally, in May
2007, the FASB issued FASB Staff Position (“FSP”) No. FIN 48-1, “Definition of
Settlement in FASB Interpretation No. 48” (“FSP FIN 48-1”), an amendment to FIN
48.  FSP FIN 48-1 clarifies how an enterprise is to determine whether
a tax position is effectively settled for the purpose of recognizing previously
unrecognized tax benefits.  The provisions of FIN 48 and FSP FIN 48-1
were effective for fiscal years beginning after December 15,
2006.   As described in Note 17, we adopted the provisions of FIN
48 and FSP FIN 48-1 effective December 1, 2007.




In
September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS
157”).  SFAS 157 provides guidance for using fair value to measure
assets and liabilities.  SFAS 157 applies when other standards require
(or permit) assets or liabilities to be measured at fair value but does not
expand the use of fair value in any new circumstances.  SFAS 157 also
requires expanded disclosure of the effect on earnings for items measured using
unobservable data (data not based on market observable information), establishes
a fair value hierarchy that prioritizes the information used to develop those
assumptions and requires separate disclosure by level within the fair value
hierarchy.  As described in Note 8, we adopted SFAS 157 effective
December 1, 2007.




In
February 2008, the FASB issued FSP No. SFAS 157-2, “Effective
Date of FASB Statement No. 157” (“FSP 157-2”).  FSP 157-2
defers the effective date of SFAS 157 for nonfinancial assets and
nonfinancial liabilities, except those that are recognized or disclosed at fair
value in the financial statements on a recurring basis (at least annually), to
fiscal years and interim periods within those fiscal years, beginning after
November 15, 2008, or our fiscal 2009.  We are currently
evaluating the impact of adopting the provisions of FSP 157-2.




In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
Financial Assets and Financial Liabilities” (“SFAS 159”).  SFAS 159
permits entities to choose to measure certain financial assets and liabilities
at fair value.  Unrealized gains and losses on items for which the
fair value option has been elected are reported in earnings. We adopted SFAS 159
effective December 1, 2007 without choosing to elect to measure certain
financial assets or liabilities at fair value that were not previously measured
at fair value.




In
December 2007, the FASB issued SFAS No. 141R, “Business Combinations” (“SFAS
141R”).  SFAS 141R establishes principles and requirements for how the
acquirer in a business combination recognizes and measures the identifiable
assets acquired, liabilities assumed, and intangible assets acquired and
determines what information to disclose to enable users of the financial
statements to evaluate the nature and financial effects of the business
combination.  The provisions of SFAS 141R are effective for
acquisitions closing after the first annual reporting period beginning after
December 15, 2008.  Accordingly,


7


we will
apply the provisions of SFAS 141R prospectively to business combinations
consummated beginning in the first quarter of our fiscal 2010.





In March
2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments
and Hedging Activities – An Amendment of FASB Statement No. 133” (“SFAS
161”).  SFAS 161 requires enhanced disclosures for derivative and
hedging activities.  SFAS 161 is effective for financial statements
issued for fiscal years and interim periods beginning after November 15, 2008,
or our fiscal 2009.  We are currently evaluating the impact, if any,
of SFAS 161.





In
April 2008, the FASB issued FSP No. FAS 142-3, “Determination of the
Useful Life of Intangible Assets” (“FSP FAS 142-3”).  In determining the
useful life of intangible assets, FSP FAS 142-3 removes the requirement to
consider whether an intangible asset can be renewed without substantial cost of
material modifications to the existing terms and conditions and, instead,
requires an entity to consider its own historical experience in renewing similar
arrangements. FSP FAS 142-3 also requires expanded disclosure related to the
determination of intangible asset useful lives.  FSP FAS 142-3 is effective
for financial statements issued for fiscal years beginning after
December 15, 2008, or our fiscal 2010.




In May
2008, the FASB issued FSP Accounting Principles Board Opinion No. 14-1,
“Accounting for Convertible Debt Instruments that may be Settled in Cash upon
Conversion (Including Partial Cash Settlement)” (“FSP 14-1”).  FSP
14-1 specifies that issuers of convertible debt instruments are to separately
account for the liability and equity components in a manner that will reflect
the entity’s nonconvertible debt borrowing rate when interest cost is recognized
in periods subsequent to adoption.  In addition, transaction costs
incurred with third parties that directly relate to the issuance of convertible
debt instruments will be allocated to the liability and equity components in
proportion to the allocation of proceeds and accounted for as debt issuance
costs and equity issuance costs, respectively.  Upon adoption of FSP
14-1 on December 1, 2009, we will recognize the cumulative effect of the change
in accounting principle for periods prior to December 1, 2009 that represents
the cumulative amortization of the additional amounts to be recognized by FSP
14-1, reclassify from long-term debt to a component of equity the calculated
equity component of our 2.0% Convertible Notes and 1.625% Convertible Notes,
reclassify the deferred debt issuance costs allocated to equity issuance to a
component of equity and restate the consolidated financial statements for any
prior fiscal year presented to reflect the impact of FSP 14-1.  We are
currently assessing the impact of adopting FSP 14-1 on our consolidated
financial statements.  The provisions of FSP 14-1 are to be applied
retrospectively to all periods presented upon adoption and are effective for
fiscal years beginning after December 15, 2008, or our fiscal 2010, and interim
periods within those fiscal years.





4.
            STOCK-BASED
      COMPENSATION




We
currently provide stock-based compensation under five stock incentive plans that
have been approved by our shareholders.  Our 1998 Non-Statutory Stock
Option Plan provides for the issuance of up to 1,400 shares of common stock to
key employees while the 1999 Non-Statutory Stock Option Plan for Non-Employee
Directors allows for the issuance of up to 200 shares of common
stock.  The 2000 Non-Statutory Stock Option Plan provides for the
issuance of up to 1,500 shares of common stock.  The 2003 and 2005
Stock Incentive Plans both provide for the issuance of up to 1,500 shares of
common stock.  Stock options granted under all of these plans
generally vest over four years from the date of grant as specified in the plans
or by the compensation committee of our board of directors and are exercisable
for a period of up to ten years from the date of grant.





We
account for stock-based compensation under the provisions of SFAS No. 123
(revised 2004), “Share-Based Payment” (“SFAS 123R”), which requires the
recognition of the cost of employee services received in exchange for an award
of equity instruments in the financial statements and is measured based on the
grant date fair value of the award.  SFAS 123R also requires the stock
option compensation expense to be recognized over the period during which an
employee is required to provide service in exchange for the award (the vesting
period).





For the
three and six months ended May 31, 2008, we recorded compensation expense
related to stock options that reduced income from operations by $1,241 and
$2,580, provision for income taxes by $442 and $918, net income by $799 and
$1,662, basic net income per share by $.04 and $.09, respectively, and diluted
net income per share by $.04 and $.08, respectively.  For the three
and six months ended May 31, 2007, we recorded compensation expense related to
stock options that reduced income from operations by $1,428 and $2,632,
provision for income taxes by $493 and $908, net income by $935 and $1,724, and
basic and diluted net income per share by $.05 and $.09,
respectively.  The stock option compensation expense was included
partly in cost of sales, advertising and promotion expenses and selling, general
and administrative expenses in the accompanying consolidated statements of
income.  We capitalized $209 and $217 of stock option compensation
cost as a component of the carrying cost of inventory on-hand as of May 31, 2008
and 2007, respectively.


8


The
weighted average grant-date fair value of stock options granted during the three
and six months ended May 31, 2008 was $27.99, and for stock options granted
during the three and six months ended May 31, 2007 was $24.50.  The
fair value of each stock option grant was estimated on the date of grant using a
Flex Lattice Model.  The following assumptions were used to determine
the fair value of stock option grants during the six months ended May 31, 2008
and 2007:





Six
      Months Ended
              May 31,2008
            
            
            2007Expected
      life
            
            6.0
      years
            
            
            6.0
      yearsVolatility
            
            
            36%
            
            
            
            34%Risk-free
      interest rate
            
            
            3.84%
            
            
            
            4.47%Dividend
      yield
            
            
            0%
            
            
            
            0%Forfeitures
            
            
            0.3%
            
            
            
            1.2%





The
expected life of stock options represents the period of time that the stock
options granted are expected to be outstanding based on historical exercise
trends.  The expected volatility is based on consideration of the
historical and implied price volatility of our common stock.  The
risk-free interest rate represents the U.S. Treasury bill rate for the expected
life of the related stock options.  The dividend yield represents our
anticipated cash dividend over the expected life of the stock
options.  In connection with using the Flex Lattice Model to determine
the fair value of stock option grants, the forfeiture rate was determined by
analyzing post vesting stock option activity for three separate groups
(non-employee directors, officers and other employees).





A summary
of stock option activity for the six months ended May 31, 2008 is presented
below:





Shares
              Under
              Option
            
            
            Weighted
              Average
              Exercise
              Price
            
            Weighted
              Average
              Remaining
              Contractual
              Life
            
            Aggregate
              Intrinsic
              ValueOutstanding
      at December 1, 2007
            
            
            1,458
            
            
            $
            40.43Granted
            
            
            362
            
            
            
            70.92Exercised
            
            
            (90
            )
            
            
            23.98Cancelled
            
            
            (2
            )
            
            
            67.62Outstanding
      at May 31, 2008
            
            
            1,728
            
            
            $
            47.65
            
            5.0
      years
            
            $
            28,389Exercisable
      at May 31, 2008
            
            
            856
            
            
            $
            35.86
            
            4.5
      years
            
            $
            22,562





The total
fair value of stock options that vested during the three months ended May 31,
2008 and 2007 was $1,249 and $1,450, respectively, and during the six
months ended May 31, 2008 and 2007 was $2,605 and $2,665,
respectively.  The total intrinsic value of stock options exercised
during the three months ended May 31, 2008 and 2007 was $163 and $6,434,
respectively, and during the six months ended May 31, 2008 and 2007 was $4,703
and $17,906, respectively.





As of May
31, 2008, we had $19,221 of unrecognized compensation cost related to stock
options that will be recorded over a weighted average period of approximately
3.1 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 May 31, 2008 and 2007 was $64 and $175,
respectively, and for the six months ended May 31, 2008 and 2007 was $157 and
$358, respectively.


9


Restricted
share activity for the six months ended May 31, 2008 under the plans is
summarized as follows:





Number
      of
              Shares
            
            
            Weighted
      Average
              Grant
      Date Fair
              ValueNonvested
      at December 1, 2007
            
            
            9
            
            
            $
            33.11Granted
            
            
            —
            
            
            
            —Vested
            
            
            (5
            )
            
            
            30.95Forfeited
            
            
            —
            
            
            
            —Nonvested
      at May 31, 2008
            
            
            4
            
            
            $
            35.37





As of May
31, 2008, we had $171 of unrecognized compensation cost related to restricted
shares that will be recorded over a weighted average period of approximately 0.7
years.





5.
            EARNINGS PER
      SHARE





The
following table presents the computation of per share earnings for the three and
six months ended May 31, 2008 and 2007, respectively:





For
      the Three Months
              Ended May
    31,
            
            
            For
      the Six Months
              Ended May 31,2008
            
            
            2007
            
            
            2008
            
            
            2007NET
      INCOME
            
            $
            20,732
            
            
            $
            14,908
            
            
            $
            35,605
            
            
            $
            28,558NUMBER
      OF COMMON SHARES:Weighted
      average outstanding
            
            
            19,118
            
            
            
            19,021
            
            
            
            19,112
            
            
            
            18,841Issued
      upon assumed exercise of outstanding stock options
            
            
            101
            
            
            
            328
            
            
            
            101
            
            
            
            385Issued
      upon assumed exercise of convertible notes
            
            
            296
            
            
            
            —
            
            
            
            376
            
            
            
            —Effect
      of issuance of restricted common shares
            
            
            3
            
            
            
            10
            
            
            
            3
            
            
            
            11Weighted
      average and potential dilutive outstanding (1)
            
            
            19,518
            
            
            
            19,359
            
            
            
            19,592
            
            
            
            19,237NET
      INCOME PER COMMON SHARE:Basic
            
            $
            1.08
            
            
            $
            .78
            
            
            $
            1.86
            
            
            $
            1.52Diluted
            
            $
            1.06
            
            
            $
            .77
            
            
            $
            1.82
            
            
            $
            1.48





(1)  Because their effects
are anti-dilutive, excludes shares issuable under stock option plans whose grant
price was greater than the average market price of common shares outstanding as
follows: 528 and 168 shares for the three months ended May 31, 2008 and 2007,
respectively, and 465 and 85 shares for the six months ended May 31, 2008 and
2007, respectively.


10





6.
            LONG-TERM
      DEBT





Long-term
debt consisted of the following as of May 31, 2008 and November 30,
2007:





2008
            
            
            2007Revolving
      Credit Facility due 2010 at a variable rate of 4.16% and
      6.19% as of May 31, 2008 and November
      30, 2007, respectively
            
            $
            45,188
            
            
            $
            30,0002.0%
      Convertible Senior Notes due 2013
            
            
            125,000
            
            
            
            125,0001.625%
      Convertible Senior Notes due 2014
            
            
            100,000
            
            
            
            100,000Term
      Loan due 2013 at a variable rate of 4.46% and 6.97% as of May 31,
      2008 and November 30, 2007, respectively
            
            
            109,000
            
            
            
            145,5007.0%
      Senior Subordinated Notes due 2014
            
            
            107,500
            
            
            
            107,500Total
      long-term debt
            
            
            486,688
            
            
            
            508,000Less:  current
      maturities
            
            
            3,000
            
            
            
            3,000Total
      long-term debt, net of current maturities
            
            $
            483,688
            
            
            $
            505,000





In
February 2004, we entered into a Senior Secured Revolving Credit Facility with a
maturity date of February 2009 (the “Revolving Credit Facility”) with Bank of
America, N.A. that provided an initial borrowing capacity of $25,000 and an
additional $25,000, subject to successful syndication.  In March 2004,
we entered into a commitment agreement with a syndicate of commercial banks led
by Bank of America, N.A., as agent, that enabled us to borrow up to a total of
$50,000 under the Revolving Credit Facility and an additional $50,000, subject
to successful syndication.  In November 2005, we entered into an
amendment to our Revolving Credit Facility (the “Amended Revolving Credit
Facility”) that, among other things, increased our borrowing capacity under the
facility from $50,000 to $100,000, increased our flexibility to repurchase
shares of our stock, improved our borrowing rate under the facility and extended
the maturity date to November 2010.  Upon successful syndication, we
will be able to increase the borrowing capacity under the Amended Revolving
Credit Facility by $50,000 to an aggregate of $150,000.  In November
2006, we entered into an amendment to our Amended Revolving Credit Facility
that, among other things, permitted the sale of the 2.0% Convertible Senior
Notes due 2013 (the “2.0% Convertible Notes”).  In January 2007, we
completed an amendment to the Amended Revolving Credit Facility providing for up
to a $100,000 revolving credit facility and a $300,000 term loan (the “Credit
Facility”).  The proceeds from the term loan under the Credit Facility
were used to finance in part the acquisition of the five consumer and OTC brands
from Johnson & Johnson.  The Credit Facility includes “accordion”
features that permit us under certain circumstances to increase our borrowings
under the revolving credit facility by $50,000 and to borrow an additional
$50,000 as a term loan, subject to successful syndication.  In April
2007, we entered into an amendment to our Credit Facility that, among other
things, permitted the sale of the 1.625% Convertible Senior Notes due
2014  (the “1.625% Convertible Notes”) and reduced the applicable
interest rates on the revolving credit facility portion of our Credit
Facility.





Borrowings
under the revolving credit facility portion of our Credit Facility bear interest
at LIBOR plus applicable percentages of 0.875% to 1.500% or the higher of the
federal funds rate plus 0.50% or the prime rate (the “Base
Rate”).  The applicable percentages are calculated based on our
leverage ratio.  As of May 31, 2008 and November 30, 2007, we had
$45,188 and $30,000, respectively, of borrowings outstanding under the revolving
credit facility portion of our Credit Facility.  As of July 1, 2008,
we had $52,188 of borrowings outstanding under the revolving credit facility
portion of our Credit Facility and our borrowing capacity was
$47,812.





The term
loan under the Credit Facility bears interest at either LIBOR plus 1.75% or the
Base Rate plus 0.75%.  The term loan borrowings are to be repaid in
increments of $750 each calendar quarter, with the first principal payment paid
June 2007.  The principal outstanding after scheduled repayment and
any unscheduled prepayments matures and is payable January 2013.  In
April 2007, we utilized the net proceeds from the 1.625% Convertible Notes and
borrowings under the revolving credit facility portion of our Credit Facility to
repay $128,000 of the term loan under the Credit Facility.   In
July 2007, we utilized borrowings under the revolving credit facility portion of
our Credit Facility to repay an additional $25,000 of the term loan under the
Credit Facility.  In connection with the term loan repayments during
April 2007 and July 2007, we retired a proportional share of the term loan debt
issuance costs and recorded the resulting loss on early extinguishment of debt
of $2,633 in fiscal 2007.  In January 2008, we utilized borrowings
under the revolving credit facility portion of our Credit Facility to repay an
additional $35,000 of the term loan under the Credit Facility.  In
connection with the term loan repayment in January, we retired a proportional
share of the term loan debt issuance costs and recorded the resulting loss on
early extinguishment of debt of $526 in the first quarter of fiscal
2008.





Borrowings
under the Credit Facility are secured by substantially all of our assets, except
real property, and shares of capital stock of our domestic subsidiaries held by
us and by the assets of the guarantors (our domestic
subsidiaries).  The Credit


11


Facility
contains covenants, representations, warranties and other agreements by us that
are customary in credit agreements and security instruments relating to
financings of this type.  The significant financial covenants include
fixed charge coverage ratio, leverage ratio, senior secured leverage ratio and
brand value calculations.





In
February 2004, we issued and sold $125,000 of 7.0% Senior Subordinated Notes due
2014 (the “7.0% Subordinated Notes”).  During fiscal 2005, we
repurchased $17,500 of our 7.0% Subordinated Notes in the open market at an
average premium of 1.6% over the principal amount of the notes.  The
outstanding balance of the remaining 7.0% Subordinated Notes was reduced to
$107,500.





Interest
payments on the 7.0% Subordinated Notes are due semi-annually in arrears in
March and September.  Our domestic subsidiaries are guarantors of the
7.0% Subordinated Notes.  The guarantees of the 7.0% Subordinated
Notes are unsecured senior subordinated obligations of the
guarantors.  At any time after March 1, 2009, we may redeem any of the
7.0% Subordinated Notes upon not less than 30 nor more than 60 days’ notice at
redemption prices (expressed in percentages of principal amount), plus accrued
and unpaid interest, if any, and liquidation damages, if any, to the applicable
redemption rate, if redeemed during the twelve-month periods beginning March
2009 at 103.500%, March 2010 at 102.333%, March 2011 at 101.167% and March 2012
and thereafter at 100.000%.





The
indenture governing the 7.0% Subordinated Notes, among other things, limits our
ability and the ability of our restricted subsidiaries to: (i) borrow money or
sell preferred stock, (ii) create liens, (iii) pay dividends on or redeem or
repurchase stock, (iv) make certain types of investments, (v) sell stock in our
restricted subsidiaries, (vi) restrict dividends or other payments from
restricted subsidiaries, (vii) enter into transactions with affiliates, (viii)
issue guarantees of debt and (ix) sell assets or merge with other
companies.  In addition, if we experience specific kinds of changes in
control, we must offer to purchase the 7.0% Subordinated Notes at 101.0% of
their principal amount plus accrued and unpaid interest.





