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________________________________________________________________________________


UNITED STATES SECURITIES AND EXCHANGE
COMMISSION

Washington, DC 20549


Form 10-K

|  |  |                                                                                             
|- |  | --------------------------------------------------------------------------------------------
|þ |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934    
|  |  | For the fiscal year ended December 31,
    2002                                             
| 
|o |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR
    15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number 0-21185

aaiPharma Inc.

(Exact name of Registrant as specified in its
charter)


|                                                                   |  |                                         
|------------------------------------------------------------------ |  | ----------------------------------------
|Delaware                                                           |  | 04-2687849                              
|(State or other jurisdiction of
    incorporation or organization) |  | (I.R.S. employer
    identification no.)

2320 Scientific Park Drive, Wilmington, NC
28405

(Address of principal executive offices) (Zip
code)


(910) 254-7000

(Registrants telephone number, including
area code)


Securities registered pursuant to
Section 12(g) of the Act:

COMMON STOCK, $0.001 PAR VALUE PER
SHARE

(Title of class)


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.     Yes þ     No o

Indicate by check mark if disclosure of
delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be
contained, to the best of registrants knowledge, in
definitive proxy or information statements incorporated by
reference in Part III of this Form 10-K or any amendment to
this
Form 10-K.     o

Indicate by check mark whether the registrant is
an accelerated filer (as defined in Exchange Act
Rule 12b-2)     Yes þ     No o

The aggregate market value of the voting and
non-voting common equity held by non-affiliates computed by
reference to the price at which the common equity was last sold,
or the average bid and asked price of such common equity, as of
June 28, 2002, was $151,434,250.

The number of shares outstanding of
registrants common stock, as of March 12, 2003 was
27,608,540 shares.



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PART I

Item 1.     Business

The terms we, us or
our in this Form 10-K include aaiPharma Inc.,
its corporate predecessors and its subsidiaries, except where
the context may indicate otherwise. Our corporation was
incorporated in 1986, although its corporate predecessor was
founded in 1979. In 1999, we merged with Medical & Technical
Research Associates, Inc.

Our principal executive offices are located at
2320 Scientific Park Drive, Wilmington, North Carolina
(telephone: 910-254-7000).

Our Internet address is www.aaipharma.com. We
make available through our internet website our annual reports
on Form 10-K, quarterly reports on Form 10-Q, current
reports on Form 8-K, and amendments to those reports filed
or furnished pursuant to Section 13(a) of the Securities
Exchange Act of 1934 as soon as reasonably practicable after we
electronically file such material with, or furnish it to, the
Securities and Exchange Commission.

Trademarks and Trade Names

We own the following registered and unregistered
trademarks: Darvon®, Darvon-N®, Darvocet-N®,
M.V.I.®, M.V.I.-12®, M.V.I. Pediatric, M.V.I.
Adult, Aquasol®, Aquasol A®, Aquasol E®,
Brethine®, ProSorb®, ProSorb-D, ProSLO,
ProSLO II, ProCore®, ProSpher®, ProLonic,
ProMelt®, NeoSan, AzaSan, aaiPharma, and
AAI®. References in this document to Darvon are to
Darvon® and Darvon-N® collectively and references to
Darvocet are to Darvocet-N®. We also reference trademarks
owned by other companies. Cataflam® is a registered
trademark of Novartis Corporation, Infuvite® is a
registered trademark of Sabex Inc., Oxycontin® is a
registered trademark of Purdue Pharma L.P., Prilosec® is a
registered trademark of AstraZeneca AB, Proventil® is a
registered trademark of Schering Corporation, Prozac® is a
registered trademark of Eli Lilly and Company, Volmax® is a
registered trademark of GlaxoSmithKline, Imuran® is a
registered trademark of Prometheus Laboratories, Inc. and
Ultram® is a registered trademark of Johnson & Johnson.
All references in this document to any of these terms lacking
the ® or  symbols are defined
terms that reference the products, technologies or businesses
bearing the trademarks with these symbols.

Overview

We are a science-based specialty pharmaceutical
company focused on the commercialization of branded
pharmaceutical products that we develop or acquire. We have over
23 years of pharmaceutical research and development
experience, with operations primarily in the United States and
Europe. We have acquired three branded product lines since
August 2001  the M.V.I. and Aquasol family of
products, Brethine and the Darvon and Darvocet family of
products. In addition, we are developing our own proprietary
products, as well as developing improvements and line extensions
to our acquired products, by applying our scientific expertise
and portfolio of proprietary and in-licensed drug-delivery
technologies. Historically, we have generated our revenues by
providing a comprehensive spectrum of pharmaceutical research
and development services on a fee-for-service basis to a broad
base of customers, including large pharmaceutical companies such
as AstraZeneca PLC, Bayer AG, Eli Lilly and Company, Novartis
Corporation, Medicis Pharmaceuticals Corp., and Roche
Pharmaceuticals.

In 2001, we began acquiring established, branded
pharmaceutical products within our targeted therapeutic
classes critical care, pain management, and
gastrointestinal diseases. We seek to acquire products whose
sales we believe can be increased through enhanced marketing and
promotion and that we can improve by applying our significant
research and development capabilities.

We operate through the following businesses:



| |   |                                                                                                                                                                                                                 
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Pharmaceuticals
    Division.The Pharmaceuticals Division
    of aaiPharma (including our wholly-owned subsidiary aaiPharma
    LLC, formerly NeoSan Pharmaceuticals, Inc.) (collectively, the
    Pharmaceuti-

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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | cals Division) commercializes branded
    pharmaceutical products in our targeted therapeutic classes. We
    market and promote our branded products directly through our
    sales force to high-prescribing physicians of our products and
    other products in our targeted therapeutic classes. When we
    acquire products, we seek products that we believe will benefit
    from our sales promotion and to which we can apply the
    scientific expertise of our other divisions to develop product
    line extensions and improvements. The Pharmaceuticals Division
    had $128.5 million of net revenues in 2002.                                                                                                                                                                                                                                                               
|
| |  | Research and Development
    Division.Our Research and Development
    Division (the Research and Development Division)
    provides research and development expertise and our portfolio of
    drug-delivery technologies and intellectual property rights,
    which we use to enhance and develop products that are
    innovative, safer or more effective, convenient or
    cost-efficient. This can result in renewed regulatory or patent
    exclusivity, adding to the commercially valuable life of the
    product. We apply this expertise to internally develop our own
    new products and improve our acquired products. In addition, we
    offer these product improvement, or life cycle management,
    activities to our customers for royalties, milestone payments
    and fees. Net revenues for the Research and Development Division
    in 2002 were $19.6 million.
|
| |  | AAI International.AAI International offers a comprehensive range of pharmaceutical
    product development services to our customers on an
    international basis. These services include formulation,
    development, analytical, microbiological, bioanalytical and
    stability testing services, biotechnology analysis and
    synthesis, human clinical trials, regulatory consulting, and
    manufacturing. These services generally are provided on a
    fee-for-service basis. Net revenues for AAI International in
    2002 were $82.4 million.                                                                                                                                                                                                                                                                                                                                   

Pharmaceuticals Division  Our Product
Sales Business

The Pharmaceuticals Division commercializes
branded pharmaceutical products that we develop and acquire in
our targeted therapeutic classes  critical care, pain
management, and gastrointestinal diseases. We market and promote
our branded products directly through our sales force to
high-prescribing physicians. We directly hire and manage our own
internal sales force and, as of February 28, 2003, we had a
sales force of approximately 80 representatives, which we plan
to significantly expand during the remainder of 2003 to 150
sales representatives. We use data generated by third-parties to
identify physicians who prescribe our products and other
products in our targeted therapeutic classes. When we acquire
products, we seek products that we believe will benefit from our
sales promotion and to which we can apply the scientific
expertise of our other divisions to develop product line
extensions and improvements.

In August 2001, we acquired from AstraZeneca the
U.S. rights to the M.V.I. and Aquasol branded product lines of
critical care injectable and oral nutritional products, which
provide nutrients to cancer, AIDS, post-operative and
nutritionally compromised patients. In December 2001, we
acquired from Novartis the U.S. rights to the Brethine branded
product line, which treats asthma. In February 2002, we acquired
from Aesgen Inc. the U.S. rights to calcitriol, an injectable
vitamin D nutritional product, as a line extension opportunity
for the Aquasol product line. In March 2002, we acquired from
Eli Lilly the U.S. rights to the Darvon and Darvocet branded
product lines, which treat mild-to-moderate pain.

Through the Pharmaceuticals Division, we seek
commercially stable products within our targeted therapeutic
classes with strong brand recognition and high gross margins. We
also seek to acquire and commercialize established
pharmaceutical products that we believe have not been actively
marketed and promoted for at least several years prior to our
acquiring them. Our goal is to increase the value of the brands
that we acquire by promoting them to high-prescribing
physicians, using one-on-one meetings, product sampling,
educational programs, advertising, direct mail, and website
promotion. In the future, we intend to acquire products that we
can promote to our existing customer base, thereby leveraging
our sales force.

We also plan to apply the scientific expertise of
AAI International and the Research and Development
Divisions portfolio of patents and proprietary and
in-licensed drug-delivery technologies and other intellectual
property to develop new formulations, delivery systems,
indications, dosage forms and line extensions for our branded
products that will improve their safety, efficacy, convenience
or cost effectiveness

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or reduce their side effects. Once approved by
the FDA, we intend to market these products under the acquired
brand names, thereby leveraging the value of the existing brands
for our product improvements and line extensions. Additionally,
we will seek renewed regulatory or patent exclusivity for these
improved products. A new indication for an existing product or
changes in product composition, method of use, formulation and
process may, in appropriate cases with the addition of Phase III
studies showing efficacy and safety, provide three-year
non-patent regulatory exclusivity or longer-term patent
protection.


Additionally, through the development expertise
of the Research and Development Division, our Pharmaceuticals
Division is continuing internal development efforts on our own
branded pharmaceutical products. Product candidates in the later
stages of development include an imidapril tablet, which is an
angiotensin converting enzyme (ACE) inhibitor, for
treatment of cardiovascular disease. Earlier stage products
include a quick-dissolving omeprazole tablet for treatment of
stomach and ulcer ailments and a controlled release mesalamine
tablet for treatment of ulcerative colitis, or Crohns
disease, a particular type of gastrointestinal disease. The
details of our pipeline of product candidates from the
development work of our Research and Development Division is
discussed in Research and Development Division  Our
Product Development Business. However, because of the
inherent uncertainties of pharmaceutical development, we do not
know whether we will ever be able to successfully commercialize
any of these product candidates.

Darvon and Darvocet

On March 28, 2002, we acquired from Eli
Lilly the U.S. rights to the Darvon and Darvocet branded product
lines in the U.S. (and the existing inventory of these products)
for $211.4 million in cash, subject to adjustments described
below. The Darvon and Darvocet products are prescribed for the
treatment of mild-to-moderate pain. The acquired products
include Darvon (propoxyphene hydrochloride), Darvocet-N
(propoxyphene napsylate and acetaminophen) and Darvon-N
(propoxyphene napsylate).

These product lines have been sold in the U.S.
for over 25 years, with the initial marketing of Darvon
beginning in 1957. Darvon lost its patent exclusivity in 1973
and Darvon-N and Darvocet-N in 1985. The first generic version
of Darvon was introduced in 1973, and by 1985, numerous generic
products were being marketed for substitution for Darvon and
Darvocet. We believe that Eli Lilly ceased actively promoting
these brands in approximately 1993.

Acquisition Terms.We paid $211.4 million in cash for the rights in the U.S. to
these products and Eli Lillys existing inventory of these
products. In addition, we have agreed to pay Eli Lilly royalties
upon sales of our future developed improvements to the Darvon
and Darvocet products or other products containing the active
ingredient propoxyphene and any other pharmaceutical products
sold under the name Darvon, Darvocet or certain other
trademarks. We will pay a royalty on sales of each of these
future products during each calendar quarter for a ten-year
period beginning upon the products commercial
introduction, provided that the total net sales of all of these
future products, combined with the total net sales of the
current Darvon and Darvocet products, exceed $15.8 million in
the applicable calendar quarter. We will not owe any royalties
on the sales of the Darvon and Darvocet products themselves that
we acquired from Eli Lilly.

Supply of Product.Under a manufacturing agreement that we have entered into with
Eli Lilly, Eli Lilly agreed to supply a specified percentage of
our requirements from and after closing for the existing twelve
Darvon and Darvocet product presentations (form and dosage). The
supply agreement will extend through December 31, 2004.
Upon the satisfaction of certain conditions, including payment
by us of a $4.0 million extension fee, we may extend the
agreement for an additional six months, during which Eli Lilly
will use commercially reasonable efforts to supply the
Pharmaceuticals Division with a full calendar years supply
of products during the extension period, subject to certain
maximum and minimum quantities. Under this agreement, we have
agreed to order the manufacture of certain minimum amounts of
Darvon and Darvocet products and certain minimum percentages of
our requirements: 60% of our requirements in the first year, 50%
in the second year, and 40% in the third year. Also under this
agreement, the supply obligation of Eli Lilly is subject to a
maximum amount of the Darvon and Darvocet products over the life
of the contract. We anticipate that this maximum supply
obligation of Eli Lilly is sufficient to cover all of our supply
needs through the end of 2005. We will purchase these products
manufactured by Eli Lilly for a fixed unit cost,

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subject to a percentage increase on each January
1 plus any increase in Eli Lillys cost of raw materials
during that year. However, the purchase price for these products
will be no less than Eli Lillys standard cost of
manufacturing, which includes raw materials, direct labor, and
plant overhead attributable to the Darvon and Darvocet products.
Prior to expiration of this agreement, we intend to have FDA
approval permitting the transfer of the manufacturing of these
products to our manufacturing facilities, one or more
third-party manufacturing facilities, or a combination of these
facilities. This approval, however, could require significant
expense and time, and it is possible that we never receive it.


Brethine

On December 13, 2001, we acquired the U.S.
rights to the Brethine branded product line from Novartis
Pharmaceuticals Corporation and Novartis Corporation for $26.6
million in cash. Brethine is administered in oral and injectable
forms for the prevention and reversal of bronchospasm in
patients age 12 and older with asthma and reversible
bronchospasm associated with bronchitis and emphysema. Although
physicians also prescribe Brethine to stop premature labor, this
drug has not been approved by the FDA for this indication and
thus it cannot be marketed or promoted for this use. Brethine
was initially marketed beginning in 1975. We believe that
Novartis ceased actively promoting Brethine in the early 1990s,
although Novartis selectively marketed and promoted Brethine
since then and a third party provided marketing support for
Brethine during 1999 and 2000.

Brethine, or terbutaline sulfate, is a
beta-adrenergic agonist bronchodilator, meaning that it aids in
the flow of air through the bronchial tubes for people suffering
from asthma, emphysema, chronic bronchitis, and other lung
diseases. IMPAX Laboratories has been marketing a generic form
of the oral form of Brethine since July 2001. There are no
approved generic forms of the injectable form of this drug.
Major branded products competing against Brethine to treat these
ailments include Volmax, Proventil, and branded and generic
forms of albuterol.

Supply of Product.We entered into an interim supply agreement with Novartis
providing for its manufacture and packaging of the oral and
injectable form of Brethine for sale by us in the U.S. through
December 13, 2004. We may terminate the manufacturing
component of the supply agreement on twelve months notice
and the packaging component on six months notice. Under
the supply agreement, we may purchase the products for a fixed
unit cost during the term of the agreement, subject to an annual
price adjustment on January 1, 2003 and January 1,
2004 tied to the Consumer Price Index and to a downward
adjustment in the event product packaging is moved to a third
party. We intend to transfer the Brethine manufacturing
processes to our own facilities prior to expiration of the
supply agreement. This move, however, is subject to FDA
approval, and it is possible that this approval will involve
significant expense and will not be obtained on a timely basis,
if at all.

M.V.I. and
Aquasol

On August 17, 2001, we acquired the U.S.
rights to a line of critical care injectable and oral
nutritional products from AstraZeneca. These products are
M.V.I.-12, M.V.I. Pediatric, Aquasol A and Aquasol E. The
M.V.I.-12, M.V.I. Pediatric and Aquasol A products are
administered by intravenous or injected solution to provide
nutrients to severely ill patients for whom oral nutrition is
not feasible. Aquasol E is administered by oral solution. We
acquired these products for up to $100 million in cash, of which
we paid $52.5 million at closing of the acquisition. A
post-acquisition guaranteed payment of $1.0 million was paid in
August 2002. A second guaranteed payment of $1.0 million is due
in August 2003. The acquisition agreement provided for future
contingent payments. A contingent payment of $2.0 million would
have been due in August 2003 if the FDA had approved by
December 31, 2002 the reformulated M.V.I.-12 product with a
minimum shelf life of 12 months. In addition, a contingent
payment of up to $43.5 million is due in August 2004 if FDA
approval of the reformulated M.V.I.-12 product is received on or
before December 31, 2003, with the $43.5 million payment
being reduced by $1.0 million for each month after
December 31, 2002 during which FDA approval has not been
obtained. The $43.5 million payment will become zero in the
event FDA approval is not obtained on or before
December 31, 2003. An application for approval of this
reformulated product was submitted to the FDA in February 2003.

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The initial M.V.I. product and Aquasol A were
approved for marketing over 45 years ago, and M.V.I. Pediatric
was approved in 1983. No FDA approval is necessary to market
Aquasol E.

The M.V.I. products and Aquasol A are approved by
the FDA for the following uses:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | M.V.I.-12 is a multivitamin solution for
    intravenous use as a daily multivitamin for adults and children
    over 11 years receiving parenteral nutrition. It also is
    used in other situations where intravenous dosing is required
    due to nutrient depletion, including in surgery, for extensive
    burns, fractures and other trauma, for severe infectious
    diseases, and for comatose states.                                                       
|
| |  | M.V.I. Pediatric is a sterile powder intended for
    reconstitution as a solution for intravenous use as a daily
    multivitamin for infants and children up to 11 years of age
    receiving parenteral nutrition. It also is used in other
    situations where intravenous dosing is required due to nutrient
    depletion, including in surgery, for extensive burns, fractures
    and other trauma, for severe infectious diseases, and for
    comatose states.
|
| |  | Aquasol A (vitamin A) is an injectable vitamin
    solution used to provide vitamin A. Aquasol E Drops, which do
    not require FDA approval to be marketed, are nutritional
    supplements taken orally to provide vitamin E.                                                                                                                                                                                                                                         

The FDA has examined the product formulation and
the current state of medical thought on the vitamin and nutrient
levels needed in M.V.I.-12. After examining data from a public
workshop between the FDA and the American Medical Association as
to the appropriate dosage level of vitamins in parenteral
multivitamin preparations, the FDA increased the targeted dosage
levels of vitamins B1, B6, C and folic acid to be included in
multivitamin injectable products to a level greater than that
included in any existing product and required the inclusion of
Vitamin K. Prior to our acquisition of the M.V.I. product line
from AstraZeneca, we had been working with AstraZeneca on a
fee-for-service basis to reformulate M.V.I.-12 to meet these
guidelines.

Supply of Product.In connection with the M.V.I. and Aquasol acquisition, we
entered into an interim supply arrangement with AstraZeneca to
supply us with M.V.I.-12 in single-dose vials, multi-dose vials
and bulk, Aquasol A and Aquasol E. The initial term of this
interim supply agreement was for two years through
August 17, 2003, and we have exercised the option to extend
the term for an additional year, through August 17, 2004.
Under the interim supply agreement, we may purchase the products
for a fixed unit cost for the first two years equal to
AstraZenecas variable cost of goods sold during 2000 for
the relevant product, adjusted in August 2002 for changes in the
cost of raw materials and adjusted (limited to changes in the
Consumer Price Index) for changes in other manufacturing costs.
During the third year of supply, the price will increase to
AstraZenecas full variable and fixed costs plus 20%. If we
obtain FDA approval for the reformulated M.V.I.-12 product,
AstraZeneca will supply the reformulated product to us at a
price equal to AstraZenecas costs, including materials,
labor and variable overhead. In addition, AstraZeneca assigned
to us its manufacturing agreement with a third-party supplier
for the production of M.V.I. Pediatric for an indefinite period
of time, provided that either party can terminate this agreement
upon at least four years prior notice.

M.V.I. product line shortages existed in the
mid-1990s due to third-party manufacturing problems, which were
resolved in 2000 when AstraZeneca brought manufacturing of
M.V.I.-12 in-house. Similarly, M.V.I. Pediatric product line
shortages existed after a September 2001 inspection by the FDA
of the facilities of our third party supplier in which this
product is manufactured, which led to a cessation of production
until the manufacturer resumed production in February 2002.
Shipments of new M.V.I. Pediatric products recommenced to our
customers in April 2002. This product is currently being
manufactured at full production levels.

We expect to transfer the manufacture of the
Aquasol products to our Charleston and Wilmington manufacturing
facilities, and to either bring the manufacture of the M.V.I.
product lines in-house or contract with third-party
manufacturers to ensure a continued, long-term supply on market
terms.

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Calcitriol

On February 13, 2002, we acquired from
Aesgen, Inc. the rights to its calcitriol product, a generic
injectable vitamin D nutritional product that we intend to
market as a line extension to our Aquasol product line. This
product is used primarily to treat chronic kidney dialysis
patients with abnormally low levels of calcium in their
circulating blood. We paid $1.0 million for this product at the
time of acquisition and agreed to make additional contingent
milestone payments of up to $1.5 million and certain royalty
payments for the eight-year period following the first
commercial sale of this product. To date, we have paid an
additional $500,000 to Aesgen with respect to this product.

On February 20, 2003, we were notified by
the FDA of marketing approval for our calcitriol product, with
shared 180-day marketing exclusivity for this drug product with
a second company. No other companies will be approved for the
sale of calcitriol until the expiration of this market
exclusivity period. In March 2003, we commenced commercial sales
of our calcitriol product and also entered into a long-term
manufacturing and co-promotion agreement with another company
with respect to such other companys calcitriol product
under their regulatory approval. We also sell product
manufactured by another source pursuant to purchase orders
issued by us.

Azasan

We have developed, and recently received FDA
approval to market, three line extensions to our current 50
milligram azathioprine tablet product: 25 milligram, 75
milligram and 100 milligram tablets. Azathioprine is an
immunosuppression agent used in the prevention of organ
rejection in kidney transplants and for the management of
severe, active rheumatoid arthritis unresponsive to rest,
aspirin or other nonsteroidal anti-inflammatory drugs, or
NSAIDs. These azathioprine products are generic forms of Imuran,
a branded product sold by Prometheus Laboratories, Inc., and
will be sold by us as branded products under our Azasan
trademark. Our 50 milligram azathioprine tablet product was
previously developed by us and launched in 1999 by Geneva
Pharmaceuticals, Inc.

These three new line extension products are
intended to provide better patient compliance and convenience to
the patients, as patients typically begin treatment with 25
milligram dosages of azathioprine and move up over time in
dosages to 150 to 200 milligrams per day, and greater
flexibility to the prescribing physician to tailor the dose for
the patient. Our Azasan products are manufactured in our own
facilities.

Sales and
Distribution of Pharmaceutical Products

We have our own sales force to sell our
pharmaceutical product lines. As of February 28, 2003, we
had a sales force of approximately 80 sales representatives,
with plans to increase the size of our sales force to 150 during
2003.

We have contracted with a subsidiary of Cardinal
Health, Inc. to provide warehousing, distribution, inventory
tracking, customer service and financial administrative
assistance related to the distribution program (including
management of applicable rebates, chargebacks and accounts
receivable collection).

Manufacturing
Capability

We currently manufacture certain high-potency and
high-toxicity drug products, along with controlled substance
products, for clients in our manufacturing facility in
Wilmington, North Carolina. Our manufacturing generally covers
small volume products, and our manufacturing capability has been
upgraded to allow manufacture of a portion of the Darvon and
Darvocet family of products in our own facility. We also
manufacture certain drugs developed on behalf of clients for
commercial sale. We also operate a 48,000 square foot sterile
facility in Charleston, South Carolina where we manufacture
sterile, injectable products. We also provide manufacturing,
packaging and labeling of clinical trial materials.

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Research and Development Division  Our
Product Development Business

The Research and Development Division provides
research and development expertise and a portfolio of
proprietary and in-licensed drug-delivery technologies and
intellectual property rights, which we use to enhance and
develop products that are innovative, safer, or more effective,
convenient or cost-efficient. This can result in renewed
regulatory or patent exclusivity, adding to the commercially
valuable life of the product. We offer these product
improvement, or life cycle management, activities to our
customers for royalties, milestone payments and fees. In
addition, we apply this expertise to improve our acquired
products and internally develop our own new products. Net
revenues for the Research and Development Division in 2002 were
$19.6 million.

In addition to product development, the Research
and Development Division seeks to develop proprietary
drug-delivery technologies for licensing to our clients. We also
dedicate a portion of our technical resources and operating
capacity to internal drug and technology development with the
objective of licensing marketing rights to third parties.

Our internal product and technology development
program has resulted in multiple product applications filed with
the FDA and European regulatory agencies. Many of these products
have been licensed or sold. Others are still in development. The
internal development program has also resulted in patents
covering drugs and drug technology and numerous pending patent
applications.

We have significant experience in providing
product life cycle management services to our clients, which we
leverage to develop our own proprietary products. Product life
cycle management offers product improvement and line extension
opportunities to clients, generally for marketed products facing
patent expiration and that could commercially benefit from
improvements or line extensions. Product improvements and line
extensions offer clients an opportunity to improve product or
product delivery characteristics, thus enhancing and extending
the commercial value of a branded product line. Improved product
characteristics may include enhancement of product stability,
creation of additional absorption profiles (e.g., quick or
sustained release), higher drug absorption or bioavailability
(permitting reduced drug loads per dose with the potential for
lower costs and side effects), improved taste, more attractive
appearance, or better dosage regimes (e.g., once a day versus
multiple doses per day). Product line extensions may include new
dosage forms, such as solids, liquids and chewables, to increase
patient populations who can benefit from such drugs (e.g.,
pediatric or geriatric patient populations), as well as new
dosage strengths that may be more convenient for doctors and
patients under current treatment regimens. Product modifications
and line extensions offer clients the opportunity to target new
patient populations and improve patient compliance and
convenience. Product life cycle management activities also can
lead to new inventions and discoveries in the course of the
research and development work, providing new opportunities for
long-term patent protection for the modified products and
potential long-term value for licensees of our technologies.

Our
Drug-Delivery Technologies

Our portfolio of internally developed and
in-licensed drug-delivery technologies provide us with some
opportunities for the expansion of a drug products
effective market life. Our currently available technologies
include:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | ProCore a
    patented multiparticulate technology for controlled release of a
    drug incorporated into a two-layer coated pellet. The first
    layer allows for control of the lag time before an active agent
    begins its release while the second layer controls the rate of
    release, and thus the duration of the sustained release effect
    for the product.                                                                                                                                                           
|
| |  | ProSorb technologies
    designed to accelerate absorption rates and thus permit weakly
    acidic compounds to exhibit a shorter onset of action relative
    to conventional dosage forms. The concept of the technology is
    that the acidic drugs incorporated into the technology form a
    dispersion pattern upon release in the stomach that allows
    faster and more complete absorption. ProSorb is a broad-based
    technology primarily used with liquid or encapsulated drug
    products. Using this technology with

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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | diclofenac, a non-steroidal anti-inflammatory
    drug, has resulted in our proprietary ProSorb-D product
    candidate, which is discussed below.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|
| |  | ProLonic a
    drug-delivery technology specifically designed to release an
    active agent in the colon. This patented technology can be
    incorporated into a tablet, a pellet, or a capsule dosage form
    and uses conventional manufacturing equipment and processes. The
    advantage represented by this technology is the ability to
    control the location and timing of release.                                                                                                                                                                                                                                                                                                                                                                                                                                               
|
| |  | ProMelt a
    fine particle, rapidly disintegrating technology that allows for
    creation of a fast melt tablet dosage form while also permitting
    taste masking, targeted delivery or controlled release of the
    active agent. The technology is particularly applicable to
    pediatric and geriatric treatments for patients who have
    difficulty swallowing more traditional dosage forms such as
    tablets and capsules.                                                                                                                                                                                                                                                                                                                                                                                                     
|
| |  | ProSpher an
    injectable, depot formulation for controlled release of active
    agents lasting from days to months. It is capable of delivering
    therapeutically important agents with reduced burst
    effect, or immediate release, upon administration, as
    compared to other depot technologies. The technology is designed
    to allow the development of convenient single dose treatment for
    drug therapies lasting up to six months.                                                                                                                                                                                                                                                                                                                                                                                   
|
| |  | ProSLO and ProSLO
    II an osmosis
    technology designed for controlled release product therapy with
    either a single drug or a combination of drugs. Osmotic action
    is the natural movement of water through a membrane and is used
    to make oral drug administration more accurate, precise and
    convenient. Our technology can also have an immediate release
    component in the outside layer of a laser drilled tablet. This
    allows a combination of multiple active ingredients with
    different release requirements. The advantages over existing
    technologies are its easy scalability, the ability to use it
    with numerous active ingredients, the ability to create both a
    long- and short-acting drug combination, and its ability to
    handle what normally are insoluble active ingredients.

The ProCore and ProSorb technologies are
proprietary to us. The ProSLO and ProSLO II technologies are
available for use by us and our clients in the U.S. through a
recently amended agreement with Osmotica Corporation. During
January 2003, we agreed to amend the original agreement from an
exclusive arrangement to a non-exclusive arrangement. As such,
Osmotica is permitted to develop its own products for use in the
U.S. without our involvement, but we may also jointly develop
products using Osmoticas technology upon mutual agreement.

Additionally, the ProLonic, ProMelt and ProSpher
technologies are available to us pursuant to a joint development
agreement with Tanabe Seiyaku Co. Ltd. This agreement with
Tanabe provides for the joint development by us and Tanabe of
certain mutually agreeable drug technologies developed by
Tanabe. Under this agreement, we have an exclusive worldwide
license, other than in certain Asian countries, to the developed
technologies and we are required to pay Tanabe a portion of all
down payments, milestone payments and royalties, received by us
in connection with the commercialization of products using these
jointly developed technologies.

The Research and Development Division has
continued our internal development of products to be licensed to
third parties that have additional marketing and distribution
capabilities or a therapeutic focus different than ours. We have
entered into multiple licensing agreements for products that are
currently in development. The terms of the agreements vary as to
amounts of milestone payments and fees, as well as methods and
extent of revenue participation such as royalties. While we
anticipate that most of our product licensing agreements will
provide that prospective clients will ultimately sponsor the
approved product, in certain instances we have made submissions
for internally developed products in our own name.

In 2002, aaiPharma and Tanabe Holding America,
the U.S. subsidiary of Tanabe Seiyaku of Japan, formed a joint
venture whose objectives are to develop, manufacture, sell and
potentially license pharmaceutical products. Tanabes
contribution consists of candidate compounds from its drug
discovery pipeline, while aaiPharmas contribution is its
extensive expertise in research, development and clinical trials
management with respect to new drug development. The joint
ventures revenue opportunities include: potential direct
marketing of drugs developed by the joint venture; potential
licensing opportunities for our

9



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Pharmaceuticals Division; potential third-party
licensing opportunities; and potential third-party co-promotion.
The initial therapeutic focus areas of the joint venture are
cardiovascular diseases and gastrointestinal diseases.


Our Internal Product Development
Pipeline

We have a number of proprietary pharmaceutical
products under development, which include the products in the
chart below. We are pursuing internal product development
candidates in three primary categories:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | existing active pharmaceutical ingredients or
    chemical compounds, where the development of product line
    extensions, new forms (such as different dosages, formulations
    or delivery mechanisms  e.g., liquids versus
    tablets), or combination drugs involving two known active
    ingredients, offer potential therapeutic or marketing
    advantages. Examples of this type of product development include
    ProSorb-D and our planned line extensions for most of our
    acquired branded drug products, as well as for a
    fexofenadine/pseudoephedrine 24-hour combination allergy product
    that we have licensed to a third party;
|
| |  | new active ingredients or compounds that are
    chemically similar to currently marketed products with
    established therapeutic and safety profiles, and that offer
    improved characteristics over the marketed products. An example
    for this category of development includes 6-omeprazole; and                                                                                                                                                                                                                                                                                                                                                      
|
| |  | new active ingredients or chemical entities that
    fall within our targeted therapeutic classes, including some
    that are marketed in other countries but not currently marketed
    in the United States. An example for us in this category of
    product development is imidapril.                                                                                                                                                                                                                                                                                                                                                                      

Our product development strategy focuses on
products that we expect will have some period of market
exclusivity, such as through patent or regulatory exclusivity,
without competition from generic substitutes or other
third-party products that infringe the patents covering our line
extensions or other developed products.

In addition to the line extensions to our
acquired products discussed above in Pharmaceuticals
Division  Our Product Sales Business, we are
developing the following products:

Darvon/Darvocet Line
Extensions.We plan to develop
improved products and line extensions with improved product
delivery and therapeutic characteristics and potential
regulatory and patent exclusivity. For example, we are
considering the development of a liquid form of Darvocet,
formulations which can be taken less frequently than every four
hours and some products that would combine propoxyphene, the
active ingredient in Darvon and Darvocet, with a non-steroidal,
anti-inflammatory drug.