In July
2006, we successfully completed a consent solicitation from the holders of the
7.0% Subordinated Notes to an amendment to the indenture to increase our
capacity to make restricted payments by an additional $85,000, including
payments for the repurchase of our common stock, and adjust the fixed charge
coverage ratio (as defined in the indenture).





In
November 2006, we completed a private offering of $125,000 of the 2.0%
Convertible Notes to qualified institutional purchasers pursuant to Section 4(2)
of the Securities Act of 1933.  The 2.0% Convertible Notes bear
interest at an annual rate of 2.0%, payable semi-annually in May and November of
each year.  The 2.0% Convertible Notes are convertible into our common
stock at an initial conversion price of $58.92 per share, upon the occurrence of
certain events, including the closing price of our common stock exceeding 130%
of the initial conversion price per share, or $76.59 per share, for 20 of the
last 30 consecutive trading days of the preceding fiscal quarter (the
“prescribed measurement period”).  The evaluation of the
classification of the 2.0% Convertible Notes occurs each fiscal
quarter.





Upon
conversion, a holder will receive, in lieu of common stock, an amount of cash
equal to the lesser of (i) the principal amount of the 2.0% Convertible
Notes, or (ii) the conversion value, determined in the manner set forth in
the indenture governing the 2.0% Convertible Notes, of a number of shares equal
to the conversion rate. If the conversion value exceeds the principal amount of
the 2.0% Convertible Notes on the conversion date, we will also deliver, at our
election, cash or common stock or a combination of cash and common stock with
respect to the conversion value upon conversion. If conversion occurs in
connection with a change of control, we may be required to deliver additional
shares of our common stock by increasing the conversion rate with respect to
such notes. The maximum aggregate number of shares that we would be obligated to
issue upon conversion of the 2.0% Convertible Notes is 2,673.





Concurrently
with the sale of the 2.0% Convertible Notes, we purchased a note hedge from an
affiliate of Merrill Lynch (the “Counterparty”), which is designed to mitigate
potential dilution from the conversion of the 2.0% Convertible Notes. Under the
note hedge, the Counterparty is required to deliver to us the number of shares
of our common stock that we are obligated to deliver to the holders of the 2.0%
Convertible Notes with respect to the conversion, calculated exclusive of shares
deliverable by us by reason of any additional premium relating to the 2.0%
Convertible Notes or by reason of any election by us to unilaterally increase
the conversion rate pursuant to the indenture governing the 2.0% Convertible
Notes. The note hedge expires at the close of trading on November 15, 2013,
which is the maturity date of the 2.0% Convertible Notes, although the
Counterparty will have ongoing obligations with respect to 2.0% Convertible
Notes properly converted on or prior to that date of which the Counterparty has
been timely notified.





In
addition, we issued warrants to the Counterparty that could require us to issue
up to approximately 2,122 shares of our common stock on November 15, 2013
upon notice of exercise by the Counterparty. The exercise price is $74.82 per
share, which represented a 60.0% premium over the closing price of our shares of
common stock on November 16, 2006. If the Counterparty exercises the
warrant, we will have the option to settle in cash or shares the excess of the
price of our shares on that date over the initially established exercise
price.


12


The note
hedge and warrant are separate and legally distinct instruments that bind us and
the Counterparty and have no binding effect on the holders of the 2.0%
Convertible Notes.





In
November 2006, we entered into an interest rate swap (“swap”) agreement
effective January 2007.  The swap has decreasing notional principal
amounts beginning October 2007 and a swap rate of 4.98% over the life of the
agreement.  During the second quarter of fiscal 2008, we retired a
portion of the swap for approximately $270, which was recorded as additional
interest expense in the accompanying consolidated statement of
income.  As of May 31, 2008, we had $138,938 of LIBOR based borrowings
hedged under the provisions of the swap.  During the six months ended
May 31, 2008, the decrease in fair value of the swap of $532, net of tax, was
recorded to other comprehensive income.  The current portion of the
fair value of the swap of $2,351 is included in accrued liabilities, and
the long-term portion of $1,217 is included in noncurrent
liabilities.  As of May 31, 2008, the swap was deemed to be an
effective cash flow hedge.  The fair value of the swap agreement is
valued by a third party.  The swap agreement terminates in January
2010.





In April
2007, we entered into an interest rate cap agreement.  The cap has
decreasing notional principal amounts beginning May 2007 and a cap rate of 5.0%
over the life of the agreement.  We paid a $114 premium to enter into
the cap agreement.  As of May 31, 2008, the value of the cap, as
valued by a third party, is insignificant.  The cap agreement
terminates in September 2008.





In April
2007, we completed a private offering of $100,000 of the 1.625% Convertible
Notes to qualified institutional investors pursuant to Rule 144A under the
Securities Act of 1933.  The 1.625% Convertible Notes bear interest at
an annual rate of 1.625%, payable semi-annually in May and November of each
year.  The 1.625% Convertible Notes are convertible into our common
stock at an initial conversion price of $73.20 per share, upon the occurrence of
certain events, including the closing price of our common stock exceeding 130%
of the initial conversion price per share, or $95.16 per share, for the
prescribed measurement period.  The evaluation of the classification
of the 1.625% Convertible Notes occurs each fiscal quarter.





Upon
conversion, a holder will receive, in lieu of common stock, an amount of cash
equal to the lesser of (i) the principal amount of the 1.625% Convertible
Notes, or (ii) the conversion value, determined in the manner set forth in
the indenture governing the 1.625%  Convertible Notes, of a number of
shares equal to the conversion rate. If the conversion value exceeds the
principal amount of the 1.625% Convertible Note on the conversion date, we will
also deliver, at our election, cash or common stock or a combination of cash and
common stock with respect to the conversion value upon conversion. If conversion
occurs in connection with a change of control, we may be required to deliver
additional shares of our common stock by increasing the conversion rate with
respect to such notes. The maximum aggregate number of shares that we would be
obligated to issue upon conversion of the 1.625% Convertible Notes is
1,694.





Concurrently
with the sale of the 1.625% Convertible Notes, we purchased a note hedge from
the Counterparty, which is designed to mitigate potential dilution from the
conversion of the 1.625% Convertible Notes. Under the note hedge, the
Counterparty is required to deliver to us the number of shares of our common
stock that we are obligated to deliver to the holders of the 1.625% Convertible
Notes with respect to the conversion, calculated exclusive of shares deliverable
by us by reason of any additional premium relating to the 1.625% Convertible
Notes or by reason of any election by us to unilaterally increase the conversion
rate pursuant to the indenture governing the 1.625% Convertible Notes. The note
hedge expires at the close of trading on May 1, 2014, which is the maturity date
of the 1.625% Convertible Notes, although the Counterparty will have ongoing
obligations with respect to 1.625% Convertible Notes properly converted on or
prior to that date of which the Counterparty has been timely
notified.





In
addition, we issued warrants to the Counterparty that could require us to issue
up to approximately 1,366 shares of our common stock on May 1, 2014 upon notice
of exercise by the Counterparty. The exercise price is $94.45 per share, which
represented a 60% premium over the closing price of our shares of common stock
on April 4, 2007. If the Counterparty exercises the warrant, we will have the
option to settle in cash or shares the excess of the price of our shares on that
date over the initially established exercise price.





Pursuant
to EITF 90-19,“Convertible Bonds with Issuer Option to Settle for Cash upon Conversion”
(“EITF 90-19”), EITF 00-19, “Accounting for Derivative Financial Instruments
Indexed to, and Potentially Settled in, a Company’s Own Stock”  (“EITF
00-19”), and EITF 01-6,  “The Meaning of Indexed to a Company’s Own
Stock”  (“EITF 01-6”), the 2.0% Convertible Notes and the 1.625%
Convertible Notes are accounted for as convertible debt in the accompanying
consolidated balance sheet and the embedded conversion option in the 2.0%
Convertible Notes and the 1.625% Convertible Notes has not been accounted for as
a separate derivative. Additionally, pursuant to EITF 00-19 and EITF 01-6, the
note hedges and warrants are accounted for as equity transactions, and
therefore, the payments associated with the issuance of the note hedges and the
proceeds received from the issuance of the warrants were recorded as a charge
and an increase, respectively, in common shares in shareholders’ equity as
separate equity transactions.


13


For
income tax reporting purposes, we have elected to integrate the 2.0% Convertible
Notes and the 1.625% Convertible Notes and the respective note hedge
transaction. Integration of the respective note hedge with the 2.0% Convertible
Notes and the 1.625% Convertible Notes creates an in-substance original issue
debt discount for income tax reporting purposes and therefore, the cost of the
note hedge transactions will be accounted for as interest expense over the term
of the 2.0% Convertible Notes and the 1.625% Convertible Notes, respectively,
for income tax reporting purposes. The income tax benefit related to each
respective convertible note issuance was recognized as a deferred tax
asset.





The
scheduled future maturities of long-term debt to be funded for the next five
successive fiscal years and those thereafter as of May 31, 2008 are as
follows:





2008
            
            $
            1,5002009
            
            
            3,0002010
            
            
            48,1882011
            
            
            3,0002012
            
            
            3,000Thereafter
            
            
            428,000$
            486,688





7.
            ACQUISITION OF
      BRANDS





In
January 2007, we acquired the U.S. rights to five leading consumer and OTC
brands from Johnson & Johnson (“J&J Acquisition”).  The
acquired brands were: ACT, an anti-cavity
mouthwash/mouth rinse; Unisom, an OTC sleep-aid;
Cortizone-10, a
hydrocortisone anti-itch product; Kaopectate, an anti-diarrhea
product; and Balmex, a
diaper rash product.  The J&J Acquisition was funded with the
proceeds from a $300,000 term loan provided under our Credit Facility,
borrowings under the revolving credit facility portion of our Credit Facility
and through the use of a portion of the proceeds derived from the issuance of
the 2.0% Convertible Notes.  The purchase price of the J&J
Acquisition was $410,000 plus $1,573 of costs directly related to the
acquisition.  The purchase price included $5,916 of inventory, $1,781
of assumed liabilities, $463 of equipment, $403,061 of trademarks, which were
assigned an indefinite life, and $3,914 of distribution rights, which was
assigned a useful life of five years.  The value assigned each of the
acquired brands was as follows:  ACT, $163,167; Unisom, $95,181; Cortizone-10, $124,318; Kaopectate, $11,653; and
Balmex,
$8,742.  Johnson & Johnson will continue to manufacture and supply
certain of the products to us for a period of up to 18 months from the close of
the acquisition, or such earlier date as we are able to move production to our
facilities.  The price we pay Johnson & Johnson for these products
is equivalent to the manufacturing cost, which includes all costs associated
with the manufacturing and delivery of the product.  Certain of the
products are manufactured and supplied under assumed agreements with third party
manufacturers.  During fiscal 2007 and 2008, the manufacturing of
certain products was transferred to our facilities.  For a period of
up to six months from the close of the acquisition, Johnson & Johnson was to
provide transition services consisting of consumer affairs, distribution and
collection services (including related financial, accounting and reporting
services).  We terminated the distribution and collections services
effective April 2, 2007 and the consumer affairs services effective June 21,
2007.  The costs charged for these transition services approximated
the actual costs incurred by Johnson & Johnson.  During the three
and six months ended May 31, 2007, we incurred $886 and $2,057, respectively, of
expenses related to these transition services, which are recorded as acquisition
expenses in the accompanying consolidated statements of income.




The
following unaudited consolidated pro forma information assumes the J&J
Acquisition had occurred at the beginning of the period presented:





PRO FORMA
CONSOLIDATED RESULTS OF OPERATIONS (Unaudited)





Six
      Months Ended
              May 31, 2007Total
      revenue
            
            $
            222,976Net
      income
            
            
            29,341Earnings
      per share – basic:
            
            
            1.56Earnings
      per share – diluted:
            
            
            1.53





The pro
forma consolidated results of operations include adjustments to give effect to
interest expense on debt to finance the J&J Acquisition, increase
advertising expense to raise brand awareness, incremental selling, general and
administrative expenses, amortization of certain intangible assets and decrease
in interest income on cash used in the J&J Acquisition, together with
related income tax effects. The pro forma information is for comparative
purposes only and does not purport to be indicative of the results that would
have occurred had the J&J Acquisition and borrowings occurred at the
beginning of the periods presented, or indicative of the results that may occur
in the future.


14


On May
25, 2007, we acquired the worldwide trademark and rights to sell and market
ACT in Western Europe
from Johnson & Johnson (“ACTAcquisition”) for $4,100
in cash plus certain assumed liabilities.  The ACT Acquisition was funded
with existing cash.








8.
            FAIR VALUE
      MEASUREMENTS





We
currently measure and record in the accompanying consolidated financial
statements securities considered available-for-sale, an interest rate cap and an
interest rate swap at fair value.  SFAS 157 establishes a fair value
hierarchy for those instruments measured at fair value that distinguishes
between assumptions based on market data (observable inputs) and our own
assumptions (unobservable inputs).  The hierarchy consists of three
levels:





Level 1 - Quoted market prices in
active markets for identical assets or liabilities;


Level 2 - Inputs other than Level 1
inputs that are either directly or indirectly observable; and


Level 3 -
Unobservable inputs developed using estimates and assumptions developed by us,
which reflect those that a market participant would use.





Determining
which category an asset or liability falls within the hierarchy requires
significant judgment.  We evaluate our hierarchy disclosures each
quarter.





The
following table summarizes the financial instruments measured at fair value in
the accompanying consolidated balance sheet as of May 31, 2008:





Fair
      Value Measurements as of
              May 31, 2008Level 1
            
            
            Level 2
            
            
            Level 3
            
            
            TotalAssetsAvailable-for-sale
      securities (1)
            
            $
            512
            
            
            $
            —
            
            
            $
            —
            
            
            $
            512Interest
      rate cap (2)
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —LiabilitiesInterest
      rate swap (3)
            
            $
            —
            
            
            $
            3,568
            
            
            $
            —
            
            
            $
            3,568




(1)
            Our
      available-for-sale securities are included in the accompanying
      consolidated balance sheet as an other noncurrent asset using the “market
      approach” valuation technique. This method uses prices and other relevant
      information observable in market transactions involving identical or
      comparable assets or liabilities.


(2)
            The
      interest rate cap is valued at an insignificant amount in the accompanying
      consolidated balance sheet as of May 31, 2008 and matures September
      2008.  We value this financial instrument using the “Income
      Approach” valuation technique.  This method uses valuation
      techniques to convert future amounts to a single present value
      amount.  The measurement is based on the value indicated by
      current market expectations about those future
  amounts.


(3)
            The
      total fair value of the interest rate swap is partially classified as a
      current and a noncurrent liability as of May 31, 2008 and matures January
      2010.  This financial instrument is valued using the “Income
      Approach” valuation technique as described
  above.





SFAS 157 requires separate disclosure
of assets and liabilities measured at fair value on a recurring basis, as
documented above, from those measured at fair value on a nonrecurring
basis.  As of May 31, 2008, no assets or liabilities are measured at
fair value on a nonrecurring basis.





9.
            ADVERTISING
      EXPENSES





We incur
significant expenditures on television, radio and print advertising to support
our nationally branded OTC health care products and
toiletries.  Customers purchase products from us with the
understanding that the brands will be supported by our extensive media
advertising.  This advertising supports the retailers’ sales effort
and maintains the important brand franchise with the consuming
public.  Accordingly, we consider our advertising program to be
clearly implicit in our sales arrangements with our
customers.  Therefore, we believe it is appropriate to allocate a
percentage of the necessary supporting advertising expenses to each dollar of
sales by charging a percentage of sales on an interim basis based upon
anticipated annual sales and advertising expenditures (in accordance with APB
Opinion No. 28, “Interim Financial Reporting”) and adjusting that accrual to the
actual expenses incurred at the end of the year.


15




10.
            SHIPPING AND
      HANDLING





Shipping
and handling costs of $3,986 and $3,163 are included in selling, general and
administrative expenses for the three months ended May 31, 2008 and 2007,
respectively, and $7,983 and $5,565 for the six months ended May 31, 2008 and
2007, respectively.





11.
            PATENT, TRADEMARKS AND
      OTHER PURCHASED PRODUCT
RIGHTS





The
carrying value of trademarks, which are not subject to amortization under the
provisions of SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”),
was $613,328 as of May 31, 2008 and November 30, 2007.  The gross
carrying amount of intangible assets subject to amortization at May 31, 2008 and
November 30, 2007, which consist primarily of non-compete agreements and
distribution rights, was $6,503 and $6,053, respectively.  The related
accumulated amortization of intangible assets at May 31, 2008 and November 30,
2007 was $3,231 and $2,797, respectively.  Amortization of our
intangible assets subject to amortization under the provisions of SFAS 142 for
the three months ended May 31, 2008 and 2007 was $228 and $222, respectively,
and for the six months ended May 31, 2008 and 2007 was $434 and $412,
respectively.   Estimated annual amortization expense for these
assets for the years ended November 30, 2009, 2010, 2011, 2012 and 2013 is $893,
$873, $873, $155 and $23, respectively.




12.
            INVENTORIES





Inventories
consisted of the following as of May 31, 2008 and November 30,
2007:





2008
            
            
            2007Raw
      materials and work in process
            
            $
            17,571
            
            
            $
            17,892Finished
      goods
            
            
            24,813
            
            
            
            25,373Total
      inventories
            
            $
            42,384
            
            
            $
            43,265





13.
            ACCRUED
      LIABILITIES





Accrued
liabilities consisted of the following as of May 31, 2008 and November 30,
2007:





2008
            
            
            2007Interest
            
            $
            3,034
            
            
            $
            3,510Salaries,
      wages and commissions
            
            
            2,991
            
            
            
            6,209Product
      advertising and promotion
            
            
            2,767
            
            
            
            3,051Litigation
      settlement and legal fees
            
            
            691
            
            
            
            2,084Income
      taxes payable
            
            
            4,051
            
            
            
            3,643Product
      recall expenses
            
            
            2,123
            
            
            
            —Interest
      rate swap
            
            
            2,351
            
            
            
            1,274Other
            
            
            1,256
            
            
            
            1,766Total
      accrued liabilities
            
            $
            19,264
            
            
            $
            21,537





14.
            COMPREHENSIVE
      INCOME





Comprehensive
income consisted of the following components for the three and six months ended
May 31, 2008 and 2007, respectively:





For
      the Three Months Ended
              May 31,
            
            
            For
      the Six Months Ended
              May 31,2008
            
            
            2007
            
            
            2008
            
            
            2007Net
      income
            
            $
            20,732
            
            
            $
            14,908
            
            
            $
            35,605
            
            
            $
            28,558Other
      – interest rate hedge adjustment
            
            
            1,361
            
            
            
            748
            
            
            
            (212
            )
            
            
            1,082Other
      – foreign currency translation adjustment
            
            
            (26
            )
            
            
            282
            
            
            
            160
            
            
            
            211Total
            
            $
            22,067
            
            
            $
            15,938
            
            
            $
            35,553
            
            
            $
            29,851








16


15.
            STOCK
      REPURCHASE





On
April 30, 2008, our Board of Directors increased the repurchase authorization to
a total of $100,000 of our common stock under the terms of our existing stock
repurchase program.  In the three and six months ended May 31, 2008,
we repurchased 183 and 187 shares of our common stock, respectively, for $12,314
and $12,554, respectively, at an average price per share of $67.04 and $67.00,
respectively.  Subsequent to May 31, 2008, we repurchased 231 shares
of our common stock for $13,773 at an average price per share of
$59.65.  The repurchased shares were retired and returned to
unissued.  As of July 1, 2008, the current amount available under the
authorization from the Board of Directors was $73,913.






16.
              POST RETIREMENT
      BENEFIT PLANS


DEFINED BENEFIT PENSION
PLAN





We have a
noncontributory defined benefit pension plan (the “Pension Plan”), which covers
substantially all employees as of December 31, 2000.  The Pension Plan
provides benefits based upon years of service and employee compensation to
employees who had completed one year of service prior to December 31,
2000.  On December 31, 2000, benefits and participation in the Pension
Plan were frozen.  Contributions to the Pension Plan are calculated by
an independent actuary and have been sufficient to provide benefits to
participants and meet the funding requirements of the Employee Retirement Income
Security Act (“ERISA”).  Plan assets as of May 31, 2008 and November
30, 2007 were invested primarily in United States government and agency
securities and corporate debt and equity securities.





Net
periodic pension cost for the three and six months ended May 31, 2008 and 2007
comprised the following components:





For
      the Three Months
              Ended May 31,
            
            
            For
      the Six Months
              Ended May 31,2008
            
            
            2007
            
            
            2008
            
            
            2007Service
      cost
            
            $
            —
            
            
            $
            —
            
            
            $
            —
            
            
            $
            —Interest
      cost
            
            
            152
            
            
            
            153
            
            
            
            304
            
            
            
            306Expected
      return on plan assets
            
            
            (234
            )
            
            
            (220
            )
            
            
            (468
            )
            
            
            (440
            )Recognized
      net actuarial (gain)/loss
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —Net
      periodic pension cost (benefit)
            
            $
            (82
            )
            
            $
            (67
            )
            
            $
            (164
            )
            
            $
            (134
            )





No
employer contributions were made for the six months ended May 31, 2008 and 2007,
and no employer contributions are expected to be made for the Pension Plan in
fiscal 2008.





DEFINED
CONTRIBUTION PLAN





We
sponsor a defined contribution plan that covers substantially all
employees.  Eligible employees are allowed to contribute up to 15% of
their eligible annual compensation.  We make matching contributions of
25% on the first 6% of contributed compensation.  The cost of the
matching contribution totaled $62 and $63 for the three months ended May 31,
2008 and 2007, respectively, and $150 and $137 for the six months ended May 31,
2008 and 2007, respectively.  In addition to matching contributions,
safe harbor contributions equaling 3% of eligible annual compensation are made
on behalf of eligible participants.  Safe harbor contributions totaled
$169 and $160 for the three months ended May 31, 2008 and 2007, respectively and
$457 and $403 for the six months ended May 31, 2008 and 2007,
respectively.  Total matching and safe harbor contributions for fiscal
2008 are expected to approximate amounts funded in fiscal 2007.  Total
matching and safe harbor contributions in fiscal 2007 were $1,061.





POSTRETIREMENT
HEALTH CARE BENEFITS PLAN





We
maintain a postretirement health care benefits plan (the “Retiree Health Plan”)
for certain eligible employees over the age of 65.  On May 31, 2006,
Retiree Health Plan eligibility was restricted to current retirees and those
active employees that were retirement eligible as of that date (age 55 and 10
years of service or age 65). Contributions to the Retiree Health Plan are
limited to approximately $2 per participant per year and are paid monthly on a
fully insured basis.  Participants are required to pay any insurance
premium amount in excess of the $2 employer
contribution.   Employer contributions expected for fiscal 2008
are approximately $78.


17





Net
periodic postretirement health care benefits cost for the three and six months
ended May 31, 2008 and 2007, included the following
components:





For
      the Three Months
              Ended May 31,
            
            
            For
      the Six Months
              Ended May 31,2008
            
            
            2007
            
            
            2008
            
            
            2007Service
      cost
            
            $
            5
            
            
            $
            14
            
            
            $
            10
            
            
            $
            28Interest
      cost
            
            
            14
            
            
            
            18
            
            
            
            28
            
            
            
            36Amortization
      of prior service cost
            
            
            —
            
            
            
            4
            
            
            
            —
            
            
            
            8Recognized
      net actuarial(gain)/loss
            
            
            (24
            )
            
            
            (4
            )
            
            
            (48
            )
            
            
            (8
            )Net
      periodic postretirement benefits cost
            
            $
            (5
            )
            
            $
            32
            
            
            $
            (10
            )
            
            $
            64








17.
                INCOME
      TAXES




We
account for income taxes using the asset and liability approach as prescribed by
SFAS 109, FIN 48 and other applicable FSP’s and FASB
Interpretations.  This approach requires recognition of deferred tax
assets and liabilities for the expected future tax consequences of events that
have been included in our consolidated financial statements or tax
returns.  Using the enacted tax rates in effect for the year in which
the differences are expected to reverse, deferred tax assets and liabilities are
determined based on the differences between the financial reporting and the tax
basis of an asset or liability.  We record income tax expense in our
consolidated financial statements based on an estimated annual effective income
tax rate.  Our estimated tax rate for the six months ended May 31,
2008 and 2007 was 35.6% and 34.5%, respectively.





Undistributed
earnings of Chattem Canada, our Canadian subsidiary, amounted to approximately
$728 and $581 for the three and six months ended May 31, 2008,
respectively.  These earnings are considered to be reinvested
indefinitely and, accordingly, no provision for U.S. federal and state income
taxes has been provided thereon.  Upon distribution of accumulated
earnings in the form of dividends or otherwise, we would be subject to U.S.
income taxes (subject to an adjustment for foreign tax credits).





We
adopted FIN 48 on December 1, 2007. The difference between the tax benefit
recognized in the financial statements for a position in accordance with FIN 48
and the tax benefit claimed in the tax return is referred to as an unrecognized
tax benefit.  In connection with the adoption of FIN 48, we recognized an
increase in the liability for unrecognized tax benefits of $1,595, which is
included in the accompanying consolidated financial statements as a reduction to
retained earnings of $711 and an increase to deferred tax assets of $884. 
We have a total unrecognized tax benefit of $2,180 as of December 1, 2007, which
includes an estimate of related interest and penalties of $312.  The total
amount of unrecognized tax benefits that, if recognized, would affect the
effective tax rate is $1,205.  We recognize interest and penalties related
to income tax matters as a component of the provision for income
taxes.





The total
unrecognized tax benefit as of May 31, 2008 is $5,380. It is reasonably possible
that the amount of unrecognized tax benefit could increase by approximately
$3,130, to approximately $8,510, during the next twelve months if certain
elements of compensation are deducted in our 2007 federal and state tax
returns.





We file
income tax returns in the U.S. federal jurisdiction and various state and
foreign jurisdictions. We are no longer subject to examinations by tax
authorities related to U.S. federal income taxes for fiscal years before 2004,
state income taxes for fiscal years before 2003 or non-U.S. income taxes for
fiscal years before 2002.


18


18.
                  PRODUCT SEGMENT
      INFORMATION


Net sales
within our single healthcare business segment for the three and six months ended
May 31, 2008 and 2007 are as follows:





For
      the Three Months
              Ended May 31,
            
            
            For
      the Six Months
              Ended May 31,2008
            
            
            2007
            
            
            2008
            
            
            2007Medicated
      skin care
            
            $
            34,471
            
            
            $
            31,595
            
            
            $
            72,124
            
            
            $
            59,427Topical
      pain care
            
            
            24,772
            
            
            
            24,927
            
            
            
            50,087
            
            
            
            52,153Oral
      care
            
            
            15,415
            
            
            
            13,731
            
            
            
            31,187
            
            
            
            22,218Internal
      OTC
            
            
            13,274
            
            
            
            12,014
            
            
            
            24,484
            
            
            
            20,463Medicated
      dandruff shampoos
            
            
            8,707
            
            
            
            8,339
            
            
            
            19,286
            
            
            
            18,636Dietary
      supplements
            
            
            5,133
            
            
            
            6,824
            
            
            
            10,507
            
            
            
            14,854Other
      OTC and toiletry products
            
            
            6,919
            
            
            
            8,788
            
            
            
            12,331
            
            
            
            13,090Total
      domestic sales
            
            
            108,691
            
            
            
            106,218
            
            
            
            220,006
            
            
            
            200,841International
      revenues
            
            
            8,025
            
            
            
            6,746
            
            
            
            17,483
            
            
            
            12,954Total
      revenues
            
            $
            116,716
            
            
            $
            112,964
            
            
            $
            237,489
            
            
            $
            213,795




19.
                  COMMITMENTS AND
      CONTINGENCIES




GENERAL
LITIGATION




We were
named as a defendant in a number of lawsuits alleging that the plaintiffs were
injured as a result of ingestion of products containing phenylpropanolamine
(“PPA”), which was an active ingredient in most of our Dexatrim products until
November 2000.  The lawsuits filed in federal court were transferred
to the United States District Court for the Western District of Washington
before United States District Judge Barbara J. Rothstein (In Re Phenylpropanolamine (“PPA”)
Products Liability Litigation, MDL No. 1407).  The remaining
lawsuits were filed in state court in a number of different states.




On April
13, 2004, we entered into a class action settlement agreement with
representatives of the plaintiffs’ settlement class, which provided for a
national class action settlement of all Dexatrim PPA
claims.  On November 12, 2004, Judge Barbara J. Rothstein of the
United States District Court for the Western District of Washington entered a
final order and judgment certifying the class and granting approval of the Dexatrim PPA
settlement.  The Dexatrim PPA settlement
included claims against us involving alleged injuries by Dexatrim products containing
PPA in which the alleged injury occurred after December 21, 1998, the date we
acquired the Dexatrim
brand.  A total of 14 claimants with alleged injuries that occurred
after December 21, 1998 elected to opt-out of the class
settlement.  Subsequently, we have settled twelve of the opt-out
claims. The other two opt-outs have not filed lawsuits against us, and we
believe the applicable statutes of limitation have run against their
claims.Consequently, we are not
currently defending any PPA products liability claims.




In
accordance with the terms of the class action settlement, approximately $70,885
was initially funded into a settlement trust.  All claims in the
settlement have been resolved and expenses of the trust have been
paid.  On June 14, 2006, we filed a motion to dissolve the settlement
trust.  The court granted this motion on July 14,
2006.  Although the court granted our motion to dissolve the
settlement trust, we have continued the trust’s existence.  These
funds are available in the event an additional PPA products liability lawsuit is
filed against us.




We were
also named as a defendant in approximately 206 lawsuits relating to Dexatrim containing PPA which
involved alleged injuries by Dexatrim products containing
PPA manufactured and sold prior to our acquisition of Dexatrim on December 21,
1998.  The DELACO Company (“DELACO”), successor by merger to the
Thompson Medical Company, Inc., which owned the brand prior to December 21,
1998, owed us an indemnity obligation for any liabilities arising from these
lawsuits.  On February 12, 2004, DELACO filed a Chapter 11 bankruptcy
petition in the United States Bankruptcy Court for the Southern District of New
York.  We filed a claim for indemnification in DELACO’s
bankruptcy.  We entered into a settlement agreement with DELACO dated
June 30, 2005 that resolved DELACO’s indemnity obligations to us (“the DELACO
Agreement”).  The DELACO Agreement was approved by the DELACO
bankruptcy court on July 28, 2005.  In accordance with the DELACO
bankruptcy plan, a settlement trust established under the plan paid us $8,750 on
March 17, 2006, which is included in our consolidated statement of income, net
of legal expenses, as litigation settlement for 2006.  The payment to
us by the DELACO settlement trust of $8,750 has conclusively compromised and
settled our indemnity claim filed in the DELACO bankruptcy. The confirmation of
the DELACO bankruptcy plan effectively released us from liability for all PPA
products liability cases with injury dates prior to December 21,
1998.


19
 
 On
December 30, 2003, the United States Food and Drug Administration (“FDA”) issued a
consumer alert on the safety of dietary supplements containing ephedrine
alkaloids and on February 6, 2004 published a final rule with respect to these
products.  The final rule prohibits the sale of dietary supplements
containing ephedrine alkaloids because such supplements present an unreasonable
risk of illness or injury.  The final rule became effective on April
11, 2004.  We discontinued the manufacturing and shipment of Dexatrim containing ephedrine
in September 2002 and have resolved all of the prior lawsuits  filed
against us alleging injuries related to the ingestion of Dexatrim containing
ephedrine.  However, we have received notification of 17 claims from
individuals alleging that they developed pulmonary arterial hypertension as
a result of ingesting Dexatrim containing ephedrine
in 2000 through 2003.  We expect that some or all of these claimants
may file lawsuits against us and we may be subject to additional claims or
lawsuits.  If lawsuits are filed, we plan to vigorously defend these
claims and believe that we have meritorious defenses, however, the outcome of
any such potential litigation cannot be predicted.


We were
named as a defendant in a putative class action lawsuit filed in the United
States District Court for the Southern District of California relating to the
labeling, advertising, promotion and sale of our Garliqueproduct.  We were served with this lawsuit on July 5,
2007.  The lawsuit seeks class certification of a nationwide class of
consumers who purchased this product.  The time period for purchases
that would apply to the class is not clear from the complaint.  The
lawsuit seeks restitution and/or disgorgement of profits, punitive damages,
costs and attorney fees, injunctive relief, and other unspecified
damages.  We plan to vigorously defend this case.





On
December 20, 2007, Avon Products, Inc. filed a patent infringement lawsuit
against us in the U.S. District Court for the Southern District of New York
alleging that our BullfrogMosquito Coast product infringes an Avon patent.  We dispute
this claim and plan to defend this lawsuit vigorously.  As of July 1,
2008, we have not been served with this lawsuit.





On
February 8, 2008, we initiated a voluntary nationwide recall of our Icy HotHeat Therapy
products, including consumer “samples” that were included on a limited
promotional basis in cartons of our 3 oz. Aspercreme product, and are
no longer marketing these products.  The recall is being conducted to
the consumer level.  We recalled these products because we received
some consumer reports of first, second and third degree burns, as well as skin
irritation resulting from consumer use or possible misuse of the
products.  As of July 1, 2008, there were approximately 140 consumers
with pending claims against us and two products liability lawsuits have been
filed against us alleging burns and skin irritation from the use of the Icy Hot Heat Therapy products.  We
may receive additional lawsuits in the future alleging burns and/or skin
irritation from use of our Heat Therapy products.  The outcome of any
such potential litigation cannot be predicted.





Other
claims, suits and complaints arise in the ordinary course of our business
involving such matters as patents and trademarks, product liability,
environmental matters, employment law issues and other alleged injuries or
damage. The outcome of such litigation cannot be predicted, but, in the opinion
of management, based in part upon assessments from counsel, all such other
pending matters are without merit or are of such kind or involve such other
amounts that are not reasonably estimable or would not have a material adverse
effect on our financial position, results of operations or cash flows if
disposed of unfavorably.





We
maintain insurance coverage for product liability claims relating to our
products under claims-made policies which are subject to annual
renewal.   For the current policy period beginning June 1, 2007
and extending through August 31, 2008, we maintain product liability insurance
coverage in the amount of $30,000 through our captive insurance subsidiary, of
which approximately $4,163 has been funded as of July 1, 2008.  We
also have $25,000 of excess coverage through a third party reinsurance policy,
which excludes coverage for our Dexatrim products containing
ephedrine.





REGULATORY




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





Certain
of our topical analgesic products are currently marketed under a FDA tentative
final external analgesic monograph. The FDA has proposed that the final
monograph exclude external analgesic products in patch, plaster or poultice
form, unless the FDA receives additional data supporting the safety and efficacy
of these products. On October 14, 2003, we submitted to the FDA information
regarding the safety of our Icy Hot patches and arguments
to support our product’s inclusion in


20


the
final monograph. We have also participated in an industry effort coordinated by
Consumer Healthcare Products Association (“CHPA”) to establish with the FDA a
protocol of additional research that will allow the patches to be marketed under
the final monograph even if the final monograph does not explicitly allow them.
The CHPA submission to the FDA was made on October 15, 2003. Thereafter, in
April 2004, we launched the Icy Hot Sleeve, a flexible,
non-occlusive fabric patch containing 16% menthol.  In February 2006,
we launched the Capzasin Back & Body
patch containing 0.025% capsaicin. In December 2007, we launched the Icy Hot PM Patch containing
0.025% capsaicin and 5% menthol.  All of these drug products contain
levels of active ingredients consistent with levels permitted in the OTC
monograph.  If additional research is required either as a preliminary
to final FDA monograph approval and/or as a requirement of future individual
product sale, we may need to invest in a considerable amount of costly testing
and data analysis. Any preliminary expenditures may be shared with other patch
manufacturers. Because the submissions made into the FDA docket have been
forwarded from its OTC Division to its Dermatological Division within the Center
for Drug Evaluation and Research (“CDER”), we are uncertain as to when this
matter is likely to become final.  For example, the FDA could choose
to hold in abeyance a final ruling on alternative dose forms even if the
monograph is otherwise finalized.  If the final monograph excludes
such products, we will have to file a new drug application (“NDA”) for
previously marketed drugs in order to continue to market the Icy Hot and AspercremePatches, the Icy Hot Sleeve, the Capzasin Back & Body
Patch and/or similar delivery systems under our other topical analgesic brands.
In such case, we would likely have to remove the existing products from the
market one year from the effective date of the final monograph, pending FDA
review and approval of an NDA. The preparation of an NDA would likely take us
six to 18 months and would be a significant cost. It typically takes the FDA at
least twelve months to rule on an NDA once it is submitted and there is no
assurance that the NDA will be approved or that the FDA will not ask for more
data or information.





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 Dayproduct,
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
made the mandated labeling changes within the time frame required by the FDA.
Product with revised labeling compliant with new FDA regulations began shipping
in February 2006.  We are also aware of the FDA’s concern about the
potential toxicity due to concomitant use of OTC and prescription products that
contain the analgesic ingredient acetaminophen, an ingredient also found in
Pamprin and Prēmsyn
PMS.  We are also aware that the FDA will revise acetaminophen
labeling to reflect the concerns similar to NSAID analgesics such as
naproxen.  We are participating in an industry-wide effort to reassure
the FDA that the current recommended dosing regimen is safe and effective and
that proper labeling and public education by both OTC and prescription drug
companies are the best policies to abate the FDA’s concern.   The
FDA will address both issues in its effort to finalize the monograph on internal
analgesic products.  We believe the FDA may issue revised labeling
requirements within the next year, perhaps prior to monograph closure that will
cause the industry to relabel its analgesic products to better inform
consumers.  We anticipate some additional cost will be associated with
this relabeling.





During the finalization of the
monograph on sunscreen products, the FDA chose to hold in abeyance specific
requirements relating to the characterization of a product’s ability to reduce
UVA radiation.  In September 2007, the FDA published a new proposed
rule amending the previously stayed final monograph on sunscreens to include new
formulation options, labeling requirements and testing standards for measuring
UVA protection and revised testing for UVB protection.  When
implemented, the final rule will require all sunscreen manufacturers to conduct
new testing and revise the labeling of their products within eighteen months
after issuance of the final rule.  We will be required to take such
actions for our BullFrog product
line.