M.V.I. Line
Extensions.Our product line strategy
for M.V.I. and Aquasol will also focus on developing and
marketing new products, product improvements and product line
extensions. The reformulation of M.V.I.-12 to add vitamin K will
create additional product line opportunities within and outside
the U.S. We also plan to formulate M.V.I. products to be used
for patients in specialized markets.

Brethine Line
Extensions.Our strategy for Brethine
also involves product line extensions and improvements. We are
developing a glass vial form of the injectable Brethine product,
rather than the current glass ampoule presentation, to improve
the safety and convenience of administering this drug. We are
also taking steps to reduce aluminum in the product to address
potential aluminum issues, and we are exploring new indications
for the Brethine product as well as development of the single
chiral isomer product.

Imidapril.We are
developing an imidapril tablet for sale in the United States.
Imidapril is an angiotensin converting enzyme
(ACE) inhibitor for the treatment of cardiovascular
disease. It has been sold in Japan since 1993 by Tanabe Seiyaku
Co., Ltd. under the name Tanatril for the treatment of
hypertension, or high blood pressure. In addition, Tanabe has
recently obtained approval in Japan to market Tanatril for the
treatment of kidney disease associated with Type I insulin
dependent diabetes mellitus. We licensed the U.S. rights to this
product from Tanabe in January 2002.

10



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Imidapril is also approved for sale in Europe for
hypertension. We are presently obtaining the clinical data from
the European dossier used by Tanabe to obtain approval for sale
of imidapril in Europe as a basis for our regulatory filings
with the FDA for approval to sell imidapril in the United States.

ProSorb-D.ProSorb-D
is a softgel capsule that combines diclofenac, a proven pain
medication, with our ProSorb rapid-absorption technology. We are
developing this product for the management of pain and have
recently completed Phase III clinical trials and plan to file a
New Drug Application, or NDA, following further discussions with
the FDA.

6-Omeprazole.We
acquired the exclusive U.S. rights to the ProMelt technology in
2001 from Tanabe Seiyaku Co. Ltd. We are using this technology
with an isomer of omeprazole patented by us to develop a
convenient quick-dissolving tablet for the treatment of ulcers,
heartburn and symptoms associated with gastroesophageal reflux
disease. The ProMelt technology allows specially coated fine
particles of omeprazole in a tablet dosage form to rapidly
disintegrate in the mouth. Our patented isomer of omeprazole is
potentially more stable than existing omeprazole products.

Fexofenadine/pseudoephedrine.Using our ProSLO II technology licensed from Osmotica
Corporation, we are developing a product that combines an
immediate release of fexofenadine with a controlled release of
pseudoephedrine. This new product will only require one dose per
day as opposed to the currently approved product, which requires
two doses per day. The currently approved product is indicated
for the relief of symptoms associated with seasonal allergic
rhinitis in adults and children age 12 and older.

We have completed the scale-up of the
manufacturing process at our clients manufacturing
facilities. Pivotal batches of this product were placed on
stability studies in the fourth quarter of 2002 and a pivotal
bioequivalence study was begun. The pivotal batches will also be
used for a clinical study comparing the pharmacokinetic effect
of this product with fed and fasted persons. We do not believe
that the FDA will require any additional clinical trials.

We have licensed the rights to this
fexofenadine/pseudoephedrine product to a client for milestones
and royalty payments. The latest milestone payment was received
in the fourth quarter of 2002.

Other Product
Candidates.In addition to the
specifically identified products named above, we have targeted
and will target additional products to develop. As we continue
our product development activities and evaluate our interim
results and other information, we may decide to change the scope
and direction of any of our development programs and projects
and we may change how we allocate our research and development
spending to pursue more promising product candidates. Moreover,
we may not be able to successfully develop, commercialize or
license any of the products discussed in this Form 10-K.

AAI International  Our Development
Services Business

AAI International offers a comprehensive range of
pharmaceutical product development services to our customers on
a worldwide basis. These services include formulation
development, analytical, microbiological, bioanalytical and
stability testing services, production scale-up, biotechnology
analysis and synthesis, human clinical trials, regulatory
consulting, and manufacturing. These services generally are
provided on a fee-for-service basis. Net revenues for AAI
International were $82.4 million in 2002.

Prior to our transition to a specialty
pharmaceutical company, this development services business was
the core of our operations. AAI International provides its
services, both individually and in an integrated fashion, to:



| |   |                                                                                                                                                                  
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | our customers, to help them develop, control, and
    improve their drug products;                                                                               
|
| |  | our Pharmaceuticals Division, to manufacture and
    improve its acquired drug products; and                                                                     
|
| |  | our Research and Development Division, to assist
    in its development of drugs and drug-delivery technologies and
    product life cycle management activities.

Since our founding in 1979, we have contributed
to the submission, approval or continued marketing of many
client products, encompassing a wide range of therapeutic
categories and technologies. We believe that

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our ability to offer an extensive portfolio of
high quality drug development and support services enables us to
effectively compete as pharmaceutical and biotechnology
companies look for a mixture of standalone and integrated drug
development solutions that offer cost-effective results on an
accelerated basis.


We have a strong base of resources, expertise and
ideas that allows us to develop and improve drug products and
carry out product life cycle management activities both for our
customers and ourselves. Our expertise covers many therapeutic
categories and types of pharmaceutical products. We are
enhancing our expertise in the key therapeutic areas of pain
management, critical care, and gastrointestinal products.

We focus on our customers individual needs
when marketing our services, often placing our technical
personnel with our clients development teams to
participate in planning meetings for the development or
improvement of a product. We assign our sales and technical
personnel as contacts for our larger clients, understanding that
technical personnel may be better able to identify the full
scope of our clients needs and suggest innovative
approaches. Additionally, we host several technical seminars
each year to help our customers stay abreast of the latest
developments in their industries.

Our organization has a long history of focus on
the needs of our clients. In order to further enhance our
ability to meet the needs of our clients, fulfill our mandate to
provide the highest level of quality, and improve our operating
efficiency, we have dedicated resources to Operation
Excellence, our internal continuous process improvement
effort. This commitment has already paid benefits to us by
providing a focal point for improvement initiatives throughout
our AAI International operations.

Our third-party product development contracts
typically provide for upfront fees and milestone payments. The
commercialization of the products on which AAI International
works is the responsibility of our client. We typically provide
signed service estimates estimating fees for specified services.
During our performance of a project, clients often adjust the
scope of services to be provided by us, at which time the amount
of fees is adjusted accordingly. Generally, AAI
Internationals fee-for-service contracts are terminable by
the client upon notice of 30 days or less. Although the
contracts typically permit payment of certain fees for winding
down a project, the loss of a large contract or the loss of
multiple contracts could adversely affect our future revenue and
profitability in our development services business. Contracts
may be terminated for a variety of reasons, including the
clients decision to stop a particular study, the failure
of product prototypes to satisfy safety requirements, and
unexpected or undesired results of product testing.

AAI Internationals core services are
organized internally along pharmaceutical, analytical,
biopharmaceutical, clinical and regulatory affairs lines to
mirror the movement of pharmaceutical products through the drug
development pipeline.

Pharmaceutical
Services

AAI International provides a variety of
pharmaceutical services to its customers, including drug
formulation development, niche manufacturing, and storage and
distribution of clinical trial supplies. The services are
organized to help clients from the pre-clinical to
post-marketing stages.

Formulation Development
Services.AAI International provides
integrated formulation development services for its
customers pharmaceutical products, by which it takes a
compound and works to develop a safe and stable product with
desired characteristics. AAI International provides formulation
development services during each phase of the drug development
process, from new compounds to modifications of existing
products. AAI Internationals formulation development
projects may support a small segment of critical development
activities for a short duration or may last for several years,
ranging from early formulation development to a validated,
production-scale, commercial product.

In addition to new drug development, AAI
Internationals formulations team provides product
modification and line extension services to clients through
product life cycle management contracts we enter into, generally
for marketed products facing patent expiration or that can
benefit from formulation improvements. Modifications of existing
products offer clients an opportunity to improve product
characteristics, increasing product market viability. Improved
product characteristics include enhancement of stability,
absorption profiles (e.g., quick, controlled or sustained
release), taste, and appearance. Product line

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extensions may include new dosage forms, such as
solids, liquids and chewables, as well as new dosage strengths.
Product modifications and line extensions offer clients the
opportunity to target new patient populations and improve
patient acceptance of the product. AAI Internationals
product optimization services also cover investigation of
impurities, contaminants and degradation, the updating of mature
products to meet current regulatory standards and laboratory
validation services.


Manufacture of Clinical Trial
Supplies.AAI International
manufactures clinical trials materials for Phase I through
IV drug-product clinical trials. It has expertise in
manufacturing tablets, capsules, sachets, liquids and
suspensions, creams, gels, lotions and ointments. Outsourcing of
clinical supply manufacturing is particularly attractive to
pharmaceutical companies that maintain large,
commercial-quantity, batch facilities, where clinical supply
manufacturing would divert resources from revenue-producing
manufacturing. AAI International has a dedicated 25,000 square
foot facility in Wilmington, North Carolina and another facility
in Neu-Ulm, Germany to distribute and track clinical trial
materials used in clinical studies, with the capacity for
controlled substance storage and handling. In addition, AAI
International provides its clients with assistance in scaling up
production of clinical supply quantities to commercial quantity
manufacturing.

Analytical
Services

AAI International provides a wide variety of
analytical services, as well as services pertaining to method
development and validation, drug product and active
pharmaceutical ingredient characterization and control,
microbiological support, stability storage and studies, and
technical support and problem solving with respect to
pharmaceuticals. In support of the drug development and
compliance programs of its customers, AAI International offers
laboratory services to characterize and measure drug components
and impurities. We have more than two decades of experience in
providing analytical testing services dedicated exclusively to
the drug industry and have developed the scientific expertise,
technologically advanced equipment, and broad range of
scientific methods to accurately and quickly analyze almost any
compound or product. Our analytical services include:



| |   |                                                
| | - | -----------------------------------------------
| |  | Method development and validation;             
|
| |  | Product characterization;                      
|
| |  | Raw materials and product release testing; and,
|
| |  | Stability studies.                             

Biopharmaceutical
Services

AAI International integrates a Phase I
clinical study capability with strong bioanalytical and
biotechnology expertise to provide biopharmaceutical services to
its customers. The analysis of drugs, metabolites and endogenous
compounds in biological samples is a core service of AAI
International. Our biopharmaceutical services include:



| |   |                                                                                                                                                                                    
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Phase I clinical services from our 60-bed
    Phase I clinical trial facility located in Research
    Triangle Park, North Carolina, and a 76-bed facility in Neu-Ulm,
    Germany;
|
| |  | Microbiological testing;                                                                                                                                                           
|
| |  | Bioanalytical testing; and                                                                                                                                                         
|
| |  | Biotechnology analysis and synthesis.                                                                                                                                              

Phase I to
IV Clinical Services

AAI International provides a broad range of
Phase I through IV clinical services to customers in the
pharmaceutical, biotechnology and medical device industries for
assistance in the drug development and regulatory approval
process in North America. The clinical services include clinical
trial management and monitoring, site selection, medical affairs
(including safety surveillance and serious adverse event
management), data management and statistics.

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Regulatory and
Other Consulting Services

AAI International provides consulting services
with respect to regulatory affairs, quality compliance, and
process validations. It assists in the preparation of regulatory
submissions for drugs, devices and biologics, audits a
clients vendors and client operations, conducts seminars,
provides training courses, and advises clients on applicable
regulatory requirements. AAI International also assists clients
in designing development programs for new or existing drugs
intended to be marketed in the United States and Europe.

aaiPharma  Our Strategy

We believe that our ability to apply our
scientific expertise to develop new and improved products and
product line extensions, to leverage our marketing and promotion
organization and our strong relationships with many large
pharmaceutical companies and to identify and acquire branded
pharmaceutical products, positions our company for continued
growth. Specifically, we intend to pursue the following growth
strategies:



| |   |                                                                                      
| | - | -------------------------------------------------------------------------------------
| |  | Enhance sales of our acquired products through
    focused marketing and promotion;  
|
| |  | Strengthen brands of our acquired products
    through product life cycle management;
|
| |  | Launch internally developed branded products; and                                    
|
| |  | Seek attractive acquisition opportunities.                                           

Information Technology

We have made significant investments in
information technology. Our customized data management system
connects analytical instruments with multiple software
architectures permitting automated data capture. We believe that
information technology will enable us to expedite the
development process by designing innovative services for
individual client needs, providing project execution, monitoring
and control capabilities that exceed a clients internal
capabilities, streamlining and enhancing data presentation to
the FDA and enhancing our own internal operational productivity
while maintaining quality.

We continue to upgrade and expand our enterprise
wide financial and operational integrated management information
system, which includes significant systems licensed from SAP.
Initial financial components became operational at year-end
1998, other operational management systems followed in 1999 and
2000, and we continue the implementation of these systems
company-wide.

Customers

Historically, our primary customers have been
large and small pharmaceutical and biotechnology companies
serviced by the Research and Development Division and AAI
International. Recently, our largest customers have been large
medical wholesalers and distributors of our pharmaceutical
products sold into the marketplace.

Significant research and development projects
have a defined cycle, and accordingly, the composition of our
customer group in the AAI International and Research and
Development Division areas of our business changes from year to
year. In addition, because of the project nature of engagements
in these segments of our business, we may have a concentration
of business among some large customers in one period that we
would not expect to continue into subsequent periods. We have
experienced concentration in these areas of our business in the
past, and we do not believe that this is unusual for companies
in the same markets as the Research and Development Division and
AAI International.

The Pharmaceuticals Divisions customers are
primarily large well-established medical wholesalers and
distributors. Cardinal Health, Inc., AmerisourceBergen
Corporation and McKesson Corporation accounted for approximately
19%, 18% and 12% of our consolidated net revenues, respectively.
We do not believe that revenues from any large pharmaceutical
company or other customer of the Research and Development
Division or AAI International is likely to exceed 10% of our
consolidated net revenues in future years.

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Backlog

Backlog consists of anticipated net revenues from
signed fee-for-service contracts for which services have not
been completed. Once contracted work begins, net revenues are
recognized as the service is performed. Backlog does not include
anticipated net revenues for work performed for internal clients
or for any variable-priced contracts. In addition, during the
course of a project, the client may substantially adjust the
requested scope of services and corresponding adjustments are
made to the price of services under the contract.

We believe that our backlog as of any date is not
a meaningful predictor of future results for much of our
business due to rapid signing and completion of many of our
contracts. Additionally, the backlog can be affected by a number
of factors, including variable size and duration of contracts
and adjustments in the scope of a contracted project as interim
results become available. At December 31, 2002 and 2001,
backlog was approximately $57 million and $66 million,
respectively. Of the 2002 amount, we do not expect to fill
approximately $12 million by December 31, 2003.

Competition

We compete with companies and organizations in
multiple segments of the pharmaceutical industry. The branded
drug products of our Pharmaceuticals Division are subject to
competition from the branded and generic products of other
pharmaceutical companies, ranging from other small specialty
pharmaceutical companies to the large pharmaceutical companies
who are among the customers of the development services business
of AAI International.

The main competition for M.V.I.-12 is Infuvite
Adult, which is marketed by Baxter Healthcare Corporation. The
main competition of M.V.I. Pediatric is Infuvite Pediatric,
which also is marketed by Baxter Healthcare Corporation. Aquasol
A is the only injectable Vitamin A product on the market.
Aquasol E competes with various other vitamin E products.

The main competition of calcitriol is Calcijex
and Zemplar, marketed by Abbott Laboratories. Other competitors
include Hectorol, marketed by Bone Care International, Inc.; a
generic calcitriol product in ampoule form, approved but not yet
marketed by American Pharmaceutical Partners, Inc.; and,
following the 180-day regulatory exclusivity period that is
triggered by the commercial sales of calcitriol by us, certain
additional generic suppliers of calcitriol products. Calcitriol
has been approved by the FDA as a generic substitute for
Calcijex, although our calcitriol product will be packaged in a
vial, rather than an ampoule, form. We believe the vial format
will be more attractive to medical professionals than competing
products in ampoule form, due to safety and convenience reasons.

Brethine competes in the market for the treatment
of asthma and related bronchial ailments, which is a market led
by Volmax, Proventil, and branded and generic forms of albuterol
sulfate.

Darvon and Darvocet compete primarily in the
broad pain management market, especially with products indicated
for the management of mild-to-moderate pain. Competitive
products indicated for the management of mild-to-moderate pain
include Ultram and other non-steroidal anti-inflammatory drugs
such as ibuprofen. Additionally, major promotional efforts in
the U.S. pain management market today involve a relatively new
class of drugs, the cyclo-oxygenase 2, or the COX-2, enzyme
inhibitors. They are designed to work as effectively as Darvon
and Darvocet and NSAIDs, but without side effects such as ulcers
and gastrointestinal bleeding. These new COX-2 inhibitors are
more selective than traditional NSAIDS. The non-selective
inhibition of both COX-1 and COX-2 enzymes in other NSAIDs is
responsible for the toxicities and side effects. However, the
existence of actual improvement in gastrointestinal side effects
of COX-2 inhibitors over diclofenac-based products is presently
unclear, with the FDA noting in June 2002, after review of a
large clinical study of a major COX-2 inhibitor product, that
the COX-2 inhibitor product did not show a safety advantage in
upper gastrointestinal events in comparison to either ibuprofen
or diclofenac.

The Darvon and Darvocet product lines no longer
have patent exclusivity. While precise data on generic
substitution for these products is not available, we believe a
vast majority of the prescriptions written for Darvon and
Darvocet are filled with generic products. These generic
substitutes are sold at significantly lower

15



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prices, without the research, development and
approval costs associated with the branded Darvon and Darvocet
products. Two of the worlds largest manufacturers of
generic products, Teva Pharmaceutical Industries Ltd. and Mylan
Laboratories Inc., sell propoxyphene generic substitutes to
Darvon and Darvocet.


Sellers of generic products typically do not bear
the related research and development costs associated with
branded products and, thus, are able to offer their products at
considerably lower prices. There are, however, a number of
factors that enable branded products to remain profitable once
patent protection has ceased. These include the establishment of
a strong brand image with the prescriber or the consumer,
supported by the development of improved products and line
extensions to differentiate the branded products from the
generic competition.

Our AAI International and Research and
Development Divisions compete primarily with in-house research,
development, quality control, and other support service
departments of pharmaceutical and biotechnology companies, as
well as university research laboratories and other contract
research organizations. In addition, we believe that although
there are numerous fee-for-service competitors in our industry,
there are few competitors that offer the depth or breadth of
scientific capabilities that we provide. Some of our
competitors, however, may have significantly greater resources
than we do. Competitive factors generally include reliability,
turn-around time, reputation for innovative and quality science,
capacity to perform numerous required services, financial
viability, and price. We believe that we compete favorably in
each of these areas.

Government Regulation

The services that we perform and the
pharmaceutical products that we develop and manufacture are
subject to various rigorous regulatory requirements designed to
ensure the safety, effectiveness, quality and integrity of
pharmaceutical products, primarily under the Federal Food, Drug,
and Cosmetic Act, including current Good Manufacturing Practice
regulations. These regulations are commonly referred to as the
cGMP regulations and are administered by the FDA in accordance
with current industry standards. Our services and development
efforts performed outside the U.S. and products intended to be
sold outside the U.S. are also subject to additional foreign
regulatory requirements and government agencies.

U.S. laws and federal regulations apply to all
phases of investigational and commercial development (i.e.
manufacturing, testing, promotion and distribution of drugs,
including with respect to our personnel, record keeping,
facilities, equipment, control of materials, processes,
laboratories, packaging, labeling, storage and advertising.) If
we fail to comply with these laws and regulations, our drugs,
drug improvements, and product line extensions will not be
approved by the FDA or will be withdrawn from the market and the
data we collect may be out of specification and not acceptable
to the FDA requirements, which may result in not being permitted
to market our products. Additionally, we could be subject to
significant monetary fines, recalls and seizures of products,
closing of our facilities, revocation of drug approvals
previously granted to us, and criminal prosecution. Any of these
regulatory actions could materially and adversely affect our
business, financial condition and results of operations.

To help assure our compliance with applicable
laws and regulations, we have quality assurance controls in
place at our facilities and we use FDA regulations and
guidelines, as well as applicable international standards, as a
basis for our quality policies and standard operating
procedures. We regularly audit test data, inspect our facilities
and revise our standard operating procedures to meet current
cGMPs in preparation for routine and periodic FDA inspections. A
system for monitoring product-related complaints for all of our
commercial products has been established.

The balance of adhering to FDA compliance while
bringing products to market requires us to continuously improve
our operating standards in order to reduce the possible risk of
additional FDA actions. In the event of any such action of a
material nature, the resulting restrictions on our business
could materially and adversely affect our business, financial
condition and operating results.

All of our drugs, investigational and commercial,
must be manufactured in conformity with International Conference
on Harmonization, or ICH, guidances, cGMP regulations and FDA
guidances and guidelines.

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Drug products subject to an approved
FDA-application must be manufactured, processed, packaged, held
and labeled in accordance with information contained in the
application. Modifications, enhancements or changes in
manufacturing sites of approved products are in many cases
subject to additional FDA inspections and supplemental approvals
to the existing application. The circumstances requiring
inspections and supplemental filings may require a lengthy
application process. Our facilities, including the facilities
used in our development services business, and those of our
third-party manufacturers are periodically subject to inspection
by the FDA and other governmental agencies. If such inspections
prove unsatisfactory, the operations at these facilities could
be interrupted or halted for lengthy periods of time.


Failure to comply with FDA or other governmental
regulations can result at first in warning letters. If those
warning letters are not adequately addressed, further actions
may lead to fines, unanticipated compliance expenditures, recall
or seizure of products or total or partial suspension of
production or distribution. For drugs under FDA review, failure
to be compliant at manufacturing facilities could stop the
FDAs review of our drug approval application that could,
in certain circumstances, extend to the termination of ongoing
research, disqualification of data for submission to regulatory
authorities, enforcement actions, injunctions and criminal
prosecution. Under certain circumstances, the FDA also has the
authority to revoke previously granted drug approvals. Although
we have instituted internal compliance programs that
consistently comply with cGMPs through strong training and
corporate quality oversight, we are cognizant that if these
programs do not meet regulatory agency standards or if
compliance is deemed deficient in any significant way, it could
have a material adverse effect on us, our third party
manufacturers and our vendors. Most of our vendors are subject
to similar regulations and periodic inspections.

Some of our development and testing activities,
including the manufacture, development and testing of the Darvon
and Darvocet products, are subject to the Controlled Substances
Act, administered by the Drug Enforcement Administration, or the
DEA, which strictly regulates all narcotic and habit-forming
substances. We maintain separate, restricted-access facilities
and heightened control procedures for projects involving such
substances due to the level of security and other controls
required by the DEA.

Our business also involves the controlled
storage, use and disposal of hazardous materials and biological
hazardous materials. We are subject to numerous federal, state,
local and foreign environmental regulations governing the use,
storage, handling and disposal of these materials. Although we
believe that our safety procedures for handling and disposing of
these hazardous materials comply in all material respects with
the standards prescribed by law and regulation in each of our
locations, the risk of accidental contamination or injury from
hazardous materials cannot be completely eliminated. We maintain
liability insurance for some environmental risks that our
management believes to be appropriate and in accordance with
industry practice. However, we may not be able to maintain this
insurance in the future on acceptable terms. In the event of an
accident, we could be held liable for damages that are in excess
or outside of the scope of our insurance coverage or that
deplete all or a significant portion of our resources.

We are also governed by federal, state and local
laws of general applicability, such as laws regulating
intellectual property, including patents and trademarks, working
conditions, equal employment opportunity, and environmental
protection.

In connection with our activities outside the
U.S., we also are subject to foreign regulatory requirements
governing the testing, approval, manufacture, labeling,
marketing and sale of pharmaceutical products, which
requirements vary from country to country. Whether or not FDA
approval has been obtained for a product, approval by comparable
regulatory authorities of foreign countries must be obtained
prior to marketing the product in those countries. For example,
some of our foreign operations are subject to regulations by the
European Medicines Evaluations Agency and the U.K. Medicines
Control Agency. The approval process may be more or less
rigorous from country to country, and the time required for
approval may be longer or shorter than that required in the
U.S., therefore pharmaceutical product approval and policies for
pricing required for marketing will vary from country to country
due to different regulations and policies required by each.

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The Drug
Development Regulatory Process

New Drug Approval
Process.FDA approval is required
before any new drug can be marketed and sold in the U.S. This
approval is obtained through the new drug application, or NDA,
process, which involves the submission to the FDA of complete
pre-clinical data about new compounds and their characteristics
and then clinical data obtained from studies in humans showing
the safety and effectiveness of the drug for the proposed
therapeutic use.

Before introducing a new drug into humans,
stringent government requirements for pre-clinical data must be
satisfied. The pre-clinical data is obtained from laboratory
studies, and tests performed on animals, which are submitted to
the FDA in an investigational new drug application, or an IND.
The pre-clinical data must provide an adequate basis for
evaluating both the safety and the scientific rationale for the
initiation of clinical trials of the new drug in humans.
Pursuant to the IND, the new drug is tested in humans for
safety, adverse effects, dosage, tolerance absorption,
metabolism, excretion and other elements of clinical
pharmacology, and for effectiveness for the proposed therapeutic
use.

Clinical trials are conducted in three sequential
phases (i.e., Phase I, Phase II, and Phase III).
The clinical development plan, or the process of completing
clinical trials during the investigational period, for a new
drug may take several years and require the expenditure of
substantial operational and financial resources. Phase I
clinical trials frequently begin with the initial introduction
of the investigational drug product into healthy humans and test
primarily for safety. Phase II clinical trials typically
involve a small sample of the intended patient population to
assess the efficacy of the investigational drug product for a
specific indication, to determine dose tolerance and the optimal
dose range and to gather additional information relating to
safety and potential adverse effects. Phase III clinical
trials are studies with a statistically qualified larger study
population that compares the active drug product against a
placebo. These studies, conducted in a randomized group where
the drug and placebo are blinded from the patient, further
evaluate clinical safety and efficacy at different study sites
to determine the overall risk-benefit ratio of the drug and
provide an adequate basis for product labeling

Each clinical trial is conducted in accordance
with rules, or protocols, that are developed to detail the
objectives of the study, including methods to monitor safety and
efficacy and the precise criteria to be evaluated. These
protocols must be submitted to the FDA as part of the IND. In
some cases, the FDA allows a company to rely on data developed
in foreign countries, or previously published data, which
eliminates the need to independently repeat some or all of the
studies.

Once sufficient data have been developed pursuant
to the IND, the NDA is submitted to the FDA to request approval
to market the new drug. Preparing an NDA involves substantial
data collection, verification and analysis, and expense, and
there is no assurance that FDA approval of an NDA can be
obtained on a timely basis, if at all. The approval process is
affected by a number of factors, primarily the risks and
benefits demonstrated in clinical trials as well as the severity
of the disease and the availability of alternative treatments.
The FDA might not approve an NDA if the regulatory criteria are
not satisfied or, alternatively, may require additional studies
to enhance the overall risk-benefit ratio prior to an approval
action.

Referencing and Relying on New Drug
Applications.With respect to the
branded pharmaceutical products (i.e., Darvon and Darvocet) that
we acquire, we are often able to reference the original NDA that
we acquired along with the marketing rights to the products. As
a result, when improving these products or developing product
line extensions, we are permitted to file a supplemental NDA, or
a new drug application known as a 505(b)(2) NDA, that directly
cross references all of the data in the original application.
This provision in the Food, Drug and Cosmetic Act allows us to
shorten our development process for improvements and line
extensions. For example, we may be able to reduce the number of
clinical trials in a clinical development plan with less
extensive, less time-consuming, and less costly Phase
II and Phase III testing, with respect to any new
products that we may select to develop.

Similarly, a 505(b)(2) application allows us to
cross reference NDAs, or information therein, that we do not own
and are not authorized to reference directly. The 505(b)(2) NDA
may, in certain cases, permit us to meet NDA approval
requirements with less original scientific data than would
normally be required, and may

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allow us to begin drug development in a later
phase, so as to reduce the time and expense involved in any
particular phase, for any new products we select to develop.
Applications under 505(b)(2) are subject to certain patent and
non-patent exclusivity rights applicable to the NDAs on which
they rely, if such rights remain in effect when such
applications are submitted. If we are unable to proceed with
anticipated 505(b)(2) applications for several of the products
that we are developing, our FDA approval costs will increase.


Abbreviated New Drug Application Process for
Generic Products.A generic drug
contains the same active ingredient as a specified brand name
drug and usually can be substituted for the brand name drug by
the pharmacist. FDA approval is required before a generic drug
can be marketed. Approval of a generic drug is obtained through
the filing of an abbreviated new drug application, or an ANDA,
under section 505(j) of the Food, Drug and Cosmetic Act.
Submission and approval of an ANDA is subject to certain patent
and non-patent exclusivity rights applicable to the brand name
drug, if such rights remain in effect when the ANDA is
submitted. When processing an ANDA, the FDA waives the
requirement of conducting full clinical studies provided that
the drug is proven bioequivalent to the innovators drug
(i.e., the applicant of the NDA) in a Phase I study
conducted in a small number of healthy volunteers.
Bioavailability relates to the rate and extent of absorption and
levels of concentration of a drug active ingredient in the blood
stream needed to produce a therapeutic effect. Bioequivalence
compares the bioavailability of one drug with another that
contains the same active ingredient, and when established,
indicates that the rate and extent of absorption and levels of
concentration of a generic drug in the body are the same as the
previously approved brand name drug. An ANDA may be submitted
for a drug on the basis that it is the equivalent to a
previously approved drug or, in the case of a new dosage form or
other close variant, is suitable for use under the conditions
specified.

The timing of final FDA approval of ANDAs depends
on a variety of factors, including whether the applicant
challenges any listed patents for the brand name drug and
whether the brand-name manufacturer is entitled to one or more
non-patent statutory exclusivity periods, during which the FDA
is prohibited from accepting or approving applications for
generic drugs.

Under section 505(j), the FDA may impose
debarment and other penalties on individuals and companies that
commit certain illegal acts relating to the generic drug
approval process. In some situations, the FDA is required not to
accept or review ANDAs for a period of up to three years from a
company or an individual that has committed certain violations.
The FDA may temporarily deny approval of ANDAs during the
investigation of certain violations that could lead to debarment
and also, in more limited circumstances, suspend the marketing
of approved generic drugs by the affected company. The FDA also
may impose civil penalties and withdraw previously approved
ANDAs. Neither we nor any of our employees have ever been the
subject of debarment procedures.

Manufacturing
Requirements.Before approving a drug,
the FDA also requires that our procedures and operations conform
to cGMP regulations, ICH guidances and manufacturing guidelines
and guidances published by FDA. We must closely be in compliance
with all of the regulatory and quality regulations at all times
during the manufacture of our products. To help insure
compliance with the regulatory and quality regulations, we must
continue to spend time, money and effort in the areas of
production and quality control to ensure full technical
compliance. If the FDA believes a company is not in compliance
with its regulations, it may withhold new drug approvals, as
well as approvals for supplemental changes to existing
approvals, preventing the company from exporting its products.
It may also classify the company as an unacceptable supplier,
thereby disqualifying the company from selling products to
federal agencies. We believe we are currently in compliance with
the cGMP regulations.

Post-approval
Requirements.After initial FDA
approval for the marketing of a drug has been obtained, further
studies, including Phase IV studies, typically regarded as
post-marketing studies, may be required to provide additional
data on safety or effectiveness. Also, the FDA may require
post-marketing reporting to monitor the adverse effects of the
drug. Results of post-marketing programs may limit or expand the
further marketing of the drug. Further, if there are any
modifications to the drug, including changes in indication,
manufacturing process, or manufacturing facility, a supplemental
application seeking approval of the modifications must be
submitted to the FDA or other regulatory authority.
Prospectively, the FDA

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regulates our post-approval promotional labeling
and advertising activities to assure that such activities are
being conducted in conformity with statutory and regulatory
requirements.


Health Care Fraud and Abuse Laws

Federal and state health care fraud and abuse
laws have been applied to restrict certain marketing practices
in the pharmaceutical industry in recent years. These laws
include antikickback statutes and false claims statutes. The
federal health care program antikickback statute makes it
illegal for anyone to knowingly and willfully make or receive
kickbacks in return for any health care item or
service reimbursed under any federally financed healthcare
program. This statute applies to arrangements between
pharmaceutical companies and the persons to whom they market,
promote, sell and distribute their products. In August 1994, the
Office of the Inspector General of the Department of Health and
Human Services issued a Special Fraud Alert
describing pharmaceutical companies activities that may
violate the statute. There are a number of exemptions and safe
harbors protecting certain common marketing activities from
prosecution. These include exemptions or safe harbors for
product discounts, payments to employees, personal services
contracts, warranties, and administrative fees paid to group
purchasing organizations. These exemptions and safe harbors,
however, are drawn narrowly.

Federal false claims laws prohibit any person
from knowingly making a false claim to the federal government
for payment. Recently, several pharmaceutical companies have
been investigated or prosecuted under these laws, even though
they did not submit claims to government healthcare programs.
The prosecutors alleged that they were inflating drug prices
they report to pricing services, which are in turn used by the
government to set Medicare and Medicaid reimbursement rates.
Pharmaceutical companies also have been prosecuted under these
laws for allegedly providing free products to customers with the
expectation that the customers would seek reimbursement under
federal programs for the products.

Additionally, the majority of states have laws
similar to the federal antikickback law and false claims laws.
Sanctions under these federal and state laws include monetary
penalties, exclusion from reimbursement for products under
government programs, criminal fines and imprisonment.

We have internal policies and practices requiring
and detailing compliance with the health care fraud and abuse
laws and false claims laws. Because of the breadth of these laws
and the narrowness of the safe harbors, however, it is possible
that some of our business practices could be subject to
challenge under one or more of these laws, which could have a
material adverse effect on our business, financial condition and
results of operations.

Employees

At December 31, 2002, we had approximately
1,160 full-time equivalent employees, of which 82 hold Ph.D. or
M.D. degrees, or the foreign equivalent. We believe that our
relations with our employees are good. None of our employees in
the U.S. are represented by a union. German and French laws
provide certain representative rights to our employees in those
jurisdictions.

Our continued performance depends on our ability
to attract and retain qualified professional, scientific and
technical staff. The level of competition among employers for
these skilled personnel is high. We believe that our employee
benefit plans enhance employee morale, professional commitment
and work productivity and provide an incentive for employees to
remain with aaiPharma. We have experienced difficulty in
attracting and retaining qualified staff for certain positions
in our Phase II and III operations, where high turnover is an
industry-wide problem. It is possible that as competition for
these skilled employees increases at our other locations, we
could experience similar problems there as well.

Intellectual Property

Our ability to successfully commercialize new
branded products or technologies is significantly enhanced by
our ability to secure strong intellectual property
rights  generally patents  covering these
products and technologies and to avoid infringement of valid
third-party patents. We intend to seek patent protection in the

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United States and selected foreign countries and
to vigorously prosecute patent infringements, as we deem
appropriate. We currently own 29 patents issued by the U.S.
Patent and Trademark Office, and we currently have 17 patent
applications filed and pending with the Patent and Trademark
Office. Additionally, we have assigned or transferred an
additional six of our patents to third parties for value.


Our patents cover proprietary processes and
techniques, or formulation technologies, that may be applied to
both new and existing products and chemical compounds. Our
patents also cover new chemical entities or compounds,
pharmaceutical formulations, and methods of using certain
compounds. We also seek to patent discoveries of new structures
of known compounds, new physical and chemical characteristics of
known compounds, and previously unknown compounds.

We have two exclusive licenses in the U.S. and
some other countries to use the patents, patent applications,
and know-how associated with four pharmaceutical formulation
technologies for mutually acceptable drug candidates. The ProSLO
and ProSLO II technologies are licensed from Osmotica
Corporation. The other three technologies, ProLonic, ProMelt and
ProSpher are licensed from Tanabe Seiyaku. Like our own
formulation technologies mentioned above, these technologies may
be used to develop mutually acceptable new drug products or
improve the physical characteristics of mutually acceptable
existing products and compounds.

In addition to our patents, we rely upon trade
secrets and unpatented proprietary know-how where we believe the
public disclosures and limited patent life associated with
obtaining patent protection would not be in our best strategic
interest. We seek to protect these assets as permitted under
state or federal law and by requiring our employees,
consultants, licensees, and other companies to enter into
confidentiality and nondisclosure agreements and, when
appropriate, assignment of invention agreements.

In the case of strategic partnerships or
collaborative arrangements requiring the sharing of data, our
policy is to disclose to our partner only such data as relevant
to the partnership or arrangement during its term and so long as
our partner agrees to keep that data confidential.



|        |           
|------- | ----------
|Item 2. | Properties

Our principal executive offices are located in
Wilmington, North Carolina, in a 73,000-square foot owned
facility. Our primary U.S. facilities are located in Wilmington,
North Carolina; Research Triangle Park, North Carolina; North
Brunswick, New Jersey; Natick, Massachusetts; Charleston, South
Carolina; and Shawnee, Kansas. These facilities provide
approximately 437,000 square feet of total operational and
administrative space. Our primary European facilities are
located in Neu-Ulm, Germany and include approximately 112,400
square feet of operational and administrative space. We also
have U.S. sales representatives based throughout the United
States and foreign sales representatives based in Belgium,
Canada, Italy, Japan, Sweden, Switzerland, Germany and the U.K.
We believe that our facilities are adequate for our current
operations and that suitable additional space will be available
when needed.

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Primary Operating Facilities

|                     |  |                                           |  |             |         |              |  |                                     
|-------------------- |  | ----------------------------------------- |  | ----------- | ------- | ------------ |  | ------------------------------------
|                     |  |                                           |  | Approximate |         |             
|                     |  |                                           |  | Square      |         |             
|Location             |  | Primary Use                               |  | Footage     |         | Leased/Owned
|                     |  |                                           |  |             |         |             
|Wilmington, N.C.     |  | Corporate Headquarters                    |  |             | 73,000  |              |  | Owned                               
|Wilmington, N.C.     |  | Manufacturing/ Warehouse/ Office          |  |             | 45,200  |              |  | Owned                               
|Wilmington, N.C.     |  | Laboratory/ Office                        |  |             | 20,000  |              |  | Leased; lease expires October 2006  
|Wilmington, N.C.     |  | Storage for Stability Studies             |  |             | 4,000   |              |  | Owned                               
|Wilmington, N.C.     |  | Laboratory/ Office                        |  |             | 33,000  |              |  | Owned                               
|Wilmington, N.C.     |  | Clinical Distribution Warehouse           |  |             | 25,600  |              |  | Leased; lease expires September 2008
|Chapel Hill, N.C.    |  | Laboratory/ Clinic                        |  |             | 31,000  |              |  | Owned                               
|North Brunswick,N.J. |  | Laboratory/ Office/ Warehouse             |  |             | 74,600  |              |  | Leased; lease expires August 2010   
|Shawnee, Kansas      |  | Laboratory/ Office/ Warehouse             |  |             | 31,500  |              |  | Leased; lease expires December 2005 
|Natick, Mass         |  | Office                                    |  |             | 44,800  |              |  | Leased; lease expires March 2005    
|Charleston, S.C.     |  | Sterile Manufacturing/ Office             |  |             | 48,000  |              |  | Leased; lease expires July 2011     
|Neu-Ulm, Germany     |  | European Headquarters/ Laboratory/ Clinic |  |             | 112,400 |              |  | Leased; lease expires December 2008 



|        |                  
|------- | -----------------
|Item 3. | Legal Proceedings

We are party to lawsuits and administrative
proceedings incidental to the normal course of our business.
While we cannot predict the outcomes of these suits, we do not
believe that any liabilities related to such lawsuits or
proceedings will have a material adverse effect on our
consolidated financial condition, results of operations or cash
flows and we intend to vigorously pursue all defenses available.
In cases where we have initiated an action, we intend to
prosecute our claims to the full extent of our rights under the
law.

We are a party to a number of legal actions with
generic drug companies. We filed three cases in the United
States District Court for the Eastern District of North Carolina
claiming infringement of certain of our fluoxetine hydrochloride
patents. Fluoxetine hydrochloride is an active ingredient in the
drug marketed by Eli Lilly as Prozac. The defendants in these
three actions, Dr. Reddys Laboratories Ltd., a
pharmaceutical company based in India, and its U.S. affiliate,
Dr. Reddys Laboratories, Inc. (formerly
Reddy-Cheminor, Inc.) sell a generic fluoxetine hydrochloride
product in the United States.

In the first action, filed in August 2001, we
alleged that the defendants are infringing our fluoxetine
hydrochloride Form A patent and are seeking an injunction
to prevent the sale of products that infringe this patent, as
well as compensatory and punitive damages and attorneys
fees. In the second case, filed in October 2001, we alleged that
the defendants are infringing three additional fluoxetine
patents and are seeking an injunction to prevent the defendants
from selling infringing fluoxetine products, and monetary
damages. In the third action, filed in November 2001, we have
brought similar claims against the defendants regarding a fifth
fluoxetine patent. In each case, the defendants have filed
counterclaims alleging patent invalidity, violations of the
North Carolina Unfair Trade Practices Act and tortious
interference with the defendants distribution agreements.
We have denied the substantive allegations of their claims. The
cases are all in the initial stages and discovery is occurring.
It is possible that the patents subject to these lawsuits will
be found invalid, unenforceable or not infringed.

We are also involved in four actions centered on
our omeprazole-related patents. Omeprazole is the active
ingredient found in Prilosec, a drug sold by AstraZeneca.

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Two omeprazole-related cases have been filed
against us by Dr. Reddys Laboratories Ltd. and
Dr. Reddys Laboratories, Inc. in the United States
District Court for the Southern District of New York in July
2001 and November 2001. These plaintiffs have sought but, as of
February 28, 2003 have not obtained, approval from the FDA
to market a generic form of Prilosec. In addition, these
plaintiffs omeprazole product has been found in separate
litigation to infringe certain patents of AstraZeneca. The
plaintiffs in these cases are challenging the validity of five
patents that we have obtained relating to omeprazole and are
seeking a declaratory judgment that their generic form of
Prilosec does not infringe these patents. Additionally, they
have alleged misappropriation of trade secrets, tortious
interference, unfair competition and violations of the North
Carolina Unfair Trade Practice Act. We have denied the
substantive allegations made in these cases. Both cases are in
the initial stages and discovery is just beginning. No date has
been set for trial. We intend to vigorously defend the
patents validity and to determine whether or not
Dr. Reddys product infringes any of our relevant
patents.

The third case involving our omeprazole patents
was brought in August 2001 by Andrx Pharmaceuticals, Inc. in the
United States District Court for the Southern District of New
York. Andrx has received FDA approval for its generic omeprazole
product. However, to our knowledge, it is not currently
marketing this drug in the U.S. following a judicial finding
that Andrxs omeprazole product infringed certain
AstraZeneca patents. Andrx is challenging the validity of three
of our omeprazole patents and is also seeking a declaratory
judgment that its generic omeprazole product does not infringe
these patents. Furthermore, Andrx claims violations of federal
and state antitrust laws with respect to the licensing of these
omeprazole patents and is seeking injunctive relief and
unspecified treble damages. We have denied the substantive
allegations made by Andrx. This case is in the initial stages of
discovery. No date has been set for trial. aaiPharma has
recently filed a motion to dismiss the litigation (or,
alternatively, with respect to the antitrust claims, to stay
them pending the appellate decision in the Andrx litigation with
Astra). Andrxs motion papers are not due until late March
2003, with the decision of the court on the motion to dismiss to
occur thereafter.

The fourth case involving our omeprazole patents
was brought in December 2002 by us against Kremers Urban
Development Co., Schwarz Pharma Inc. and Schwarz Pharma AG
(collectively, KUDCO) in the United States District
Court for the Southern District of New York. The case involves
claims of infringement of our omeprazole patent dealing with a
dry-blend process of manufacturing omeprazole products. KUDCO
has a generic omeprazole product with final FDA marketing
approval, was found not to infringe the Astra patents in the
separate AstraZeneca patent litigation, and is currently selling
its generic substitute for Prilosec in the U.S. marketplace.
KUDCO has filed its answer to the Companys complaint,
denying the Companys claims, asserting various affirmative
defenses to the Companys claims, and asserting
counterclaims of patent invalidity, product non-infringement and
antitrust violations under federal and state antitrust laws.
aaiPharma has previously indicated to KUDCO a willingness to
grant a license under aaiPharmas omeprazole patents for an
appropriate royalty. In the absence of a license, aaiPharma
intends to vigorously defend its patent rights and defend
against the foregoing defenses and counterclaims asserted by
KUDCO. It is possible that the omeprazole-related patents
subject to the foregoing four lawsuits will be found invalid,
unenforceable or not infringed.

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PART II

Item 5.     Market
for the Registrants Common Equity and Related Stockholder
Matters

The price range of the our common stock, which is
traded on the NASDAQ market under the symbol AAII,
is listed below by quarter for the years ended December 31,
2002 and 2001:

|      |      |         |   |        |  |       |   |        |  |  |   |       |  |  |   |       | 
|----- | ---- | ------- | - | ------ |  | ----- | - | ------ |  |  | - | ----- |  |  | - | ----- | 
|      |      |        
|      |      | Quarter
|      |      |        
|      |      | First   |   | Second |  | Third |   | Fourth
|      |      |         |   |        |  |       |   |       
|2002: |      |         |   |        |  |       |   |        |  |  |   |       |  |  |   |      
|      | High |         | $ | 23.96  |  |       | $ | 25.35  |  |  | $ | 14.36 |  |  | $ | 11.51 | 
|      | Low  |         | $ | 14.09  |  |       | $ | 11.73  |  |  | $ | 7.68  |  |  | $ | 6.54  | 
|2001: |      |         |   |        |  |       |   |        |  |  |   |       |  |  |   |      
|      | High |         | $ | 8.46   |  |       | $ | 12.15  |  |  | $ | 15.37 |  |  | $ | 16.77 | 
|      | Low  |         | $ | 5.67   |  |       | $ | 8.33   |  |  | $ | 10.11 |  |  | $ | 9.23  | 

The foregoing prices have been adjusted for the
3-for-2 common stock split, effected through a stock dividend,
paid on March 10, 2003.

We estimate there were approximately 2,050
holders of record for our common stock as of March 14,
2003. No cash dividends were declared during 2002 or 2001.

On August 2, 2002, the Company awarded
Dr. Philip S. Tabbiner, the Companys President and
Chief Executive Officer, 25,000 shares of restricted stock for
services (37,500 after adjustment for the 3-for-2 stock split).
No other consideration was paid by Dr. Tabbiner for these
shares. Such transaction was exempt from the registration
requirements of the Securities Act of 1933, as amended, pursuant
to Section 4(2) thereof and Rule 506 thereunder.

24



---



##### 



Item 6.     Selected
Consolidated Financial Data.

The selected historical financial data set forth
below are not necessarily indicative of the results of future
operations and should be read in conjunction with
Managements Discussion and Analysis of Financial
Condition and Results of Operations and our consolidated
financial statements and related notes and other financial
information appearing elsewhere in this report.

SELECTED FINANCIAL DATA

|                                                                                                     |                                                                                        |                                          |         |        |   |      |         |        |  |      |         |        |   |   |         |        |   |   |        |        | 
|---------------------------------------------------------------------------------------------------- | -------------------------------------------------------------------------------------- | ---------------------------------------- | ------- | ------ | - | ---- | ------- | ------ |  | ---- | ------- | ------ | - | - | ------- | ------ | - | - | ------ | ------ | 
|                                                                                                     |                                                                                        |                                         
|                                                                                                     |                                                                                        | Years Ended December 31,                
|                                                                                                     |                                                                                        |                                         
|                                                                                                     |                                                                                        | 2002                                     |         | 2001   |   | 2000 |         | 1999   |  | 1998
|                                                                                                     |                                                                                        |                                          |         |        |   |      |         |        |  |     
|                                                                                                     |                                                                                        |                                         
|                                                                                                     |                                                                                        | (in thousands, except per share amounts)
|Statement of Operations Data:                                                                        |                                                                                        |                                          |         |        |   |      |         |        |  |      |         |        |   |   |         |        |   |   |        |       
|Net revenues                                                                                         |                                                                                        | $                                        | 230,510 |        |   | $    | 141,073 |        |  | $    | 104,245 |        |   | $ | 102,175 |        |   | $ | 98,243 |       
|Direct costs (excluding depreciation)                                                                |                                                                                        |                                          | 81,458  |        |   |      | 67,197  |        |  |      | 47,642  |        |   |   | 52,611  |        |   |   | 48,156 |       
|Selling                                                                                              |                                                                                        |                                          | 23,077  |        |   |      | 13,749  |        |  |      | 11,652  |        |   |   | 11,945  |        |   |   | 9,782  |       
|General and administrative                                                                           |                                                                                        |                                          | 40,108  |        |   |      | 26,538  |        |  |      | 23,773  |        |   |   | 21,992  |        |   |   | 19,424 |       
|Depreciation and amortization                                                                        |                                                                                        |                                          | 9,571   |        |   |      | 7,755   |        |  |      | 7,253   |        |   |   | 7,249   |        |   |   | 5,394  |       
|Research and development                                                                             |                                                                                        |                                          | 20,854  |        |   |      | 10,482  |        |  |      | 11,891  |        |   |   | 10,760  |        |   |   | 5,884  |       
|Direct pharmaceutical start-up costs                                                                 |                                                                                        |                                          |        |        |   |      | 2,123   |        |  |      |        |        |   |   |        |        |   |   |       |       
|Transaction, integration and restructuring costs
    (1)                                             |                                                                                        |                                          |        |        |   |      |        |        |  |      |        |        |   |   | 6,400   |        |   |   |       |       
|                                                                                                     |                                                                                        |                                          |         |        |   |      |         |        |  |      |         |        |   |   |         |        |   |   |        |       
|Income (loss) from operations                                                                        |                                                                                        |                                          | 55,442  |        |   |      | 13,229  |        |  |      | 2,034   |        |   |   | (8,782  | )      |   |   | 9,603  |       
|Other (expense) income, net                                                                          |                                                                                        |                                          | (18,905 | )      |   |      | (4,090  | )      |  |      | (1,916  | )      |   |   | (1,409  | )      |   |   | 502    |       
|                                                                                                     |                                                                                        |                                          |         |        |   |      |         |        |  |      |         |        |   |   |         |        |   |   |        |       
|Income (loss) before income taxes,
    extraordinary loss and cumulative effect of accounting change |                                                                                        |                                          | 36,537  |        |   |      | 9,139   |        |  |      | 118     |        |   |   | (10,191 | )      |   |   | 10,105 |       
|Provision for (benefit from) income taxes                                                            |                                                                                        |                                          | 13,884  |        |   |      | 3,199   |        |  |      | (441    | )      |   |   | (2,278  | )      |   |   | 3,567  |       
|                                                                                                     |                                                                                        |                                          |         |        |   |      |         |        |  |      |         |        |   |   |         |        |   |   |        |       
|Income (loss) before extraordinary loss and
    cumulative effect of accounting change               |                                                                                        |                                          | 22,653  |        |   |      | 5,940   |        |  |      | 559     |        |   |   | (7,913  | )      |   |   | 6,538  |       
|Extraordinary loss, net of a tax benefit of
    $2,714 (2)                                           |                                                                                        |                                          | (5,339  | )      |   |      |        |        |  |      |        |        |   |   |        |        |   |   |       |       
|Cumulative effect of a change in accounting
    principle, net of a tax benefit of $495              |                                                                                        |                                          |        |        |   |      |        |        |  |      | (961    | )      |   |   |        |        |   |   |       |       
|                                                                                                     |                                                                                        |                                          |         |        |   |      |         |        |  |      |         |        |   |   |         |        |   |   |        |       
|Net income (loss)                                                                                    |                                                                                        | $                                        | 17,314  |        |   | $    | 5,940   |        |  | $    | (402    | )      |   | $ | (7,913  | )      |   | $ | 6,538  |       
|                                                                                                     |                                                                                        |                                          |         |        |   |      |         |        |  |      |         |        |   |   |         |        |   |   |        |       
|Basic earnings (loss) per share (3):                                                                 |                                                                                        |                                          |         |        |   |      |         |        |  |      |         |        |   |   |         |        |   |   |        |       
|                                                                                                     | Income (loss) before extraordinary loss and
    cumulative effect of accounting change |                                          | $       | 0.83   |   |      | $       | 0.22   |  |      | $       | 0.02   |   |   | $       | (0.31  | ) |   | $      | 0.25   | 
|                                                                                                     | Extraordinary loss                                                                     |                                          |         | (0.20  | ) |      |         |       |  |      |         |       |   |   |         |       |   |   |        |       | 
|                                                                                                     | Cumulative effect of accounting change                                                 |                                          |         |       |   |      |         |       |  |      |         | (0.04  | ) |   |         |       |   |   |        |       | 
|                                                                                                     |                                                                                        |                                          |         |        |   |      |         |        |  |      |         |        |   |   |         |        |   |   |        |       
|                                                                                                     | Net income (loss)                                                                      |                                          | $       | 0.63   |   |      | $       | 0.22   |  |      | $       | (0.02  | ) |   | $       | (0.31  | ) |   | $      | 0.25   | 
|                                                                                                     |                                                                                        |                                          |         |        |   |      |         |        |  |      |         |        |   |   |         |        |   |   |        |       
|                                                                                                     | Weighted average shares outstanding                                                    |                                          |         | 27,348 |   |      |         | 26,691 |  |      |         | 26,232 |   |   |         | 25,806 |   |   |        | 25,686 | 
|                                                                                                     |                                                                                        |                                          |         |        |   |      |         |        |  |      |         |        |   |   |         |        |   |   |        |       
|Diluted earnings (loss) per share (3):                                                               |                                                                                        |                                          |         |        |   |      |         |        |  |      |         |        |   |   |         |        |   |   |        |       
|                                                                                                     | Income (loss) before extraordinary loss and
    cumulative effect of accounting change |                                          | $       | 0.80   |   |      | $       | 0.22   |  |      | $       | 0.02   |   |   | $       | (0.31  | ) |   | $      | 0.25   | 
|                                                                                                     | Extraordinary loss                                                                     |                                          |         | (0.19  | ) |      |         |       |  |      |         |       |   |   |         |       |   |   |        |       | 
|                                                                                                     | Cumulative effect of accounting change                                                 |                                          |         |       |   |      |         |       |  |      |         | (0.04  | ) |   |         |       |   |   |        |       | 
|                                                                                                     |                                                                                        |                                          |         |        |   |      |         |        |  |      |         |        |   |   |         |        |   |   |        |       
|                                                                                                     | Net income (loss)                                                                      |                                          | $       | 0.61   |   |      | $       | 0.22   |  |      | $       | (0.02  | ) |   | $       | (0.31  | ) |   | $      | 0.25   | 
|                                                                                                     |                                                                                        |                                          |         |        |   |      |         |        |  |      |         |        |   |   |         |        |   |   |        |       
|                                                                                                     | Weighted average shares outstanding                                                    |                                          |         | 28,359 |   |      |         | 27,462 |  |      |         | 26,657 |   |   |         | 25,806 |   |   |        | 26,583 | 
|                                                                                                     |                                                                                        |                                          |         |        |   |      |         |        |  |      |         |        |   |   |         |        |   |   |        |       

25



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##### 



|                                     |                            |                    |         |         |  |      |        |         |  |      |        |         |  |   |        |         |  |   |        |         | 
|------------------------------------ | -------------------------- | ------------------ | ------- | ------- |  | ---- | ------ | ------- |  | ---- | ------ | ------- |  | - | ------ | ------- |  | - | ------ | ------- | 
|                                     |                            |                   
|                                     |                            | As of December 31,
|                                     |                            |                   
|                                     |                            | 2002               |         | 2001    |  | 2000 |        | 1999    |  | 1998
|                                     |                            |                    |         |         |  |      |        |         |  |     
|                                     |                            |                   
|                                     |                            | (in thousands)    
|Balance Sheet Data:                  |                            |                    |         |         |  |      |        |         |  |      |        |         |  |   |        |         |  |   |        |        
|Cash and cash equivalents            |                            | $                  | 6,532   |         |  | $    | 6,371  |         |  | $    | 1,225  |         |  | $ | 1,988  |         |  | $ | 12,299 |        
|Working capital                      |                            |                    | 15,357  |         |  |      | 20,493 |         |  |      | 10,558 |         |  |   | 6,507  |         |  |   | 26,160 |        
|Property and equipment, net          |                            |                    | 53,125  |         |  |      | 37,035 |         |  |      | 42,161 |         |  |   | 45,026 |         |  |   | 38,802 |        
|Goodwill, net                        |                            |                    | 210,792 |         |  |      | 49,380 |         |  |      | 10,554 |         |  |   | 12,391 |         |  |   | 14,964 |        
|Intangible assets, net               |                            |                    | 89,078  |         |  |      | 39,124 |         |  |      | 712    |         |  |   | 649    |         |  |   | 545    |        
|                                     | Total assets               |                    |         | 440,325 |  |      |        | 196,286 |  |      |        | 112,151 |  |   |        | 123,558 |  |   |        | 121,252 | 
|Long-term debt, less current portion |                            |                    | 277,899 |         |  |      | 78,878 |         |  |      | 509    |         |  |   | 962    |         |  |   | 7,749  |        
|Redeemable warrants                  |                            |                    |        |         |  |      | 2,855  |         |  |      |       |         |  |   |       |         |  |   |       |        
|                                     | Total stockholders equity |                    |         | 99,450  |  |      |        | 76,364  |  |      |        | 65,721  |  |   |        | 66,558  |  |   |        | 75,122  | 






|    |                                                                                                                                                                                                     
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | In connection with our merger with Medical &
    Technical Research Associates, Inc., we recorded a $6.4 million
    unusual item in 1999.                                                          
|   
|(2) | In March 2002, we recorded an extraordinary loss
    of $5.3 million, net of taxes, to record the write-off of
    deferred financing fees and other costs related to our prior
    debt facilities.
|   
|(3) | All share and per share amounts have been
    restated to reflect the three-for-two stock split for all
    periods presented.                                                                      



|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|Item 7. | Managements Discussion and Analysis of
    Financial Condition and Results of Operations

You should read the following discussion and
analysis of our financial condition and results of operations
together with our consolidated financial statements and related
notes included elsewhere in this report. The notes to our
consolidated financial statements set forth our critical
accounting policies, including polices relating to revenue
recognition, research and development expense and the use of
estimates. These policies are summarized below under
Critical Accounting Policies.

Overview

aaiPharma Inc. is a science-based specialty
pharmaceutical company focused on the commercialization of
branded pharmaceutical products that we develop or acquire. In
2002, the majority of our net revenues were from our product
sales and product development businesses. Prior to 2002, the
majority of our net revenues were in our development services
business. Major customers for our pharmaceutical products are
large, well-established medical wholesalers and distributors.
Major customers for our development services and product
development businesses are pharmaceutical and biotechnology
companies.

On January 30, 2003, our board of directors
approved a 3-for-2 stock split of our common shares. On
March 10, 2003, each stockholder received one additional
share of common stock for every two shares they owned on the
record date of February 19, 2003. All share and per share
amounts have been restated to reflect the stock split for all
periods presented.

Pharmaceuticals
Division  Our Product Sales Business

Our product sales business unit commercializes
branded pharmaceutical products in our targeted therapeutic
classes. We are focused on acquiring established, branded
pharmaceutical products, developing improved products and
product line extensions, and marketing and promoting these
products. We currently market products under the M.V.I.,
Aquasol, Brethine, Darvon, Darvocet-N and Azasan brand names
and, in March 2003, we began marketing a generic calcitriol
product. Product sales also include the commercial manufacturing
of low volume products marketed and sold by other pharmaceutical
companies. The principal

26



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##### 



costs of this business include manufacturing
costs under agreements with third-party manufacturers, selling
expense of our sales force and general and administrative costs
of our business unit management team.


Our results of operations can be influenced by
the timing of purchases made by our customers. These customers
are wholesalers and may increase their purchases if they
anticipate a price increase. Wholesalers may anticipate a price
increase due to the timing of prior increases, the acquisition
of a product by a new supplier or other reasons. Any increase in
revenues during one period due to an anticipated price increase
may likely be offset by decreased revenues in subsequent
periods. Thus, there may be some volatility of our
pharmaceutical product revenues in future periods due to the
timing of our customers purchasing decisions.

Research and Development
Division  Our Product Development Business

Our product development business unit uses our
research and development expertise and capabilities to enhance
and develop new drug-delivery technologies and improve existing
pharmaceutical products. We apply this expertise to internally
develop our own new products and improve our acquired products.
We license the developed technologies and products to customers,
usually before the development is complete. We generally receive
payments for our efforts and innovations upon the occurrence of
defined events, known as milestones, which are intended to help
cover the costs of development. These milestone payments are not
refundable. In most cases, we also receive royalties on the
eventual sales of the product. Because of the long-term nature
of these projects, we may recognize revenues from milestone
payments or royalties in one period and the associated expenses
in prior periods. The principal expense of this business is
research and development expense, which consists primarily of
labor costs, raw material expenses, third-party consulting and
testing costs and costs for clinical trials. In some cases,
these costs may be directly reimbursed by our customers.

AAI International  Our
Development Services Business

Our development services business unit, AAI
International, provides a comprehensive range of development
services through two primary groups, a non-clinical group and a
clinical group. The non-clinical group analyzes and tests
various chemical compounds and provides small scale
manufacturing of chemical compounds to be used for human
clinical trials. The services performed by the non-clinical
group also include chemical analysis, chemical synthesis, drug
formulation, bio-analytical testing, product life cycle
management studies, and regulatory and compliance consulting.
All of these non-clinical services involve either laboratory
work or consulting services. The clinical group performs testing
for customers of new pharmaceutical products in humans under
controlled conditions as part of the regulatory approval process
for pharmaceutical products. These clinical services involve
conducting human clinical studies and the statistical analysis
relating to these studies.

Both the non-clinical and clinical groups receive
requests for services from customers, often on a competitive
basis. These projects vary in length from one month to several
years. In general, our customers may cancel a project upon 30
days notice. The principal expenses of this business are
labor costs, including employee benefits, and equipment and
facility-related costs.

Acquisitions

Darvon and Darvocet-N Product
Lines

On March 28, 2002, we acquired the U.S.
rights to the Darvon and Darvocet-N branded product lines, which
treat mild-to-moderate pain, and existing inventory from Eli
Lilly, in a business combination accounted for as a purchase. We
acquired these product lines and related intangible assets for
$211.4 million. To finance this acquisition, which included $1.8
million of inventory, we used the proceeds from our senior
secured credit facilities and senior subordinated notes, as
described below in Liquidity and Capital Resources.
The Darvon and Darvocet-N product lines did not have separable
assets and liabilities associated with them, other than
inventory, therefore we allocated the purchase price, including
acquisition related expenses, to acquired identifiable assets,
with the excess of the purchase price over the identifiable
tangible and intangible assets recorded as goodwill.

27



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##### 



M.V.I. and Aquasol Product
Lines

On August 17, 2001, we acquired the M.V.I.
and Aquasol branded lines of critical care injectable and oral
nutritional products from AstraZeneca for up to $100 million,
payable over three years. Of this amount, we paid $52.5 million
at closing. We funded this purchase price with increased
borrowings under our then-existing senior credit facilities. A
guaranteed additional payment of $1.0 million was made in August
2002 and a future guaranteed payment of $1.0 million is due in
August 2003. The acquisition agreement provided for future
contingent payments. A contingent payment of $2.0 million would
have been due in August 2003 if the FDA had approved by
December 31, 2002 the reformulated M.V.I.-12 product with a
minimum shelf life of 12 months. In addition, a contingent
payment of up to $43.5 million is due in August 2004 if FDA
approval of the reformulated M.V.I.-12 product is received on or
before December 31, 2003, with the $43.5 million
payment being reduced by $1.0 million for each month after
December 31, 2002 during which FDA approval has not been
obtained. The $43.5 million payment will become zero in the
event FDA approval is not obtained on or before
December 31, 2003. An application for approval of this
reformulated product was submitted to the FDA in February 2003.
These contingent obligations have not been recorded as a
liability on our consolidated balance sheet. The M.V.I. and
Aquasol product lines did not have separable assets and
liabilities associated with them other than inventory, therefore
we allocated the remaining purchase price to acquired
identifiable intangible assets, with the excess of the purchase
price over the identifiable tangible and intangible assets
recorded as goodwill.

Brethine Product Line

On December 13, 2001, we acquired the
Brethine branded line of products from Novartis for $26.6
million. We used borrowings of $25.0 million under our
then-existing senior credit facilities and cash on hand to pay
the purchase price. The Brethine product line did not have
separable assets and liabilities associated with it, therefore
we allocated the purchase price to acquired identifiable
intangible assets, with the excess of the purchase price over
the identifiable intangible assets recorded as goodwill.

Critical Accounting Policies

Revenue Recognition

Net Revenues.Our
net revenues represent our total revenues less allowances for
customer credits, including estimated discounts, rebates,
chargebacks, product returns and non-research and development
expenses reimbursed by customers. We accept returns of expired
products.

Product Sales.We
recognize revenues for product sales at the time our products
are shipped.

Product Development.We recognize licensing revenues upon completion of interim
contract milestones. Revenues from upfront licensing fees are
deferred and amortized over the term of the associated agreement
or as on-going services are performed. We recognize revenues for
achieving contract milestones when achieved and royalty revenues
as earned based on sales of the underlying products. We bear the
risk that some of the development projects may not be approved
or that the eventual sales of a royalty-generating product may
not meet expectations.

Development
Services.We recognize revenues from
fee-for-service contracts on a percentage-of-completion basis as
the work is performed, based on the ratio of costs incurred to
total estimated costs, or on a time and materials basis in
accordance with the specific contract terms. Revenues recognized
prior to contract billing terms are recorded as
work-in-progress. Provisions for losses on contracts, if any,
are recognized when identified.