21


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





On
February 8, 2008, we initiated a voluntary nationwide recall of all lots of the
medical device, Icy Hot
Heat Therapy Air Activated Heat patch (Back and Arm, Neck and Leg), including
consumer “samples” that were included on a limited promotional basis in cartons
of our 3 oz. Aspercreme
product.  The recall was due to adverse events reports which
associated the use of the products with temporary or medically reversible health
consequences, skin irritation and burns.  The recall was voluntary and
conducted with the full knowledge of FDA. On February 5-8, 2008, FDA conducted a
medical device inspection of our manufacturing plant, manufacturing records, and
consumer complaint handling system related to the manufacture and distribution
of the Heat Therapy device.  On February 8, 2008, the FDA issued a
Form FDA-483 noting three inspectional observations pertaining to medical device
reporting, device correction reports, and corrective and preventive action
procedures.  We responded to the Form FDA-483 on February 14 and
February 20, 2008 committing to correct the cited observations. On June 10,
2008, we received a warning letter from FDA asserting the Heat Therapy devices
are misbranded and adulterated based on the inspectional observations and
requesting additional information to correct the observations.  On
June 24, 2008, we responded to the warning letter addressing the noted
violations and providing the requested documentation.  We believe our
response responded fully to the warning letter, but we have not yet received a
response from FDA acknowledging this and there is no assurance that FDA will be
satisfied with our response.  We are no longer marketing the Icy Hot Heat Therapy
products.





In June
2007, FDA published a final rule establishing regulations requiring current good
manufacturing practices for dietary supplements.  This final rule,
which became effective June 2008, implements new rules covering supplement
production and process controls, packaging, labeling and consumer complaints, to
ensure the quality and safety of finished dietary supplements.





20.
                    CONSOLIDATING
      FINANCIAL
STATEMENTS




The
consolidating financial statements, for the dates or periods indicated, of
Chattem, Inc.  (“Chattem”), Signal Investment & Management Co.
(“Signal”), SunDex, LLC (“SunDex”) and Chattem (Canada) Holdings, Inc.
(“Canada”), the guarantors of the long-term debt of Chattem, and the
non-guarantor direct and indirect wholly-owned subsidiaries of Chattem are
presented below.  Signal is 89% owned by Chattem and 11% owned by
Canada.  SunDex and Canada are wholly-owned subsidiaries of
Chattem.  The guarantees of Signal, SunDex and Canada are full and
unconditional and joint and several.  The guarantees of Signal, SunDex
and Canada as of May 31, 2008 arose in conjunction with Chattem’s Credit
Facility and Chattem’s issuance of the 7.0% Subordinated Notes (See Note
6).  The maximum amount of future payments the guarantors would be
required to make under the guarantees as of May 31, 2008 is
$261,688.


22


Note 20


CHATTEM,
INC. AND SUBSIDIARIES
 CONSOLIDATING
BALANCE SHEETS
 
 MAY 31,
2008
 (Unaudited
and in thousands)
 CHATTEM
              
              
              GUARANTOR SUBSIDIARY COMPANIES
              
              
              NON-GUARANTOR
                SUBSIDIARY
                COMPANIES
              
              
              ELIMINATIONS
              
              
              CONSOLIDATEDASSETSCURRENT
      ASSETS:Cash
      and cash equivalents
              
              $
              893
              
              
              $
              504
              
              
              $
              10,578
              
              
              $
              —
              
              
              $
              11,975Accounts
      receivable, less allowances of $14,296
              
              
              48,885
              
              
              
              17,604
              
              
              
              6,559
              
              
              
              (17,603
              )
              
              
              55,445Interest
      receivable
              
              
              85
              
              
              
              642
              
              
              
              (68
              )
              
              
              (659
              )
              
              
              —Inventories
              
              
              36,657
              
              
              
              1,853
              
              
              
              3,874
              
              
              
              —
              
              
              
              42,384Deferred
      income taxes
              
              
              7,007
              
              
              
              —
              
              
              
              43
              
              
              
              —
              
              
              
              7,050Prepaid
      expenses and other current assets
              
              
              2,033
              
              
              
              —
              
              
              
              207
              
              
              
              —
              
              
              
              2,240Total
      current assets
              
              
              95,560
              
              
              
              20,603
              
              
              
              21,193
              
              
              
              (18,262
              )
              
              
              119,094PROPERTY,
      PLANT AND EQUIPMENT, NET
              
              
              31,065
              
              
              
              775
              
              
              
              716
              
              
              
              —
              
              
              
              32,556OTHER
      NONCURRENT ASSETS:Patents,
      trademarks and other purchased product rights, net
              
              
              3,273
              
              
              
              674,057
              
              
              
              1,561
              
              
              
              (62,290
              )
              
              
              616,601Debt
      issuance costs, net
              
              
              13,567
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              13,567Investment
      in subsidiaries
              
              
              328,345
              
              
              
              33,000
              
              
              
              66,860
              
              
              
              (428,205
              )
              
              
              —Note
      receivable
              
              
              —
              
              
              
              33,000
              
              
              
              —
              
              
              
              (33,000
              )
              
              
              —Other
              
              
              4,619
              
              
              
              —
              
              
              
              512
              
              
              
              —
              
              
              
              5,131Total
      other noncurrent assets
              
              
              349,804
              
              
              
              740,057
              
              
              
              68,933
              
              
              
              (523,495
              )
              
              
              635,299TOTAL
      ASSETS
              
              $
              476,429
              
              
              $
              761,435
              
              
              $
              90,842
              
              
              $
              (541,757
              )
              
              $
              786,949LIABILITIES
      AND SHAREHOLDERS’ EQUITYCURRENT
      LIABILITIES:Current
      maturities of long-term debt
              
              $
              3,000
              
              
              $
              —
              
              
              $
              —
              
              
              $
              —
              
              
              $
              3,000Accounts
      payable and other
              
              
              10,429
              
              
              
              —
              
              
              
              1,973
              
              
              
              —
              
              
              
              12,402Bank
      overdraft
              
              
              6,338
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              6,338Accrued
      liabilities
              
              
              33,610
              
              
              
              794
              
              
              
              3,123
              
              
              
              (18,263
              )
              
              
              19,264Total
      current liabilities
              
              
              53,377
              
              
              
              794
              
              
              
              5,096
              
              
              
              (18,263
              )
              
              
              41,004LONG-TERM
      DEBT, less current maturities
              
              
              483,088
              
              
              
              (1,200
              )
              
              
              34,800
              
              
              
              (33,000
              )
              
              
              483,688DEFERRED
      INCOME TAXES
              
              
              (23,753
              )
              
              
              52,899
              
              
              
              —
              
              
              
              —
              
              
              
              29,146OTHER
      NONCURRENT LIABILITIES
              
              
              2,221
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              2,221INTERCOMPANY
      ACCOUNTS
              
              
              (269,379
              )
              
              
              260,546
              
              
              
              8,833
              
              
              
              —
              
              
              
              —SHAREHOLDERS’
      EQUITY:Preferred
      shares, without par value, authorized 1,000, none
    issued
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —Common
      shares, without par value, authorized 100,000, issued and
      outstanding 18,997
              
              
              31,140
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              31,140Shares
      of subsidiaries
              
              
              —
              
              
              
              329,704
              
              
              
              39,804
              
              
              
              (369,508
              )
              
              
              —Dividends
              
              
              —
              
              
              
              (34,899
              )
              
              
              —
              
              
              
              34,899
              
              
              
              —Retained
      earnings
              
              
              200,549
              
              
              
              153,591
              
              
              
              669
              
              
              
              (154,260
              )
              
              
              200,549231,689
              
              
              
              448,396
              
              
              
              40,473
              
              
              
              (488,869
              )
              
              
              231,689Cumulative
      other comprehensive income, net of tax:Interest
      rate hedge adjustment
              
              
              (1,959
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (1,959
              )Foreign
      currency translation adjustment
              
              
              1,153
              
              
              
              —
              
              
              
              1,640
              
              
              
              (1,625
              )
              
              
              1,168Unrealized
      actuarial gains and losses
              
              
              (8
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (8
              )Total
      shareholders’ equity
              
              
              230,875
              
              
              
              448,396
              
              
              
              42,113
              
              
              
              (490,494
              )
              
              
              230,890TOTAL
      LIABILITIES AND SHAREHOLDERS’ EQUITY
              
              $
              476,429
              
              
              $
              761,435
              
              
              $
              90,842
              
              
              $
              (541,757
              )
              
              $
              786,949
 23
 Note 20
 CHATTEM,
INC. AND SUBSIDIARIES
 CONSOLIDATING
BALANCE SHEETS
 
 NOVEMBER
30, 2007
 (In
thousands)
  CHATTEM
              
              
              GUARANTOR
                SUBSIDIARY
                COMPANIES
              
              
              NON-GUARANTOR
                SUBSIDIARY
                COMPANIES
              
              
              ELIMINATIONS
              
              
              CONSOLIDATEDASSETSCURRENT
      ASSETS:Cash
      and cash equivalents
              
              $
              4,685
              
              
              $
              590
              
              
              $
              10,132
              
              
              $
              —
              
              
              $
              15,407Accounts
      receivable, less allowances of $13,810
              
              
              37,492
              
              
              
              16,693
              
              
              
              6,261
              
              
              
              (16,693
              )
              
              
              43,753Interest
      receivable
              
              
              101
              
              
              
              625
              
              
              
              (84
              )
              
              
              (642
              )
              
              
              —Inventories
              
              
              36,220
              
              
              
              3,242
              
              
              
              3,803
              
              
              
              —
              
              
              
              43,265Deferred
      income taxes
              
              
              6,709
              
              
              
              —
              
              
              
              41
              
              
              
              —
              
              
              
              6,750Prepaid
      expenses and other current assets
              
              
              1,913
              
              
              
              —
              
              
              
              302
              
              
              
              (150
              )
              
              
              2,065Total
      current assets
              
              
              87,120
              
              
              
              21,150
              
              
              
              20,455
              
              
              
              (17,485
              )
              
              
              111,240PROPERTY,
      PLANT AND EQUIPMENT, NET
              
              
              30,902
              
              
              
              775
              
              
              
              672
              
              
              
              —
              
              
              
              32,349OTHER
      NONCURRENT ASSETS:Patents,
      trademarks and other purchased product rights, net
              
              
              3,482
              
              
              
              674,058
              
              
              
              1,560
              
              
              
              (62,290
              )
              
              
              616,810Debt
      issuance costs, net
              
              
              15,430
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              15,430Investment
      in subsidiaries
              
              
              336,936
              
              
              
              33,000
              
              
              
              66,860
              
              
              
              (436,796
              )
              
              
              —Note
      receivable
              
              
              —
              
              
              
              33,000
              
              
              
              —
              
              
              
              (33,000
              )
              
              
              —Other
              
              
              4,218
              
              
              
              —
              
              
              
              513
              
              
              
              —
              
              
              
              4,731Total
      other noncurrent assets
              
              
              360,066
              
              
              
              740,058
              
              
              
              68,933
              
              
              
              (532,086
              )
              
              
              636,971TOTAL
      ASSETS
              
              $
              478,088
              
              
              $
              761,983
              
              
              $
              90,060
              
              
              $
              (549,571
              )
              
              $
              780,560LIABILITIES
      AND SHAREHOLDERS’ EQUITYCURRENT
      LIABILITIES:Current
      maturities of long-term debt
              
              $
              3,000
              
              
              $
              —
              
              
              $
              —
              
              
              $
              —
              
              
              $
              3,000Accounts
      payable and other
              
              
              16,439
              
              
              
              —
              
              
              
              1,800
              
              
              
              —
              
              
              
              18,239Bank
      overdraft
              
              
              7,584
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              7,584Accrued
      liabilities
              
              
              33,561
              
              
              
              691
              
              
              
              4,770
              
              
              
              (17,485
              )
              
              
              21,537Total
      current liabilities
              
              
              60,584
              
              
              
              691
              
              
              
              6,570
              
              
              
              (17,485
              )
              
              
              50,360LONG-TERM
      DEBT, less current maturities
              
              
              504,400
              
              
              
              (1,200
              )
              
              
              34,800
              
              
              
              (33,000
              )
              
              
              505,000DEFERRED
      INCOME TAXES
              
              
              (23,976
              )
              
              
              45,032
              
              
              
              —
              
              
              
              —
              
              
              
              21,056OTHER
      NONCURRENT LIABILITIES
              
              
              2,436
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              2,436INTERCOMPANY
      ACCOUNTS
              
              
              (267,058
              )
              
              
              259,083
              
              
              
              7,975
              
              
              
              —
              
              
              
              —SHAREHOLDERS’
      EQUITYPreferred
      shares, without par value, authorized 1,000, none
    issued
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —Common
      shares, without par value, authorized 100,000, issued and
      outstanding, 19,092
              
              
              36,800
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              36,800Shares
      of subsidiaries
              
              
              —
              
              
              
              329,704
              
              
              
              39,804
              
              
              
              (369,508
              )
              
              
              —Dividends
              
              
              —
              
              
              
              (18,046
              )
              
              
              (9,000
              )
              
              
              27,046
              
              
              
              —Retained
      earnings
              
              
              165,655
              
              
              
              146,719
              
              
              
              8,430
              
              
              
              (155,149
              )
              
              
              165,655202,455
              
              
              
              458,377
              
              
              
              39,234
              
              
              
              (497,611
              )
              
              
              202,455Cumulative
      other comprehensive income, net of taxes:Interest
      rate hedge adjustment
              
              
              (1,747
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (1,747
              )Foreign
      currency translation adjustment
              
              
              1,002
              
              
              
              —
              
              
              
              1,481
              
              
              
              (1,475
              )
              
              
              1,008Unrealized
      actuarial gains and losses
              
              
              (8
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (8
              )Total
      shareholders’ equity
              
              
              201,702
              
              
              
              458,377
              
              
              
              40,715
              
              
              
              (499,086
              )
              
              
              201,708TOTAL
      LIABILITIES AND SHAREHOLDERS’ EQUITY
              
              $
              478,088
              
              
              $
              761,983
              
              
              $
              90,060
              
              
              $
              (549,571
              )
              
              $
              780,560
  24
 Note
20
 
 CHATTEM,
INC. AND SUBSIDIARIES
 CONSOLIDATING
STATEMENTS OF INCOME
 
 FOR THE
SIX MONTHS ENDED MAY 31, 2008
 (Unaudited
and in thousands)
 
 CHATTEM
              
              
              GUARANTOR
                SUBSIDIARY
                COMPANIES
              
              
              NON-GUARANTOR
                SUBSIDIARY
                COMPANIES
              
              
              ELIMINATIONS
              
              
              CONSOLIDATEDTOTAL
      REVENUES
              
              $
              216,390
              
              
              $
              46,210
              
              
              $
              12,435
              
              
              $
              (37,546
              )
              
              $
              237,489COSTS
      AND EXPENSES:Cost
      of sales
              
              
              61,020
              
              
              
              2,387
              
              
              
              5,638
              
              
              
              (1,671
              )
              
              
              67,374Advertising
      and promotion
              
              
              57,984
              
              
              
              3,611
              
              
              
              3,148
              
              
              
              —
              
              
              
              64,743Selling,
      general and administrative
              
              
              29,114
              
              
              
              226
              
              
              
              1,312
              
              
              
              —
              
              
              
              30,652Product
      recall expenses
              
              
              5,555
              
              
              
              —
              
              
              
              488
              
              
              
              —
              
              
              
              6,043Equity
      in subsidiary income
              
              
              (24,908
              )
              
              
              —
              
              
              
              —
              
              
              
              24,908
              
              
              
              —Total
      costs and expenses
              
              
              128,765
              
              
              
              6,224
              
              
              
              10,586
              
              
              
              23,237
              
              
              
              168,812INCOME
      FROM OPERATIONS
              
              
              87,625
              
              
              
              39,986
              
              
              
              1,849
              
              
              
              (60,783
              )
              
              
              68,677OTHER
      INCOME (EXPENSE):Interest
      expense
              
              
              (13,112
              )
              
              
              —
              
              
              
              (1,285
              )
              
              
              1,280
              
              
              
              (13,117
              )Investment
      and other income, net
              
              
              58
              
              
              
              1,285
              
              
              
              1,440
              
              
              
              (2,530
              )
              
              
              253Loss
      on early extinguishment of debt
              
              
              (526
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (526
              )Royalties
              
              
              (34,224
              )
              
              
              (1,652
              )
              
              
              —
              
              
              
              35,876
              
              
              
              —Corporate
      allocations
              
              
              1,006
              
              
              
              (926
              )
              
              
              (80
              )
              
              
              —
              
              
              
              —Total
      other income (expense)
              
              
              (46,798
              )
              
              
              (1,293
              )
              
              
              75
              
              
              
              34,626
              
              
              
              (13,390
              )INCOME
      BEFORE INCOME TAXES
              
              
              40,827
              
              
              
              38,693
              
              
              
              1,924
              
              
              
              (26,157
              )
              
              
              55,287PROVISION
      FOR INCOME TAXES
              
              
              5,222
              
              
              
              13,775
              
              
              
              685
              
              
              
              —
              
              
              
              19,682NET
      INCOME
              
              $
              35,605
              
              
              $
              24,918
              
              
              $
              1,239
              
              
              $
              (26,157
              )
              
              $
              35,605
     25
 Note
20
 
 CHATTEM,
INC. AND SUBSIDIARIES
 CONSOLIDATING
STATEMENTS OF INCOME
 
 FOR THE
SIX MONTHS ENDED MAY 31, 2007
 (Unaudited
and in thousands)
 
 CHATTEM
              
              
              GUARANTOR
                SUBSIDIARY
                COMPANIES
              
              
              NON-GUARANTOR
                SUBSIDIARY
                COMPANIES
              
              
              ELIMINATIONS
              
              
              CONSOLIDATEDTOTAL
      REVENUES
              
              $
              189,701
              
              
              $
              47,237
              
              
              $
              10,512
              
              
              $
              (33,655
              )
              
              $
              213,795COSTS
      AND EXPENSES:Cost
      of sales
              
              
              58,130
              
              
              
              4,413
              
              
              
              4,895
              
              
              
              (1,363
              )
              
              
              66,075Advertising
      and promotion
              
              
              50,098
              
              
              
              5,418
              
              
              
              2,935
              
              
              
              —
              
              
              
              58,451Selling,
      general and administrative
              
              
              26,351
              
              
              
              (391
              )
              
              
              762
              
              
              
              —
              
              
              
              26,722Acquisition
      expenses
              
              
              2,057
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              2,057Equity
      in subsidiary income
              
              
              (23,385
              )
              
              
              —
              
              
              
              —
              
              
              
              23,385
              
              
              
              —Total
      costs and expenses
              
              
              113,251
              
              
              
              9,440
              
              
              
              8,592
              
              
              
              22,022
              
              
              
              153,305INCOME
      FROM OPERATIONS
              
              
              76,450
              
              
              
              37,797
              
              
              
              1,920
              
              
              
              (55,677
              )
              
              
              60,490OTHER
      INCOME (EXPENSE):Interest
      expense
              
              
              (15,650
              )
              
              
              —
              
              
              
              (1,324
              )
              
              
              1,419
              
              
              
              (15,555
              )Investment
      and other income, net
              
              
              534
              
              
              