SAB 101.In December
1999, the Securities and Exchange Commission, or the SEC, issued
Staff Accounting Bulletin No. 101, Revenue
Recognition in Financial Statements. This bulletin
specifically addresses revenue recognition issues related to
certain upfront payments or fees. Under this bulletin, certain
upfront fees and payments recognized as income in prior periods
were required to be deferred and amortized into revenues over
the terms of the relevant agreements or as the on-going services
were performed. We implemented Staff Accounting Bulletin
No. 101 in the fourth quarter of 2000 and the cumulative
effect of a

28



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##### 



change in accounting principle was retroactively
adopted as of the beginning of the first quarter of 2000. During
the year ended December 31, 2000, we recorded a charge of
$1.5 million ($1.0 million after tax), or a loss of ($0.04) per
share for the cumulative effect of this change in accounting
principle. We recognized $0.6 million in 2002 and $0.5
million in 2001 of revenues related to the amortization of these
deferred amounts. At December 31, 2002, no balance remains
to be amortized into revenue in future periods.


Research and Development
Expense

Research and development expense consists of
salaries of research and development personnel, raw material
expenses, third-party consulting and testing costs, and indirect
costs such as management and administrative overhead and
facilities costs. Research and development costs are charged to
expense as incurred.

Goodwill and Other Intangibles,
Net

For the years ended December 31, 2001 and
2000, goodwill, defined as the excess of the purchase price over
the fair value of the net assets of acquired businesses, was
amortized over 20 years. In accordance with Statement of
Financial Accounting Standards No. 141, Business
Combinations (SFAS No. 141), we ceased
amortization of goodwill as of January 1, 2002. For
purchase business combinations consummated subsequent to
June 30, 2001, goodwill and indefinite-lived intangible
assets are not amortized, but are evaluated for impairment on an
annual basis or as impairment indicators are identified. Other
identifiable intangible assets are amortized, if applicable, on
a straight-line basis over their estimated useful lives, which
range from 3 to 20 years.

On an ongoing basis, we assess the value of our
goodwill, intangibles and other assets by determining their
ability to recover the unamortized balances over the remaining
useful lives. Goodwill, intangibles and other long-lived assets
determined to be unrecoverable would be written-off in the
period in which such determination is made.

Use of Estimates

The preparation of consolidated financial
statements in conformity with accounting principles generally
accepted in the United States requires us to make estimates and
assumptions that affect the amounts reported in our consolidated
financial statements and accompanying notes. The most
significant estimates relate to the allowance for doubtful
accounts, inventory reserves, sales allowances and useful lives
for intangible assets. Actual results could differ from such
estimates and changes in such estimates may affect amounts
reported in future periods.

Research and Development
Arrangements

Research and development expense was 9% of our
net revenues in 2002, and we expect research and development
activities to account for between 8% and 10% of budgeted annual
net revenues in 2003. The following product development table
identifies, for each of our major development programs in 2002,
the stage of development at December 31, 2002 of the lead
product or products in each program, research and development
spending on each program in 2002, cumulative research and
development spending on each program from inception through
December 31, 2002, an estimate of the additional research
and development expense to complete the development of the lead
product in the program, and the year in which we anticipate
completing the lead product in the program. The estimated
additional expense to complete the lead product and the timing
of completion represent our estimates. As we continue these
development programs and evaluate our interim results and other
information, we may decide to change the scope and direction of
a program and we may change how we allocate our research and
development spending to pursue more promising product
candidates. In addition, our actual costs in developing these
products may be materially different from our estimates due to
uncertainties inherent in product development. Moreover, because
of these inherent uncertainties, we may not be able to
successfully develop, commercialize or license the products or
technologies included in the table within the time periods
specified, if at all.

29



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##### 



|                            |                           |                          |  |                   |                     |                        |      |             |     |                   |   |      |      |  |   |     |     |  |  |      |      | 
|--------------------------- | ------------------------- | ------------------------ |  | ----------------- | ------------------- | ---------------------- | ---- | ----------- | --- | ----------------- | - | ---- | ---- |  | - | --- | --- |  |  | ---- | ---- | 
|                            |                           |                          |  |                   |                     |                        |      | Estimated   |     |                  
|                            |                           |                          |  |                   |                     |                        |      | Additional  |     |                  
|                            |                           |                          |  |                   |                     |                        |      | R&D         |     |                  
|                            |                           |                          |  |                   |                     |                        |      | Spending to |     |                  
|                            |                           |                          |  |                   |                     | Cumulative Program R&D |      | Complete    |     | Estimated Year of
|Major Development           |                           | Stage of Development for |  | 2002 Program      |                     | Spending Through       |      | Lead        |     | Completion of    
|Program (and Lead Products) |                           | Lead Products in Program |  | R&D Spending(1)   |                     | December 31, 2002      |      | Products    |     | Lead Products    
|                            |                           |                          |  |                   |                     |                        |      |             |     |                  
|                            |                           |                         
|                            |                           | (dollars in millions)   
|Products:                   |                           |                          |  |                   |                     |                        |      |             |     |                   |   |      |      |  |   |     |     |  |  |     
|                            | Pain Management           |                          |  |                   |                     |                        | $    | 12.6        |     |                   | $ | 15.4 |      |  |   |     |     |  |  |      |     
|                            | (Darvocet LE-1)           |                          |  | Phase I           |                     |                        |      |             |     |                   |   |      |      |  | $ | 1.7 |     |  |  | 2004 |     
|                            | (Darvocet LE-2)           |                          |  | Pre-clinical      |                     |                        |      |             |     |                   |   |      |      |  |   | 6.0 |     |  |  | 2005 |     
|                            | (ProSorb-D)               |                          |  | Phase III         |                     |                        |      |             |     |                   |   |      |      |  |   | 5.3 |     |  |  | 2004 |     
|                            | Gastrointestinal (Ecabet) |                          |  | Phase II          |                     |                        |      | 3.1         |     |                   |   | 12.1 |      |  |   | 9.9 |     |  |  | 2006 |     
|                            | Critical Care (Brethine   |                          |  | Preparing to file |                     |                        |      |             |     |                   |   |      |      |  |   |     |     |  |  |      |     
|                            |                           | line extension)          |  |                   | SNDA                |                        |      |             | 2.0 |                   |   |      | 2.6  |  |   |     | 0.5 |  |  |      | 2004 | 
|                            | Other                     |                          |  | n/a               |                     |                        |      | 2.8         |     |                   |   | n/a  |      |  |   | n/a |     |  |  | n/a  |     
|Technologies:               |                           |                          |  |                   |                     |                        |      |             |     |                   |   |      |      |  |   |     |     |  |  |     
|                            | Drug Delivery             |                          |  |                   |                     |                        |      |             |     |                   |   |      |      |  |   |     |     |  |  |      |     
|                            |                           | (Fexofenadine/           |  |                   | Phase III/Preparing |                        |      |             |     |                   |   |      |      |  |   |     |     |  |  |      |      | 
|                            |                           | Pseudoephedrine)         |  |                   | to file SNDA(2)     |                        |      |             | 0.4 |                   |   |      | 13.7 |  |   |     | 0.2 |  |  |      | 2004 | 
|                            |                           |                          |  |                   |                     |                        |      |             |     |                   |   |      |      |  |   |     |     |  |  |     
|                            |                           |                          |  |                   |                     | $                      | 20.9 |             |     |                   |   |      |      |  |   |     |     |  |  |     
|                            |                           |                          |  |                   |                     |                        |      |             |     |                   |   |      |      |  |   |     |     |  |  |     




|    |                                                                                                                                                                                                     
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Includes an allocation of $7.3 million of
    indirect costs, primarily management and administrative overhead
    and facilities costs, based on direct research and development
    costs in 2002.
|   
|(2) | This product is being developed for a customer
    pursuant to a development agreement. The customer will file the
    SNDA.                                                                        

In addition to the specifically identified
programs named in the table, we have targeted additional product
development programs or projects. These other programs or
projects may require significant research and development
spending in future periods.

There is a risk that any specific research and
development program or project may not produce revenues. We
believe that the potential profit margins from successful
development programs or projects will compensate for costs
incurred for unsuccessful projects. We are currently involved in
many pharmaceutical and technology development programs or
projects and believe that these activities help to diversify our
portfolio and manage our risk. See Risk Factors
contained elsewhere in this report.

Significant Development Agreement

We have a development agreement with a customer
that provides for us to receive contingent periodic payments
based on sales of the customers product and obligates the
customer to use us on a fee-for-service basis for a product life
cycle management project related to the product. The development
agreement relates to a product with respect to which we have
licensed intellectual property that we developed in the past. We
have recognized product development revenues under this
agreement for the periodic payments based on product sales, and
have recognized development services revenue related to the
product life cycle management project. Product development
revenues from this agreement were $16.9 million in 2002,
$14.9 million in 2001 and $3.5 million in 2000. We
recognized no research and development expense in 2002, 2001 and
2000 associated with the payments we received in 2002, 2001 and
2000. The expense of our work associated with these revenues was
recognized primarily in 1999, 1998 and 1997. We do not
anticipate incurring significant expense associated with the
product development revenues under this agreement in future
periods. Development services revenue associated with this
agreement were $4.7 million in 2002, $6.3 million in
2001 and $12.6 million in 2000. Because of the research and
development nature of our activities in this product life cycle
management project and the potential that these activities could
result in continuation of product development revenues into the
future, we have recorded our costs incurred in this project as
research and development expense  $0.7 million
in 2002, $2.3 million in 2001 and $4.4 million in
2000. Accordingly, for our development services business unit,
we have recognized no expense associated with the development

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services revenue arising under this agreement, as
this expense was recognized by our product development business
unit.


We amended this agreement in December 2001. As
amended, the agreement provides that, if we remain available to
provide the customer with development and formulation services
for an identified class of pharmaceutical products on an
exclusive basis (as to third parties) in a calendar quarter, we
will be entitled to fees based on the level of sales over a
prior monthly period of the product that was the subject of our
development work. The customer is obligated to make these
quarterly payments based on whether defined market events have
occurred in the prior measurement month  e.g., if the
defined market events have not occurred during three consecutive
months, we would be entitled to fees in three consecutive
quarters, with, for example, the amount of the fees in the first
quarter being based on product sales in the first month.
However, if we do not continue to provide these development and
formulation services on an exclusive basis (as to third parties)
in any quarter, we will not be entitled to these fees for that
quarter and all subsequent quarters. Under the agreement, we
have the right, at any time, to terminate our obligation to
provide the development and formulation services on an exclusive
basis. Accordingly, we will not recognize product development
revenues under this agreement in any quarter until we have
satisfied the exclusivity requirement for that quarter.

We believe that we will be entitled to product
development fees through the first quarter of 2005 if we
continue to provide the development services to the customer on
an exclusive basis during those periods. We believe that the
annual amount of fees due in 2003 will be in the range of
$12 million to $14 million; in 2004 will be in the
range of $16 million to $18 million; and in the first
quarter of 2005 will be in the range of $3 million to
$4 million. Currently, we do not expect to receive product
development fees in subsequent future periods.

The development agreement also requires the
customer to use a minimum amount of our development services at
standard rates on the product life cycle management project in
specified calendar quarters. In 2000, the amount of research
work we performed for the customer on this project was
significantly greater than the minimum amount, and during 2001
the project wound down to the minimum contractual levels. The
customer is obligated to continue the project at minimum levels
through 2004.

Results of Operations

The following table presents the net revenues for
each of our business units and our consolidated expenses and net
income (loss) and each item expressed as a percentage of
consolidated net revenues:

|                                          |                      |                          |         |         |  |      |     |    |   |   |         |        |  |  |     |    |   |   |         |        |  |  |     |    |  
|----------------------------------------- | -------------------- | ------------------------ | ------- | ------- |  | ---- | --- | -- | - | - | ------- | ------ |  |  | --- | -- | - | - | ------- | ------ |  |  | --- | -- | -
|                                          |                      | Years Ended December 31,
|                                          |                      |                         
|                                          |                      | 2002                     |         | 2001    |  | 2000
|                                          |                      |                          |         |         |  |     
|                                          |                      | (dollars
in thousands)  
|Net revenues:                             |                      |                          |         |         |  |      |     |    |   |   |         |        |  |  |     |    |   |   |         |        |  |  |     |   
|                                          | Product sales        |                          | $       | 128,462 |  |      |     | 56 | % |   | $       | 27,448 |  |  |     | 19 | % |   | $       | 7,341  |  |  |     | 7  | %
|                                          | Product development  |                          |         | 19,610  |  |      |     | 9  |   |   |         | 20,426 |  |  |     | 14 |   |   |         | 9,896  |  |  |     | 10 |  
|                                          |                      |                          |         |         |  |      |     |    |   |   |         |        |  |  |     |    |   |   |         |        |  |  |     |   
|                                          |                      |                          | 148,072 |         |  |      | 65  |    |   |   | 47,874  |        |  |  | 33  |    |   |   | 17,237  |        |  |  | 17  |   
|                                          | Development services |                          |         | 82,438  |  |      |     | 35 |   |   |         | 93,199 |  |  |     | 67 |   |   |         | 87,008 |  |  |     | 83 |  
|                                          |                      |                          |         |         |  |      |     |    |   |   |         |        |  |  |     |    |   |   |         |        |  |  |     |   
|                                          |                      | $                        | 230,510 |         |  |      | 100 | %  |   | $ | 141,073 |        |  |  | 100 | %  |   | $ | 104,245 |        |  |  | 100 | % 
|                                          |                      |                          |         |         |  |      |     |    |   |   |         |        |  |  |     |    |   |   |         |        |  |  |     |   
|Direct costs (excluding depreciation)     |                      | $                        | 81,458  |         |  |      | 35  | %  |   | $ | 67,197  |        |  |  | 48  | %  |   | $ | 47,642  |        |  |  | 46  | % 
|Selling                                   |                      |                          | 23,077  |         |  |      | 10  |    |   |   | 13,749  |        |  |  | 10  |    |   |   | 11,652  |        |  |  | 11  |   
|General and administrative                |                      |                          | 40,108  |         |  |      | 17  |    |   |   | 26,538  |        |  |  | 19  |    |   |   | 23,773  |        |  |  | 23  |   
|Depreciation and amortization             |                      |                          | 9,571   |         |  |      | 4   |    |   |   | 7,755   |        |  |  | 5   |    |   |   | 7,253   |        |  |  | 7   |   
|Research and development                  |                      |                          | 20,854  |         |  |      | 9   |    |   |   | 10,482  |        |  |  | 7   |    |   |   | 11,891  |        |  |  | 11  |   
|Direct pharmaceutical start-up costs      |                      |                          |        |         |  |      |    |    |   |   | 2,123   |        |  |  | 2   |    |   |   |        |        |  |  |    |   
|Income from operations                    |                      |                          | 55,442  |         |  |      | 24  |    |   |   | 13,229  |        |  |  | 9   |    |   |   | 2,034   |        |  |  | 2   |   
|Interest expense, net                     |                      |                          | 19,366  |         |  |      | 8   |    |   |   | 3,646   |        |  |  | 3   |    |   |   | 2,134   |        |  |  | 2   |   
|Provision for (benefit from) income taxes |                      |                          | 13,884  |         |  |      | 6   |    |   |   | 3,199   |        |  |  | 2   |    |   |   | (441    | )      |  |  |    |   
|Net income (loss)                         |                      |                          | 17,314  |         |  |      | 8   |    |   |   | 5,940   |        |  |  | 4   |    |   |   | (402    | )      |  |  |    |   

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Year Ended December 31, 2002
Compared to Year Ended December 31, 2001

Our consolidated net revenues for the year ended
December 31, 2002 increased 63% to $230.5 million, from
$141.1 million in the same period of 2001. Net revenues
from product sales increased to $128.5 million in 2002, from
$27.4 million in 2001, due to sales of our M.V.I., Aquasol
and Brethine products, which we acquired in the second half of
2001, and sales of Darvon and Darvocet-N, which we acquired at
the end of the first quarter of 2002. Net revenues from
commercial manufacturing of products marketed by other
pharmaceutical companies, which is included in product sales,
contributed $4.1 million and $9.9 million to net
revenues from product sales in 2002 and 2001, respectively.

Net revenues from product development decreased
4% in 2002 to $19.6 million, from $20.4 million in
2001, primarily due to a decrease in third-party licensing
revenues, partially offset by an increase in product development
revenues under our significant development agreement, as
described above in Significant Development
Agreement, which increased from $14.9 million in 2001
to $16.9 million in 2002. Our expenses associated with the
development work performed under this agreement were recognized
as incurred, primarily in 1999, 1998 and 1997. No significant
expense was associated with the product development revenues
recognized in 2002, 2001 or 2000.

Net revenues from our development services
business decreased 12% in 2002 to $82.4 million, from
$93.2 million in 2001. This decrease was principally
attributable to the redeployment of a portion of our internal
resources from external revenue-producing projects to research
and development projects relating to our own pharmaceutical
products, both current and future, as well as other market
factors.

This redeployment of resources is a strategic
decision we have made to expand our proprietary product
development pipeline through the increased use of our
development service (fee-for-service) segments core
competencies. This strategy allows us to better control project
flow, at lower costs, and accordingly, we believe this trend
will continue into future years, reflecting the development of
our proprietary product pipeline.

Gross margin dollars, or net revenues less direct
costs, increased $75.2 million, or 102%, to $149.1 million,
from $73.9 million in 2001, reflecting our increased net
revenues in 2002 over the prior year. As a percentage of net
revenues, gross margin dollars increased to 65% in 2002 from 52%
in 2001. Gross margin dollars from our product sales business
increased $81.7 million, to $95.8 million in 2002, from
$14.1 million in 2001, with a gross margin percentage of
75% in 2002, compared to 51% in 2001. The higher margins
generated by our product sales business were partially offset by
decreases in revenues and gross margin percentage from our
development services business in 2002, reflecting the
redeployment of resources discussed above.

Selling expenses increased 68% in 2002 to $23.1
million, from $13.7 million in 2001. This increase is
principally due to additional selling expenses incurred by our
product sales business associated with marketing and promoting
our entire product line, maintaining and enhancing distribution
channels, and growing and developing our product sales force. As
a percentage of net revenues, selling expenses in 2002 increased
slightly from 2001. At the end of 2002, we had 50 pharmaceutical
product sales representatives, as compared to 20 at the end of
2001. This amount increased to 80 sales representatives in
January 2003. We anticipate our sales representatives to
increase to approximately 150 by the end of 2003.

General and administrative costs increased 51% in
2002 to $40.1 million, from $26.5 million in 2001. This increase
was primarily due to expenses related to the management build-up
for our product sales business. As a percentage of net revenues,
general and administrative expenses in 2002 decreased to 17%,
from 19% in 2001.

Research and development expenses were
approximately 9% of net revenues, or $20.9 million, in 2002, an
increase from 7% of net revenues, or $10.5 million, in 2001.
This increase resulted primarily from clinical trials started in
2002 for our ProSorb-D pain management product and line
extension development of our critical care products.

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There were no direct pharmaceutical start-up
costs recorded in 2002, as compared to $2.1 million in 2001.
These costs were incurred prior to our acquisition of any
pharmaceutical product lines in 2001 and were expensed as
incurred.

Consolidated income from operations was $55.4
million in 2002, or $42.2 million higher than the prior year,
and is due to the expansion of our product sales business.

Income from operations for our product sales
business was $73.7 million in 2002, compared to
$7.7 million in the prior year. This increase is
attributable to the revenues and gross margin generated from our
product line acquisitions.

Income from operations for our product
development business was $19.6 million in 2002, compared to
income from operations of $20.4 million in 2001. This change
resulted from the decreased revenues under our significant
development agreement, as discussed above.

We recorded income from operations for our
development services business of $0.6 million in 2002, compared
to income from operations of $8.9 million in 2001. This decrease
is primarily due to the decline in development services revenue,
as described above.

Unallocated corporate expenses increased in 2002
to $17.1 million, from $13.0 million in 2001. This
increase was due to additions to our corporate infrastructure to
accommodate our expansion and increased legal fees to support
our intellectual property. As a percentage of net revenues,
unallocated corporate expenses in 2002 decreased to 7%, from 9%
in 2001.

Net interest expense increased to
$19.4 million in 2002, from $3.6 million in 2001. This
increase is primarily attributable to the net borrowings that
funded our product line acquisitions. These borrowings are
discussed below in Liquidity and Capital Resources.

We recorded a tax provision of $13.9 million
in 2002, based on an effective tax rate of 38%. This rate is
approximately equal to the statutory rate. Our effective tax
rate for 2001 was 35%, which reflected the utilization of tax
loss-carryforwards generated by our European operations.

In March 2002, we recorded an extraordinary loss
of $5.3 million, net of a tax benefit of $2.7 million,
to record the write-off of deferred financing and other costs
related to our prior debt facilities.

Year Ended December 31, 2001
Compared to Year Ended December 31, 2000

Our net revenues for the year ended
December 31, 2001 increased 35% to $141.1 million,
from $104.2 million in 2000. This increase was primarily
due to the acquisition by our pharmaceutical products business
unit of the M.V.I., Aquasol and Brethine branded products and an
increase of $5.1 million of net revenues associated with
our significant development agreement, described above.

Net revenues from product sales increased 274% in
2001 to $27.4 million, from $7.3 million in 2000, due
to sales of our M.V.I., Aquasol and Brethine products after we
acquired them. Net revenues from product sales in 2000 and prior
periods consist of revenues from commercial manufacturing of
products marketed by other pharmaceutical companies. Net
revenues from commercial manufacturing contributed
$9.9 million and $7.3 million to net revenues from
product sales in 2001 and 2000, respectively.

Net revenues from product development increased
106% in 2001 to $20.4 million, from $9.9 million in
2000, primarily due to a 325% increase, or an increase of
$11.4 million, of product development revenues under an
agreement described above in Significant Development
Agreement. Our expenses associated with the development
work performed under this agreement were recognized primarily in
1999, 1998 and 1997. No significant expense was associated with
the product development revenues recognized in 2001 or 2000.

Net revenues from our development services
business increased 7% in 2001 to $93.2 million, from
$87.0 million in 2000. This increase was primarily
attributable to revenues generated from significant new
Phase III clinical trial contracts that we entered into in
the second half of 2000, including amendments to those
contracts, in 2001. Net revenues from our development services
business associated with our significant development agreement
described above decreased 50% in 2001 to $6.3 million, from
$12.6 million in 2000.

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Gross margin dollars, or net revenues less direct
costs, increased $17.3 million, or 31%, to
$73.9 million, from $56.6 million in 2000, reflecting
our increased net revenues in 2001 over the prior year. As a
percentage of net revenues, gross margin dollars decreased
slightly to 52% in 2001 from 54% in 2000. Gross margin dollars
from our product sales business increased $12.1 million in
2001, from $2.0 million in 2000, with a gross margin
percentage of 51% in 2001. Additionally, gross margin dollars
from our product development business increased 106% to
$20.4 million in 2001 from $9.9 million in 2000,
benefiting significantly from the $14.9 million of product
development revenues from our significant development agreement.
These higher margins generated by our product sales and product
development businesses were offset by the lower gross margin
percentage of our development services business in 2001,
reflecting a significant increase in lower-margin clinical
revenues and decrease in higher-margin fee-for-service revenues
under our significant development agreement.

Selling expenses increased 18% in 2001 to
$13.7 million, from $11.7 million in 2000. This
increase was primarily due to additional selling expenses
incurred by our product sales business associated with marketing
and promoting our new products, maintaining and enhancing
distribution channels, and developing our product sales force.

General and administrative costs increased 12% in
2001 to $26.5 million, from $23.8 million in 2000.
This increase was primarily due to increases in employee
benefits and legal fees related to protecting our intellectual
property rights.

Research and development expenses were
approximately 7% of net revenues, or $10.5 million, in
2001, a decrease from 11% of net revenues, or
$11.9 million, in 2000. This decrease was primarily
attributable to the winding down in 2001 of a significant
product life cycle management project associated with the
significant development agreement, described above.

The direct pharmaceutical start-up costs of
$2.1 million in 2001 represent costs of developing our
pharmaceutical products organizational and marketing
infrastructure. These costs were incurred prior to our
acquisition of any product lines and were expensed as incurred
in accordance with the American Institute of Certified Public
Accountants Statement of Position 98-5, Reporting on
the Costs of Start-Up Activities. Upon the acquisition of
our first product line in August 2001, we began classifying
similar costs as selling or general and administrative costs, as
appropriate.

Net interest expense increased 71% in 2001 to
$3.6 million, from $2.1 million in 2000. This
$1.5 million increase was primarily attributable to the
borrowings in 2001 that funded our product line acquisitions.

Income from operations was $13.2 million in
2001, an $11.2 million increase over the prior year. This
increase was primarily attributable to the expansion of our
product sales business and an increase in product development
revenues (with low associated expenses) from our significant
development agreement described above. This increase was offset
by a decrease in income from operations in our development
services business caused by the changing mix of revenues in that
business. We recorded income from operations for our product
sales business of $7.7 million in 2001, compared to a loss
from operations of ($0.7) million in the prior year. This
increase was primarily attributable to our acquisitions of the
M.V.I., Aquasol and Brethine product lines during 2001.

We recorded income from operations for our
product development business of $20.4 million in 2001,
compared to income from operations of $9.9 million in 2000.
This resulted from increases in net revenues related to our
significant development agreement.

We recorded income from operations for our
development services business of $8.9 million in 2001,
compared to $16.4 million in 2000. This decrease was
primarily due to the changing mix of development services
revenue, with a significant increase in lower-margin clinical
revenues and a decline in higher margin product life cycle
management revenues.

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Unallocated corporate expenses increased by 14%
in 2001 to $13.0 million, from $11.3 million in 2000.
This higher level was attributable to additions to our corporate
infrastructure to accommodate the expansion of our overall
business.

We recorded a tax provision of $3.2 million in
2001, based on an effective tax rate of 35%. This rate was
slightly higher than the statutory rate due principally to
permanent differences of $0.4 million. We recorded a net
deferred tax asset of $3.6 million at December 31, 2001.

Liquidity and Capital Resources

Historically, we have funded our businesses with
cash flows provided by operations and proceeds from borrowings.
Cash flow provided by operations in 2002 was $28.1 million, up
from $20.4 million in 2001. This increase was primarily due to
the increases in net income and accrued interest payable on our
senior subordinated notes, partially offset by increases in
accounts receivable and inventories related to the product lines
we acquired, and prepaid financing fees related to the financing
of our Darvon and Darvocet-N acquisition. Cash flow provided by
operations subsequent to the Darvon and Darvocet-N acquisition
on March 28, 2002 was $47.7 million.

Cash used in investing activities was $235.1
million in 2002. This included $211.4 million related to our
acquisition of the Darvon and Darvocet-N branded product lines
as further described below, and $14.1 million for the
purchase of assets formerly covered by our tax retention
operating lease, including our corporate headquarters in
Wilmington, N.C. and a laboratory and clinical facility in
Chapel Hill, N.C. Capital expenditures were $8.5 million during
2002. Capital assets purchased during 2002 were primarily
related to purchases of information technology hardware and
software, upgrading and replacing laboratory equipment and
setting up and transferring the production for our acquired
products.

Cash provided by financing activities during 2002
was $207.0 million, primarily representing net proceeds of
$244.5 million in additional borrowings under our new debt
facilities, as described below, $10.5 million related to
the unamortized proceeds from the sales of our interest rate
swaps and $3.2 million of cash proceeds from the exercise of
stock options, partially offset by the repayment of $51.9
million of borrowings in the last nine months of 2002.

In 2001, $20.4 million of cash flow was provided
by operations, an increase of $5.6 million over 2000. This was
primarily due to our improved management of working capital,
which was strongly influenced by the timing of transactions,
including our receipt of $14.9 million of product development
payments associated with our significant development agreement
described above and the collection of a significant receivable
associated with this agreement. Our working capital improvement
was partially offset by additional working capital needed for
the M.V.I., Aquasol and Brethine product lines. During 2001,
cash used in investing activities was $81.8 million, which was
primarily related to our acquisition of these branded product
lines. Capital expenditures were $6.3 million during 2001, and
in March 2001, we completed a sale/leaseback transaction on
manufacturing equipment, which provided cash of $3.1 million.
Cash provided by financing activities during 2001 was $66.6
million, primarily representing net proceeds of $78.9 million in
borrowings to fund our product line acquisitions and $5.1
million of cash proceeds from the exercise of stock options,
offset by repayments under our revolving credit facility of
$16.3 million.

In 2000, $14.7 million of cash was provided by
operations, benefiting from cash generated under our significant
development agreement and improved working capital management.
During 2000, cash used in investing activities was $3.9 million,
primarily consisting of capital expenditures of $4.6 million.
Cash used in financing activities during 2000 was $11.5 million,
of which $10.7 million represented repayments of borrowings.

On March 28, 2002, we acquired the U.S.
rights to the Darvon and Darvocet-N branded product lines and
existing inventory from Eli Lilly and Company for $211.4 million
in cash, subject to potential reduction based on the net sales
of these products after the closing of the acquisition. In
connection with the acquisition, we entered into $175 million of
senior credit facilities, issued $175 million of senior
subordinated

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notes due 2010, repaid all $78 million of
borrowings outstanding under our prior senior credit facilities,
and terminated our tax retention operating lease and purchased
the underlying properties.


Our $175 million senior secured credit facilities
consist of a $75 million five-year revolving credit facility and
a $100 million five-year term loan facility. The term loan
facility amortizes over the full five-year term. The senior
facilities were subsequently reduced to $125 million due to the
$50 million of repayments we made under the term loan facility.
The availability of borrowings under our revolving credit
facility is not limited by a borrowing base. Our senior credit
facilities provide for variable interest rates based on LIBOR or
an alternate base rate, at our option. Such facilities are
guaranteed by all of our domestic subsidiaries and secured by a
security interest on substantially all of our domestic assets,
all of the stock of our domestic subsidiaries, and 65% of the
stock of our material foreign subsidiaries. Our senior credit
facilities require the payment of certain commitment fees based
on the unused portion of the revolving credit facility. Under
the terms of the credit agreement for our senior credit
facilities, we are required to comply with various covenants
including, but not limited to, those pertaining to maintenance
of certain financial ratios and incurrence of additional
indebtedness. We were in compliance with these covenants at
December 31, 2002. These senior credit facilities may be
prepaid at our option at any time without a premium.

On March 28, 2002, we issued $175 million of
senior subordinated unsecured notes due 2010. These notes have a
fixed interest rate of 11% per annum and are guaranteed on a
subordinated basis by all of our existing domestic subsidiaries
and all of our future domestic subsidiaries of which we own 80%
or more of the equity interests. Prior to March 28, 2005,
up to 35% of the notes are redeemable with the proceeds of
qualified sales of equity at 111% of par value. The terms of our
senior credit facilities require us to repay all of the
indebtedness under these facilities before we could repurchase
any of the notes. On or after March 28, 2006, all or any
portion of the notes are redeemable at declining premiums to par
value, beginning at 105.5%. Under the terms of the indenture for
the notes, we are required to comply with various covenants
including, but not limited to, a covenant relating to incurrence
of additional indebtedness. We were in compliance with these
covenants at December 31, 2002.

Concurrent with the issuance of our senior
subordinated notes, we entered into an interest rate swap
agreement to effectively convert interest expense on $140
million of senior subordinated notes for the term of the notes
from an 11% fixed annual rate to a floating annual rate equal to
6-month LIBOR plus a base rate. On May 30, 2002,
August 5, 2002 and September 19, 2002, we sold the
then outstanding swap agreements for $4.4 million, $5.6 million
and $3.7 million, respectively. The amounts we received, less
the interest benefit earned through the dates of sale, have been
recorded as a premium to the carrying amount of the notes and
are being amortized into interest income over their remaining
life. At December 31, 2002, we had an interest rate swap
agreement in place covering $150 million of the notes, at a rate
of 6-month LIBOR plus 6.54%. Under this agreement, 6-month LIBOR
was locked at 1.85%, giving us an all-in rate of 8.39%. On
February 27, 2003, this interest rate swap was sold for
$2.3 million, and a new swap was entered covering $150 million
of the notes, at a rate of 6-month LIBOR plus 6.94%, giving us
an estimated all-in rate of 8.28%. The terms of these interest
rate swap agreements, other than the notional amount and the
base rate, were identical and were perfectly matched with the
terms of the related hedged instrument. On December 31,
2002 and February 28, 2003, 6-month LIBOR was 1.38% and
1.34%, respectively.

36



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##### 



The following schedule summarizes contractual
obligations and commitments at December 31, 2002 (in
thousands):

|                          |  |          |        |             |  |            |        |           |  |       |        |  |  |   |         |  |  |   |         | 
|------------------------- |  | -------- | ------ | ----------- |  | ---------- | ------ | --------- |  | ----- | ------ |  |  | - | ------- |  |  | - | ------- | 
|                          |  |          |        |             |  | Over       |        |           |  |      
|                          |  |          |        | Over One    |  | Three      |        |           |  |      
|                          |  | One Year |        | Through     |  | Through    |        | Over Five |  |      
|                          |  | or Less  |        | Three Years |  | Five Years |        | Years     |  | Total
|                          |  |          |        |             |  |            |        |           |  |      
|Long-term debt            |  | $        | 5,921  |             |  | $          | 22,369 |           |  | $     | 69,210 |  |  | $ | 175,000 |  |  | $ | 272,500 | 
|Operating leases          |  |          | 6,799  |             |  |            | 11,337 |           |  |       | 7,585  |  |  |   | 9,470   |  |  |   | 35,191  | 
|Capital lease obligations |  |          | 419    |             |  |            | 451    |           |  |       | 124    |  |  |   |        |  |  |   | 994     | 
|Purchase commitments      |  |          | 24,836 |             |  |            |       |           |  |       |       |  |  |   |        |  |  |   | 24,836  | 
|                          |  |          |        |             |  |            |        |           |  |       |        |  |  |   |         |  |  |   |         | 
|                          |  | $        | 37,975 |             |  | $          | 34,157 |           |  | $     | 76,919 |  |  | $ | 184,470 |  |  | $ | 333,521 | 
|                          |  |          |        |             |  |            |        |           |  |       |        |  |  |   |         |  |  |   |         | 

Our purchase commitments are primarily related to
outstanding orders with suppliers to purchase finished goods
related to our pharmaceutical products.

Our liquidity needs increased significantly
during 2002, and our annual net interest expense may exceed $19
million in 2003. The M.V.I. and Aquasol acquisition agreement
provided for a $1 million guaranteed payment in August 2003, and
future contingent payments of $2.0 million and $43.5 million
potentially due in August 2003 and August 2004, respectively,
depending on the status of certain reformulation activities
being carried out by AstraZeneca. As previously discussed, the
conditions to the contingent payments were not met by the
required date, so that the $2.0 million amount is no longer a
contingent obligation of ours and the potential $43.5 million
contingent payment is decreasing by $1.0 million for each full
month that the conditions continue to be unmet. If such
conditions are not satisfied by December 31, 2003, the
remaining contingent payment obligation to AstraZeneca will
decrease to zero. In addition, we may have to make contingent
payments of $4.8 million over four years in connection with the
purchase of our Charleston, South Carolina manufacturing
facility, based on the level of manufacturing revenues at this
facility. These contingent payment obligations, including the
contingent payments potentially due in connection with the
acquisition of the M.V.I. and Aquasol product lines, have not
yet been recorded as a liability on our consolidated balance
sheet. We have $5.9 million of principal repayments due in the
next twelve months under our senior credit facilities and will
make interest payments on the senior subordinated notes of
$9.6 million in April and October 2003. These interest
payments will be reduced by approximately $0.4 million and $1.9
million to be received under our interest rate swap agreement in
April 2003 and October 2003, respectively.

We believe that our senior credit facilities and
cash flow provided by operations will be sufficient to fund
near-term growth and fund our guaranteed and contingent payment
obligations arising from our acquisitions. We may require
additional financing to pursue other acquisition opportunities
or for other reasons. We may from time to time seek to obtain
additional funds through the public or private issuance of
equity or debt securities. While we remain confident that we can
obtain additional financing, if necessary, we cannot assure you
that additional financing will be available or that the terms
will be acceptable to us.

Related Party Transactions

In 1994, as part of our internal development
program, we organized Endeavor Pharmaceuticals, Inc. to continue
development of products that we had been developing on our own
and to permit investors to directly invest in the development of
these products. We assigned our rights to these products to
Endeavor in return for approximately 47% of Endeavors
fully diluted equity. As a result of additional issuances of
equity by Endeavor to third party investors, our fully diluted
ownership interest in Endeavor has been reduced to approximately
13%. As of December 31, 2002, Dr. Frederick D.
Sancilio, our Executive Chairman and Chief Scientific Officer,
owned 0.8% of Endeavors fully diluted equity and an
affiliate of James L. Waters, one of our directors, owned 0.6%.
We had net revenues for services provided to Endeavor at our
standard rates of approximately $1.1 million in 2002, $0.2
million in 2001 and $0.7 million in 2000. We had approximately
$0.3 million and $0.1 million in related accounts receivable at
December 31, 2002 and 2001, respectively.

37



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##### 



We organized Aesgen, Inc. with an affiliate of
the Mayo Clinic in 1994 and funded it in 1995 with an affiliate
of the Mayo Clinic, MOVA Pharmaceutical Corporation and certain
other investors to combine our development capabilities with the
medical expertise of the Mayo Clinic and to permit investors to
directly invest in the development of these products. We
distributed our initial common stock investment in Aesgen to our
shareholders prior to our initial public offering in 1996. As a
result, some of our directors, executive officers and holders of
5% or more of common stock who held our stock prior to the
initial public offering beneficially own common equity of
Aesgen. In the aggregate they own less than 10% of Aesgens
fully diluted common equity. In October 2001, we agreed to
provide development services to Aesgen, through AAI
International, at our standard rates in exchange for $1.1
million of Aesgen convertible preferred stock. Through
December 31, 2002, we had performed $580,000 of services
under this agreement. At December 31, 2002, we held
convertible preferred shares of Aesgen that represented
approximately 10.0% of Aesgens fully diluted common
equity, which included 5.4% earned through December 31,
2002, for services performed under this agreement. If all $1.1
million of services are performed, we expect to own 14.2% of
Aesgens common equity on a fully diluted basis.

In December 2001, we acquired rights, title and
interest to some of the products being developed by Aesgen.
These products include five products for which abbreviated new
drug applications have been approved by the FDA, and two other
products under development. As consideration for the purchase of
these products, we waived all claims to amounts due from Aesgen.
At December 31, 2002, the approximate book value of these
assets was $600,000.

In February 2002, we purchased a generic
injectable vitamin D nutritional product from Aesgen for payment
of $1.0 million in cash and additional contingent milestone
payments of up to $1.5 million. Recently, the prerequisite for
payment of an additional $500,000 of such contingent milestones
occurred and such payment was made to Aesgen, while the
prerequisites for payment of the remaining $1.0 million were not
met and no further payment of this amount is owed by us. We
intend to market this product as an extension of our Aquasol
product line. Under this agreement, we are obligated to pay
royalty payments equal to 30% of the net revenues of the product
acquired from Aesgen, less certain costs incurred in its
manufacture and marketing, for the eight-year period following
the first commercial sale of this product.

We recognized net revenues of approximately
$494,000, $86,000 and $100,000 from Aesgen for the years ended
December 31, 2002, 2001 and 2000, respectively. We had no
related accounts receivable or work-in-progress at
December 31, 2002 or 2001.

See Certain Relationships and Related
Transactions and note 8 to our consolidated financial
statements included elsewhere in this report for a more detailed
description of these related party transactions.

Inflation

We believe that the effects of inflation
generally do not have a material adverse effect on our
consolidated results of operations or financial condition.

New Accounting Standards

In April 2002, the Financial Accounting Standards
Board (the FASB) issued Statement of Financial
Accounting Standards No. 145, Rescission of FASB
Statements No. 4, 44, and 64, Amendment of FASB Statement
No. 13, and Technical Corrections (SFAS
No. 145). This statement eliminates the automatic
classification of gain or loss on early extinguishment of debt
as an extraordinary item and requires that any such gain or loss
be reviewed under the criteria of Accounting Principles Board
No. 30 Reporting Results of Operations. This
statement also requires sale-leaseback accounting for certain
lease modifications that have economic effects that are similar
to sale-leaseback transactions, and makes various other
technical corrections to existing pronouncements. The statement
is effective for fiscal years beginning after May 15, 2002.
We do not expect that the adoption of SFAS No. 145 will
have a significant impact on our consolidated results of
operations, financial position or cash flows.

38



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##### 



In June 2002, the FASB issued Statement of
Financial Accounting Standards No. 146, Accounting for
Costs Associated with Exit or Disposal Activities
(SFAS No. 146). SFAS No. 146 is effective
for exit or disposal activities that are initiated after
December 31, 2002. The Company does not expect that the
adoption of SFAS No. 146 will have a significant impact on
the Companys consolidated results of operations, financial
position or cash flows.

In December 2002, the FASB issued Statement of
Financial Accounting Standards No. 148, Accounting
for Stock-Based Compensation  Transition and
Disclosure (SFAS No. 148). SFAS
No. 148 amends Statement of Financial Accounting Standards
No. 123, Accounting for Stock-Based
Compensation (SFAS No. 123), to provide alternative
methods of transition to SFAS No. 123s fair value
method of accounting for stock-based employee compensation. SFAS
No. 148 also amends the disclosure provisions in SFAS
No. 123 and APB Opinion No. 28, Interim
Financial Reporting, to require disclosure in the summary
of significant accounting policies of the effects of an
entitys accounting policy with respect to stock-based
employee compensation on reported net income and earnings per
share in annual and interim financial statements. The adoption
of SFAS No. 148 did not have a significant impact on the
Companys consolidated results of operations, financial
position or cash flows.

Forward Looking Statements, Risk Factors and
Safe Harbor Language

This report contains certain forward-looking
statements, within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. All statements that
include the words may, will,
estimate, intend, project,
target, objective, goal,
should, could, might,
continue, believe, expect,
plan, anticipate and other similar words
are intended to be forward-looking statements. We assume no
obligation to update forward-looking statements, or any other
statements, contained in this report.

For purposes of illustration, these
forward-looking statements include statements relating to the
amount, timing, and use of proceeds of future issuance of
equity; the sufficiency of our senior credit facilities and cash
flow from operations to fund near-term growth and to fund
guaranteed and contingent acquisition payment obligations; the
availability of future financing, if necessary; the expected
amounts owed under future contingent acquisition payment
obligations; our R&D activities, funding and trends and the
expected use of our fee-for-service resources in support
thereof; anticipated product development and development
services net revenues and profitability levels and trends;
expected levels of future net interest expenses; targeted
research and development expenditures as a percentage of net
revenues; anticipated levels of sales and general and
administrative costs as a percentage of net revenues; and
expected net revenues, expenses and profitability of our product
sales.

Although we believe that the expectations
underlying any of our forward-looking statements are reasonable,
these expectations may prove to be incorrect and all of these
statements are subject to risks and uncertainties. Should one or
more of these risks and uncertainties materialize, or should
underlying assumptions, projections or expectations prove
incorrect, actual results, performance or financial condition
may vary materially and adversely from those anticipated,
estimated or expected. We have identified below some important
factors that could cause our forward-looking statements to
differ materially from actual results, performance or financial
condition:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | We have transitioned our company to a specialty
    pharmaceutical company with different challenges and risks;                                                                                                                                                                                                                                                                                
|
| |  | We may devote significant operational and
    financial resources to develop products that we may never be
    able to successfully commercialize;                                                                                                                                                                                                                                             
|
| |  | We have increased our sales and net income
    through a series of acquisitions of branded products, and we
    intend to seek more acquisition opportunities; we may have
    overpaid, or may overpay in the future, for a branded product
    line that may not produce sufficient cash flow to repay our
    debt, including indebtedness incurred in connection with that
    acquisition;

39



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##### 





| |   |                                                                                                                                                                                                                                                                          
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | We are dependent on third parties for essential
    business functions and problems with these third-party
    arrangements could materially adversely affect our ability to
    manufacture and sell products and our financial condition and
    results of operations;
|
| |  | Competition from the sale of generic products and
    the development by other companies of new branded products could
    cause the revenues from our branded products to decrease
    significantly;                                                                   
|
| |  | We may be unable to obtain government approval
    for our products or comply with government regulations relating
    to our business; and                                                                                                                              
|
| |  | Changes in government regulations may favor sales
    of generic products that compete with our branded products.                                                                                                                                                        

Additional factors that may cause the actual
results to differ materially are discussed in Exhibit 99.1
to this report hereto and incorporated herein by reference and
in our recent filings with the SEC, including, but not limited
to, our Form 8-K reports, and other periodic filings.
Whenever you read or hear any subsequent written or oral
forward-looking statements attributable to us or any person
acting on our behalf, you should keep in mind the cautionary
statements contained or referred to in this section. We do not
undertake any obligation to release publicly any revisions to
these forward-looking statements to reflect events or
circumstances after the date of this document or to reflect the
occurrence of unanticipated events.

Item 7A.     Quantitative
and Qualitative Disclosures About Market Risk

As a result of global operating activities, we
are exposed to risks associated with changes in foreign exchange
rates. As foreign exchange rates change, the U. S. Dollar
equivalent of revenues and expenses denominated in foreign
currencies change and can have an adverse impact on our
operating results. To seek to minimize its risk from foreign
exchange movement, we may use local debt to fund our foreign
operations. If foreign exchange rates were to decrease by 10%,
our operating results would have been lower by $17,000 in 2002
due to the reduction in reported results from European
operations.

We are also exposed to fluctuations in interest
rates on variable rate debt instruments tied to LIBOR, as
discussed in Managements Discussion and Analysis of
Financial Condition  Liquidity and Capital
Resources. If interest rates were to increase by 1%,
annual interest expense on variable rate debt tied to interest
rates would increase by approximately $1.1 million.

40



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##### 



Item 8.     Financial
Statements and Supplementary Data

Report of Independent Auditors

Board of Directors and Stockholders

aaiPharma Inc.


We have audited the accompanying consolidated
balance sheets of aaiPharma Inc. as of December 31, 2002
and 2001, and the related consolidated statements of operations,
cash flows, stockholders equity and comprehensive income
(loss) for each of the three years in the period ended
December 31, 2002. Our audits also included the financial
statement schedule listed in the Index at Item 15(d). These
financial statements and schedule are the responsibility of the
Companys management. Our responsibility is to express an
opinion on these financial statements and schedule based on our
audits.

We conducted our audits in accordance with
auditing standards generally accepted in the United States.
Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits
provide a reasonable basis for our opinion.

In our opinion, the consolidated financial
statements referred to above present fairly, in all material
respects, the consolidated financial position of aaiPharma Inc.
at December 31, 2002 and 2001, and the consolidated results
of its operations and its cash flows for each of the three years
in the period ended December 31, 2002, in conformity with
accounting principles generally accepted in the United States.
Also, in our opinion, the related financial statement schedule,
when considered in relation to the basic financial statements
taken as a whole, presents fairly in all material respects the
information set forth therein.

As disclosed in Note 1 to the consolidated
financial statements, as of January 1, 2002 the Company changed
its method of evaluating goodwill for impairment.



| |                      
| | ---------------------
| | /s/ ERNST & YOUNG LLP

Raleigh, North Carolina

January 27, 2003


except for Note 1, as to which the date is


March 10, 2003


41



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##### 



aaiPharma Inc.

CONSOLIDATED STATEMENTS OF
OPERATIONS

(In thousands, except per share
amounts)


|                                                                                              |                                                                                          |                          |                    |         |        |        |         |        |        |        |         |        |        |        | 
|--------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------- | ------------------------ | ------------------ | ------- | ------ | ------ | ------- | ------ | ------ | ------ | ------- | ------ | ------ | ------ | 
|                                                                                              |                                                                                          |                         
|                                                                                              |                                                                                          | Years Ended December 31,
|                                                                                              |                                                                                          |                         
|                                                                                              |                                                                                          | 2002                     |                    | 2001    |        | 2000  
|                                                                                              |                                                                                          |                          |                    |         |        |       
|Net revenues:                                                                                 |                                                                                          |                          |                    |         |        |        |         |        |        |        |         |       
|                                                                                              | Product sales                                                                            |                          | $                  | 128,462 |        |        | $       | 27,448 |        |        | $       | 7,341  |       
|                                                                                              | Product development                                                                      |                          |                    | 19,610  |        |        |         | 20,426 |        |        |         | 9,896  |       
|                                                                                              | Development services (includes related party net
    revenues of $1,556, $323, and $761) |                          |                    | 82,438  |        |        |         | 93,199 |        |        |         | 87,008 |       
|                                                                                              |                                                                                          |                          |                    |         |        |        |         |        |        |        |         |       
|                                                                                              |                                                                                          |                          | 230,510            |         |        |        | 141,073 |        |        |        | 104,245 |       
|                                                                                              |                                                                                          |                          |                    |         |        |        |         |        |        |        |         |       
|Operating costs and expenses:                                                                 |                                                                                          |                          |                    |         |        |        |         |        |        |        |         |       
|                                                                                              | Direct costs (excluding depreciation):                                                   |                          |                    |         |        |        |         |        |        |        |         |        |       
|                                                                                              |                                                                                          | Product sales            |                    |         | 32,645 |        |         |        | 13,337 |        |         |        | 5,378  |       
|                                                                                              |                                                                                          | Development services     |                    |         | 48,813 |        |         |        | 53,860 |        |         |        | 42,264 |       
|                                                                                              |                                                                                          |                          |                    |         |        |        |         |        |        |        |         |       
|                                                                                              |                                                                                          |                          | Total direct costs |         |        | 81,458 |         |        |        | 67,197 |         |        |        | 47,642 | 
|                                                                                              | Selling                                                                                  |                          |                    | 23,077  |        |        |         | 13,749 |        |        |         | 11,652 |       
|                                                                                              | General and administrative                                                               |                          |                    | 40,108  |        |        |         | 26,538 |        |        |         | 23,773 |       
|                                                                                              | Depreciation and amortization                                                            |                          |                    | 9,571   |        |        |         | 7,755  |        |        |         | 7,253  |       
|                                                                                              | Research and development                                                                 |                          |                    | 20,854  |        |        |         | 10,482 |        |        |         | 11,891 |       
|                                                                                              | Direct pharmaceutical start-up costs                                                     |                          |                    |        |        |        |         | 2,123  |        |        |         |       |       
|                                                                                              |                                                                                          |                          |                    |         |        |        |         |        |        |        |         |       
|Total operating costs and expenses                                                            |                                                                                          |                          | 175,068            |         |        |        | 127,844 |        |        |        | 102,211 |       
|                                                                                              |                                                                                          |                          |                    |         |        |        |         |        |        |        |         |       
|Income from operations                                                                        |                                                                                          |                          | 55,442             |         |        |        | 13,229  |        |        |        | 2,034   |       
|Other expense:                                                                                |                                                                                          |                          |                    |         |        |        |         |        |        |        |         |       
|                                                                                              | Interest, net                                                                            |                          |                    | (19,366 | )      |        |         | (3,646 | )      |        |         | (2,134 | )     
|                                                                                              | Other                                                                                    |                          |                    | 461     |        |        |         | (444   | )      |        |         | 218    |       
|                                                                                              |                                                                                          |                          |                    |         |        |        |         |        |        |        |         |       
|                                                                                              |                                                                                          |                          | (18,905            | )       |        |        | (4,090  | )      |        |        | (1,916  | )     
|                                                                                              |                                                                                          |                          |                    |         |        |        |         |        |        |        |         |       
|Income before income taxes, extraordinary loss
    and cumulative effect of accounting change |                                                                                          |                          | 36,537             |         |        |        | 9,139   |        |        |        | 118     |       
|Provision for (benefit from) income taxes                                                     |                                                                                          |                          | 13,884             |         |        |        | 3,199   |        |        |        | (441    | )     
|                                                                                              |                                                                                          |                          |                    |         |        |        |         |        |        |        |         |       
|Income before extraordinary loss and cumulative
    effect of accounting change               |                                                                                          |                          | 22,653             |         |        |        | 5,940   |        |        |        | 559     |       
|Extraordinary loss, net of a tax benefit of $2,714                                            |                                                                                          |                          | (5,339             | )       |        |        |        |        |        |        |        |       
|Cumulative effect of a change in accounting
    principle, net of a tax benefit of $495       |                                                                                          |                          |                   |         |        |        |        |        |        |        | (961    | )     
|                                                                                              |                                                                                          |                          |                    |         |        |        |         |        |        |        |         |       
|Net income (loss)                                                                             |                                                                                          | $                        | 17,314             |         |        | $      | 5,940   |        |        | $      | (402    | )     
|                                                                                              |                                                                                          |                          |                    |         |        |        |         |        |        |        |         |       
|Basic earnings (loss) per share:                                                              |                                                                                          |                          |                    |         |        |        |         |        |        |        |         |       
|                                                                                              | Income before extraordinary loss and cumulative
    effect                               |                          | $                  | 0.83    |        |        | $       | 0.22   |        |        | $       | 0.02   |       
|                                                                                              | Extraordinary loss                                                                       |                          |                    | (0.20   | )      |        |         |       |        |        |         |       |       
|                                                                                              | Cumulative effect of accounting change                                                   |                          |                    |        |        |        |         |       |        |        |         | (0.04  | )     
|                                                                                              |                                                                                          |                          |                    |         |        |        |         |        |        |        |         |       
|                                                                                              | Net income (loss)                                                                        |                          | $                  | 0.63    |        |        | $       | 0.22   |        |        | $       | (0.02  | )     
|                                                                                              |                                                                                          |                          |                    |         |        |        |         |        |        |        |         |       
|                                                                                              | Weighted average shares outstanding                                                      |                          |                    | 27,348  |        |        |         | 26,691 |        |        |         | 26,232 |       
|                                                                                              |                                                                                          |                          |                    |         |        |        |         |        |        |        |         |       
|Diluted earnings (loss) per share:                                                            |                                                                                          |                          |                    |         |        |        |         |        |        |        |         |       
|                                                                                              | Income before extraordinary loss and cumulative
    effect                               |                          | $                  | 0.80    |        |        | $       | 0.22   |        |        | $       | 0.02   |       
|                                                                                              | Extraordinary loss                                                                       |                          |                    | (0.19   | )      |        |         |       |        |        |         |       |       
|                                                                                              | Cumulative effect of accounting change                                                   |                          |                    |        |        |        |         |       |        |        |         | (0.04  | )     
|                                                                                              |                                                                                          |                          |                    |         |        |        |         |        |        |        |         |       
|                                                                                              | Net income (loss)                                                                        |                          | $                  | 0.61    |        |        | $       | 0.22   |        |        | $       | (0.02  | )     
|                                                                                              |                                                                                          |                          |                    |         |        |        |         |        |        |        |         |       
|                                                                                              | Weighted average shares outstanding                                                      |                          |                    | 28,359  |        |        |         | 27,462 |        |        |         | 26,657 |       
|                                                                                              |                                                                                          |                          |                    |         |        |        |         |        |        |        |         |       

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

42



---



##### 



aaiPharma Inc.

CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)


|                                         |                                                                                                                                  |                                            |         |         |         |  |        |        |         | 
|---------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ------- | ------- | ------- |  | ------ | ------ | ------- | 
|                                         |                                                                                                                                  |                                           
|                                         |                                                                                                                                  | December 31,                              
|                                         |                                                                                                                                  |                                           
|                                         |                                                                                                                                  | 2002                                       |         | 2001   
|                                         |                                                                                                                                  |                                            |         |        
|ASSETS                                   |                                                                                                                                  |                                            |         |         |         |  |        |       
|Current assets:                          |                                                                                                                                  |                                            |         |         |         |  |        |       
|                                         | Cash and cash equivalents                                                                                                        |                                            | $       | 6,532   |         |  | $      | 6,371  |        
|                                         | Accounts receivable, net                                                                                                         |                                            |         | 29,467  |         |  |        | 26,594 |        
|                                         | Work-in-progress                                                                                                                 |                                            |         | 10,515  |         |  |        | 10,464 |        
|                                         | Inventories                                                                                                                      |                                            |         | 17,004  |         |  |        | 9,057  |        
|                                         | Prepaid and other current assets                                                                                                 |                                            |         | 7,633   |         |  |        | 5,972  |        
|                                         |                                                                                                                                  |                                            |         |         |         |  |        |       
|                                         |                                                                                                                                  | Total current assets                       |         |         | 71,151  |  |        |        | 58,458  | 
|                                         | Property and equipment, net                                                                                                      |                                            |         | 53,125  |         |  |        | 37,035 |        
|                                         | Goodwill, net                                                                                                                    |                                            |         | 210,792 |         |  |        | 49,380 |        
|                                         | Intangible assets, net                                                                                                           |                                            |         | 89,078  |         |  |        | 39,124 |        
|                                         | Other assets                                                                                                                     |                                            |         | 16,179  |         |  |        | 12,289 |        
|                                         |                                                                                                                                  |                                            |         |         |         |  |        |       
|                                         |                                                                                                                                  | Total assets                               |         | $       | 440,325 |  |        | $      | 196,286 | 
|                                         |                                                                                                                                  |                                            |         |         |         |  |        |       
|LIABILITIES AND STOCKHOLDERS
    EQUITY |                                                                                                                                  |                                            |         |         |         |  |        |       
|Current liabilities:                     |                                                                                                                                  |                                            |         |         |         |  |        |       
|                                         | Current maturities of long-term debt and
    short-term debt                                                                     |                                            | $       | 5,921   |         |  | $      |       |        
|                                         | Accounts payable                                                                                                                 |                                            |         | 17,671  |         |  |        | 15,444 |        
|                                         | Customer advances                                                                                                                |                                            |         | 15,051  |         |  |        | 13,349 |        
|                                         | Accrued wages and benefits                                                                                                       |                                            |         | 6,718   |         |  |        | 3,879  |        
|                                         | Interest payable                                                                                                                 |                                            |         | 5,232   |         |  |        | 371    |        
|                                         | Other accrued liabilities                                                                                                        |                                            |         | 5,201   |         |  |        | 4,922  |        
|                                         |                                                                                                                                  |                                            |         |         |         |  |        |       
|                                         |                                                                                                                                  | Total current liabilities                  |         |         | 55,794  |  |        |        | 37,965  | 
|Long-term debt, less current portion     |                                                                                                                                  |                                            | 277,899 |         |         |  | 78,878 |       
|Other liabilities                        |                                                                                                                                  |                                            | 7,182   |         |         |  | 224    |       
|Commitments and contingencies            |                                                                                                                                  |                                            |        |         |         |  |       |       
|Redeemable warrants                      |                                                                                                                                  |                                            |        |         |         |  | 2,855  |       
|Stockholders equity:                    |                                                                                                                                  |                                            |         |         |         |  |        |       
|                                         | Preferred stock, $.001 par value, 5 million
    shares authorized, none outstanding in 2002 or 2001                              |                                            |         |        |         |  |        |       |        
|                                         | Common stock, $.001 par value; 100 million shares
    authorized, 27,502,709 outstanding 2002; 26,996,286
    outstanding 2001 |                                            |         | 27      |         |  |        | 27     |        
|Paid-in capital                          |                                                                                                                                  |                                            | 79,049  |         |         |  | 75,224 |       
|Retained earnings                        |                                                                                                                                  |                                            | 20,592  |         |         |  | 3,278  |       
|Accumulated other comprehensive losses   |                                                                                                                                  |                                            | (218    | )       |         |  | (2,165 | )     
|                                         |                                                                                                                                  |                                            |         |         |         |  |        |       
|                                         |                                                                                                                                  | Total stockholders equity                 |         |         | 99,450  |  |        |        | 76,364  | 
|                                         |                                                                                                                                  |                                            |         |         |         |  |        |       
|                                         |                                                                                                                                  | Total liabilities and stockholders equity |         | $       | 440,325 |  |        | $      | 196,286 | 
|                                         |                                                                                                                                  |                                            |         |         |         |  |        |       

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

43



---



##### 



aaiPharma Inc.

CONSOLIDATED STATEMENTS OF CASH
FLOWS

(In thousands)


|                                                         |                                                                                                                                                            |                                              |                                                              |          |       |         |         |         |       |        |         |         |       |        |  
|-------------------------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------------------------- | ------------------------------------------------------------ | -------- | ----- | ------- | ------- | ------- | ----- | ------ | ------- | ------- | ----- | ------ | -
|                                                         |                                                                                                                                                            |                                             
|                                                         |                                                                                                                                                            | Years Ended December 31,                    
|                                                         |                                                                                                                                                            |                                             
|                                                         |                                                                                                                                                            | 2002                                         |                                                              | 2001     |       | 2000   
|                                                         |                                                                                                                                                            |                                              |                                                              |          |       |        
|Cash flows from operating activities:                    |                                                                                                                                                            |                                              |                                                              |          |       |         |         |         |       |        |         |        
|                                                         | Income before extraordinary loss and cumulative
    effect of accounting change                                                                            |                                              | $                                                            | 22,653   |       |         | $       | 5,940   |       |        | $       | 559     |      
|                                                         | Adjustments to reconcile income before
    extraordinary loss and cumulative effect of accounting change to
    net cash provided by operating activities: |                                              |                                                              |          |       |         |         |         |       |        |         |         |      
|                                                         |                                                                                                                                                            | Depreciation and amortization                |                                                              |          | 9,571 |         |         |         | 7,755 |        |         |         | 7,253 |       
|                                                         |                                                                                                                                                            | Other                                        |                                                              |          | 145   |         |         |         | 1,265 |        |         |         | 463   |       
|                                                         |                                                                                                                                                            | Changes in operating assets and liabilities: |                                                              |          |       |         |         |         |       |        |         |         |       |       
|                                                         |                                                                                                                                                            |                                              | Accounts receivable, net                                     |          |       | (2,380  | )       |         |       | (3,112 | )       |         |       | 6,718  |  
|                                                         |                                                                                                                                                            |                                              | Work-in-progress                                             |          |       | 643     |         |         |       | 6,502  |         |         |       | (300   | )
|                                                         |                                                                                                                                                            |                                              | Inventories                                                  |          |       | (7,853  | )       |         |       | (5,452 | )       |         |       | (1,939 | )
|                                                         |                                                                                                                                                            |                                              | Prepaid and other assets                                     |          |       | (10,761 | )       |         |       | (2,232 | )       |         |       | 1,432  |  
|                                                         |                                                                                                                                                            |                                              | Accounts payable                                             |          |       | 1,937   |         |         |       | 6,673  |         |         |       | 1,964  |  
|                                                         |                                                                                                                                                            |                                              | Customer advances                                            |          |       | 1,227   |         |         |       | 1,522  |         |         |       | 2,943  |  
|                                                         |                                                                                                                                                            |                                              | Interest payable                                             |          |       | 4,861   |         |         |       | 227    |         |         |       | (4     | )
|                                                         |                                                                                                                                                            |                                              | Accrued wages and benefits and other accrued
    liabilities |          |       | 8,066   |         |         |       | 1,263  |         |         |       | (4,385 | )
|                                                         |                                                                                                                                                            |                                              |                                                              |          |       |         |         |         |       |        |         |        
|Net cash provided by operating activities                |                                                                                                                                                            |                                              | 28,109                                                       |          |       |         | 20,351  |         |       |        | 14,704  |        
|                                                         |                                                                                                                                                            |                                              |                                                              |          |       |         |         |         |       |        |         |        
|Cash flows from investing activities:                    |                                                                                                                                                            |                                              |                                                              |          |       |         |         |         |       |        |         |        
|                                                         | Purchases of property and equipment                                                                                                                        |                                              |                                                              | (8,529   | )     |         |         | (6,315  | )     |        |         | (4,586  | )    
|                                                         | Purchase of property and equipment previously
    leased                                                                                                   |                                              |                                                              | (14,145  | )     |         |         |        |       |        |         |        |      
|                                                         | Proceeds from sales of property and equipment                                                                                                              |                                              |                                                              | 131      |       |         |         | 3,513   |       |        |         | 307     |      
|                                                         | Acquisitions                                                                                                                                               |                                              |                                                              | (211,997 | )     |         |         | (79,100 | )     |        |         |        |      
|                                                         | Other                                                                                                                                                      |                                              |                                                              | (593     | )     |         |         | 151     |       |        |         | 334     |      
|                                                         |                                                                                                                                                            |                                              |                                                              |          |       |         |         |         |       |        |         |        
|Net cash used in investing activities                    |                                                                                                                                                            |                                              | (235,133                                                     | )        |       |         | (81,751 | )       |       |        | (3,945  | )      
|                                                         |                                                                                                                                                            |                                              |                                                              |          |       |         |         |         |       |        |         |        
|Cash flows from financing activities:                    |                                                                                                                                                            |                                              |                                                              |          |       |         |         |         |       |        |         |        
|                                                         | Net payments on short-term debt                                                                                                                            |                                              |                                                              |         |       |         |         | (16,272 | )     |        |         | (10,655 | )    
|                                                         | Proceeds from long-term borrowings                                                                                                                         |                                              |                                                              | 244,486  |       |         |         | 78,878  |       |        |         |        |      
|                                                         | Payments on long-term borrowings                                                                                                                           |                                              |                                                              | (51,900  | )     |         |         | (1,024  | )     |        |         | (673    | )    
|                                                         | Proceeds from interest rate swap, net                                                                                                                      |                                              |                                                              | 10,486   |       |         |         |        |       |        |         |        |      
|                                                         | Issuance of common stock                                                                                                                                   |                                              |                                                              | 3,243    |       |         |         | 5,123   |       |        |         | 405     |      
|                                                         | Other                                                                                                                                                      |                                              |                                                              | 702      |       |         |         | (152    | )     |        |         | (577    | )    
|                                                         |                                                                                                                                                            |                                              |                                                              |          |       |         |         |         |       |        |         |        
|Net cash provided by (used in) financing
    activities  |                                                                                                                                                            |                                              | 207,017                                                      |          |       |         | 66,553  |         |       |        | (11,500 | )      
|                                                         |                                                                                                                                                            |                                              |                                                              |          |       |         |         |         |       |        |         |        
|Net (decrease) increase in cash and cash
    equivalents |                                                                                                                                                            |                                              | (7                                                           | )        |       |         | 5,153   |         |       |        | (741    | )      
|Effect of exchange rate changes on cash                  |                                                                                                                                                            |                                              | 168                                                          |          |       |         | (7      | )       |       |        | (22     | )      
|Cash and cash equivalents, beginning of year             |                                                                                                                                                            |                                              | 6,371                                                        |          |       |         | 1,225   |         |       |        | 1,988   |        
|                                                         |                                                                                                                                                            |                                              |                                                              |          |       |         |         |         |       |        |         |        
|Cash and cash equivalents, end of year                   |                                                                                                                                                            | $                                            | 6,532                                                        |          |       | $       | 6,371   |         |       | $      | 1,225   |        
|                                                         |                                                                                                                                                            |                                              |                                                              |          |       |         |         |         |       |        |         |        
|Supplemental information, cash paid for:                 |                                                                                                                                                            |                                              |                                                              |          |       |         |         |         |       |        |         |        
|                                                         | Interest                                                                                                                                                   |                                              | $                                                            | 16,835   |       |         | $       | 2,719   |       |        | $       | 2,312   |      
|                                                         |                                                                                                                                                            |                                              |                                                              |          |       |         |         |         |       |        |         |        
|                                                         | Income taxes                                                                                                                                               |                                              | $                                                            | 1,346    |       |         | $       | 370     |       |        | $       | 67      |      
|                                                         |                                                                                                                                                            |                                              |                                                              |          |       |         |         |         |       |        |         |        