              1,274
              
              
              
              1,746
              
              
              
              (2,670
              )
              
              
              884Loss
      on early extinguishment of debt
              
              
              (2,219
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (2,219
              )Royalties
              
              
              (29,853
              )
              
              
              (2,439
              )
              
              
              —
              
              
              
              32,292
              
              
              
              —Corporate
      allocations
              
              
              1,363
              
              
              
              (1,331
              )
              
              
              (32
              )
              
              
              —
              
              
              
              —Total
      other income (expense)
              
              
              (45,825
              )
              
              
              (2,496
              )
              
              
              390
              
              
              
              31,041
              
              
              
              (16,890
              )INCOME
      BEFORE INCOME TAXES
              
              
              30,625
              
              
              
              35,301
              
              
              
              2,310
              
              
              
              (24,636
              )
              
              
              43,600PROVISION
      FOR INCOME TAXES
              
              
              2,067
              
              
              
              12,178
              
              
              
              797
              
              
              
              —
              
              
              
              15,042NET
      INCOME
              
              $
              28,558
              
              
              $
              23,123
              
              
              $
              1,513
              
              
              $
              (24,636
              )
              
              $
              28,558
     26
 Note
20
 
 CHATTEM,
INC. AND SUBSIDIARIES
 CONSOLIDATING
STATEMENTS OF CASH FLOWS
 
 FOR THE
SIX MONTHS ENDED MAY 31, 2008
 (Unaudited
and in thousands)
  CHATTEM
              
              
              GUARANTOR
                SUBSIDIARY
                COMPANIES
              
              
              NON-GUARANTOR
                SUBSIDIARY
                COMPANIES
              
              
              ELIMINATIONS
              
              
              CONSOLIDATEDOPERATING
      ACTIVITIES:Net
      income
              
              $
              35,605
              
              
              $
              24,918
              
              
              $
              1,239
              
              
              $
              (26,157
              )
              
              $
              35,605Adjustments
      to reconcile net income to net cashprovided
      by (used in) operating activities:Depreciation
      and amortization
              
              
              4,152
              
              
              
              —
              
              
              
              64
              
              
              
              —
              
              
              
              4,216Deferred
      income taxes
              
              
              1,033
              
              
              
              —
              
              
              
              (2
              )
              
              
              —
              
              
              
              8,898Tax
      benefit realized from stock options exercised
              
              
              (1,855
              )
              
              
              7,867
              
              
              
              —
              
              
              
              —
              
              
              
              (1,855
              )Stock-based
      compensation
              
              
              2,580
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              2,580Loss
      on early extinguishment of debt
              
              
              526
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              526Other,
      net
              
              
              112
              
              
              
              —
              
              
              
              23
              
              
              
              —
              
              
              
              135Equity
      in subsidiary income
              
              
              (26,157
              )
              
              
              —
              
              
              
              —
              
              
              
              26,157
              
              
              
              —Changes
      in operating assets and liabilities:Accounts
      receivable
              
              
              (11,393
              )
              
              
              (911
              )
              
              
              (299
              )
              
              
              911
              
              
              
              (11,692
              )Interest
      Receivable
              
              
              16
              
              
              
              (16
              )
              
              
              (16
              )
              
              
              16
              
              
              
              —Inventories
              
              
              (412
              )
              
              
              1,389
              
              
              
              (71
              )
              
              
              —
              
              
              
              906Prepaid
      expenses and other current assets
              
              
              (125
              )
              
              
              —
              
              
              
              95
              
              
              
              (150
              )
              
              
              (180
              )Accounts
      payable and accrued liabilities
              
              
              (5,701
              )
              
              
              103
              
              
              
              (1,475
              )
              
              
              (777
              )
              
              
              (7,850
              )Net
      cash (used in) provided by operating activities
              
              
              (1,619
              )
              
              
              33,350
              
              
              
              (442
              )
              
              
              —
              
              
              
              31,289INVESTING
      ACTIVITIES:Purchases
      of property, plant and equipment
              
              
              (2,388
              )
              
              
              —
              
              
              
              (78
              )
              
              
              —
              
              
              
              (2,466
              )(Increase)
      decrease in other assets, net
              
              
              (1,271
              )
              
              
              —
              
              
              
              131
              
              
              
              —
              
              
              
              (1,140
              )Net
      cash (used in) provided by investing activities
              
              
              (3,659
              )
              
              
              —
              
              
              
              53
              
              
              
              —
              
              
              
              (3,606
              )FINANCING
      ACTIVITIES:Repayment
      of long-term debt
              
              
              (36,500
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (36,500
              )Proceeds
      from borrowings under revolving credit facility
              
              
              109,500
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              109,500Repayments
      of revolving credit facility
              
              
              (94,312
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (94,312
              )Proceeds
      from exercise of stock options
              
              
              2,165
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              2,165Change
      in bank overdraft
              
              
              (1,246
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (1,246
              )Repurchase
      of common shares
              
              
              (12,554
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (12,554
              )Tax
      benefit realized from stock options exercised
              
              
              1,855
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              1,855Changes
      in intercompany accounts
              
              
              (1,071
              )
              
              
              1,463
              
              
              
              (392
              )
              
              
              —
              
              
              
              —Dividends
      paid
              
              
              33,649
              
              
              
              (34,899
              )
              
              
              1,250
              
              
              
              —
              
              
              
              —Net
      cash (used in) provided by financing activities
              
              
              1,486
              
              
              
              (33,436
              )
              
              
              858
              
              
              
              —
              
              
              
              (31,092
              )EFFECT
      OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS
              
              
              —
              
              
              
              —
              
              
              
              (23
              )
              
              
              —
              
              
              
              (23
              )CASH
      AND CASH EQUIVALENTS:(Decrease)
      increase for the period
              
              
              (3,792
              )
              
              
              (86
              )
              
              
              446
              
              
              
              —
              
              
              
              (3,432
              )At
      beginning of period
              
              
              4,685
              
              
              
              590
              
              
              
              10,132
              
              
              
              —
              
              
              
              15,407At
      end of period
              
              $
              893
              
              
              $
              504
              
              
              $
              10,578
              
              
              $
              —
              
              
              $
              11,975
  27
 Note 20
 
 CHATTEM,
INC. AND SUBSIDIARIES
 CONSOLIDATING
STATEMENTS OF CASH FLOWS
 
 FOR THE
SIX MONTHS ENDED MAY 31, 2007
 (Unaudited
and in thousands)
  CHATTEM
              
              
              GUARANTOR
                SUBSIDIARY
                COMPANIES
              
              
              NON-GUARANTOR
                SUBSIDIARY
                COMPANIES
              
              
              ELIMINATIONS
              
              
              CONSOLIDATEDOPERATING
      ACTIVITIES:Net
      income
              
              $
              28,558
              
              
              $
              23,123
              
              
              $
              1,513
              
              
              $
              (24,636
              )
              
              $
              28,558Adjustments
      to reconcile net income to net cashprovided
      by (used in) operating activities:Depreciation
      and amortization
              
              
              4,192
              
              
              
              —
              
              
              
              86
              
              
              
              —
              
              
              
              4,278Deferred
      income taxes
              
              
              6,648
              
              
              
              —
              
              
              
              (1
              )
              
              
              —
              
              
              
              6,647Tax
      benefit realized from stock options
              
              
              (3,966
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (3,966
              )Stock-based
      compensation
              
              
              2,632
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              2,632Loss
      on early extinguishment of debt
              
              
              2,219
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              2,219Other,
      net
              
              
              146
              
              
              
              —
              
              
              
              (29
              )
              
              
              —
              
              
              
              117Equity
      in subsidiary income
              
              
              (24,636
              )
              
              
              —
              
              
              
              —
              
              
              
              24,636
              
              
              
              —Changes
      in operating assets and liabilities:Accounts
      receivable
              
              
              (21,229
              )
              
              
              (7,953
              )
              
              
              (747
              )
              
              
              7,953
              
              
              
              (21,976
              )Interest
      Receivable
              
              
              —
              
              
              
              —
              
              
              
              (182
              )
              
              
              182
              
              
              
              —Inventories
              
              
              3,001
              
              
              
              92
              
              
              
              162
              
              
              
              —
              
              
              
              3,255Refundable
      income taxes
              
              
              2,475
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              2,475Prepaid
      expenses and other current assets
              
              
              1,105
              
              
              
              —
              
              
              
              (5
              )
              
              
              30
              
              
              
              1,130Accounts
      payable and accrued liabilities
              
              
              23,492
              
              
              
              (2
              )
              
              
              2,681
              
              
              
              (8,165
              )
              
              
              18,006Net
      cash provided by operating activities
              
              
              24,637
              
              
              
              15,260
              
              
              
              3,478
              
              
              
              —
              
              
              
              43,375INVESTING
      ACTIVITIES:Purchases
      of property, plant and equipment
              
              
              (1,501
              )
              
              
              —
              
              
              
              (79
              )
              
              
              —
              
              
              
              (1,580
              )Purchases
      of trademarks and other product rights
              
              
              (8,090
              )
              
              
              (406,435
              )
              
              
              (1,455
              )
              
              
              —
              
              
              
              (415,980
              )Change
      in other assets, net
              
              
              779
              
              
              
              467
              
              
              
              1,212
              
              
              
              —
              
              
              
              2,458Net
      cash used in investing activities
              
              
              (8,812
              )
              
              
              (405,968
              )
              
              
              (322
              )
              
              
              —
              
              
              
              (415,102
              )FINANCING
      ACTIVITIES:Repayment
      of long-term debt
              
              
              (128,000
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (128,000
              )Intercompany
      debt proceeds (payments)
              
              
              6,400
              
              
              
              (1,200
              )
              
              
              (5,200
              )
              
              
              —
              
              
              
              —Proceeds
      from long–term debt
              
              
              400,000
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              400,000Proceeds
      from borrowings under revolving credit facility
              
              
              89,000
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              89,000Repayments
      of revolving credit facility
              
              
              (57,000
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (57,000
              )Change
      in bank overdraft
              
              
              (1,392
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (1,392
              )Proceeds
      from exercise of stock options
              
              
              8,434
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              8,434Purchase
      of note hedge
              
              
              (29,500
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (29,500
              )Proceeds
      from issuance of warrants
              
              
              17,430
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              17,430Increase
      in debt issuance costs
              
              
              (9,110
              )
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (9,110
              )Excess
      tax benefit from stock-based compensation
              
              
              3,966
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              3,966Changes
      in intercompany accounts
              
              
              (392,290
              )
              
              
              391,855
              
              
              
              435
              
              
              
              —
              
              
              
              —Dividends
      paid
              
              
              —
              
              
              
              (1,250
              )
              
              
              1,250
              
              
              
              —
              
              
              
              —Net
      cash (used in) provided by financing activities
              
              
              (92,062
              )
              
              
              389,405
              
              
              
              (3,515
              )
              
              
              —
              
              
              
              293,828EFFECT
      OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS
              
              
              —
              
              
              
              —
              
              
              
              29
              
              
              
              —
              
              
              
              29CASH
      AND CASH EQUIVALENTS:Decrease
      for the period
              
              
              (76,237
              )
              
              
              (1,303
              )
              
              
              (330
              )
              
              
              —
              
              
              
              (77,870
              )At
      beginning of period
              
              
              80,198
              
              
              
              1,967
              
              
              
              8,362
              
              
              
              —
              
              
              
              90,527At
      end of period
              
              $
              3,961
              
              
              $
              664
              
              
              $
              8,032
              
              
              $
              —
              
              
              $
              12,657
  28


Item 2. Management’s
Discussion and Analysis of Financial Condition and Results of
Operations





The
following discussion and analysis of our financial condition and results of
operations should be read in conjunction with the audited consolidated financial
statements and related notes thereto included in our 2007 Annual Report on Form
10-K filed with the Securities and Exchange Commission (“SEC”).  This
discussion and analysis contains forward-looking statements that involve risks,
uncertainties and assumptions.  The actual results may differ
materially from those anticipated in these forward-looking statements as a
result of a number of factors, including, but not limited to, those described in
our filings with the SEC.





Overview





Founded
in 1879, we are a leading marketer and manufacturer of a broad portfolio of
branded over-the-counter (“OTC”) healthcare products, toiletries and dietary
supplements including such categories as medicated skin care, topical pain care,
oral care, internal OTC, medicated dandruff shampoos, dietary supplements, and
other OTC and toiletry products. Our portfolio of products includes
well-recognized brands such as:








•
            Gold Bond, Balmex and
      Cortizone-10–
      medicated skin care;





•
            Icy Hot, Capzasin and
      Aspercreme–
      topical pain care;





•
            ACT and Herpecin-L– oral
      care;





•
            Unisom, Pamprin and Kaopectate– internal
      OTC;





•
            Selsun Blue and Selsun Natural–
      medicated dandruff shampoos;





•
            Dexatrim, Garlique and New Phase– dietary
      supplements; and





•
            Bullfrog, Ultraswim and Sun-In – other OTC and
      toiletry products.





Our
products target niche markets that are often outside the focus of larger
companies where we believe we can achieve and sustain significant market share
through product innovation and strong advertising and promotion support. Many of
our products are among the U.S. market leaders in their respective categories.
For example, our portfolio of topical pain care brands, our Cortizone-10 anti-itch
ointment and our Gold
Bond medicated body powders have the leading U.S. market share in these
categories. We support our brands through extensive and cost-effective
advertising and promotion, the expenditures for which represented approximately
27% of our total revenues in the first half of fiscal 2008. We sell our products
nationally through mass merchandiser, drug and food channels, principally
utilizing our own sales force.





Our
experienced management team has grown our business by acquiring brands,
developing product line extensions and increasing market penetration of our
existing products.





Developments
During Fiscal 2008





Products





In the
first half of fiscal 2008, we introduced the following product line extensions:
Unisom Sleep Melts,
Cortizone-10 Intensive
Healing, Gold Bond
Ultimate Restoring Lotion, Gold Bond Ultimate Foot
Cream, Icy Hot PM
Lotion, Icy Hot PM
Patch, Aspercreme Heat
Pain Relieving Gel, Aspercreme Nighttime Lotion
and Dexatrim Max
Daytime Control.





Product
Recall





On
February 8, 2008, we initiated a voluntary nationwide recall of our Icy Hot Heat Therapy product.
Icy HotHeat Therapy is
an air-activated, self-heating disposable device for temporary relief of
muscular and joint pain.  We recalled these products because we
received some consumer reports of first, second and third degree burns and skin
irritation resulting from the use or possible misuse of the
product.  Based in part on consideration of on-hand factory inventory
and retail point of sales data, during the first quarter of fiscal 2008 we
recorded an estimate of approximately $6.0 million of recall expenses related to
product returns, inventory obsolescence, destruction costs, consumer refunds,
legal fees and other estimated expenses.  The remaining estimate for
product recall expenses was $2.1 million as of May 31, 2008.


29


Results
of Operations





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




For
      the Three Months
              Ended May 31,
            
            
            For
      the Six  Months
              Ended May 31,2008
            
            
            2007
            
            
            2008
            
            
            2007TOTAL
      REVENUES
            
            
            100.0
            %
            
            
            100.0
            %
            
            
            100.0
            %
            
            
            100.0
            %COSTS
      AND EXPENSES:Cost
      of sales
            
            
            28.0
            
            
            
            31.1
            
            
            
            28.4
            
            
            
            30.9Advertising
      and promotion
            
            
            25.9
            
            
            
            26.2
            
            
            
            27.3
            
            
            
            27.3Selling,
      general and administrative
            
            
            13.0
            
            
            
            12.7
            
            
            
            12.9
            
            
            
            12.5Product
      recall expenses
            
            
            —
            
            
            
            —
            
            
            
            2.5
            
            
            
            —Acquisition
      expenses
            
            
            —
            
            
            
            0.8
            
            
            
            —
            
            
            
            1.0Total
      costs and expenses
            
            
            66.9
            
            
            
            70.8
            
            
            
            71.1
            
            
            
            71.7INCOME
      FROM OPERATIONS
            
            
            33.1
            
            
            
            29.2
            
            
            
            28.9
            
            
            
            28.3OTHER
      INCOME (EXPENSE):
            
            
            (5.6
            )
            
            
            (7.4
            )
            
            
            (5.5
            )
            
            
            (7.3
            )Interest
      expense
            
            
            0.1
            
            
            
            0.3
            
            
            
            0.1
            
            
            
            0.4Investment
      and other income, net
            
            
            —
            
            
            
            (2.0
            )
            
            
            (0.2
            )
            
            
            (1.0
            )Loss
      on early extinguishment of debt
            
            
            (5.5
            )
            
            
            (9.1
            )
            
            
            (5.6
            )
            
            
            (7.9
            )Total
      other income (expense)INCOME
      BEFORE INCOME TAXES
            
            
            27.6
            
            
            
            20.1
            
            
            
            23.3
            
            
            
            20.4PROVISION
      FOR INCOME TAXES
            
            
            9.8
            
            
            
            6.9
            
            
            
            8.3
            
            
            
            7.0NET
      INCOME
            
            
            17.8
            %
            
            
            13.2
            %
            
            
            15.0
            %
            
            
            13.4
            %





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 unaudited consolidated financial
statements for the three and six months ended May 31, 2008.





Allowance
for Doubtful Accounts





As of May
31, 2008, an estimate was made of the collectibility of the outstanding accounts
receivable balances.   This estimate requires the utilization of
outside credit services, knowledge about the customer and the customer’s
industry, new developments in the customer’s industry and operating results of
the customer as well as general economic conditions and historical
trends.  When all these facts are compiled, a judgment as to the
collectibility of the individual account is made.   Many factors
can impact this estimate, including those noted in this
paragraph.  The adequacy of the estimated allowance may be impacted by
the deterioration in the financial condition of a large customer, weakness in
the economic environment resulting in a higher level of customer bankruptcy
filings or delinquencies and the competitive environment in which the customer
operates.  During the second quarter of fiscal 2008, we performed a
detailed assessment of the collectibility of trade accounts receivable and did
not make any significant adjustments to our estimate of allowance for doubtful
accounts.  The balance of allowance for doubtful accounts was $0.4
million at May 31, 2008 and November 30, 2007.





Revenue
Recognition





Revenue
is recognized when our products are shipped to our customers.  It is
generally our policy across all classes of customers that all sales are
final.   As is common in the consumer products industry,
customers return products for a variety of reasons including products damaged in
transit, discontinuance of a particular size or form of product and shipping
errors.  As sales are recorded, we accrue an estimated amount for
product returns, as a reduction of these sales, based upon our historical


30


experience
and consideration of discontinued products, products divestitures, estimated
inventory levels held by our customers and retail point of sale data on existing
and newly introduced products.  The level of returns may fluctuate
from our estimates due to several factors including weather conditions, customer
inventory levels and competitive conditions.  We charge the allowance
account resulting from this accrual with any authorized deduction from
remittance by the customer or product returns upon receipt of the
product.