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

44



---



##### 



aaiPharma Inc.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS
EQUITY

(In thousands)


|                                                            |  |              |        |         |  |              |    |               |  |               |        |            |  |       |        |   |  |   |        |   |  |   |     |   |  |   |        |  
|----------------------------------------------------------- |  | ------------ | ------ | ------- |  | ------------ | -- | ------------- |  | ------------- | ------ | ---------- |  | ----- | ------ | - |  | - | ------ | - |  | - | --- | - |  | - | ------ | -
|                                                            |  |              |        |         |  | Retained     |    | Accumulated   |  |               |        |           
|                                                            |  | Common Stock |        |         |  | Earnings     |    | Other         |  | Stock         |        |           
|                                                            |  |              |        | Paid-in |  | (Accumulated |    | Comprehensive |  | Subscriptions |        |           
|                                                            |  | Shares       |        | Amount  |  | Capital      |    | Deficit)      |  | Income (Loss) |        | Receivable |  | Total
|                                                            |  |              |        |         |  |              |    |               |  |               |        |            |  |      
|Balance, December 31, 1999                                  |  |              | 25,808 |         |  | $            | 26 |               |  | $             | 69,723 |            |  | $     | (2,260 | ) |  | $ | (906   | ) |  | $ | (25 | ) |  | $ | 66,558 |  
|Stock options exercised                                     |  |              | 639    |         |  |              | 1  |               |  |               | 629    |            |  |       |       |   |  |   |       |   |  |   |    |   |  |   | 630    |  
|Currency translation adjustment                             |  |              |       |         |  |              |   |               |  |               |       |            |  |       |       |   |  |   | (477   | ) |  |   |    |   |  |   | (477   | )
|Unrealized loss on investments                              |  |              |       |         |  |              |   |               |  |               |       |            |  |       |       |   |  |   | (591   | ) |  |   |    |   |  |   | (591   | )
|Payments on stock subscriptions                             |  |              |       |         |  |              |   |               |  |               |       |            |  |       |       |   |  |   |       |   |  |   | 3   |   |  |   | 3      |  
|Net loss                                                    |  |              |       |         |  |              |   |               |  |               |       |            |  |       | (402   | ) |  |   |       |   |  |   |    |   |  |   | (402   | )
|                                                            |  |              |        |         |  |              |    |               |  |               |        |            |  |       |        |   |  |   |        |   |  |   |     |   |  |   |        |  
|Balance, December 31, 2000                                  |  |              | 26,447 |         |  |              | 27 |               |  |               | 70,352 |            |  |       | (2,662 | ) |  |   | (1,974 | ) |  |   | (22 | ) |  |   | 65,721 |  
|Stock options exercised                                     |  |              | 549    |         |  |              |   |               |  |               | 4,872  |            |  |       |       |   |  |   |       |   |  |   |    |   |  |   | 4,872  |  
|Currency translation adjustment                             |  |              |       |         |  |              |   |               |  |               |       |            |  |       |       |   |  |   | (672   | ) |  |   |    |   |  |   | (672   | )
|Realized loss on investments reclassified into
    earnings |  |              |       |         |  |              |   |               |  |               |       |            |  |       |       |   |  |   | 481    |   |  |   |    |   |  |   | 481    |  
|Payments on stock subscriptions                             |  |              |       |         |  |              |   |               |  |               |       |            |  |       |       |   |  |   |       |   |  |   | 22  |   |  |   | 22     |  
|Net income                                                  |  |              |       |         |  |              |   |               |  |               |       |            |  |       | 5,940  |   |  |   |       |   |  |   |    |   |  |   | 5,940  |  
|                                                            |  |              |        |         |  |              |    |               |  |               |        |            |  |       |        |   |  |   |        |   |  |   |     |   |  |   |        |  
|Balance, December 31, 2001                                  |  |              | 26,996 |         |  |              | 27 |               |  |               | 75,224 |            |  |       | 3,278  |   |  |   | (2,165 | ) |  |   |    |   |  |   | 76,364 |  
|Stock options exercised                                     |  |              | 507    |         |  |              |   |               |  |               | 3,825  |            |  |       |       |   |  |   |       |   |  |   |    |   |  |   | 3,825  |  
|Currency translation adjustment                             |  |              |       |         |  |              |   |               |  |               |       |            |  |       |       |   |  |   | 1,837  |   |  |   |    |   |  |   | 1,837  |  
|Realized loss on investments reclassified into
    earnings |  |              |       |         |  |              |   |               |  |               |       |            |  |       |       |   |  |   | 110    |   |  |   |    |   |  |   | 110    |  
|Net income                                                  |  |              |       |         |  |              |   |               |  |               |       |            |  |       | 17,314 |   |  |   |       |   |  |   |    |   |  |   | 17,314 |  
|                                                            |  |              |        |         |  |              |    |               |  |               |        |            |  |       |        |   |  |   |        |   |  |   |     |   |  |   |        |  
|Balance, December 31, 2002                                  |  |              | 27,503 |         |  | $            | 27 |               |  | $             | 79,049 |            |  | $     | 20,592 |   |  | $ | (218   | ) |  | $ |    |   |  | $ | 99,450 |  
|                                                            |  |              |        |         |  |              |    |               |  |               |        |            |  |       |        |   |  |   |        |   |  |   |     |   |  |   |        |  



CONSOLIDATED STATEMENTS OF COMPREHENSIVE
INCOME (LOSS)

(In thousands)


|                                                                                            |  |              |        |      |  |      |       |   |  |   |        |  
|------------------------------------------------------------------------------------------- |  | ------------ | ------ | ---- |  | ---- | ----- | - |  | - | ------ | -
|                                                                                            |  |             
|                                                                                            |  | Years Ended 
|                                                                                            |  | December 31,
|                                                                                            |  |             
|                                                                                            |  | 2002         |        | 2001 |  | 2000
|                                                                                            |  |              |        |      |  |     
|Net income (loss)                                                                           |  | $            | 17,314 |      |  | $    | 5,940 |   |  | $ | (402   | )
|Currency translation adjustments                                                            |  |              | 1,837  |      |  |      | (672  | ) |  |   | (477   | )
|Unrealized loss on investments                                                              |  |              |       |      |  |      |      |   |  |   | (591   | )
|Realized loss on investments reclassified into
    earnings from other comprehensive income |  |              | 110    |      |  |      | 481   |   |  |   |       |  
|                                                                                            |  |              |        |      |  |      |       |   |  |   |        |  
|Comprehensive income (loss)                                                                 |  | $            | 19,261 |      |  | $    | 5,749 |   |  | $ | (1,470 | )
|                                                                                            |  |              |        |      |  |      |       |   |  |   |        |  

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

45



---



##### 



aaiPharma Inc.

Notes to Consolidated Financial Statements

December 31, 2002





1. Significant Accounting Policies and
Other Matters



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Organization                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | aaiPharma Inc. (aaiPharma or the
    Company) is a science-based specialty pharmaceutical
    company focused on the commercialization of branded
    pharmaceutical products that the Company develops or acquires.
    The Company also has a comprehensive range of pharmaceutical
    development capabilities primarily in the United States and
    Europe. In 2002, the majority of the Companys net revenues
    came from the sale of commercial pharmaceutical products and to
    developing new products or improving existing products. Prior to
    2002, the majority of the Companys net revenues were
    earned in the development services business. Major customers for
    the Companys pharmaceutical products are large,
    well-established medical wholesalers and distributors. Major
    customers for the development services and product development
    businesses are large and small pharmaceutical and biotechnology
    companies.                                                                                                                                                                                                                                      
|
| | Basis of Presentation and
    Consolidation                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | The consolidated financial statements include the
    accounts of aaiPharma Inc. and its wholly-owned subsidiaries.
    All material intercompany transactions have been eliminated.
    Certain balances in the prior years consolidated financial
    statements have been reclassified to conform to the
    December 31, 2002 presentation.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|
| | On January 30, 2003, aaiPharmas board
    of directors approved a 3-for-2 stock split of the
    Companys common shares. On March 10, 2003, each
    stockholder received one additional share of common stock for
    every two shares they owned on the record date of
    February 19, 2003. All share and per share amounts have
    been restated to reflect the stock split for all periods
    presented.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|
| | Revenue Recognition                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | Revenues for product sales are recognized at the
    time the products are shipped. Development services revenue from
    fee-for-service contracts are recognized on a
    percentage-of-completion basis as the work is performed, based
    on the relationship between costs incurred and total estimated
    costs, or on a time and materials basis in accordance with the
    specific contract terms. Product development revenues consist of
    licensing and royalty revenues. Licensing revenues are
    recognized upon completion of interim contract milestones.
    Royalty revenues are recognized as earned in accordance with
    contract terms. Revenues from upfront licensing fees are
    deferred and amortized over the term of the relevant agreement
    or as on-going services are performed. Revenues from contract
    milestones based on product approval are recognized when the
    applicable product is approved. Work-in-progress represents
    revenues recognized prior to contract billing terms. Provisions
    for losses on contracts, if any, are recognized when identified.                                                                                       
|
| | In December 1999, the Securities and Exchange
    Commission issued Staff Accounting Bulletin No. 101
    (SAB 101), Revenue Recognition in Financial
    Statements. SAB 101 specifically addresses revenue
    recognition issues related to certain upfront payments or fees.
    Under SAB 101, certain upfront fees and payments recognized as
    income in prior periods were required to be deferred and
    amortized into revenue over the terms of the relevant agreements
    or as the on going services were performed. Although the Company
    implemented SAB 101 in the fourth quarter of 2000, the
    cumulative effect of a change in accounting principle has been
    retroactively adopted as of the beginning of the first quarter
    of 2000. For the year 2000, the Company recorded a charge of
    $1,456,000 ($961,000 after tax) for the cumulative effect of
    this change in accounting principle. In 2002, 2001 and 2000, the
    Company recognized $591,000, $500,000 and $733,000,
    respectively, of revenue related to the amortization of these
    deferred amounts. At December 31, 2002, no balance remains
    to be amortized into revenue in future periods.

46



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##### 





| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Income Taxes                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | Income taxes have been accounted for using the
    liability method in accordance with Financial Accounting
    Standards Board (FASB) Statement of Financial
    Accounting Standards No. 109 Accounting for Income
    Taxes. Deferred tax assets and liabilities are recognized
    for the expected tax consequences of temporary differences
    between the tax bases of assets and liabilities and their
    reported amounts.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|
| | Research and Development Costs                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | The Company engages in numerous research and
    development (R&D) projects with the objective of
    growth and utilization of a portfolio of proprietary
    technologies and patent and intellectual property rights to
    bring products to market or to license or sell these
    technologies to others. R&D expenses represent direct
    salaries of R&D personnel, raw material expenses,
    third-party consulting and testing costs, along with an
    allocation of indirect costs such as management and
    administrative overhead costs and facilities costs. R&D
    costs are charged to expense as incurred. Although there is a
    risk that any specific R&D project may not produce revenues,
    the Company believes that the potential profit margins from
    successful development projects will compensate for costs
    incurred for unsuccessful projects. The Company is currently
    involved in many pharmaceutical and technology development
    projects and believes that these activities help to diversify
    its R&D portfolio and manage its risk.
|
| | Advertising                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | The Company expenses advertising costs as
    incurred, and these costs are included in selling expenses.
    Advertising costs were $4.5 million, $0.9 million and $0.6
    million for the years ended December 31, 2002, 2001 and
    2000, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|
| | Earnings (Loss) per Share                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | Basic earnings (loss) per share are based on
    the weighted average number of common shares outstanding during
    the year. Diluted earnings (loss) per share are computed
    assuming that the weighted average number of common shares was
    increased by the conversion of stock options issued to employees
    and members of the Companys Board of Directors. The
    diluted per share amounts reflect a change in the number of
    shares outstanding (the denominator) to include the
    options as if they were converted to shares and issued, unless
    their inclusion would be anti-dilutive. In 2002, 2001 and 2000,
    2,296,001, 824,378 and 2,700,407 options were excluded as they
    were anti-dilutive. In each year presented, the net income
    (loss) (the numerator) is the same for both basic
    and diluted per share computations.                                                                                                                                                                                                                  
|
| | The following table provides a reconciliation of
    the denominators for the basic and diluted earnings
    (loss) per share computations:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        

|                                   |                                                                        |                          |  |        |  |      |  |        |  |  |  |        | 
|---------------------------------- | ---------------------------------------------------------------------- | ------------------------ |  | ------ |  | ---- |  | ------ |  |  |  | ------ | 
|                                   |                                                                        |                         
|                                   |                                                                        | Years Ended December 31,
|                                   |                                                                        |                         
|                                   |                                                                        | 2002                     |  | 2001   |  | 2000
|                                   |                                                                        |                          |  |        |  |     
|                                   |                                                                        |                         
|                                   |                                                                        | (In thousands)          
|Basic earnings (loss) per share:   |                                                                        |                          |  |        |  |      |  |        |  |  |  |       
|                                   | Weighted average number of shares                                      |                          |  | 27,348 |  |      |  | 26,691 |  |  |  | 26,232 | 
|Effect of dilutive securities:     |                                                                        |                          |  |        |  |      |  |        |  |  |  |       
|                                   | Stock options                                                          |                          |  | 1,011  |  |      |  | 771    |  |  |  | 425    | 
|                                   |                                                                        |                          |  |        |  |      |  |        |  |  |  |       
|Diluted earnings (loss) per share: |                                                                        |                          |  |        |  |      |  |        |  |  |  |       
|                                   | Adjusted weighted average number of shares and
    assumed conversions |                          |  | 28,359 |  |      |  | 27,462 |  |  |  | 26,657 | 
|                                   |                                                                        |                          |  |        |  |      |  |        |  |  |  |       



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Concentration of Credit Risk                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | The Company is subject to a concentration of
    credit risk with respect to its accounts receivable balance, all
    of which is due from wholesalers, distributors and large and
    small pharmaceutical and biotechnology companies. Approximately
    35% of the accounts receivable balance at December 31, 2002
    represented amounts due from two customers. At December 31,
    2001, no single customer accounted for more than 10% of the
    Companys accounts receivable balance. The Company performs
    ongoing credit evaluations of its customers and maintains
    reserves for potential uncollectible accounts. Actual losses
    from uncollectible accounts have been minimal.

47



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##### 





| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | In 2002, three customers accounted for
    approximately 19%, 18% and 12%, respectively, of the
    Companys revenues. One customer accounted for
    approximately 15% of the Companys revenue in both 2001 and
    2000.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|
| | Cash and Cash Equivalents                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | The Company considers all highly liquid
    investments purchased with a maturity of three months or less to
    be cash equivalents.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|
| | Work-in-Progress                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | Work-in-progress represents revenues recognized
    prior to contract billing terms.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|
| | Inventories                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | Inventories are stated at the lower of cost
    (determined on a first-in, first-out basis) or market.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|
| | Property and Equipment                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | Property and equipment is recorded at cost.
    Depreciation is recognized using the straight-line method over
    the estimated useful lives of the assets. Depreciable lives are
    31.5 years for buildings and improvements and 3 to 15 years
    for equipment. Leasehold improvements are amortized over the
    lesser of the asset life or the lease term.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|
| | Goodwill and Other Intangibles, Net                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | For the years ended December 31, 2001 and
    2000, goodwill, defined as the excess of the purchase price over
    the fair value of the net assets of acquired businesses, was
    amortized over 20 years. In accordance with Statement of
    Financial Accounting Standards No. 141, Business
    Combinations (SFAS No. 141), the Company
    ceased amortization of goodwill as of January 1, 2002. For
    purchase business combinations consummated subsequent to
    June 30, 2001, goodwill and indefinite-lived intangible
    assets are not amortized, but are evaluated for impairment on an
    annual basis or as impairment indicators are identified.
    Goodwill amortization for the year ended December 31, 2001
    was $0.6 million. At December 31, 2002 and 2001, the
    amounts for accumulated amortization of goodwill were
    approximately $4.0 million and $3.4 million, respectively. The
    change in accumulated goodwill amortization from
    December 31, 2001 to December 31, 2002 is due to
    foreign currency exchange rate changes. Other identifiable
    intangible assets are amortized, if applicable (see note 2), on
    a straight-line basis over their estimated useful lives, which
    range from 3 to 20 years. At December 31, 2002 and
    2001, the amounts of accumulated amortization of identifiable
    intangibles were approximately $3.0 million and
    $0.3 million, respectively.
|
| | The changes in the carrying value of goodwill by
    operating segment for the year ended December 31, 2002 were:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             

|                     |  |                |        |           |  |             |         |              |  |   |       |  |  |   |         | 
|-------------------- |  | -------------- | ------ | --------- |  | ----------- | ------- | ------------ |  | - | ----- |  |  | - | ------- | 
|                     |  | Balance at     |        |           |  | Foreign     |         | Balance at  
|                     |  | January 1,     |        |           |  | Currency    |         | December 31,
|                     |  | 2002           |        | Additions |  | Translation |         | 2002        
|                     |  |                |        |           |  |             |         |             
|                     |  |               
|                     |  | (In thousands)
|Product sales        |  | $              | 39,717 |           |  | $           | 159,697 |              |  | $ |      |  |  | $ | 199,414 | 
|Development services |  |                | 9,663  |           |  |             | 241     |              |  |   | 1,474 |  |  |   | 11,378  | 
|                     |  |                |        |           |  |             |         |              |  |   |       |  |  |   |         | 
|                     |  | $              | 49,380 |           |  | $           | 159,938 |              |  | $ | 1,474 |  |  | $ | 210,792 | 
|                     |  |                |        |           |  |             |         |              |  |   |       |  |  |   |         | 



| |                                                                                                       
| | ------------------------------------------------------------------------------------------------------
| | The changes in identifiable intangible assets for
    the years ended December 31, 2002 and 2001 were:

|                                              |  |                |        |           |  |              |        |              |  |             |        |   |  |   |        |  |  |  |              | 
|--------------------------------------------- |  | -------------- | ------ | --------- |  | ------------ | ------ | ------------ |  | ----------- | ------ | - |  | - | ------ |  |  |  | ------------ | 
|                                              |  | Balance at     |        |           |  |              |        | Balance at   |  |            
|                                              |  | January 1,     |        |           |  | Amortization |        | December 31, |  | Amortizable
|                                              |  | 2002           |        | Additions |  | Expense      |        | 2002         |  | Life       
|                                              |  |                |        |           |  |              |        |              |  |            
|                                              |  |               
|                                              |  | (in thousands)
|Indefinite-lived intangibles                  |  | $              | 28,000 |           |  | $            |       |              |  | $           |       |   |  | $ | 28,000 |  |  |  | Indefinite   | 
|Trademarks, technology and license agreements |  |                | 11,124 |           |  |              | 52,653 |              |  |             | (2,699 | ) |  |   | 61,078 |  |  |  | 3 - 20 years | 
|                                              |  |                |        |           |  |              |        |              |  |             |        |   |  |   |        |  |  |  |              | 
|                                              |  | $              | 39,124 |           |  | $            | 52,653 |              |  | $           | (2,699 | ) |  | $ | 89,078 |  |  |  |              | 
|                                              |  |                |        |           |  |              |        |              |  |             |        |   |  |   |        |  |  |  |              | 

48



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##### 



|                                              |  |                |     |           |  |              |        |              |  |             |     |   |  |   |        |  |  |  |              | 
|--------------------------------------------- |  | -------------- | --- | --------- |  | ------------ | ------ | ------------ |  | ----------- | --- | - |  | - | ------ |  |  |  | ------------ | 
|                                              |  | Balance at     |     |           |  |              |        | Balance at   |  |            
|                                              |  | January 1,     |     |           |  | Amortization |        | December 31, |  | Amortizable
|                                              |  | 2001           |     | Additions |  | Expense      |        | 2001         |  | Life       
|                                              |  |                |     |           |  |              |        |              |  |            
|                                              |  |               
|                                              |  | (in thousands)
|Indefinite-lived intangibles                  |  | $              |    |           |  | $            | 28,000 |              |  | $           |    |   |  | $ | 28,000 |  |  |  | Indefinite   | 
|Trademarks, technology and license agreements |  |                | 712 |           |  |              | 10,505 |              |  |             | (93 | ) |  |   | 11,124 |  |  |  | 3 - 20 years | 
|                                              |  |                |     |           |  |              |        |              |  |             |     |   |  |   |        |  |  |  |              | 
|                                              |  | $              | 712 |           |  | $            | 38,505 |              |  | $           | (93 | ) |  | $ | 39,124 |  |  |  |              | 
|                                              |  |                |     |           |  |              |        |              |  |             |     |   |  |   |        |  |  |  |              | 



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The total intangible asset amortization expense
    for the year ended December 31, 2002, was
    $2.7 million, and is included in general and administrative
    expenses. Amortization expense for the next five years is
    estimated to be approximately $3.3 million per year.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|
| | On an ongoing basis, the Company assesses the
    value of its goodwill, intangibles and other assets by
    determining their ability to recover the unamortized balances
    over the remaining useful lives. Goodwill, intangibles and other
    long-lived assets determined to be unrecoverable would be
    written-off in the period in which such determination is made.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|
| | Foreign Currency Translation                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | The financial statements of foreign subsidiaries
    have been translated into U.S. dollars in accordance with
    Statement of Financial Accounting Standards No. 52
    Foreign Currency Translation. All balance sheet
    accounts have been translated using the exchange rates in effect
    at the balance sheet dates. Income statement amounts have been
    translated using the average exchange rates for the respective
    years. The gains and losses resulting from the changes in
    exchange rates from year to year have been reported in
    accumulated other comprehensive income (loss) included in
    the consolidated statements of stockholders equity.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|
| | Derivative Financial Instruments                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | aaiPharma uses an interest rate swap agreement to
    modify its fixed rate obligation to a variable rate obligation,
    thereby adjusting the interest rate to the current market rate
    and ensuring that the debt instrument is always reflected at
    fair value. The Company follows Statement of Financial
    Accounting Standards No. 133, Accounting for
    Derivative Instruments and Hedging Activities, as amended
    (SFAS No. 133), to account for its interest
    rate swap using hedge accounting treatment. The Company has
    outstanding one interest rate swap agreement to convert a
    portion of fixed rate debt to a floating rate basis, thus
    hedging for changes in the fair value of the fixed rate debt
    being hedged. The Company has determined that this interest rate
    swap agreement, designated as a fair value hedge, qualifies for
    treatment under the short-cut method of measuring effectiveness.
    Under the provisions of SFAS No. 133, this hedge is
    determined to be perfectly effective, and there is
    no requirement to periodically evaluate effectiveness. See Note
    6 for additional details on the outstanding interest rate swap
    agreement.
|
| | Impact of Recently Issued Accounting
    Standards                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | In April 2002, the FASB issued Statement of
    Financial Accounting Standards No. 145, Rescission of FASB
    Statements No. 4, 44, and 64, Amendment of FASB Statement
    No. 13, and Technical Corrections (SFAS
    No. 145). This statement eliminates the automatic
    classification of gain or loss on early extinguishment of debt
    as an extraordinary item and requires that any such gain or loss
    be reviewed under the criteria of Accounting Principles Board
    No. 30 Reporting Results of Operations. This
    statement also requires sale-leaseback accounting for certain
    lease modifications that have economic effects that are similar
    to sale-leaseback transactions, and makes various other
    technical corrections to existing pronouncements. The statement
    is effective for fiscal years beginning after May 15, 2002.
    We do not expect that the adoption of SFAS No. 145 will
    have a significant impact on our results of operations,
    consolidated financial position or cash flows.                                                                                                                                                                             
|
| | In June 2002, the FASB issued Statement of
    Financial Accounting Standards No. 146, Accounting
    for Costs Associated with Exit or Disposal Activities
    (SFAS No. 146). SFAS No. 146 is effective
    for exit or disposal activities that are initiated after
    December 31, 2002. The Company does not expect that the
    adoption of SFAS No. 146 will have a significant impact on
    the Companys consolidated results of operations, financial
    position or cash flows.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        

49



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##### 





| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | In December 2002, the FASB issued Statement of
    Financial Accounting Standards No. 148, Accounting
    for Stock-Based Compensation  Transition and
    Disclosure (SFAS No. 148). SFAS
    No. 148 amends Statement of Financial Accounting Standards
    No. 123, Accounting for Stock-Based
    Compensation (SFAS No. 123), to provide alternative
    methods of transition to SFAS No. 123s fair value
    method of accounting for stock-based employee compensation. SFAS
    No. 148 also amends the disclosure provisions in SFAS
    No. 123 and APB Opinion No. 28, Interim
    Financial Reporting, to require disclosure in the summary
    of significant accounting policies of the effects of an
    entitys accounting policy with respect to stock-based
    employee compensation on reported net income and earnings per
    share in annual and interim financial statements. The adoption
    of SFAS No. 148 did not have a significant impact on the
    Companys consolidated results of operations, financial
    position or cash flows.
|
| | Employee Stock-Based Compensation                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | The Company follows Accounting Principles Board
    Opinion No. 25, Accounting for Stock Issued to
    Employees (APB No. 25) and related
    Interpretations in accounting for its employee stock options as
    permitted by SFAS No. 123 Accounting for Stock-Based
    Compensation and make the required pro forma disclosures
    required by SFAS No. 123 and SFAS No. 148. Under APB
    No. 25, if the exercise price of the Companys stock
    options is not less than the estimated fair market value of the
    underlying stock on the date of grant, no compensation expense
    is recognized.                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|
| | The fair value for stock options was estimated at
    the date of grant using a Black-Scholes pricing model with the
    following weighted average assumptions:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   

|                                      |  |              |       |      |  |      |       |   |  |  |      |  
|------------------------------------- |  | ------------ | ----- | ---- |  | ---- | ----- | - |  |  | ---- | -
|                                      |  |             
|                                      |  | Years Ended 
|                                      |  | December 31,
|                                      |  |             
|                                      |  | 2002         |       | 2001 |  | 2000
|                                      |  |              |       |      |  |     
|Expected dividend yield               |  |              | 0.0   | %    |  |      | 0.0   | % |  |  | 0.0  | %
|Risk-free interest rate               |  |              | 3.8   | %    |  |      | 4.6   | % |  |  | 5.9  | %
|Expected volatility                   |  |              | 113.0 | %    |  |      | 120.0 | % |  |  | 67.0 | %
|Expected life (in years from vesting) |  |              | 5     |      |  |      | 5     |   |  |  | 5    |  



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | For purposes of pro forma disclosures, the
    estimated fair value of the stock options is amortized to
    expense over the vesting period. The grant date Black-Scholes
    weighted average fair value of options issued at market price
    was $11.49, $8.90 and $3.29 per share for 2002, 2001 and 2000,
    respectively, and the weighted average fair value of options
    issued in excess of market price was $9.94 per share in 2002. No
    options were issued in excess of market price in 2001 or 2000.
|
| | The Company applies APB Opinion No. 25 and
    related Interpretations in accounting for its stock option
    plans; therefore, compensation expense has not been recognized
    for options granted at fair value. If compensation cost for the
    Companys plans had been determined based on the fair value
    at the grant dates for awards under those plans consistent with
    the fair value method of SFAS No. 123,                                                                                         

50



---



##### 



| |                                                                                                                                        
| | ---------------------------------------------------------------------------------------------------------------------------------------
| | the Companys net income (loss) and
    earnings (loss) per share would have been changed to the
    pro forma amounts indicated below:

|                                                        |               |                           |        |      |      |      |       |   |      |   |        |   |       |  
|------------------------------------------------------- | ------------- | ------------------------- | ------ | ---- | ---- | ---- | ----- | - | ---- | - | ------ | - | ----- | -
|                                                        |               |                          
|                                                        |               | Years Ended December 31, 
|                                                        |               |                          
|                                                        |               | 2002                      |        | 2001 |      | 2000
|                                                        |               |                           |        |      |      |     
|                                                        |               |                          
|                                                        |               | (In thousands, except per
|                                                        |               | share data)              
|Net income (loss), as reported                          |               | $                         | 17,314 |      |      | $    | 5,940 |   |      | $ | (402   | )
|Pro forma stock-based compensation cost, net of
    tax |               |                           | 6,520  |      |      |      | 2,366 |   |      |   | 2,067  |  
|Pro forma net income (loss)                             |               |                           | 10,794 |      |      |      | 3,574 |   |      |   | (2,469 | )
|Earnings (loss) per share:                              |               |                           |        |      |      |      |       |   |      |   |        |  
|                                                        | As reported  |                           |        |      |      |      |       |   |      |   |        |   |      
|                                                        |               | Basic                     |        | $    | 0.63 |      |       | $ | 0.22 |   |        | $ | (0.02 | )
|                                                        |               | Diluted                   |        | $    | 0.61 |      |       | $ | 0.22 |   |        | $ | (0.02 | )
|                                                        | Pro forma    |                           |        |      |      |      |       |   |      |   |        |   |      
|                                                        |               | Basic                     |        | $    | 0.39 |      |       | $ | 0.13 |   |        | $ | (0.09 | )
|                                                        |               | Diluted                   |        | $    | 0.38 |      |       | $ | 0.13 |   |        | $ | (0.09 | )



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Fair Value of Financial Instruments                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | The carrying values of cash and cash equivalents,
    accounts receivable, work-in-progress and current liabilities
    approximate fair values as of December 31, 2002 and 2001. Based
    on borrowing rates currently available to the Company, the
    carrying value of the variable rate debt approximated fair
    value. The fair market value of the Companys fixed rate
    debt is estimated based on market quotations. At
    December 31, 2002, the fair market value was approximately
    the carrying value.                                                                                           
|
| | Use of Estimates                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | The preparation of consolidated financial
    statements in conformity with accounting principles generally
    accepted in the United States requires management to make
    estimates and assumptions that affect the amounts reported in
    the consolidated financial statements and accompanying notes.
    The most significant estimates relate to the allowance for
    doubtful accounts, inventory reserves, sales allowances and
    useful lives for intangible assets. Actual results could differ
    from such estimates and changes in such estimates may affect
    amounts reported in future periods.
|
| | Extraordinary Loss                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | In March 2002, the Company recorded a charge of
    $5.3 million, net of a tax benefit of $2.7 million, to record
    the write-off of deferred financing and other costs related to
    its prior debt facilities.                                                                                                                                                                                                                                                                                                                                                                                                      

2. Business Combinations



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | On March 28, 2002, the Company acquired the
    U.S. rights to the Darvon and Darvocet-N branded product lines,
    which treat mild-to-moderate pain, and existing inventory from
    Eli Lilly and Company, in a business combination accounted for
    as a purchase. The Company acquired these product lines and
    related intangible assets for $211.4 million. To finance this
    acquisition, which included $1.8 million of inventory, the
    Company used the proceeds from the senior secured credit
    facilities and senior subordinated notes, as described in note
    6. The Darvon and Darvocet-N product lines did not have
    separable assets and liabilities associated with them, other
    than inventory, therefore the Company allocated the purchase
    price, including acquisition related expenses, to acquired
    identifiable assets, with the excess of the purchase price over
    the identifiable tangible and intangible assets recorded as
    goodwill. Based on this allocation, $51.2 million of intangible
    assets have been identified and will be amortized over
    20 years. In accordance with SFAS No. 141 and
    Statement of Financial Accounting Standards No. 142
    Accounting for Goodwill and Intangibles, the excess
    of the purchase price over identifiable intangible assets has
    been classified as goodwill, which is not subject to
    amortization.

51



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##### 





| |                                                                                                                                                                                                                                                                       
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Pro Forma Financial Information                                                                                                                                                                                                                                       
| | The following unaudited pro forma consolidated
    financial information reflects the results of operations for the
    years ended December 31, 2002 and 2001 as if the
    Darvon/Darvocet-N acquisition had occurred at the beginning of
    each period presented.

|                                 |                                  |                 |         |      |  |   |         |      | 
|-------------------------------- | -------------------------------- | --------------- | ------- | ---- |  | - | ------- | ---- | 
|                                 |                                  |                
|                                 |                                  | Years Ended    
|                                 |                                  | December 31,   
|                                 |                                  |                
|                                 |                                  | 2002            |         | 2001
|                                 |                                  |                 |         |     
|                                 |                                  |                
|                                 |                                  | (In thousands, 
|                                 |                                  | except         
|                                 |                                  | per share data)
|Net revenues                     |                                  | $               | 240,242 |      |  | $ | 203,975 |     
|Income before extraordinary loss |                                  |                 | 21,484  |      |  |   | 18,205  |     
|Net income                       |                                  |                 | 16,145  |      |  |   | 18,205  |     
|Basic earnings per share:        |                                  |                 |         |      |  |   |         |     
|                                 | Income before extraordinary loss |                 | $       | 0.79 |  |   | $       | 0.68 | 
|                                 | Net income                       |                 | $       | 0.59 |  |   | $       | 0.68 | 
|Diluted earnings per share:      |                                  |                 |         |      |  |   |         |     
|                                 | Income before extraordinary loss |                 | $       | 0.76 |  |   | $       | 0.66 | 
|                                 | Net income                       |                 | $       | 0.57 |  |   | $       | 0.66 | 



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | In December 2001, the Company acquired from
    Novartis Pharmaceutical Corporation and Novartis Corporation a
    line of asthma products used in the prevention and reversal of
    bronchospasm in patients age 12 and older with asthma and
    reversible bronchospasm associated with bronchitis and
    emphysema, in a business combination accounted for as a
    purchase. The product line acquired is marketed under the
    Brethine brand name. The Company acquired this product line and
    related intangible assets for $26.6 million. To finance this
    acquisition, the Company used the proceeds from an additional
    $25 million term loan, which was refinanced by the new senior
    secured credit facility as described in note 6, and used working
    capital to pay the remainder of the purchase price. Revenues
    from the sales of these products are included in the
    Companys results of operations beginning on the
    acquisition date. The Brethine product line did not have
    separable assets and liabilities associated with it, therefore
    the Company allocated the purchase price, including acquisition
    related expenses, to acquired identifiable intangible assets in
    the amount of $9.9 million, which are being amortized over
    20 years, with the excess of the purchase price over the
    identifiable intangible assets recorded as goodwill in the
    amount of $16.7 million.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|
| | In August 2001, the Company completed the
    acquisition of a line of critical care injectable and oral
    nutrition products from AstraZeneca AB, an affiliate of
    AstraZeneca PLC, in a business combination accounted for as a
    purchase. The product lines acquired are marketed under the
    M.V.I. and Aquasol brand names. The Company acquired these
    product lines and related intangible assets for payments of up
    to $100 million over three years. To finance the initial payment
    for this acquisition of $52.5 million, which included $3.7
    million of inventory, the Company used the proceeds from a term
    loan, which was refinanced under the senior secured credit
    facility as described in note 6. An additional guaranteed
    payment of $1.0 million was made in August 2002 and a future
    guaranteed payment of $1.0 million is due in August 2003. The
    acquisition agreement provided for future contingent payments. A
    contingent payment of $2.0 million would have been due in August
    2003 if the FDA had approved by December 31, 2002 the
    reformulated M.V.I.-12 product with a minimum shelf life of
    12 months. In addition, a contingent payment of up to $43.5
    million is due in August 2004 if FDA approval of the
    reformulated M.V.I.-12 product is received on or before
    December 31, 2003, with the $43.5 million payment being
    reduced by $1.0 million for each month after December 31,
    2002 during which FDA approval has not been obtained. The $43.5
    million payment will become zero in the event FDA approval is
    not obtained on or before December 31, 2003. An application
    for approval of this reformulated product was submitted to the
    FDA in February 2003. These contingent obligations have not been
    recorded as a liability on the Companys balance sheet.
    Revenues from the sales of these products are included in the
    Companys results of operations beginning on the
    acquisition date. The M.V.I. and Aquasol product lines did not
    have separable assets and liabilities associated with them,
    other than inventory, therefore the Company allocated the
    purchase price, including acquisition related expenses, to
    acquired identifiable tangible and intangible assets in the
    amount of $32.0 million, with

52



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##### 



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | the excess of the purchase price over the
    identifiable intangible assets recorded as goodwill in the
    amount of $19.2 million.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|
| | In connection with the M.V.I. and Aquasol
    acquisition, the Company recorded $32.0 million in intangible
    assets which meet the criteria for having an indefinite life. In
    accordance with SFAS No. 142, these intangible assets are
    not being amortized. The intangible assets recorded in
    connection with this acquisition represents the trademarks,
    technology and know-how associated with the product lines. In
    addition, the value recorded as goodwill is not being amortized
    and is evaluated for impairment on an annual basis in accordance
    with SFAS No. 142.                             
|
| | During July 2001, the Company made an initial
    payment of $0.9 million to acquire the assets of a sterile
    manufacturing facility located in Charleston, South Carolina. In
    2002, a $0.2 million payment was made based on the level of
    manufacturing revenues at this facility. Additional contingent
    payments of up to $4.8 million plus additional royalties may
    become due in increments through June 30, 2006 based on the
    level of manufacturing revenues during this period. These
    contingent payment obligations have not yet been recorded as a
    liability on our consolidated balance sheets.

3. Accounts Receivable, Net



| |                                                                        
| | -----------------------------------------------------------------------
| | The following table presents the components of
    accounts receivable:

|                                |                                |                |        |        |  |   |        |        | 
|------------------------------- | ------------------------------ | -------------- | ------ | ------ |  | - | ------ | ------ | 
|                                |                                |               
|                                |                                | December 31,  
|                                |                                |               
|                                |                                | 2002           |        | 2001  
|                                |                                |                |        |       
|                                |                                |               
|                                |                                | (In thousands)
|Trade                           |                                | $              | 30,843 |        |  | $ | 27,559 |       
|Related parties                 |                                |                | 292    |        |  |   | 79     |       
|                                |                                |                |        |        |  |   |        |       
|                                | Total accounts receivable      |                |        | 31,135 |  |   |        | 27,638 | 
|Allowance for doubtful accounts |                                |                | (1,668 | )      |  |   | (1,044 | )     
|                                |                                |                |        |        |  |   |        |       
|                                | Total accounts receivable, net |                | $      | 29,467 |  |   | $      | 26,594 | 
|                                |                                |                |        |        |  |   |        |       

4. Inventories



| |                                                                
| | ---------------------------------------------------------------
| | The following table presents the components of
    inventories:

|                           |                   |                |        |        |  |   |       |       | 
|-------------------------- | ----------------- | -------------- | ------ | ------ |  | - | ----- | ----- | 
|                           |                   |               
|                           |                   | December 31,  
|                           |                   |               
|                           |                   | 2002           |        | 2001  
|                           |                   |                |        |       
|                           |                   |               
|                           |                   | (In thousands)
|Finished goods             |                   | $              | 10,389 |        |  | $ | 5,478 |      
|Work-in-process            |                   |                | 1,866  |        |  |   | 1,069 |      
|Raw materials and supplies |                   |                | 4,749  |        |  |   | 2,510 |      
|                           |                   |                |        |        |  |   |       |      
|                           | Total inventories |                | $      | 17,004 |  |   | $     | 9,057 | 
|                           |                   |                |        |        |  |   |       |      

53



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##### 



5. Property and Equipment, Net



| |                                                                           
| | --------------------------------------------------------------------------
| | The following table presents the components of
    property and equipment:

|                               |                                   |                |         |        |  |   |         |        | 
|------------------------------ | --------------------------------- | -------------- | ------- | ------ |  | - | ------- | ------ | 
|                               |                                   |               
|                               |                                   | December 31,  
|                               |                                   |               
|                               |                                   | 2002           |         | 2001  
|                               |                                   |                |         |       
|                               |                                   |               
|                               |                                   | (In thousands)
|Land                           |                                   | $              | 2,688   |        |  | $ | 968     |       
|Buildings and improvements     |                                   |                | 29,893  |        |  |   | 17,554  |       
|Machinery and equipment        |                                   |                | 62,814  |        |  |   | 57,990  |       
|Construction-in-progress       |                                   |                | 3,921   |        |  |   | 2,373   |       
|                               |                                   |                |         |        |  |   |         |       
|Cost of property and equipment |                                   |                | 99,316  |        |  |   | 78,885  |       
|Less, accumulated depreciation |                                   |                | (46,191 | )      |  |   | (41,850 | )     
|                               |                                   |                |         |        |  |   |         |       
|                               | Total property and equipment, net |                | $       | 53,125 |  |   | $       | 37,035 | 
|                               |                                   |                |         |        |  |   |         |       



| |                                                                                                                                                                
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Depreciation expense was approximately $6.9
    million, $7.0 million, and $6.6 million for the years ended
    December 31, 2002, 2001 and 2000, respectively.

6. Debt and Credit Line



| |                                                                                                             
| | ------------------------------------------------------------------------------------------------------------
| | The following table presents the components of
    current maturities of long-term debt and short-term debt:

|                                                             |  |              |       |      |  |   |   | 
|------------------------------------------------------------ |  | ------------ | ----- | ---- |  | - | - | 
|                                                             |  |             
|                                                             |  | December 31,
|                                                             |  |             
|                                                             |  | 2002         |       | 2001
|                                                             |  |              |       |     
|                                                             |  |             
|                                                             |  | (In         
|                                                             |  | thousands)  
|Current maturities of long-term debt and
    short-term debt |  | $            | 5,921 |      |  | $ |  | 
|                                                             |  |              |       |      |  |   |   | 



| |                                                                   
| | ------------------------------------------------------------------
| | The following table presents the components of
    long-term debt:

|                                                                           |                                         |                |         |         |  |   |        |        | 
|-------------------------------------------------------------------------- | --------------------------------------- | -------------- | ------- | ------- |  | - | ------ | ------ | 
|                                                                           |                                         |               
|                                                                           |                                         | December 31,  
|                                                                           |                                         |               
|                                                                           |                                         | 2002           |         | 2001   
|                                                                           |                                         |                |         |        
|                                                                           |                                         |               
|                                                                           |                                         | (In thousands)
|U.S. bank term loan                                                        |                                         | $              | 50,000  |         |  | $ | 78,000 |       
|U.S. revolving credit facility                                             |                                         |                | 47,500  |         |  |   |       |       
|11% senior subordinated notes due 2010, net of
    original issue discount |                                         |                | 173,963 |         |  |   |       |       
|Interest rate swap monetization deferred income                            |                                         |                | 10,486  |         |  |   |       |       
|Fair value of interest rate swap                                           |                                         |                | 1,871   |         |  |   |       |       
|Obligations under asset purchase agreement                                 |                                         |                |        |         |  |   | 878    |       
|Less: current maturities of long-term debt                                 |                                         |                | (5,921  | )       |  |   |       |       
|                                                                           |                                         |                |         |         |  |   |        |       
|                                                                           | Total long-term debt due after one year |                | $       | 277,899 |  |   | $      | 78,878 | 
|                                                                           |                                         |                |         |         |  |   |        |       



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | In March 2002, the Company entered into a $175
    million senior secured credit facility consisting of a $75.0
    million five-year revolving credit facility and a $100 million
    five-year term loan facility. The term loan facility amortizes
    over the full five-year term. The senior facilities were
    subsequently reduced to $125 million due to the $50 million of
    repayments made under the term loan facility. The availability
    of borrowings under the revolving credit facility is not limited
    by a borrowing base. At December 31, 2002, the Company had
    unused availability under the revolving credit facility of
    $27.5 million. The senior credit facilities provide for
    variable interest rates based on LIBOR or an alternate base
    rate, at the Companys option. On December 31, 2002,
    30-day LIBOR was 1.38%. Such facilities are guaranteed by all
    domestic subsidiaries and secured by a security interest on
    substantially all domestic assets, all of the stock of domestic
    subsidiaries and 65% of the stock of material foreign
    subsidiaries. The senior credit facilities require the payment
    of certain commitment fees based on the unused portion of the
    revolving credit facility. These senior credit facilities may be
    prepaid at any time without a premium.

54



---



##### 





| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Also in March 2002, the Company issued $175
    million of senior subordinated notes due April 1, 2010. The
    proceeds from the issuance of these notes were $173.9 million,
    which was net of the original issue discount. This discount will
    be charged to interest expense over the term of the notes. These
    notes have a fixed interest rate of 11% per annum and are
    guaranteed on a subordinated basis by all existing domestic
    subsidiaries and all future domestic subsidiaries that are owned
    80% or more by the Company. The notes are not secured. Prior to
    the third anniversary of the date of issuance of the notes, up
    to 35% of the notes are redeemable with the proceeds of
    qualified sales of equity at 111% of par value. The terms of the
    senior credit facilities require repayment of all of the
    indebtedness under these facilities before repurchase of any of
    the notes. On or after the fourth anniversary of the date of
    issuance of the notes, all or any portion of the notes are
    redeemable at declining premiums to par value, beginning at
    105.5%.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|
| | Concurrent with the issuance of the senior
    subordinated notes, the Company entered into an interest rate
    swap agreement to effectively convert interest expense on $140
    million of senior subordinated notes for the term of the notes
    from an 11% fixed annual rate to a floating annual rate equal to
    6-month LIBOR plus a base rate. On May 30, 2002,
    August 5, 2002 and September 19, 2002, the Company
    sold the then outstanding swap agreements for $4.4 million, $5.6
    million and $3.7 million, respectively. The amounts received,
    less the interest benefit earned through the dates of sale, have
    been recorded as a premium to the carrying amount of the notes
    and are being amortized into interest income over their
    remaining life. At December 31, 2002, the Company had an
    interest rate swap agreement in place covering $150 million of
    the notes, at a rate of 6-month LIBOR plus 6.54%. Under this
    agreement, 6-month LIBOR was locked at 1.85%, giving us an
    all-in rate of 8.39%. On February 27, 2003, this interest
    rate swap was sold for $2.3 million, and a new swap was entered
    into covering $150 million of the notes, at a rate of 6-month
    LIBOR plus 6.94%, giving us an estimated all-in rate of 8.28%.
    The terms of the interest rate swap agreements, other than the
    notional amount and the base rate, were identical and were
    perfectly matched with the terms of the related hedged
    instrument. On December 31, 2002 and February 28,
    2003, 6-month LIBOR was 1.38% and 1.34%, respectively.
|
| | Under the terms of the senior secured credit
    facility and the senior subordinated notes, the Company is
    required to comply with various covenants including, but not
    limited to, those pertaining to maintenance of certain financial
    ratios and incurring additional indebtedness. The Company was in
    compliance with the covenants at December 31, 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|
| | Scheduled maturities of long-term debt as of
    December 31, 2002, are as follows (in thousands):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 

|                                              |       |   |         |         | 
|--------------------------------------------- | ----- | - | ------- | ------- | 
|2003                                          |       | $ | 5,921   |        
|2004                                          |       |   | 9,869   |        
|2005                                          |       |   | 12,500  |        
|2006                                          |       |   | 17,105  |        
|2007(including the revolving credit facility) |       |   | 52,105  |        
|2010                                          |       |   | 175,000 |        
|                                              |       |   |         |        
|                                              | Total |   | $       | 272,500 | 
|                                              |       |   |         |        

7. Stockholders Equity



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The authorized capital stock of the Company at
    December 31, 2002 and 2001 was 100 million shares of voting
    common stock, $0.001 par value per share, and 5 million shares
    of preferred stock, $0.001 par value per share. The preferred
    stock is issuable in one or more series by the Companys
    Board of Directors without further stockholder approval. No
    preferred stock was outstanding at December 31, 2002 or
    2001. The Company has reserved 6,612,753 shares of common stock
    for issuance under the stock option plans at December 31,
    2002.

| |                                                                                                                                                                                                                                         
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | Stock Option and Award
Plans
The Company has five stock option plans: the 2000
    Stock Option Plan for Non-Employee Directors (the 2000
    Plan), the 1997 Stock Option Plan (the 1997
    Plan), the 1996 Stock Option Plan (the

55



---



##### 



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 1996 Plan), the 1995 Stock Option
    Plan (the 1995 Plan) and the 1996 Incentive and
    Non-Qualified Stock Option Plan (the MTRA Plan).
    Under the 1995 Plan, the Board of Directors initially could
    grant options to purchase up to 363,807 shares of common stock.
    However, the Company has no obligation to issue the shares upon
    exercise of such options until it has purchased an equal number
    of shares from certain existing stockholders. Under the 2000
    Plan, the 1997 Plan and the 1996 Plan, the Board of Directors
    initially could grant options to purchase up to 615,000,
    3,966,000 and 743,441, respectively, of newly issued shares of
    common stock. The Board of Directors reserved 776,250 shares to
    cover the exercise of the options under the MTRA Plan. The plans
    require that the exercise price of options cannot be less than
    either 100% (2000 Plan, 1997 Plan and MTRA Plan) or 75% (1996
    and 1995 Plans) of the estimated fair market value of the
    Companys shares of common stock on the date of grant.
|
| | The combined activity from all plans is presented
    in the following table:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         

|                               |  |        |           |                  |  |   |       | 
|------------------------------ |  | ------ | --------- | ---------------- |  | - | ----- | 
|                               |  |        |           | Weighted Average
|                               |  | Shares |           | Exercise Price  
|                               |  |        |           |                 
|Outstanding, December 31, 1999 |  |        | 3,228,300 |                  |  | $ | 6.40  | 
|Granted                        |  |        | 1,248,198 |                  |  |   | 5.21  | 
|Exercised                      |  |        | (580,538  | )                |  |   | 0.58  | 
|Forfeited                      |  |        | (334,207  | )                |  |   | 8.03  | 
|                               |  |        |           |                  |  |   |       | 
|Outstanding, December 31, 2000 |  |        | 3,561,753 |                  |  |   | 6.78  | 
|Granted                        |  |        | 857,748   |                  |  |   | 10.61 | 
|Exercised                      |  |        | (594,024  | )                |  |   | 6.43  | 
|Forfeited                      |  |        | (329,499  | )                |  |   | 8.11  | 
|                               |  |        |           |                  |  |   |       | 
|Outstanding, December 31, 2001 |  |        | 3,495,978 |                  |  |   | 7.65  | 
|Granted                        |  |        | 3,387,798 |                  |  |   | 14.24 | 
|Exercised                      |  |        | (512,423  | )                |  |   | 6.33  | 
|Forfeited                      |  |        | (962,380  | )                |  |   | 14.13 | 
|                               |  |        |           |                  |  |   |       | 
|Outstanding, December 31, 2002 |  |        | 5,408,973 |                  |  |   | 10.79 | 
|                               |  |        |           |                  |  |   |       | 



| |                                                                                                                                       
| | --------------------------------------------------------------------------------------------------------------------------------------
| | Information regarding stock options outstanding
    and options exercisable at December 31, 2002 is summarized
    in the table below:

|                         |  |                     |           |                     |  |          |      |             |  |          |       |  |  |  |           |  |  |   |       | 
|------------------------ |  | ------------------- | --------- | ------------------- |  | -------- | ---- | ----------- |  | -------- | ----- |  |  |  | --------- |  |  | - | ----- | 
|                         |  |                     |           |                    
|                         |  | Options Outstanding |           | Options Exercisable
|                         |  |                     |           |                    
|                         |  |                     |           | Weighted            |  |          |      |            
|                         |  |                     |           | Average             |  | Weighted |      |             |  | Weighted
|                         |  |                     |           | Remaining           |  | Average  |      |             |  | Average 
|                         |  | Shares              |           | Life                |  | Exercise |      | Shares      |  | Exercise
|Range of Exercise Prices |  | Outstanding         |           | (Years)             |  | Price    |      | Exercisable |  | Price   
|                         |  |                     |           |                     |  |          |      |             |  |         
|$ 4.59  $ 8.17          |  |                     | 1,390,754 |                     |  |          | 7.27 |             |  | $        | 5.75  |  |  |  | 944,943   |  |  | $ | 5.65  | 
|$ 8.48  $11.00          |  |                     | 1,353,722 |                     |  |          | 7.26 |             |  |          | 9.41  |  |  |  | 704,766   |  |  |   | 8.96  | 
|$11.02  $14.81          |  |                     | 1,785,248 |                     |  |          | 9.02 |             |  |          | 12.81 |  |  |  | 180,291   |  |  |   | 12.12 | 
|$14.96  $22.54          |  |                     | 879,249   |                     |  |          | 9.35 |             |  |          | 16.77 |  |  |  |          |  |  |   |      | 
|                         |  |                     |           |                     |  |          |      |             |  |          |       |  |  |  |           |  |  |   |       | 
|$ 4.59  $22.54          |  |                     | 5,408,973 |                     |  |          | 8.18 |             |  |          | 10.79 |  |  |  | 1,830,000 |  |  |   | 7.57  | 
|                         |  |                     |           |                     |  |          |      |             |  |          |       |  |  |  |           |  |  |   |       | 



| |                                                                                                                                                         
| | --------------------------------------------------------------------------------------------------------------------------------------------------------
| | At December 31, 2002, 2001 and 2000,
    exercisable options representing 1,830,000, 1,379,003 and
    1,443,797 shares, respectively, were outstanding.

8. Related Party Transactions

| |                                                                                                                                                                                                                                                                                                                                                       
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | Endeavor
Pharmaceuticals, Inc.
In 1994, aaiPharma organized Endeavor
    Pharmaceuticals, Inc. with Berlex Laboratories, Inc. and several
    other investors to fund the development of hormone
    pharmaceutical products, initially focusing on several generic
    hormone products already under development by the Company. The
    Company has

56



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##### 



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | also agreed to permit Endeavor, under certain
    circumstances, the first right to purchase additional
    proprietary hormone pharmaceutical products developed by
    aaiPharma. aaiPharma obtained a 47% equity interest in Endeavor
    through the contribution of its accumulated product research and
    development and technical know-how. The other investors
    contributed cash in exchange for their interests which, for all
    investors, was in the form of convertible preferred stock. Based
    on subsequent investments by other investors, at
    December 31, 2002 the Companys interest, assuming
    conversion, had been reduced to approximately 13% of the fully
    diluted common equity of Endeavor. Subsequent to the reduction
    in ownership percentage and its reduced influence over the
    Endeavor operations, the Company ceased accounting for this as
    an equity method investment and began to account for it under
    the cost method. Endeavor has accumulated significant losses
    since inception and this investment has been recorded at zero
    value since 1995.
|
| | The Company had net sales to Endeavor of
    approximately $1.1 million, $0.2 million, and $0.7 million for
    the years ended December 31, 2002, 2001 and 2000,
    respectively. aaiPharma had approximately $292,000 and $79,000
    in related accounts receivable at December 31, 2002 and
    2001, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | Aesgen, Inc.
Aesgen, Inc. (Aesgen) was formally
    organized with an affiliate of the Mayo Clinic and MOVA
    Pharmaceutical Corporation and funded in 1995 through the
    issuance of approximately $11 million of nonconvertible,
    nonvoting, mandatorily redeemable, preferred stock. The Company
    made a cash investment of $1.6 million in such preferred stock,
    which is carried at cost, and is included in other noncurrent
    assets on the consolidated balance sheets.                                                                                                                                                                                                                                                                                                                                                                                                                        
|
| | In October 2001, the Company entered into a
    Service Agreement and a Subscription Agreement with Aesgen,
    whereby the Company has agreed to perform certain clinical work
    for Aesgen and to receive Aesgen preferred stock in lieu of cash
    for the services performed. The Company has subscribed to $1.1
    million of preferred stock, and will receive up to 10,829 shares
    of such stock, in lieu of cash for the related shares. Through
    December 31, 2002, the Company has performed services under
    the agreement of $580,000. At December 31, 2002, the
    Company held approximately 10.0% of Aesgens fully diluted
    common stock. If all $1.1 million of services are performed, the
    Company expects to own 14.2% of Aesgen on a fully diluted basis.
    The preferred shares are to be issued in accordance with a
    timetable established by the Subscription Agreement.
|
| | In December 2001, the Company entered into a
    Product Sales Agreement with Aesgen. Under this agreement,
    Aesgen sold its rights, title and interest to certain products
    to the Company. These products include five products for which
    abbreviated new drug applications have been filed with the
    United States Food and Drug Administration, and two products
    under development. As consideration for the purchase of these
    products, the Company waived all claims to amounts due from
    Aesgen and terminated the development and licensing agreement,
    as described below. At December 31, 2002, the approximate
    book value of these assets was $600,000.                                                                                                                                                                                                                        
|
| | In February 2002, the Company purchased a
    proprietary product from Aesgen for payments of
    $1.0 million in cash and additional contingent milestone
    payments of up to $1.5 million. Recently, the prerequisite for
    payment of an additional $500,000 of such contingent milestones
    occurred and such payment was made to Aesgen, while the
    prerequisites for payment of the remaining $1.0 million were not
    met and no further payment of this amount is owed by the
    Company. The Company intends to market this product as an
    extension of the Aquasol product line. Under this agreement, the
    Company is obligated to pay royalty payments equal to 30% of the
    net revenues of the product acquired from Aesgen, less certain
    costs incurred in its manufacture and marketing, for the
    eight-year period following the first commercial sale of the
    product.    
|
| | In 1996, the Company sold to Aesgen marketing
    rights to a product under development by the Company. Under the
    agreement, Aesgen paid a license fee and would have paid
    additional royalties upon marketing the product. aaiPharma had
    the right, under its development agreement with Aesgen, to
    provide certain product development and support services to
    Aesgen with respect to some generic drugs currently being
    developed by Aesgen, provided that aaiPharmas fees for
    such services were comparable to those of a competitor. In
    addition, under such development agreement, the Company had
    agreed not to develop, for its own account or any other person,
    a formulation of any of the                                                                                                                                                                            

57



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##### 



| |                                                                                                                                                                                                                                                                                   
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | generic products currently under development for
    Aesgen and any additional drugs that aaiPharma agrees to develop
    in the future for Aesgen.                                                                                                                               
|
| | aaiPharma recognized net revenues of
    approximately $494,000, $86,000 and $100,000 from Aesgen for the
    years ended December 31, 2002, 2001 and 2000, respectively.
    The Company had no related accounts receivable or
    work-in-progress at December 31, 2002 or 2001.

Cetan
Technologies, Inc.

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | In 1999, the Company advanced $300,000 to Cetan
    Technologies, Inc. (Cetan), formerly known as
    PharmComm, Inc., a company whose principal stockholders include
    Dr. Frederick Sancilio and Mr. James Waters, both
    directors of aaiPharma.                                                                                                                                                                                                                                                           
|
| | The advance payment was for services to be
    rendered by Cetan during 1999 and 2000 for scanning and indexing
    services required as part of aaiPharmas regulatory
    compliance and record retention policies. aaiPharma has engaged
    Cetan to perform these services since 1996 and has compensated
    Cetan pursuant to written agreements for the services. Cetan
    also has provided computer validation services to aaiPharma,
    which are required for compliance with regulatory requirements.
|
| | Total payments for scanning and validation
    services provided to aaiPharma by Cetan were approximately
    $7,000, $4,000, and $308,000 (excluding the advance payment) for
    the years ended December 31, 2002, 2001 and 2000,
    respectively. At December 31, 2000, the advance payment had
    been fully utilized.                                                                                                                                                                                       

9. Income Taxes



| |                                                                                                   
| | --------------------------------------------------------------------------------------------------
| | The following table presents the components for
    the provision for (benefit from) income taxes:

|                                           |           |                          |                                           |      |        |        |  |   |       |       |  |   |        |      |  
|------------------------------------------ | --------- | ------------------------ | ----------------------------------------- | ---- | ------ | ------ |  | - | ----- | ----- |  | - | ------ | ---- | -
|                                           |           |                         
|                                           |           | Years Ended December 31,
|                                           |           |                         
|                                           |           | 2002                     |                                           | 2001 |        | 2000  
|                                           |           |                          |                                           |      |        |       
|                                           |           |                         
|                                           |           | (In thousands)          
|Income before income taxes:                |           |                          |                                           |      |        |        |  |   |       |       |  |  
|                                           |           | United States            |                                           | $    | 36,635 |        |  | $ | 9,096 |       |  | $ | (5,199 | )   
|                                           |           | Non-U.S.                 |                                           |      | (98    | )      |  |   | 43    |       |  |   | 5,317  |     
|                                           |           |                          |                                           |      |        |        |  |   |       |       |  |  
|                                           |           |                          | Income before taxes                       |      | $      | 36,537 |  |   | $     | 9,139 |  |   | $      | 118  |  
|                                           |           |                          |                                           |      |        |        |  |   |       |       |  |  
|Provision for (benefit from) income taxes: |           |                          |                                           |      |        |        |  |   |       |       |  |  
|                                           | Current:  |                          |                                           |      |        |        |  |   |       |       |  |   |       
|                                           |           | Federal                  |                                           | $    | 4,556  |        |  | $ | 1,654 |       |  | $ |       |     
|                                           |           | State                    |                                           |      | 219    |        |  |   | 1,397 |       |  |   |       |     
|                                           |           | Non-U.S.                 |                                           |      | 355    |        |  |   |      |       |  |   |       |     
|                                           |           |                          |                                           |      |        |        |  |   |       |       |  |  
|                                           |           |                          | Total current taxes                       |      |        | 5,130  |  |   |       | 3,051 |  |   |        |     |  
|                                           |           |                          |                                           |      |        |        |  |   |       |       |  |  
|                                           | Deferred: |                          |                                           |      |        |        |  |   |       |       |  |   |       
|                                           |           | Federal                  |                                           |      | 6,905  |        |  |   | 1,067 |       |  |   | (882   | )   
|                                           |           | State                    |                                           |      | 1,849  |        |  |   | (919  | )     |  |   | 441    |     
|                                           |           |                          |                                           |      |        |        |  |   |       |       |  |  
|                                           |           |                          | Total deferred taxes                      |      |        | 8,754  |  |   |       | 148   |  |   |        | (441 | )
|                                           |           |                          |                                           |      |        |        |  |   |       |       |  |  
|                                           |           |                          | Provision for (benefit from) income taxes |      | $      | 13,884 |  |   | $     | 3,199 |  |   | $      | (441 | )
|                                           |           |                          |                                           |      |        |        |  |   |       |       |  |  

58



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##### 





| |                                                                                                                                                                         
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The following table presents the reconciliation
    of the provision for income taxes to the amount computed by
    applying the U.S. federal statutory income tax rate:

|                                                                                               |                                           |                          |        |        |  |      |       |       |  |   |        |      |  
|---------------------------------------------------------------------------------------------- | ----------------------------------------- | ------------------------ | ------ | ------ |  | ---- | ----- | ----- |  | - | ------ | ---- | -
|                                                                                               |                                           |                         
|                                                                                               |                                           | Years Ended December 31,
|                                                                                               |                                           |                         
|                                                                                               |                                           | 2002                     |        | 2001   |  | 2000
|                                                                                               |                                           |                          |        |        |  |     
|                                                                                               |                                           |                         
|                                                                                               |                                           | (In thousands)          
|Income before income taxes                                                                     |                                           | $                        | 36,537 |        |  | $    | 9,139 |       |  | $ | 118    |     
|                                                                                               |                                           |                          |        |        |  |      |       |       |  |   |        |     
|Tax expense using U.S. statutory income tax rate
    of 35% for 2002 and 34% for 2001 and 2000 |                                           | $                        | 12,788 |        |  | $    | 3,107 |       |  | $ | 40     |     
|State income taxes, net                                                                        |                                           |                          | 1,381  |        |  |      | (11   | )     |  |   | 461    |     
|Permanent items, net                                                                           |                                           |                          | 184    |        |  |      | 395   |       |  |   | 1,160  |     
|Non-U.S. operations, net                                                                       |                                           |                          | (194   | )      |  |      | (53   | )     |  |   |       |     
|Tax credits                                                                                    |                                           |                          | (677   | )      |  |      | (368  | )     |  |   | (100   | )   
|Change in reserve for deferred tax assets                                                      |                                           |                          | 362    |        |  |      | 129   |       |  |   | (2,002 | )   
|                                                                                               |                                           |                          |        |        |  |      |       |       |  |   |        |     
|                                                                                               | Provision for (benefit from) income taxes |                          | $      | 13,844 |  |      | $     | 3,199 |  |   | $      | (441 | )
|                                                                                               |                                           |                          |        |        |  |      |       |       |  |   |        |     



| |                                                                                                                                                                                                                                                                                                                                                         
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Deferred income taxes arise from temporary
    differences between the tax bases of assets and liabilities and
    their reported amounts in the financial statements. Deferred
    taxes are included in prepaids and other current assets and
    other accrued liabilities. The following table presents the
    deferred tax assets and liabilities:

|                                          |                                       |                                       |        |        |        |   |        |        |        | 
|----------------------------------------- | ------------------------------------- | ------------------------------------- | ------ | ------ | ------ | - | ------ | ------ | ------ | 
|                                          |                                       |                                      
|                                          |                                       | December 31,                         
|                                          |                                       |                                      
|                                          |                                       | 2002                                  |        | 2001  
|                                          |                                       |                                       |        |       
|                                          |                                       |                                      
|                                          |                                       | (In thousands)                       
|Deferred tax assets, resulting from:      |                                       |                                       |        |        |        |   |        |       
|                                          | Accrued liabilities                   |                                       | $      | 1,724  |        |   | $      | 1,202  |       
|                                          | Accounts receivable                   |                                       |        | 1,493  |        |   |        | 825    |       
|                                          | Deferred revenue                      |                                       |        | 903    |        |   |        | 4,667  |       
|                                          | Tax credits                           |                                       |        |       |        |   |        | 518    |       
|                                          | U.S. net operating loss carryforwards |                                       |        | 1,811  |        |   |        | 1,801  |       
|                                          | Non-U.S. net operating losses         |                                       |        | 2,826  |        |   |        | 2,539  |       
|                                          | Other items                           |                                       |        | 276    |        |   |        | (92    | )     
|                                          |                                       | Total deferred tax assets             |        |        | 9,033  |   |        |        | 11,460 | 
|Deferred tax liabilities, resulting from: |                                       |                                       |        |        |        |   |        |       
|                                          | Amortization                          |                                       |        | (5,765 | )      |   |        |       |       
|                                          | Property and equipment                |                                       |        | (5,453 | )      |   |        | (5,253 | )     
|Valuation allowances on tax assets        |                                       |                                       | (3,011 | )      |        |   | (2,649 | )     
|                                          |                                       |                                       |        |        |        |   |        |       
|                                          |                                       | Net deferred tax assets (liabilities) |        | $      | (5,196 | ) |        | $      | 3,558  | 
|                                          |                                       |                                       |        |        |        |   |        |       



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Valuation allowances have been provided for
    certain assets resulting from accumulated net operating losses
    from foreign entities since realization of such assets cannot be
    predicted with reasonable certainty at this time. As of
    December 31, 2002, the Company had approximately $2.3
    million of federal net operating loss carryforwards expiring in
    2019 and $18.7 million of state net operating loss carryforwards
    with the following expirations: $6.7 million in 2015, and $12.0
    million in 2016.