We
separate returns into the two categories of seasonal and non-seasonal
products.  We use the historical return detail of seasonal and
non-seasonal products for at least the most recent three fiscal years on
generally all products, which is normalized for any specific occurrence that is
not reasonably likely to recur, to determine the amount of product return as a
percentage of sales, and estimate an allowance for potential returns based on
product sold in the current period.  To consider product sold in
current and prior periods, an estimate of inventory held by our retail customers
is calculated based on customer inventory detail.  This estimate of
inventory held by our customers, along with historical returns as a percentage
of sales, is used to determine an estimate of potential product
returns.  This estimate of the allowance for seasonal and non-seasonal
returns is further analyzed by considering retail customer point of sale
data.  We also consider specific events, such as discontinued product
or product divestitures, when determining the adequacy of the
allowance.  Based on consideration of the sales of Icy Hot Pro Therapy
performing below expectations, review of retail point of sales data and an
estimate of inventory on hand at customers, an allowance for returns of $4.5
million was recorded as of November 30, 2007.  As of May 31, 2008, the
allowance remaining for Icy
Hot Pro Therapyreturns is $2.8 million.





Our
estimate of product returns for seasonal and non-seasonal products as of May 31,
2008 was $2.5 million and $1.1 million, respectively, and $1.2 million and $1.3
million, respectively, as of November 30, 2007.  For the six months
ended May 31, 2008, we increased our estimate of returns for seasonal products
by approximately $1.3 million which resulted in a decrease to net sales in our
consolidated financial statements and decreased our estimate for non-seasonal
returns by approximately $0.2 million which resulted in an increase to net sales
in our consolidated financial statements.  During the six months ended
May 31, 2007, we increased our estimate of returns for seasonal products by
approximately $1.3 million which resulted in a decrease to net sales in our
consolidated financial statements and decreased our estimate for non-seasonal
returns by approximately $0.1 million which resulted in an increase to net sales
in our consolidated financial statements.  Each percentage point
change in the seasonal return rate would impact net sales by approximately $0.1
million.  Each percentage point change in the non-seasonal return rate
would impact net sales by approximately $0.5 million.





We
routinely enter into agreements with customers to participate in promotional
programs.  The cost of these programs is recorded as either
advertising and promotion expense or as a reduction of sales as prescribed by
Emerging Issues Task Force 01-9, “Accounting for Consideration Given by a Vendor
to a Customer (Including a Reseller of the Vendor’s Products)”.  A
significant portion of the programs are recorded as a reduction of sales and
generally take the form of coupons and vendor allowances, which are normally
taken via temporary price reductions, scan downs, display activity and
participations in in-store programs provided uniquely by the
customer.  We also enter into cooperative advertising programs with
certain customers, the cost of which is recorded as advertising and promotion
expense.  In order for retailers to receive reimbursement under such
programs, the retailer must meet specified advertising guidelines and provide
appropriate documentation of the advertisement being run.





We
analyze promotional programs in two primary categories -- coupons and vendor
allowances.  Customers normally utilize vendor allowances in the form
of temporary price reductions, scan downs, display activity and participations
in in-store programs provided uniquely by the customer.  We estimate
the accrual for outstanding coupons by utilizing a third-party clearinghouse to
track coupons issued, coupon value, distribution and expiration dates, quantity
distributed and estimated redemption rates that are provided by
us.  We estimate the redemption rates based on an internal analysis of
historical coupon redemption rates and expected future retail sales by
considering recent point of sale data.  The estimate for vendor
allowances is based on estimated unit sales of a product under a program and
amounts committed for such programs in each fiscal year.  Estimated
unit sales are determined by considering customer forecasted sales, point of
sale data and the nature of the program being offered.  The three most
recent years of expected program payments versus actual payments made and
current year retail point of sale trends are analyzed to determine future
expected payments.  Customer delays in requesting promotional program
payments due to their audit of program participation and resulting request for
reimbursement is also considered to evaluate the accrual for vendor
allowances.  The costs of these programs is often variable based on
the number of units actually sold.  As of May 31, 2008, the coupon
accrual and reserve for vendor allowances were $1.9 million and $6.4 million,
respectively and $2.0 million and $5.9 million, respectively as of May 31,
2007.  Each percentage point change in promotional program
participation and advertising and promotion expense would impact net sales by
approximately $0.1 million.





Income
Taxes





We
account for income taxes using the asset and liability approach as prescribed by
SFAS 109, FIN 48 and other applicable FSP’s and FASB
Interpretations.  This approach requires recognition of deferred tax
assets and liabilities for the expected future tax consequences of events that
have been included in the consolidated financial statements or tax
returns.


31


Using the
enacted tax rates in effect for the year in which the differences are expected
to reverse, deferred tax assets and liabilities are determined based on the
differences between the financial reporting and the tax basis of an asset or
liability.  We adopted FIN 48 on December 1, 2007.  FIN 48
clarifies the accounting for uncertainty in income taxes recognized in the
financial statements in accordance with SFAS 109.  We record income
tax expense in our consolidated financial statements based on an estimated
annual effective income tax rate.  Our estimated tax rate for the six
months ended May 31, 2008 was 35.6%, as compared to 34.5% for the six months
ended May 31, 2007.





Accounting
for Acquisitions and Intangible Assets





We
account for our acquisitions under the purchase method of accounting for
business combinations as prescribed by SFAS No. 141, “Business Combinations”
(“SFAS 141”).  Under SFAS 141, the cost, including transaction costs,
are allocated to the underlying net assets, based on their respective estimated
fair values.





We
account for our Intangible Assets in accordance with SFAS 142.  Under
SFAS 142, intangible assets with indefinite useful lives are not amortized but
are reviewed for impairment at least annually. Intangible assets with finite
lives are amortized over their estimated useful lives using the straight-line
method.





The
judgments made in determining the estimated fair value and expected useful lives
assigned to each class of assets and liabilities acquired can significantly
affect net income.  For example, the useful life of property, plant,
and equipment acquired will differ substantially from the useful life of brand
licenses and trademarks.  Consequently, to the extent a longer-lived
asset is ascribed greater value under the purchase method than a shorter-lived
asset or a value is assigned to an indefinite-lived asset, net income in a given
period may be higher.





Determining
the fair value of certain assets and liabilities acquired is judgmental in
nature and often involves the use of significant estimates and
assumptions.  An area that requires significant judgment is the fair
value and useful lives of intangible assets.  In this process, we
often obtain the assistance of a third party valuation firm for certain
intangible assets.





Our
intangible assets consist of exclusive brand licenses, trademarks and other
intellectual property, customer relationships and non-compete
agreements.  We have determined that our trademarks have indefinite
useful lives, as cash flows from the use of the trademarks are expected to be
generated indefinitely. The useful lives of our intangible assets are reviewed
as circumstances dictate using the guidance of applicable accounting
literature.





The value
of our intangible assets is exposed to future adverse changes if we experience
declines in operating results or experience significant negative industry or
economic trends.  We review our indefinite-lived intangible assets for
impairment at least annually by comparing the carrying value of the intangible
assets to its estimated fair value.  The estimate of fair value is
determined by discounting the estimate of future cash flows of the intangible
assets.  During the quarter ended November 30, 2007, we performed our
annual impairment testing of these assets and no impairment or adjustment was
required.





Fair
Value Measurements




On
December 1, 2007, we adopted SFAS 157, which provides guidance for using fair
value to measure assets and liabilities.  SFAS 157 applies both to
items recognized and reported at fair value in the financial statements and to
items disclosed at fair value in the notes to the financial
statements.  SFAS 157 does not change existing accounting rules
governing what can or must be recognized and reported at fair value and
clarifies that fair value is defined as the price received to sell an asset, or
paid to transfer a liability, in an orderly transaction between market
participants at the measurement date.  Additionally, SFAS 157 does not
eliminate practicability exceptions that exist in accounting pronouncements
amended by SFAS 157 when measuring fair value.  As a result, we are
not required to recognize any new assets or liabilities at fair
value.




SFAS 157
also establishes a framework for measuring fair value.  Fair value is
generally determined based on quoted market prices in active markets for
identical assets or liabilities.  If quoted market prices are not
available, SFAS 157 provides guidance on alternative valuation techniques that
place greater reliance on observable inputs and less reliance on unobservable
inputs.


32


Stock-Based
Compensation





We
account for stock-based compensation under the provisions of SFAS 123R, which
requires the recognition of the cost of employee services received in exchange
for an award of equity instruments in the financial statements and is measured
based on the grant date fair value of the award.  The fair value of
each stock option grant is estimated using a Flex Lattice Model.  The
input assumptions used in determining fair value are the expected life of the
stock options, the expected volatility of our common stock, the risk-free
interest rate over the expected life of the option and the expected forfeiture
rate of the options granted.  We recognize stock option compensation
expense over the period during which an employee provides service in exchange
for the award (the vesting period).








Comparison
of Three Months Ended May 31, 2008 and 2007





To
facilitate discussion of our operating results for the three months ended May
31, 2008 and 2007, we have included the following selected data from our
unaudited Consolidated Statements of Income:





Increase (Decrease)2008
            
            
            2007
            
            
            Amount
            
            
            Percentage(dollars
      in thousands)Domestic
      net sales
            
            $
            108,691
            
            
            $
            106,218
            
            
            $
            2,473
            
            
            
            2.3
            %International
      revenues (including royalties)
            
            
            8,025
            
            
            
            6,746
            
            
            
            1,279
            
            
            
            19.0Total
      revenues
            
            
            116,716
            
            
            
            112,964
            
            
            
            3,752
            
            
            
            3.3Cost
      of sales
            
            
            32,641
            
            
            
            35,095
            
            
            
            (2,454
            )
            
            
            (7.0
            )Advertising
      and promotion expense
            
            
            30,247
            
            
            
            29,664
            
            
            
            583
            
            
            
            2.0Selling,
      general and administrative expense
            
            
            15,186
            
            
            
            14,311
            
            
            
            875
            
            
            
            6.1Acquisition
      expenses
            
            
            —
            
            
            
            886
            
            
            
            (886
            )
            
            
            (100.0
            )Interest
      expense
            
            
            6,565
            
            
            
            8,319
            
            
            
            (1,754
            )
            
            
            (21.1
            )Loss
      on early extinguishment of debt
            
            
            —
            
            
            
            2,219
            
            
            
            (2,219
            )
            
            
            (100.0
            )Net  income
            
            
            20,732
            
            
            
            14,908
            
            
            
            5,824
            
            
            
            39.1





Domestic
Net Sales





Domestic
net sales for the three months ended May 31, 2008 increased $2.5 million, or
2.3%, to $108.7 million from $106.2 million in the prior year
quarter.   A comparison of domestic net sales for the categories
of products included in our portfolio of OTC healthcare products is as
follows:




Increase (Decrease)2008
            
            
            2007
            
            
            Amount
            
            
            Percentage(dollars
      in thousands)Medicated
      skin care
            
            $
            34,471
            
            
            $
            31,595
            
            
            $
            2,876
            
            
            
            9.1
            %Topical
      pain care
            
            
            24,772
            
            
            
            24,927
            
            
            
            (155
            )
            
            
            (0.6
            )Oral
      care
            
            
            15,415
            
            
            
            13,731
            
            
            
            1,684
            
            
            
            12.3Internal
      OTC
            
            
            13,274
            
            
            
            12,014
            
            
            
            1,260
            
            
            
            10.5Medicated
      dandruff shampoos
            
            
            8,707
            
            
            
            8,339
            
            
            
            368
            
            
            
            4.4Dietary
      supplements
            
            
            5,133
            
            
            
            6,824
            
            
            
            (1,691
            )
            
            
            (24.8
            )Other
      OTC and toiletry products
            
            
            6,919
            
            
            
            8,788
            
            
            
            (1,869
            )
            
            
            (21.3
            )Total
            
            $
            108,691
            
            
            $
            106,218
            
            
            $
            2,473
            
            
            
            2.3





Net sales
in the medicated skin care category increased $2.9 million, or 9.1%, in the
second quarter of fiscal 2008 compared to the prior year quarter.  Net
sales of Gold Bond
increased 12.4% compared to the prior year quarter, led by sales of Gold Bond Ultimate Restoring
Lotion, launched in the first quarter of fiscal 2008, and increased sales of
Gold Bond Ultimate
Softening Lotion.  Continued growth of the Cortizone-10 brand due to the
launch ofCortizone-10
Intensive Healing in the first quarter of fiscal 2008 also contributed to the
increase in net sales in this category.





Net sales
in the topical pain care category decreased $0.2 million, or 0.6%, for the
second quarter of fiscal 2008 compared to the same prior year quarter, due
primarily to the discontinuance of shipments of Icy HotHeat Therapy
following the February 8, 2008 voluntary recall of the product, and continued
sales declines of Icy HotPro Therapy. Excluding sales of
Icy Hot Heat Therapy
andIcy HotPro Therapy, the category increased
12.0% compared to the prior year quarter, led by the new


33


products
introduced in the first quarter of fiscal 2008, Icy Hot PM Lotion, Icy Hot PM Patch, Aspercreme Heat Pain Gel and
Aspercreme Nighttime
Lotion.





Net sales
in the oral care category increased $1.7 million, or 12.3%, in the second
quarter of fiscal 2008 compared to the prior year quarter.  This
increase was led by the continued growth of ACT resulting from additional
product distribution and advertising support.





Net sales
in the internal OTC category increased $1.3 million, or 10.5%, in the second
quarter of fiscal 2008 compared to the prior year quarter.  This
increase was led by the introduction of Unisom Sleep Melts in the
second quarter of fiscal 2008.





Net sales
in the medicated dandruff shampoos category increased $0.4 million, or 4.4%, in
the second quarter of fiscal 2008 compared to the prior year quarter primarily
resulting from sales of Selsun
BlueNaturals, which was introduced in the second quarter of fiscal 2007
and partially offset by declining sales of SelsunSalon.





Net sales
in the dietary supplements category decreased $1.7 million, or 24.8%, for the
second quarter of fiscal 2008 compared to the prior year quarter.  Net
sales of Dexatrim
decreased 43.2% primarily resulting from increased competitive pressures in the
category and the decline in sales of Dexatrim Max2O, partially offset by the
launch of Dexatrim Max
Daytime Control in the first quarter of fiscal 2008.





Net sales
in the other OTC and toiletry products category decreased $1.9 million, or
21.3%, in the second quarter of fiscal 2008 compared to the prior year quarter
primarily due to reduced sales of Bullfrog and the early
shipments of Bullfrog
in the first quarter of fiscal 2008 compared to the prior year
quarter.





Domestic
sales variances were principally the result of changes in unit sales volume with
the exception of certain selected products for which we implemented a unit sales
price increase effective April 2008.





International
Revenues





For the
second quarter of fiscal 2008, international revenues increased $1.3 million, or
19.0%, compared to the second quarter of fiscal 2007 due principally to the
fluctuation of currency exchange rates in the second quarter of fiscal 2008
compared to the currency exchange rates in the prior year quarter, along with
the timing of sales to certain customers in the quarter compared to the prior
year quarter.





Cost
of Sales





Cost of
sales in the second quarter of fiscal 2008 was $32.6 million, or 28.0% as a
percentage of total revenues for the second quarter of fiscal 2008 compared to
31.1% in the prior year quarter resulting in gross margin for the second quarter
of fiscal 2008 of 72.0% compared to 68.9% in the prior year
quarter.  The increase in gross margin was largely attributable to the
fourth quarter of fiscal 2007 integration of manufacturing of certain of the
acquired brands from the J&J Acquisition.





Advertising
and Promotion Expense





Advertising
and promotion expenses in the second quarter of fiscal 2008 increased $0.6
million, or 2.0%, compared to the prior year quarter and were 25.9% of
total revenues in the second quarter of fiscal 2008 compared to 26.2% for the
prior year quarter.  The decrease in advertising and promotion expense
as a percentage of revenue for the current period reflects the leverage of the
fixed cost component of our advertising and promotion expenditures and our
advertising costs not increasing commensurate with the percentage increase in
domestic net sales.





Selling,
General and Administrative Expense





Selling,
general and administrative expenses in the second quarter of fiscal 2008
increased $0.9 million, or 6.1%, compared to the prior year
quarter.  Selling, general and administrative expenses were 13.0% and
12.7% of total revenues for the second quarter of fiscal 2008 and 2007,
respectively.  The increase in selling, general and administrative
expenses as a percentage of total revenues was largely attributable to the
absorption of transition service costs similar to those paid to Johnson &
Johnson related to freight and administrative costs that were recorded as
acquisition expenses in the second quarter of fiscal 2007 and higher
transportation costs.





Acquisition
Expenses





Acquisition
expenses of $0.9 million were recorded in the second quarter of fiscal 2007
related to transition services provided by Johnson & Johnson under a
transition services agreement entered into in connection with the J&J
Acquisition.  The


34


transition
services provided by Johnson & Johnson included consumer affairs,
distribution and collection services, which included related financial
accounting and reporting services.  The distribution and collection
services were terminated in April 2007 and the consumer affairs services were
terminated in June 2007.





Interest
Expense





Interest
expense decreased $1.8 million, or 21.1%, in the second quarter of fiscal 2008
compared to the prior year quarter reflecting the repayment of the principal
portion of debt since the second quarter of fiscal 2007.  Until our
indebtedness is reduced substantially, interest expense will continue to
represent a significant percentage of our income from operations.





Loss
on Early Extinguishment of Debt





During the second quarter of fiscal
2007, we utilized the net proceeds from the 1.625% Convertible Notes and
borrowings under the revolving credit facility portion of our Credit Facility to
repay $128.0 million of the term loan under the Credit Facility.  In
connection with the repayment, we retired a proportional share of the term loan
debt issuance costs, which resulted in a loss on early extinguishment of debt of
$2.2 million during the second quarter of fiscal 2007.  No
corresponding charge was incurred in the second quarter of fiscal
2008.





Comparison of Six Months
Ended May 31, 2008 and 2007





To
facilitate discussion of our operating results for the six months ended May 31,
2008 and 2007, we have included the following selected data from our unaudited
Consolidated Statements of Income:





Increase (Decrease)2008
            
            
            2007
            
            
            Amount
            
            
            Percentage(dollars
      in thousands)Domestic
      net sales
            
            $
            220,006
            
            
            $
            200,841
            
            
            $
            19,165
            
            
            
            9.5
            %International
      revenues (including royalties)
            
            
            17,483
            
            
            
            12,954
            
            
            
            4,529
            
            
            
            35.0Total
      revenues
            
            
            237,489
            
            
            
            213,795
            
            
            
            23,694
            
            
            
            11.1Cost
      of sales
            
            
            67,374
            
            
            
            66,075
            
            
            
            1,299
            
            
            
            2.0Advertising
      and promotion expense
            
            
            64,743
            
            
            
            58,451
            
            
            
            6,292
            
            
            
            10.8Selling,
      general and administrative expense
            
            
            30,652
            
            
            
            26,722
            
            
            
            3,930
            
            
            
            14.7Product
      recall expenses
            
            
            6,043
            
            
            
            —
            
            
            
            6,043
            
            
            
            100.0Acquisition
      expenses
            
            
            —
            
            
            
            2,057
            
            
            
            (2,057
            )
            
            
            (100.0
            )Interest
      expense
            
            
            13,117
            
            
            
            15,555
            
            
            
            (2,438
            )
            
            
            (15.7
            )Loss
      on early extinguishment of debt
            
            
            526
            
            
            
            2,219
            
            
            
            (1,693
            )
            
            
            (76.3
            )Net
      income
            
            
            35,605
            
            
            
            28,558
            
            
            
            7,047
            
            
            
            24.7





Domestic
Net Sales





Domestic
net sales for the six months ended May 31, 2008 increased $19.2 million,
or 9.5%, compared to the same period in fiscal 2007.   A
comparison of domestic net sales for the categories of products included in our
portfolio of OTC healthcare products is as follows:




Increase (Decrease)2008
            
            
            2007
            
            
            Amount
            
            
            Percentage(dollars
      in thousands)Medicated
      skin care
            
            $
            72,124
            
            
            $
            59,427
            
            
            $
            12,697
            
            
            
            21.4
            %Topical
      pain care
            
            
            50,087
            
            
            
            52,153
            
            
            
            (2,066
            )
            
            
            (4.0
            )Oral
      Care
            
            
            31,187
            
            
            
            22,218
            
            
            
            8,969
            
            
            
            40.4Internal
      OTC
            
            
            24,484
            
            
            
            20,463
            
            
            
            4,021
            
            
            
            19.7Medicated
      dandruff shampoos
            
            
            19,286
            
            
            
            18,636
            
            
            
            650
            
            
            
            3.5Dietary
      supplements
            
            
            10,507
            
            
            
            14,854
            
            
            
            (4,347
            )
            
            
            (29.3
            )Other
      OTC and toiletry products
            
            
            12,331
            
            
            
            13,090
            
            
            
            (759
            )
            
            
            (5.8
            )Total
            
            $
            220,006
            
            
            $
            200,841
            
            
            $
            19,165
            
            
            
            9.5





Net sales
in the medicated skin care category increased $12.7 million, or 21.4%, for the
first six months of fiscal 2008 compared to the same period in fiscal 2007 as a
result of our ownership of the Cortizone-10 and Balmex brands for the six
month period of fiscal 2008 compared to five months of ownership in the same
period of fiscal 2007, the launch of Gold Bond Ultimate Restoring
Lotion and Cortizone-10
Intensive Healing in the first quarter of fiscal 2008, and the continued success
of Gold Bond Ultimate
Softening Lotion.


35


Net sales
in the topical pain care products category decreased $2.1 million, or 4.0%, for
the first six months of fiscal 2008 compared to the same period in fiscal 2007,
principally as a result of the discontinuance of shipments of Icy HotHeat Therapy
following our February 8, 2008 voluntary recall of the product, and the
continued decline of Icy
HotPro Therapy sales. Excluding sales of Icy Hot Heat Therapy andIcy HotPro Therapy, sales in the category
increased 6.7% compared to the prior year period, led by the new products
introduced in the first quarter of fiscal 2008, Icy Hot PM Lotion, Icy Hot PM Patch, Aspercreme Heat Pain Gel and
Aspercreme Nighttime
Lotion.





Net sales
in the oral care category increased $9.0 million, or 40.4%, for the first six
months of fiscal 2008 compared to the same period in 2007.  The
increase results from our ownership of the ACT brand for the six month
period of the first half of fiscal 2008 compared to five months of ownership in
the same period of fiscal 2007 and growth of ACT resulting from additional
product distribution and advertising support.





Net sales
in the internal OTC category increased $4.0 million, or 19.7%, for the first six
months of fiscal 2008 compared to the same period in 2007 as a result of our
ownership of the Unisom
and Kaopectate brands
for the six month period of the first half of fiscal 2008 compared to five
months of ownership in the same period of fiscal 2007 and the introduction of
UnisomSleep Melts in
the second quarter of fiscal 2008.





Net sales
in the medicated dandruff shampoos category increased $0.7 million, or 3.5%, for
the first six months of fiscal 2008 compared to the same period in 2007
primarily resulting from sales of Selsun BlueNaturals, which
was introduced in the second quarter of fiscal 2007 and partially offset by
declining sales of SelsunSalon.





Net sales
in the dietary supplements category decreased $4.3 million, or 29.3%, for the
first six months of fiscal 2008 compared to the same period in
2007.  Net sales of Dexatrim decreased 45.0%
primarily resulting from increased competitive pressures in the category and the
decline in sales of Dexatrim
Max2O, partially offset by the
launch of Dexatrim Max
Daytime Control in the first quarter of fiscal 2008.





Net sales
in the other OTC and toiletry products category decreased $0.8 million, or 5.8%,
for the first six months of fiscal 2008 compared to the same period in fiscal
2007 primarily due to lower sales of Bullfrog.





Domestic
sales variances were principally the result of changes in unit sales volume with
the exception of certainselected products for
which we implemented a unit sales price increase effective April
2008.





International
Revenues





For the
six months ended May 31, 2008, international revenues increased $4.5 million, or
35.0%, compared to the same period in fiscal 2007 primarily due to increased
sales in the Latin American market from the brands acquired in the J&J
Acquisition in January 2007, the ACT Acquisition in May 2007 and the fluctuation
of currency exchange rates in the first half of fiscal 2008 compared to the
currency exchange rates in the comparable prior year period.





Cost
of Sales





Cost of
sales for the six months ended May 31, 2008 was 28.4% as a percentage of total
revenues compared to 30.9% in the prior year period and gross margin for the
same period of fiscal 2008 was 71.6% compared to 69.1% in the prior year
period.  The increase in gross margin was largely attributable to the
fourth quarter of fiscal 2007 integration of the manufacturing of certain of the
acquired brands from the J&J Acquisition.





Advertising
and Promotion Expense





Advertising
and promotion expenses for the six months ended May 31, 2008 increased $6.3
million, or 10.8%, compared to the same period in fiscal 2007 and were 27.3% of
total revenues for the six months ended May 31, 2008 and 2007.  The
increase in advertising and promotion expenses results from higher expected
expenditures for advertising and promotion in fiscal 2008 and ownership of the
brands acquired in the J&J Acquisition for the six month period ended May
31, 2008 as compared to five months of ownership in the same period in
2007.





Selling,
General and Administrative Expense





Selling,
general and administrative expenses for the six months ended May 31, 2008
increased $3.9 million, or 14.7%, compared to the same period of fiscal
2007 and were 12.9% and 12.5% of total revenues for the six months ended
May 31, 2008 and 2007, respectively.  The increase in selling, general
and administrative expenses as a percentage of total revenues was largely
attributable to the absorption of transition service costs similar to those paid
to Johnson & Johnson related to freight and


36


administrative
costs that were recorded as acquisition expenses in the comparable period of
fiscal 2007 and higher transportation costs.





Product
Recall Expenses





The $6.0 million of product recall
expenses in the first half of fiscal 2008 related to the voluntary recall of our
Icy Hot Heat Therapy
product initiated in February 2008.  The product recall expenses
include product returns, inventory obsolescence, destruction costs, consumer
refunds, legal fees and other estimated expenses.  The estimate was
made by management based on consideration of on-hand inventory and retail point
of sales data.  As of May 31, 2008, the remaining estimate for product
recall expenses was $2.1 million.





Acquisition
Expenses





Acquisition
expenses of $2.1 million were recorded in the first half of fiscal 2007 related
to transition services provided by Johnson & Johnson under a transition
services agreement entered into in connection with the J&J
Acquisition.  The transition services provided by Johnson &
Johnson included consumer affairs, distribution and collection services, which
included related financial accounting and reporting services.  The
distribution and collection services were terminated in April 2007 and the
consumer affairs services were terminated in June 2007.





Interest
Expense





Interest
expense decreased $2.4 million, or 15.7%, for the six months ended May 31, 2008
compared to the same period in fiscal 2007 reflecting the repayment of principal
since May 31, 2007.  Until our indebtedness is reduced substantially,
interest expense will continue to represent a significant percentage of our
income from operations.





Loss
on Early Extinguishment of Debt





During the first quarter of fiscal
2008, we utilized borrowings under the revolving credit facility portion of our
Credit Facility to repay $35.0 million of the term loan under the Credit
Facility.  In connection with the term loan repayment, we retired a
proportional share of the term loan debt issuance costs and recorded the
resulting loss on extinguishment of debt of $0.5 million.  During the
second quarter of fiscal 2007, we utilized the net proceeds from the 1.625%
Convertible Notes and borrowings under the revolving credit facility portion of
our Credit Facility to repay $128.0 million of the term loan under the Credit
Facility.  In connection with the repayment, we retired a proportional
share of the term loan debt issuance costs, which resulted in a loss on early
extinguishment of debt of $2.2 million during the second quarter of fiscal
2007.





Liquidity
and Capital Resources





We have
historically financed our operations with a combination of internally generated
funds and borrowings.  Our principal uses of cash are for operating
expenses, servicing long-term debt, acquisitions, working capital, repurchases
of our common stock, payment of income taxes and capital
expenditures.





Cash of
$31.3 million and $43.4 million was provided by operations for the six
months ended May 31, 2008 and 2007, respectively.  The decrease in
cash flows from operations over the prior year period was primarily attributable
to decreased accounts payable and accrued liabilities and accounts receivable,
partially offset by increased net income.





Investing activities used cash of $3.6
million and $415.1 million in the six months ended May 31, 2008 and 2007,
respectively.  The reduction in cash used for investing activities in
the six months ended May 31, 2008 relates to the absence of an acquisition in
the 2008 period compared to the J&J Acquisition and ACT Acquisition in the
prior year period.





Financing
activities used cash of $31.1 million and provided cash of $293.8 million in the
six months ended May 31, 2008 and 2007, respectively.  The decrease in
cash provided was primarily attributable to amounts borrowed in the prior year
period to fund the J&J Acquisition.





We
believe that cash provided by operating activities, our cash and cash
equivalents balance and funds available under our Credit Facility will be
sufficient to fund our capital expenditures, debt service and working capital
requirements for the foreseeable future as our business is currently
conducted.  It is likely that any acquisitions we make in the future
will require us to obtain additional financing.  If additional
financing is required, there are no assurances that it will be available, or, if
available, that it can be obtained on terms favorable to us or not dilutive to
our shareholders.




As of May
31, 2008, we had $45.2 million of borrowings outstanding under our $100.0
million revolving credit facility portion of our Credit
Facility.


37


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 six months ended May 31, 2008
and 2007, these subsidiaries accounted for 5% of total revenues in each period,
and 3% and 2% of total assets, respectively.  It has not been our
practice to hedge our assets and liabilities in Canada, the U.K. or Ireland or
our intercompany transactions due to the inherent risks associated with foreign
currency hedging transactions and the timing of payments between us and our
foreign subsidiaries. Historically, gains or losses from foreign currency
transactions have not had a material impact on our operating
results.  An insignificant gain and a gain of $0.1 million for the six
months ended May 31, 2008 and 2007, respectively, resulted from foreign currency
transactions and are included in selling, general and administrative expenses in
the unaudited Consolidated Statements of Income.





Recent
Accounting Pronouncements





In July
2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation
No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), which clarifies
the accounting for uncertainty in income taxes recognized in the financial
statements in accordance with Statement of Financial Accounting Standard
(“SFAS”)  No. 109, “Accounting for Income Taxes” (“SFAS 109”). FIN 48
provides guidance on the financial statement recognition and measurement of a
tax position taken or expected to be taken in a tax return. FIN 48 also provides
guidance on de-recognition, classification, interest and penalties, accounting
in interim periods, disclosures and transition.  Additionally, in May
2007, the FASB issued FASB Staff Position (“FSP”) No. FIN 48-1, “Definition of
Settlement in FASB Interpretation No. 48” (“FSP FIN 48-1”), an amendment to FIN
48.  FSP FIN 48-1 clarifies how an enterprise is to determine whether
a tax position is effectively settled for the purpose of recognizing previously
unrecognized tax benefits.  The provisions of FIN 48 and FSP FIN 48-1
were effective for fiscal years beginning after December 15,
2006.   As described in Note 17, we adopted the provisions of FIN
48 and FSP FIN 48-1 effective December 1, 2007.




In
September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS
157”).  SFAS 157 provides guidance for using fair value to measure
assets and liabilities.  SFAS 157 applies when other standards require
(or permit) assets or liabilities to be measured at fair value but does not
expand the use of fair value in any new circumstances.  SFAS 157 also
requires expanded disclosure of the effect on earnings for items measured using
unobservable data (data not based on market observable information), establishes
a fair value hierarchy that prioritizes the information used to develop those
assumptions and requires separate disclosure by level within the fair value
hierarchy.  As described in Note 8, we adopted SFAS 157 effective
December 1, 2007.




In
February 2008, the FASB issued FSP No. SFAS 157-2, “Effective
Date of FASB Statement No. 157” (“FSP 157-2”).  FSP 157-2
defers the effective date of SFAS 157 for nonfinancial assets and
nonfinancial liabilities, except those that are recognized or disclosed at fair
value in the financial statements on a recurring basis (at least annually) to
fiscal years and interim periods within those fiscal years, beginning after
November 15, 2008, or our fiscal 2009.  We are currently
evaluating the impact of adopting the provisions of FSP 157-2.




In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
Financial Assets and Financial Liabilities” (“SFAS 159”).  SFAS 159
permits entities to choose to measure certain financial assets and liabilities
at fair value.  Unrealized gains and losses on items for which the
fair value option has been elected are reported in earnings. We adopted SFAS 159
effective December 1, 2007 without choosing to elect to measure certain
financial assets or liabilities at fair value that were not previously measured
at fair value.




In
December 2007, the FASB issued SFAS No. 141R, “Business Combinations” (“SFAS
141R”).  SFAS 141R establishes principles and requirements for how the
acquirer in a business combination recognizes and measures the identifiable
assets acquired, liabilities assumed, and intangible assets acquired and
determines what information to disclose to enable users of the financial
statements to evaluate the nature and financial effects of the business
combination.  The provisions of SFAS 141R are effective for
acquisitions closing after the first annual reporting period beginning after
December 15, 2008.  Accordingly, we will apply the provisions of SFAS
141R prospectively to business combinations consummated beginning in the first
quarter of our fiscal 2010.





In March
2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments
and Hedging Activities – An Amendment of FASB Statement No. 133” (“SFAS
161”).  SFAS 161 requires enhanced disclosures for derivative and
hedging activities.  SFAS 161 is effective for financial statements
issued for fiscal years and interim periods beginning after November 15, 2008,
or our fiscal 2009.  We are currently evaluating the impact, if any,
of SFAS 161.


38


In
April 2008, the FASB issued FSP No. FAS 142-3, “Determination of the
Useful Life of Intangible Assets” (“FSP FAS 142-3”).  In determining the
useful life of intangible assets, FSP FAS 142-3 removes the requirement to
consider whether an intangible asset can be renewed without substantial cost of
material modifications to the existing terms and conditions and, instead,
requires an entity to consider its own historical experience in renewing similar
arrangements. FSP FAS 142-3 also requires expanded disclosure related to the
determination of intangible asset useful lives.  FSP FAS 142-3 is effective
for financial statements issued for fiscal years beginning after
December 15, 2008, or our fiscal 2010.




In May
2008, the FASB issued FSP Accounting Principles Board Opinion No. 14-1,
“Accounting for Convertible Debt Instruments that may be Settled in Cash upon
Conversion (Including Partial Cash Settlement)” (“FSP 14-1”).  FSP
14-1 specifies that issuers of convertible debt instruments are to separately
account for the liability and equity components in a manner that will reflect
the entity’s nonconvertible debt borrowing rate when interest cost is recognized
in periods subsequent to adoption.  In addition, transaction costs
incurred with third parties that directly relate to the issuance of convertible
debt instruments will be allocated to the liability and equity components in
proportion to the allocation of proceeds and accounted for as debt issuance
costs and equity issuance costs, respectively.  Upon adoption of FSP
14-1 on December 1, 2009, we will recognize the cumulative effect of the change
in accounting principle for periods prior to December 1, 2009 that represents
the cumulative amortization of the additional amounts to be recognized by FSP
14-1, reclassify from long-term debt to a component of equity the calculated
equity component of our 2.0% Convertible Notes and 1.625% Convertible Notes,
reclassify the deferred debt issuance costs allocated to equity issuance to a
component of equity and restate the consolidated financial statements for any
prior fiscal year presented to reflect the impact of FSP 14-1.  We are
currently assessing the impact of adopting FSP 14-1 on our consolidated
financial statements.  The provisions of FSP 14-1 are to be applied
retrospectively to all periods presented upon adoption and are effective for
fiscal years beginning after December 15, 2008, or our fiscal 2010, and interim
periods within those fiscal years.





Forward
Looking Statements





We may
from time to time make written and oral forward-looking statements.
Forward-looking statements may appear in writing in documents filed with the
Securities and Exchange Commission, in press releases and in reports to
shareholders or be made orally in publicly accessible conferences or conference
calls. The Private Securities Litigation Reform Act of 1995 contains a safe
harbor for forward-looking statements. We rely on this safe harbor in making
such disclosures. These forward-looking statements generally can be identified
by use of phrases such as “believe,” “plan,” “expect,” “anticipate,” “intend,”
“forecast” or other similar words or phrases.  These forward-looking
statements relate to, among other things, our strategic and business initiatives
and plans for growth or operating changes; our financial condition and results
of operation; future events, developments or performance; and management’s
expectations, beliefs, plans, estimates and projections.  The
forward-looking statements are based on management’s current beliefs and
assumptions about expectations, estimates, strategies and projections. These
statements are not guarantees of future performance and involve risks,
uncertainties and assumptions that are difficult to predict. Therefore, actual
outcomes and results may differ materially from what is expressed or forecasted
in such forward-looking statements. We undertake no obligation to update
publicly any forward-looking statements whether as a result of new information,
future events or otherwise. Factors that could cause our actual results to
differ materially from those anticipated in the forward-looking statements in
this Form 10-Q and the documents incorporated herein by reference include the
following:





•
            we
      face significant competition in the OTC healthcare, toiletries and dietary
      supplements markets;


•
            our
      acquisition strategy is subject to risk and may not be
      successful;


•
            our
      initiation of a voluntary recall of our Icy HotHeat Therapy
      products could expose us to product liability
  claims;


•
            we
      have received claims that allege personal injury from ingestion of Dexatrimcontaining
      ephedrine in 2000 and 2003;


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


•
            litigation
      may adversely affect our business, financial condition and results of
      operations;


•
            we
      have a significant amount of debt that could adversely affect our business
      and growth prospects;


•
            our
      product liability insurance coverage may be insufficient to cover existing
      or future liability claims;


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


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


•
            we
      may be adversely affected by fluctuations in buying decisions of mass
      merchandise, drug and food trade buyers and the trend toward retail trade
      consolidation;


•
            we
      rely on third party manufacturers for a portion of our product portfolio,
      including products under our Gold Bond, Icy Hot, Selsun, Dexatrim, ACT, Unisom and Kaopectatebrands;




39


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


•
            our
      business could be adversely affected if we are unable to successfully
      protect our intellectual property;


•
            because
      most of our operations are located in Chattanooga, Tennessee, we are
      subject to regional and local
risks;


•
            we
      depend on sole or limited source suppliers for ingredients in certain of
      our products, and our inability to buy these ingredients would prevent us
      from manufacturing these products;


•
            we
      are subject to the risk of doing business
  internationally;


•
            the
      terms of our outstanding debt obligations limit certain of our
      activities;


•
            to
      service our indebtedness, we will require a significant amount of
      cash;


•
            our
      operations are subject to significant environmental laws and
      regulations;


•
            we
      are dependent on certain key executives, the loss of whom could have a
      material adverse effect on our
business;


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


•
            the
      trading price of our common stock may be
  volatile;


•
            we
      have no current intentions of paying dividends to holders of our common
      stock;


•
            we
      can be affected adversely and unexpectedly by the implementation of new,
      or changes in the interpretation of existing, accounting principles
      generally accepted in the United States of America
    (“GAAP”);


•
            identification
      of material weakness in internal controls over financial reporting may
      adversely affect our financial
results;


•
            the
      convertible note hedge and warrant transactions may affect the value of
      our common stock and our convertible
notes;


•
            conversion
      of our convertible notes may dilute the ownership interest of existing
      shareholders, including holders who had previously converted their
      convertible notes;


•
            virtually
      all of our assets consists of intangibles;
and


•
            other
      risks described in our Securities and Exchange Commission
      filings.


40


Item 3. Quantitative and
Qualitative Disclosures About Market Risks





We are
exposed to market risk from changes in interest rates and foreign currency
exchange rates, which may adversely affect our results of operations and
financial condition.  We seek to minimize the risks from these
interest rates and foreign currency exchange rate fluctuations through our
regular operating and financing activities.





Our
exposure to interest rate risk currently relates to amounts outstanding under
our Credit Facility.  Loans under the revolving credit facility
portion of our Credit Facility bear interest at LIBOR plus applicable
percentages of 0.875% to 1.50% or the higher of the federal funds rate plus
0.50% or the prime rate (the “Base Rate”).  The applicable percentages
are calculated based on our leverage ratio.  The term loan under our
Credit Facility bears interest at either LIBOR plus 1.75% or the Base Rate plus
0.75%.  As of May 31, 2008, $45.2 million was outstanding under the
revolving credit facility and $109.0 million was outstanding under the term loan
portion of our Credit Facility.  The variable rate for the revolving
credit facility was LIBOR plus 1.25%, or 4.16% as of May 31, 2008, and the
variable rate for the term loan portion was LIBOR plus 1.75%, or 4.46%, as of
May 31, 2008.  The 7.0% Subordinated Notes, the 1.625% Convertible
Notes and the 2.0% Convertible Notes are fixed interest rate
obligations.





In
November 2006, we entered into an interest rate swap (“swap”) agreement
effective January 2007.  The swap has decreasing notional principal
amounts beginning October 2007 and a swap rate of 4.98% over the life of the
agreement.  As of May 31, 2008, the decrease in fair value of $0.5
million, net of tax, was recorded to other comprehensive income and the swap was
deemed to be an effective cash flow hedge.  The swap agreement
terminates in January 2010.





In April
2007, we entered into an interest rate cap (“cap”) agreement.  The cap
has decreasing notional principal amounts beginning May 2007 and a cap rate of
5.0% over the life of the agreement.  As of May 31, 2008, the value of
the cap, as valued by a third party, is insignificant. The cap agreement
terminates in September 2008.





The
impact on our results of operations of a one-point rate change on the July 1,
2008 outstanding revolving credit facility balance of $52.2 million and $108.0
million term loan balance of our Credit Facility for the next twelve months
would be approximately $1.0 million, net of tax.





We are subject to risk from changes in
the foreign exchange rates relating to our Canadian, U.K., Irish and Greek
subsidiaries. Assets and liabilities of these subsidiaries are translated to
U.S. dollars at 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
as a component of investment and other income in the accompanying consolidated
statements of income.  The potential loss resulting from a
hypothetical 10.0% adverse change in the quoted foreign currency exchange rate
amounts to approximately $1.4 million as of May 31, 2008.





This market risk discussion contains
forward-looking statements.  Actual results may differ materially from
this discussion based upon general market conditions and changes in financial
markets.





Item 4. Controls and
Procedures





Under the
supervision and with the participation of our management, including our Chief
Executive Officer and Principal 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 May 31, 2008 (the “Evaluation
Date”).  Based on such evaluation, such officers have concluded that,
as of the Evaluation Date, our disclosure controls and procedures were effective
in alerting them on a timely basis to material information relating to us
(including our consolidated subsidiaries) required to be included in our reports
filed or submitted under the Exchange Act.


41


PART II.  OTHER
INFORMATION


Item 1.  Legal
Proceedings





See Note 19 of Notes to Consolidated
Financial Statements included in Part 1, Item 1 of this Report.





Item 1A.  Risk
Factors





There have been no material changes
from the risk factors previously disclosed in our Annual Report on Form 10-K for
the year ended November 30, 2007, other than the addition of the following risk
factor.





Our initiation of a voluntary recall of
our Icy Hot Heat
Therapy products could expose us to additional product liability
claims.





On February 8, 2008, we initiated a
voluntary nationwide recall of our Icy Hot Heat Therapy
products.  The recall is being conducted to the consumer
level.  We recalled these products because we received some consumer
reports of first, second and third degree burns, as well as skin irritation
resulting from consumer use or possible misuse of the products.  We
may receive lawsuits in the future alleging skin irritation and/or burns from
use of our Heat Therapy products.  See our current Report on Form 8-K,
filed on February 14, 2008, for additional information.





We have received claims that allege
personal injury from ingestion of Dexatrim containing ephedrine
in 2000 through 2003.





We expect that some or all of these
claimants may file lawsuits against us.  If the lawsuits are filed, we
plan to vigorously defend these claims.  If notwithstanding our
defenses these or other product liability claims are resolved in favor of the
claimants, it could have a material adverse effect on our results of operation
and financial condition.





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





(a) Not applicable.





(b) Not applicable.





(c) A summary of the common stock
repurchase activity for our second quarter of fiscal 2008 is as
follows:





Period
            
            Total
      Number
              of
      Shares
              Purchased
            
            
            Average
      Price
              Paid Per Share (1)
            
            
            Total
      Number of Shares Purchased
              as
      Part of Publicly Announced Plans or Programs (2)
            
            
            Approximate
      Dollar Value of Shares that may yet be
              Purchased
      under the Plans or
              Programs (2)March
      1– March 31
            
            
            —
            
            
            $
            —
            
            
            
            —
            
            
            $
            64,306,212April
      1 – April 30
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            100,000,000May
      1 – May 31
            
            
            183,681
            
            
            
            67.04
            
            
            
            183,681
            
            
            
            87,686,314Total
      Second Quarter
            
            
            183,681
            
            
            $
            67.04
            
            
            
            183,681
            
            
            $
            87,686,314





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


(2)
            On
      April 30, 2008, our Board of Directors increased the authorization to a
      total of $100.0 million of our common stock under the terms of our
      existing stock repurchase program.  There is no expiration date
      specified for our stock buyback
program.





Item 3.  Defaults
Upon Senior Securities




None.





Item
4.  Submission of Matters to a Vote of Security
Holders





Our annual meeting of shareholders was
held on April 9, 2008 in Chattanooga, Tennessee.  At the meeting, the
following items were submitted to a vote of shareholders:


42





(1)
            The
      following persons were elected as directors to serve for a three-year
      term:  Samuel E. Allen (15,897,757 votes for and 759,318 votes
      withheld), Ruth W. Brinkley (16,375,630 votes for and 281,445 votes
      withheld), and Philip H. Sanford (16,375,438 votes for and 281,637 votes
      withheld).  Other directors whose terms of office continued
      after the annual meeting are: Gary D. Chazen, Robert E. Bosworth, Zan
      Guerry and Bill W. Stacy.


(2)
            Approval
      of the Chattem, Inc. Annual Cash Incentive Plan (16,222,887 votes for;
      398,319 votes against; and 35,868
abstentions).


(3)
              Ratification
      of Grant Thornton, LLP as the Company’s independent auditors for fiscal
      2008 (16,646,844 votes for; 6,253 votes against; and 3,978
      abstentions).




Item 5.  Other
Information





On July
8, 2008, we entered into amended and restated agreements with certain of our
officers, including certain of our named executive officers, concerning the
terms of their existing employment and severance agreements, as applicable, to
ensure compliance with Section 409A of the Internal Revenue Code of 1986, as
amended (the “Code”), and to make certain other updating changes and
clarifications. These agreements (collectively, the “Restated Agreements”)
consist of (i) the Amended and Restated Employment Agreement (the “Restated
Employment Agreement”) with Zan Guerry, our Chairman and Chief Executive
Officer, (ii) the Second Amended and Restated Severance Agreement (the “Restated
Severance Agreement”) with Mr. Guerry, and (iii) the Second Amended and Restated
Non-Competition and Severance Agreements (the “Restated Non-Competition and
Severance Agreements”) with the following officers (collectively, the
“Officers”):  Robert E. Bosworth, President and Chief Operating
Officer; Theodore K. Whitfield, Jr., Vice President, General Counsel and
Secretary; Andrea M. Crouch, Vice President – Brand Management; Ron Galante,
Vice President – New Business Development; B. Derrill Pitts, Vice President –
Operations; J. Blair Ramey, Vice President – Marketing; and Charles M.
Stafford, Vice President – Sales.  Also on July 8, 2008, we entered
into new Non-Competition and Severance Agreements (the “New Non-Competition and
Severance Agreements”) with each of the following officers:  Robert B.
Long, Vice President – Finance; Joseph J. Czerwinski, Vice President – Product
Development; and John L. Stroud, Vice President – Marketing.




Section
409A of the Code imposes various substantive limitations on the terms of
nonqualified deferred compensation arrangements, which can be deemed to include
employment agreements and change in control and severance
agreements.  Section 409A imposes penalty taxes on the officers
receiving payments under arrangements that do not comply with the requirements
of Section 409A.




Copies of
the Restated Employment Agreement, the Restated Severance Agreement, the form of
the Restated Non-Competition and Severance Agreements and the form of the New
Non-Competition and Severance Agreements are attached hereto as Exhibits 10.2,
10.3, 10.4 and 10.5, respectively, and are incorporated herein by reference
thereto.  A brief description of the terms and conditions of each
Restated Agreement, which replaces the prior agreement between us and the
officer, and of the New Non-Competition and Severance Agreement is set forth
below and is qualified in its entirety by reference to the full text of the
applicable agreement.




Restated
Employment Agreement with Mr. Guerry




The
Restated Employment Agreement is intended to secure the long-term commitment of
Mr. Guerry to remain in our employ and impose restrictions on competitive
activities should he leave our employment for any reason.  The
Restated Employment Agreement provides for a base salary as adjusted from time
to time by the Compensation Committee (the “Committee”) of our Board of
Directors and his participation in our annual bonus plan and stock option plans
as determined from time to time by the Committee.  Under the terms of
the Restated Employment Agreement, Mr. Guerry is prohibited from competing with
us with respect to certain of our products or using confidential information
(other than trade secrets, which must be maintained confidential for so long as
the information remains a trade secret, as indicated below) for a period of 18
months after termination of employment.  In addition, depending upon
the event triggering termination of employment, Mr. Guerry would be entitled to
receive certain levels of benefits described in the Restated Employment
Agreement.




The
Restated Employment Agreement is consistent with Mr. Guerry’s prior employment
agreement, except for the following amendments (among other clarifying
changes):




·
            Addition
      of a requirement that initial severance payments accrue and be paid in a
      lump sum on the first day of the seventh month after the date of
      termination of employment (or, if earlier, the date of death) in
      compliance with Section 409A of the Code with subsequent payments to be
      made in the time and manner otherwise required under the
      agreement.


·
            Clarification
      of the health, medical and life insurance benefits payable to Mr. Guerry
      in the event of termination without cause, and conformance of the
      provision of such benefits with COBRA requirements and the requirements of
      Section 409A of the Code.




43


·
            An
      update of the description of the Company’s current business and market for
      purposes of clarifying the non-competition restrictions contained in the
      agreement.


·
            Clarification
      of the definition of confidential information and trade secrets under the
      agreement and specification that trade secrets shall be maintained as
      confidential for so long as the information remains a trade
      secret.




Restated
Severance Agreement with Mr. Guerry




The
Restated Severance Agreement is intended to secure Mr. Guerry’s continued
service with us during, and to foster his unbiased and analytical assessment of,
any offer to acquire control of us.  Under the terms of the Restated
Severance Agreement, if certain events by us cause the termination of employment
of Mr. Guerry within 24 months after the occurrence of a change in “control of
control” (as defined in the agreement) or if Mr. Guerry resigns during the
period between 180 days and 240 days following a change in control, he would be
entitled to the severance benefits described in the Restated Severance
Agreement.




The
Restated Severance Agreement is consistent with Mr. Guerry’s prior severance
agreement, except for the following amendments (among other clarifying
changes):




·
            Clarification
      that a “discharge” or “constructive discharge” (as such terms are defined
      in the agreement) of Mr. Guerry after the date of a shareholder meeting
      approving a change in control but before the date of the actual change in
      control will entitle Mr. Guerry to payment of the severance benefits
      otherwise payable under the
agreement.


·
            Revision
      of the definition of “change in control” to conform to the definition
      provided in Section 409A of the Code thereby modifying descriptions of the
      triggering events relating to acquisitions and changes in the composition
      of our Board of Directors and adding triggering events relating to certain
      transactions involving the sale by us of all or substantially all of our
      assets or our consummation of a merger, consolidation, reorganization or
      business combination and shareholder approval of our liquidation or
      dissolution.


·
            Clarification
      that the reduction of certain compensation at the request of Mr. Guerry to
      prevent an excess parachute payment taxable under Section 280G and 4999 of
      the Code is subject to the acquiescence of the
  Company.


·
            Addition
      of a requirement that we indemnify Mr. Guerry on an after-tax basis for
      any excise taxes resulting from excess parachute payments taxable under
      Section 280G and 4999 of the Code in the event the limitations in the
      agreement do not operate as intended to prevent such
  taxes.


·
            Revision
      of the terms of the severance benefit payable under the agreement to
      eliminate the choice of Mr. Guerry as to the timing of the payment and to
      require a lump sum payment six months after the date of termination of
      employment (or, if earlier, the date of death) in compliance with Section
      409A of the Code.


·
            Elimination
      of mandatory arbitration to resolve any disputes arising under the terms
      of the agreement.




Restated
Non-Competition and Severance Agreements with the Officers




The
Restated Non-Competition and Severance Agreements are intended to secure
continuity of our management during, and to foster their unbiased and analytical
assessment of, any offer to acquire control of us.  Under the terms of
the Restated Non-Competition and Severance Agreements, the Officers are
prohibited from competing with us with respect to certain of our products or
using confidential information (other than trade secrets, which must be
maintained confidential for so long as the information remains a trade secret,
as indicated below) for a period of 12 months after termination of
employment.  In addition, if certain events by us cause the
termination of employment of an Officer within 24 months after the occurrence of
a change in “control of control” (as defined in the agreement) or if the Officer
resigns during the period between 180 days and 240 days following a change in
control, the Officer would be entitled to the severance benefits described in
the Restated Non-Competition and Severance Agreement.




The
Restated Non-Competition and Severance Agreements are consistent with the prior
non-competition and severance agreements with the Officers, but have been
amended to include the same changes as those noted above for the Restated
Severance Agreement with Mr. Guerry.  Moreover, the following
additional amendments (among other clarifying changes) have been
made:




·
            Reduction
      of the period during which confidential information must be maintained by
      the officer from 3 years to a period of 12 months following termination of
      employment provided that trade secrets must be maintained as confidential
      for so long as the information remains a trade
  secret.




44


·
            Revision
      of the non-competition provision to update the description of the
      Company’s current business and market  to conform to the
      language described above with respect to the Restated Employment Agreement
      for Mr. Guerry and to reduce the period of non-competition from 3 years to
      12 months after termination of
employment.


·
            Clarification
      of the health, medical and life insurance benefits payable to an Officer
      in the event of the payment of a severance benefit under the agreement,
      and conformance of the provision of such benefits with COBRA requirements
      and the requirements of Section 409A of the
  Code.


·
            Elimination
      of mandatory arbitration to resolve any disputes arising under the terms
      of the agreement and specification of the availability of injunctive
      remedies to the Company in the event of a breach of the provisions of the
      agreement by the Officer.




New
Non-Competition and Severance Agreement




The New
Non-Competition and Severance Agreement has the same purpose and generally has
terms consistent with the existing Restated Non-Competition and Severance
Agreements with the Officers, except for the following new provisions (in
addition to other updating and clarifying language) which are intended to
reflect more customary current market conditions:




·
            Reduction
      of the severance benefit payable under the agreement from 2 times the base
      compensation for purposes of the golden parachute provisions of Section
      280G of the Code (which could include certain non-cash compensation such
      as the value of stock option exercises or other extraordinary compensation
      during the 5 year period prior to termination of employment) to 2 times
      the officer’s highest annual base salary during the 1 year period prior to
      termination of employment plus the greater of the officer’s bonus for the
      immediately preceding calendar year or targeted bonus for the current
      calendar year.


·
            Reduction
      of the period after a change in control during which a “discharge” or
      “constructive discharge” triggers the payment of the severance benefit
      from 2 years to 1 year.


·
            Elimination
      of the window period from 180 days to 240 days after a change in control
      in which an officer can voluntarily terminate employment and trigger the
      payment of the severance benefit notwithstanding that neither a
      “discharge” nor “constructive discharge” has
  occurred.


·
            Expansion
      of the non-competition provisions of the agreement to prevent the
      solicitation of employees of the Company for other service by the officer
      regardless of whether such service is competitive to the business of the
      Company and to prevent disparaging remarks regarding the
      Company.·
            Addition of a
      form release of all claims which the Company may require the officer to
      sign prior to the payment of severance benefits under the
      agreement.







Item 6.
Exhibits





Exhibits
(numbered in accordance with Item 601 of Regulation S-K):





Exhibit Number
            
            Description10.1
            
            Chattem,
      Inc. Annual Cash Incentive Plan (incorporated by reference to Exhibit 10.1
      to the Registrant’s Current Report on Form 8-K filed on May 7,
      2008)10.2
            
            Amended
      and Restated Employment Agreement dated July 8, 2008 by and between
      Chattem, Inc. and Zan Guerry.10.3
            
            Second
      Amended and Restated Severance Agreement dated July 8, 2008 by and between
      Chattem, Inc. and Zan Guerry.10.4
            
            Form
      of Amended and Restated Non-Competition and Severance Agreement – Robert
      E. Bosworth, Andrea Crouch, Ron Galante, B. Derrill Pitts, Blair Ramey,
      Charles M. Stafford and Theodore K. Whitfield, Jr.10.5
            
            Form
      of Non-Competition and Severance Agreement – Joseph J. Czerwinski, Robert
      B. Long and John L. Stroud .




45


31.1
            
            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


46


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)










Date:
      July 9,
    2008
              /s/ Zan
      GuerryZan
      GuerryChairman
      and Chief Executive Officer






Date:
      July 9,
    2008
              /s/ Robert
      B. LongRobert
      B. LongVice
      President, Finance (Principal
      Financial Officer)





47


Chattem, Inc. and
Subsidiaries


Exhibit
Index








Exhibit
      Number
              
              Description10.2
              
              Amended
      and Restated Employment Agreement dated July 8, 2008 by and between
      Chattem, Inc. and Zan Guerry.10.3
              
              Second
      Amended and Restated Severance Agreement dated July 8, 2008 by and between
      Chattem, Inc. and Zan Guerry.10.4
              
              Form
      of Amended and Restated Non-Competition and Severance Agreement – Robert
      E. Bosworth, Andrea Crouch, Ron Galante, B. Derrill Pitts, Blair Ramey,
      Charles M. Stafford and Theodore K. Whitfield, Jr.10.5
              
              Form
      of Non-Competition and Severance Agreement – Joseph J. Czerwinski, Robert
      B. Long and John L. Stroud.
  31.1
              
              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
  48