10. Employee Benefit Plan



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The Company provides retirement benefits for all
    domestic aaiPharma employees with one year of service through a
    defined contribution plan qualified under section 401(k) of the
    Internal Revenue Code of 1986, as amended. Participants may
    elect to contribute a portion of their annual compensation,
    subject to limitations. The Company makes matching contributions
    in aaiPharma stock equal to 50% of a participants
    contribution up to a certain amount. Additionally, the Company
    makes profit-sharing contributions at the discretion of the
    Board of Directors. The Company has expensed

59



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##### 



| |                                                                                                                                    
| | -----------------------------------------------------------------------------------------------------------------------------------
| | $986,000, $788,000, and $880,000 for the years
    ended December 31, 2002, 2001 and 2000, respectively, for
    this benefit plan.

11. Commitments and
Contingencies



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The Company leases land, buildings and equipment
    under renewable lease agreements classified as operating leases.
    Rent expense under these agreements for the years ended
    December 31, 2002, 2001 and 2000 was $7.0 million, $6.9
    million, and $4.9 million, respectively. As of December 31,
    2002, future minimum rentals due under non-cancelable operating
    lease agreements with initial terms of one year or more were:
    $6.8 million  2003; $5.9 million  2004;
    $5.4 million  2005; $3.9 million  2006;
    $3.7 million  2007 and $9.5 million 
    thereafter. As of December 31, 2002, future minimum rentals
    due under non-cancelable capital lease agreements with initial
    terms of one year or more were: $0.4 million  2003;
    $0.3 million  2004; $0.2 million  2005;
    $0.1 million  2006; and zero  thereafter.                                                                                                           
|
| | The Company is party to lawsuits and
    administrative proceedings incidental to the normal course of
    business. While the outcomes of these suits cannot be completely
    predicted, the Company does not believe that any liabilities
    related to such lawsuits or proceedings will have a material
    adverse effect on its consolidated financial condition, results
    of operations or cash flows and intends to vigorously pursue all
    defenses available. In cases where aaiPharma has initiated an
    action, the Company intends to prosecute these claims to the
    full extent of its rights under the law.                                                                                                                                                                                                                                                                                                                                                         
|
| | The Company is party to a number of legal actions
    with companies that market generic drugs. The Company filed
    three cases in the United States District Court for the Eastern
    District of North Carolina claiming infringement of certain of
    its fluoxetine hydrochloride patents. Fluoxetine hydrochloride
    is an active ingredient in the drug marketed by Eli Lilly as
    Prozac. The defendants in these three actions,
    Dr. Reddys Laboratories Ltd., a pharmaceutical
    company based in India, and its U.S. affiliate,
    Dr. Reddys Laboratories, Inc. (formerly
    Reddy-Cheminor, Inc.) sell a generic fluoxetine hydrochloride
    product in the United States.                                                                                                                                                                                                                                                                                       
|
| | The Company is also involved in four actions
    centered on its omeprazole-related patents. Omeprazole is the
    active ingredient found in Prilosec, a drug sold by AstraZeneca
    AB. Two of these cases have been filed against the Company by
    Dr. Reddys Laboratories Ltd. and Dr. Reddys
    Laboratories, Inc. in the United States District Court for the
    Southern District of New York. In these cases, the plaintiffs
    are seeking a declaratory judgment that their omeprazole
    products do not infringe the Companys patents and in
    addition, they are challenging the validity of five of the
    Companys omeprazole patents. They also seek to recover
    costs and attorneys fees. Furthermore, in a second case,
    filed in November 2001, the plaintiffs are seeking damages for
    alleged misappropriation of trade secrets, tortious
    interference, unfair competition and violations of the North
    Carolina Unfair Trade Practice Act.
|
| | A third case involving the Companys
    omeprazole patents was brought in August 2001 by Andrx
    Pharmaceuticals, Inc. (Andrx) in the United States
    District Court for the Southern District of New York. Andrx is
    challenging the validity of three of the Companys
    omeprazole patents, and is also seeking a declaratory judgment
    that its generic omeprazole product does not infringe these
    patents. Furthermore, Andrx claims violations of federal and
    state antitrust laws with respect to the licensing of these
    omeprazole patents and is seeking injunctive relief and
    unspecified treble damages.                                                                                                                                                                                                                                                                                                                                             
|
| | The fourth case involving the omeprazole patents
    was brought in December 2002 by the Company against Kremers
    Urban Development Co., Schwarz Pharma Inc. and Schwarz Pharma AG
    (collectively, KUDCO) in the United States District
    Court for the Southern District of New York. The case involves
    claims of infringement of the omeprazole patent dealing with a
    dry-blend process of manufacturing omeprazole products. KUDCO
    has filed its answer to the complaint, denying the claims,
    asserting various affirmative defenses, and asserting
    counterclaims of patent invalidity, product non-infringement and
    antitrust violations under federal and state antitrust laws.
    aaiPharma intends to vigorously defend its patent rights and
    defend against the foregoing defenses and counterclaims asserted
    by KUDCO.                                                                                                                     
|
| | The Company may be party to other lawsuits and
    administrative proceedings incidental to the normal course of
    its business which are not considered material.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           

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12. Financial Information by Business
Segment and Geographic Area



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The Company operates in three business segments
    consisting of a product sales business, primarily comprised of
    the pharmaceuticals business unit, a product development
    business, primarily the research and development business unit,
    and a development services business, primarily the AAI
    International business unit. The product sales business provides
    for the sales of M.V.I., Aquasol, Brethine, Darvon, Darvocet-N
    and Azasan product lines and for the commercial manufacturing of
    small quantity products outsourced by other pharmaceutical
    companies. In the product development segment, the Company
    internally develops drugs and technologies for future sales by
    the product sales business or with the objective of licensing
    marketing rights to third parties in exchange for license fees
    and royalties. The core services provided by the development
    services business on a fee-for-service basis to pharmaceutical
    and biotechnology industries worldwide include comprehensive
    formulation, testing and manufacturing expertise, in addition to
    the ability to take investigational products into and through
    human clinical trials. The majority of the Companys
    non-U.S. operations are located in Germany.
|
| | Corporate income (loss) from operations
    includes general corporate overhead costs and, in fiscal 2001
    and 2000, goodwill amortization, which are not directly
    attributable to a business segment. Financial data by segment
    and geographic region are as follows (in thousands):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      

|                                           |  |                          |         |      |  |      |         |   |  |   |         |  
|------------------------------------------ |  | ------------------------ | ------- | ---- |  | ---- | ------- | - |  | - | ------- | -
|                                           |  |                         
|                                           |  | Years Ended December 31,
|                                           |  |                         
|                                           |  | 2002                     |         | 2001 |  | 2000
|                                           |  |                          |         |      |  |     
|Net revenues:                              |  |                          |         |      |  |      |         |   |  |   |         |  
|Product sales                              |  | $                        | 128,462 |      |  | $    | 27,448  |   |  | $ | 7,341   |  
|Product development                        |  |                          | 19,610  |      |  |      | 20,426  |   |  |   | 9,896   |  
|Development services                       |  |                          | 82,438  |      |  |      | 93,199  |   |  |   | 87,008  |  
|                                           |  |                          |         |      |  |      |         |   |  |   |         |  
|                                           |  | $                        | 230,510 |      |  | $    | 141,073 |   |  | $ | 104,245 |  
|                                           |  |                          |         |      |  |      |         |   |  |   |         |  
|                                          
|United States                              |  | $                        | 228,827 |      |  | $    | 129,464 |   |  | $ | 88,077  |  
|Germany                                    |  |                          | 15,520  |      |  |      | 15,442  |   |  |   | 17,888  |  
|Other                                      |  |                          | 962     |      |  |      | 916     |   |  |   | 1,554   |  
|Less intercompany                          |  |                          | (14,799 | )    |  |      | (4,749  | ) |  |   | (3,274  | )
|                                           |  |                          |         |      |  |      |         |   |  |   |         |  
|                                           |  | $                        | 230,510 |      |  | $    | 141,073 |   |  | $ | 104,245 |  
|                                           |  |                          |         |      |  |      |         |   |  |   |         |  
|Gross margin (excluding
    depreciation): |  |                          |         |      |  |      |         |   |  |   |         |  
|Product sales                              |  | $                        | 95,817  |      |  | $    | 14,111  |   |  | $ | 1,963   |  
|Product development                        |  |                          | 19,610  |      |  |      | 20,426  |   |  |   | 9,896   |  
|Development services                       |  |                          | 33,625  |      |  |      | 39,339  |   |  |   | 44,744  |  
|                                           |  |                          |         |      |  |      |         |   |  |   |         |  
|                                           |  | $                        | 149,052 |      |  | $    | 73,876  |   |  | $ | 56,603  |  
|                                           |  |                          |         |      |  |      |         |   |  |   |         |  
|Income (loss) from operations:             |  |                          |         |      |  |      |         |   |  |   |         |  
|Product sales                              |  | $                        | 73,703  |      |  | $    | 7,691   |   |  | $ | (719    | )
|Product development                        |  |                          | 19,610  |      |  |      | 20,426  |   |  |   | 9,896   |  
|Development services                       |  |                          | 557     |      |  |      | 8,920   |   |  |   | 16,417  |  
|                                           |  |                          |         |      |  |      |         |   |  |   |         |  
|                                           |  |                          | 93,870  |      |  |      | 37,037  |   |  |   | 25,594  |  
|Research and development expense           |  |                          | (21,279 | )    |  |      | (10,851 | ) |  |   | (12,221 | )
|Corporate                                  |  |                          | (17,149 | )    |  |      | (12,957 | ) |  |   | (11,339 | )
|                                           |  |                          |         |      |  |      |         |   |  |   |         |  
|                                           |  | $                        | 55,442  |      |  | $    | 13,229  |   |  | $ | 2,034   |  
|                                           |  |                          |         |      |  |      |         |   |  |   |         |  
|                                          
|United States                              |  | $                        | 55,844  |      |  | $    | 13,095  |   |  | $ | (3,504  | )
|Germany                                    |  |                          | (58     | )    |  |      | 440     |   |  |   | 6,079   |  
|Other                                      |  |                          | (344    | )    |  |      | (306    | ) |  |   | (541    | )
|                                           |  |                          |         |      |  |      |         |   |  |   |         |  
|                                           |  | $                        | 55,442  |      |  | $    | 13,229  |   |  | $ | 2,034   |  
|                                           |  |                          |         |      |  |      |         |   |  |   |         |  

61



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##### 



|                                 |  |                          |         |      |  |      |         |  |  |   |         | 
|-------------------------------- |  | ------------------------ | ------- | ---- |  | ---- | ------- |  |  | - | ------- | 
|                                 |  |                         
|                                 |  | Years Ended December 31,
|                                 |  |                         
|                                 |  | 2002                     |         | 2001 |  | 2000
|                                 |  |                          |         |      |  |     
|Depreciation and amortization:   |  |                          |         |      |  |      |         |  |  |   |         | 
|Product sales                    |  | $                        | 3,121   |      |  | $    | 552     |  |  | $ | 781     | 
|Development services             |  |                          | 3,903   |      |  |      | 4,503   |  |  |   | 4,215   | 
|Research and development expense |  |                          | 425     |      |  |      | 369     |  |  |   | 330     | 
|Corporate                        |  |                          | 2,122   |      |  |      | 2,331   |  |  |   | 1,927   | 
|                                 |  |                          |         |      |  |      |         |  |  |   |         | 
|                                 |  | $                        | 9,571   |      |  | $    | 7,755   |  |  | $ | 7,253   | 
|                                 |  |                          |         |      |  |      |         |  |  |   |         | 
|Total assets:                    |  |                          |         |      |  |      |         |  |  |   |         | 
|Product sales                    |  | $                        | 347,596 |      |  | $    | 105,541 |  |  | $ | 5,673   | 
|Product development              |  |                          | 6,024   |      |  |      | 7,832   |  |  |   | 4,856   | 
|Development services             |  |                          | 49,952  |      |  |      | 55,555  |  |  |   | 78,505  | 
|Corporate                        |  |                          | 36,753  |      |  |      | 27,358  |  |  |   | 23,117  | 
|                                 |  |                          |         |      |  |      |         |  |  |   |         | 
|                                 |  | $                        | 440,325 |      |  | $    | 196,286 |  |  | $ | 112,151 | 
|                                 |  |                          |         |      |  |      |         |  |  |   |         | 
|                                
|United States                    |  | $                        | 417,997 |      |  | $    | 176,518 |  |  | $ | 90,037  | 
|Germany                          |  |                          | 21,167  |      |  |      | 18,794  |  |  |   | 21,067  | 
|Other                            |  |                          | 1,161   |      |  |      | 974     |  |  |   | 1,047   | 
|                                 |  |                          |         |      |  |      |         |  |  |   |         | 
|                                 |  | $                        | 440,325 |      |  | $    | 196,286 |  |  | $ | 112,151 | 
|                                 |  |                          |         |      |  |      |         |  |  |   |         | 
|Goodwill, net:                   |  |                          |         |      |  |      |         |  |  |   |         | 
|Product sales                    |  | $                        | 199,414 |      |  | $    | 39,717  |  |  | $ |        | 
|Development services             |  |                          | 11,378  |      |  |      | 9,663   |  |  |   | 10,554  | 
|                                 |  |                          |         |      |  |      |         |  |  |   |         | 
|                                 |  | $                        | 210,792 |      |  | $    | 49,380  |  |  | $ | 10,554  | 
|                                 |  |                          |         |      |  |      |         |  |  |   |         | 

13. Financial Results by Quarter
(Unaudited)

|                                      |                                  |                           |        |        |   |       |        |        |  |   |        |      |  |   |        |      | 
|------------------------------------- | -------------------------------- | ------------------------- | ------ | ------ | - | ----- | ------ | ------ |  | - | ------ | ---- |  | - | ------ | ---- | 
|                                      |                                  |                          
|                                      |                                  | Quarter                  
|                                      |                                  |                          
|                                      |                                  | First                     |        | Second |   | Third |        | Fourth
|                                      |                                  |                           |        |        |   |       |        |       
|                                      |                                  |                          
|                                      |                                  | (In thousands, except per
|                                      |                                  | share amounts)           
|2002                                  |                                  |                           |        |        |   |       |        |        |  |   |        |      |  |   |        |     
|Net revenues                          |                                  | $                         | 45,620 |        |   | $     | 61,447 |        |  | $ | 61,209 |      |  | $ | 62,234 |     
|Gross margin (excluding depreciation) |                                  |                           | 24,270 |        |   |       | 40,356 |        |  |   | 41,435 |      |  |   | 42,991 |     
|Income before extraordinary loss      |                                  |                           | 2,089  |        |   |       | 6,104  |        |  |   | 7,104  |      |  |   | 7,356  |     
|Net income (loss)                     |                                  |                           | (3,250 | )      |   |       | 6,104  |        |  |   | 7,104  |      |  |   | 7,356  |     
|Basic earnings (loss) per share:      |                                  |                           |        |        |   |       |        |        |  |   |        |      |  |   |        |     
|                                      | Income before extraordinary loss |                           | $      | 0.08   |   |       | $      | 0.22   |  |   | $      | 0.26 |  |   | $      | 0.27 | 
|                                      | Net income (loss)                |                           |        | (0.12  | ) |       |        | 0.22   |  |   |        | 0.26 |  |   |        | 0.27 | 
|Diluted earnings (loss)per share:     |                                  |                           |        |        |   |       |        |        |  |   |        |      |  |   |        |     
|                                      | Income before extraordinary loss |                           | $      | 0.07   |   |       | $      | 0.21   |  |   | $      | 0.25 |  |   | $      | 0.26 | 
|                                      | Net income (loss)                |                           |        | (0.11  | ) |       |        | 0.21   |  |   |        | 0.25 |  |   |        | 0.26 | 
|                                     
|2001                                  |                                  |                           |        |        |   |       |        |        |  |   |        |      |  |   |        |     
|Net revenues                          |                                  | $                         | 30,197 |        |   | $     | 29,884 |        |  | $ | 34,908 |      |  | $ | 46,084 |     
|Gross margin (excluding depreciation) |                                  |                           | 15,439 |        |   |       | 15,375 |        |  |   | 17,402 |      |  |   | 25,660 |     
|Net income                            |                                  |                           | 816    |        |   |       | 1,014  |        |  |   | 708    |      |  |   | 3,402  |     
|Basic earnings per share              |                                  | $                         | 0.03   |        |   | $     | 0.04   |        |  | $ | 0.03   |      |  | $ | 0.13   |     
|Diluted earnings per share            |                                  |                           | 0.03   |        |   |       | 0.04   |        |  |   | 0.03   |      |  |   | 0.12   |     

62



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##### 



14. Financial Information for Subsidiary
Guarantors and Non-Guarantors



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | In the first quarter of 2002, the Company issued
    senior subordinated notes which are guaranteed by certain of the
    Companys subsidiaries.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|
| | The following presents condensed consolidating
    financial information for the Company, segregating:
    (1) aaiPharma Inc., which issued the notes (the
    Issuer); (2) the domestic subsidiaries, which
    guarantee the notes (the Guarantor Subsidiaries);
    and (3) all other subsidiaries (the Non-Guarantor
    Subsidiaries). The guarantor subsidiaries are wholly-owned
    direct subsidiaries of the Company and their guarantees are
    full, unconditional and joint and several. Wholly-owned
    subsidiaries are presented on the equity basis of accounting.
    Certain reclassifications have been made to conform all of the
    financial information to the financial presentation on a
    consolidated basis. The principal adjusting entries eliminate
    investments in subsidiaries and intercompany balances and
    transactions.
|
| | The following information presents consolidating
    statements of operations, balance sheets and cash flows for the
    periods and as of the dates indicated:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              

aaiPharma Inc.

CONSOLIDATED STATEMENT OF OPERATIONS

(In thousands)


|                                                             |                                       |                              |        |              |         |              |         |              |         |              |        |        |        |   |         |         |         |   |         |         |         | 
|------------------------------------------------------------ | ------------------------------------- | ---------------------------- | ------ | ------------ | ------- | ------------ | ------- | ------------ | ------- | ------------ | ------ | ------ | ------ | - | ------- | ------- | ------- | - | ------- | ------- | ------- | 
|                                                             |                                       |                             
|                                                             |                                       | Year Ended December 31, 2002
|                                                             |                                       |                             
|                                                             |                                       |                              |        | Non-         |         |             
|                                                             |                                       |                              |        | Guarantor    |         | Guarantor    |         |             
|                                                             |                                       | Issuer                       |        | Subsidiaries |         | Subsidiaries |         | Eliminations |         | Consolidated
|                                                             |                                       |                              |        |              |         |              |         |              |         |             
|Net revenues                                                 |                                       | $                            | 59,973 |              |         | $            | 168,854 |              |         | $            | 16,483 |        |        | $ | (14,800 | )       |         | $ | 230,510 |        
|Equity earnings from subsidiaries                            |                                       |                              | 55,365 |              |         |              |        |              |         |              |       |        |        |   | (55,365 | )       |         |   |        |        
|                                                             |                                       |                              |        |              |         |              |         |              |         |              |        |        |        |   |         |         |         |   |         |        
|                                                             |                                       | Total revenues               |        |              | 115,338 |              |         |              | 168,854 |              |        |        | 16,483 |   |         |         | (70,165 | ) |         |         | 230,510 | 
|                                                             |                                       |                              |        |              |         |              |         |              |         |              |        |        |        |   |         |         |         |   |         |        
|Operating costs and expenses:                                |                                       |                              |        |              |         |              |         |              |         |              |        |        |        |   |         |         |         |   |         |        
|                                                             | Direct costs (excluding depreciation) |                              |        | 39,051       |         |              |         | 46,458       |         |              |        | 10,438 |        |   |         | (14,489 | )       |   |         | 81,458  |        
|                                                             | Selling                               |                              |        | 6,348        |         |              |         | 14,954       |         |              |        | 1,775  |        |   |         |        |         |   |         | 23,077  |        
|                                                             | General and administrative            |                              |        | 27,504       |         |              |         | 8,928        |         |              |        | 3,676  |        |   |         |        |         |   |         | 40,108  |        
|                                                             | Depreciation and amortization         |                              |        | 4,743        |         |              |         | 3,830        |         |              |        | 998    |        |   |         |        |         |   |         | 9,571   |        
|                                                             | Research and development              |                              |        | 732          |         |              |         | 20,122       |         |              |        |       |        |   |         |        |         |   |         | 20,854  |        
|                                                             |                                       |                              |        |              |         |              |         |              |         |              |        |        |        |   |         |         |         |   |         |        
|                                                             |                                       |                              | 78,378 |              |         |              | 94,292  |              |         |              | 16,887 |        |        |   | (14,489 | )       |         |   | 175,068 |        
|                                                             |                                       |                              |        |              |         |              |         |              |         |              |        |        |        |   |         |         |         |   |         |        
|Income (loss) from operations                                |                                       |                              | 36,960 |              |         |              | 74,562  |              |         |              | (404   | )      |        |   | (55,676 | )       |         |   | 55,442  |        
|Other income (expense):                                      |                                       |                              |        |              |         |              |         |              |         |              |        |        |        |   |         |         |         |   |         |        
|                                                             | Interest, net                         |                              |        | (1,774       | )       |              |         | (17,602      | )       |              |        | 10     |        |   |         |        |         |   |         | (19,366 | )      
|                                                             | Net intercompany interest             |                              |        | (2,292       | )       |              |         | 2,494        |         |              |        | (202   | )      |   |         |        |         |   |         |        |        
|                                                             | Other                                 |                              |        | 148          |         |              |         | 12           |         |              |        | 301    |        |   |         |        |         |   |         | 461     |        
|                                                             |                                       |                              |        |              |         |              |         |              |         |              |        |        |        |   |         |         |         |   |         |        
|                                                             |                                       |                              | (3,918 | )            |         |              | (15,096 | )            |         |              | 109    |        |        |   |        |         |         |   | (18,905 | )      
|                                                             |                                       |                              |        |              |         |              |         |              |         |              |        |        |        |   |         |         |         |   |         |        
|Income (loss) before income taxes and
    extraordinary loss |                                       |                              | 33,042 |              |         |              | 59,466  |              |         |              | (295   | )      |        |   | (55,676 | )       |         |   | 36,537  |        
|Provision for income taxes                                   |                                       |                              | 14,079 |              |         |              |        |              |         |              | (195   | )      |        |   |        |         |         |   | 13,884  |        
|                                                             |                                       |                              |        |              |         |              |         |              |         |              |        |        |        |   |         |         |         |   |         |        
|Income (loss) before extraordinary loss                      |                                       |                              | 18,963 |              |         |              | 59,466  |              |         |              | (100   | )      |        |   | (55,676 | )       |         |   | 22,653  |        
|Extraordinary loss                                           |                                       |                              | (1,649 | )            |         |              | (3,690  | )            |         |              |       |        |        |   |        |         |         |   | (5,339  | )      
|                                                             |                                       |                              |        |              |         |              |         |              |         |              |        |        |        |   |         |         |         |   |         |        
|Net income (loss)                                            |                                       | $                            | 17,314 |              |         | $            | 55,776  |              |         | $            | (100   | )      |        | $ | (55,676 | )       |         | $ | 17,314  |        
|                                                             |                                       |                              |        |              |         |              |         |              |         |              |        |        |        |   |         |         |         |   |         |        

63



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##### 



aaiPharma Inc.

CONSOLIDATED STATEMENT OF OPERATIONS

(In thousands)


|                                  |                                       |                              |        |              |   |              |        |              |   |              |        |        |   |   |         |         |   |   |         |         |  
|--------------------------------- | ------------------------------------- | ---------------------------- | ------ | ------------ | - | ------------ | ------ | ------------ | - | ------------ | ------ | ------ | - | - | ------- | ------- | - | - | ------- | ------- | -
|                                  |                                       |                             
|                                  |                                       | Year Ended December 31, 2001
|                                  |                                       |                             
|                                  |                                       |                              |        | Non-         |   |             
|                                  |                                       |                              |        | Guarantor    |   | Guarantor    |        |             
|                                  |                                       | Issuer                       |        | Subsidiaries |   | Subsidiaries |        | Eliminations |   | Consolidated
|                                  |                                       |                              |        |              |   |              |        |              |   |             
|Net revenues                      |                                       | $                            | 57,842 |              |   | $            | 71,622 |              |   | $            | 16,357 |        |   | $ | (4,748  | )       |   | $ | 141,073 |        
|Equity earnings from subsidiaries |                                       |                              | 22,419 |              |   |              |       |              |   |              |       |        |   |   | (22,419 | )       |   |   |        |        
|                                  |                                       |                              |        |              |   |              |        |              |   |              |        |        |   |   |         |         |   |   |         |        
|                                  | Total revenues                        |                              |        | 80,261       |   |              |        | 71,622       |   |              |        | 16,357 |   |   |         | (27,167 | ) |   |         | 141,073 |  
|Operating costs and expenses:     |                                       |                              |        |              |   |              |        |              |   |              |        |        |   |   |         |         |   |   |         |        
|                                  | Direct costs (excluding depreciation) |                              |        | 34,760       |   |              |        | 26,979       |   |              |        | 10,206 |   |   |         | (4,748  | ) |   |         | 67,197  |  
|                                  | Selling                               |                              |        | 7,170        |   |              |        | 5,202        |   |              |        | 1,377  |   |   |         |        |   |   |         | 13,749  |  
|                                  | General and administrative            |                              |        | 18,742       |   |              |        | 4,486        |   |              |        | 3,310  |   |   |         |        |   |   |         | 26,538  |  
|                                  | Depreciation and amortization         |                              |        | 3,661        |   |              |        | 2,764        |   |              |        | 1,330  |   |   |         |        |   |   |         | 7,755   |  
|                                  | Research and development              |                              |        | 1,757        |   |              |        | 8,725        |   |              |        |       |   |   |         |        |   |   |         | 10,482  |  
|                                  | Direct pharmaceutical start-up costs  |                              |        |             |   |              |        | 2,123        |   |              |        |       |   |   |         |        |   |   |         | 2,123   |  
|                                  |                                       |                              |        |              |   |              |        |              |   |              |        |        |   |   |         |         |   |   |         |        
|                                  |                                       |                              | 66,090 |              |   |              | 50,279 |              |   |              | 16,223 |        |   |   | (4,748  | )       |   |   | 127,844 |        
|                                  |                                       |                              |        |              |   |              |        |              |   |              |        |        |   |   |         |         |   |   |         |        
|Income (loss) from operations     |                                       |                              | 14,171 |              |   |              | 21,343 |              |   |              | 134    |        |   |   | (22,419 | )       |   |   | 13,229  |        
|Other income (expense):           |                                       |                              |        |              |   |              |        |              |   |              |        |        |   |   |         |         |   |   |         |        
|                                  | Interest, net                         |                              |        | (1,377       | ) |              |        | (2,123       | ) |              |        | (146   | ) |   |         |        |   |   |         | (3,646  | )
|                                  | Net intercompany interest             |                              |        | (3,621       | ) |              |        | 3,781        |   |              |        | (160   | ) |   |         |        |   |   |         |        |  
|                                  | Other                                 |                              |        | (182         | ) |              |        | (477         | ) |              |        | 215    |   |   |         |        |   |   |         | (444    | )
|                                  |                                       |                              |        |              |   |              |        |              |   |              |        |        |   |   |         |         |   |   |         |        
|                                  |                                       |                              | (5,180 | )            |   |              | 1,181  |              |   |              | (91    | )      |   |   |        |         |   |   | (4,090  | )      
|                                  |                                       |                              |        |              |   |              |        |              |   |              |        |        |   |   |         |         |   |   |         |        
|Income (loss) before income taxes |                                       |                              | 8,991  |              |   |              | 22,524 |              |   |              | 43     |        |   |   | (22,419 | )       |   |   | 9,139   |        
|Provision for income taxes        |                                       |                              | 3,051  |              |   |              | 153    |              |   |              | (5     | )      |   |   |        |         |   |   | 3,199   |        
|                                  |                                       |                              |        |              |   |              |        |              |   |              |        |        |   |   |         |         |   |   |         |        
|Net income (loss)                 |                                       | $                            | 5,940  |              |   | $            | 22,371 |              |   | $            | 48     |        |   | $ | (22,419 | )       |   | $ | 5,940   |        
|                                  |                                       |                              |        |              |   |              |        |              |   |              |        |        |   |   |         |         |   |   |         |        

64



---



##### 



aaiPharma Inc.

CONSOLIDATED STATEMENT OF OPERATIONS

(In thousands)


|                                                                                        |                                       |                              |        |              |   |              |        |              |   |              |        |        |   |   |         |         |   |   |         |         |  
|--------------------------------------------------------------------------------------- | ------------------------------------- | ---------------------------- | ------ | ------------ | - | ------------ | ------ | ------------ | - | ------------ | ------ | ------ | - | - | ------- | ------- | - | - | ------- | ------- | -
|                                                                                        |                                       |                             
|                                                                                        |                                       | Year Ended December 31, 2000
|                                                                                        |                                       |                             
|                                                                                        |                                       |                              |        | Non-         |   |             
|                                                                                        |                                       |                              |        | Guarantor    |   | Guarantor    |        |             
|                                                                                        |                                       | Issuer                       |        | Subsidiaries |   | Subsidiaries |        | Eliminations |   | Consolidated
|                                                                                        |                                       |                              |        |              |   |              |        |              |   |             
|Net revenues                                                                            |                                       | $                            | 59,960 |              |   | $            | 28,119 |              |   | $            | 19,441 |        |   | $ | (3,275  | )       |   | $ | 104,245 |        
|Equity earnings from subsidiaries                                                       |                                       |                              | 12,841 |              |   |              |       |              |   |              |       |        |   |   | (12,841 | )       |   |   |        |        
|                                                                                        |                                       |                              |        |              |   |              |        |              |   |              |        |        |   |   |         |         |   |   |         |        
|                                                                                        | Total revenues                        |                              |        | 72,801       |   |              |        | 28,119       |   |              |        | 19,441 |   |   |         | (16,116 | ) |   |         | 104,245 |  
|Operating costs and expenses:                                                           |                                       |                              |        |              |   |              |        |              |   |              |        |        |   |   |         |         |   |   |         |        
|                                                                                        | Direct costs (excluding depreciation) |                              |        | 26,583       |   |              |        | 16,785       |   |              |        | 7,549  |   |   |         | (3,275  | ) |   |         | 47,642  |  
|                                                                                        | Selling                               |                              |        | 7,855        |   |              |        | 2,380        |   |              |        | 1,417  |   |   |         |        |   |   |         | 11,652  |  
|                                                                                        | General and administrative            |                              |        | 15,266       |   |              |        | 6,591        |   |              |        | 1,916  |   |   |         |        |   |   |         | 23,773  |  
|                                                                                        | Depreciation and amortization         |                              |        | 4,892        |   |              |        | 967          |   |              |        | 1,394  |   |   |         |        |   |   |         | 7,253   |  
|                                                                                        | Research and development              |                              |        | 10,040       |   |              |        | 224          |   |              |        | 1,627  |   |   |         |        |   |   |         | 11,891  |  
|                                                                                        |                                       |                              |        |              |   |              |        |              |   |              |        |        |   |   |         |         |   |   |         |        
|                                                                                        |                                       |                              | 64,636 |              |   |              | 26,947 |              |   |              | 13,903 |        |   |   | (3,275  | )       |   |   | 102,211 |        
|                                                                                        |                                       |                              |        |              |   |              |        |              |   |              |        |        |   |   |         |         |   |   |         |        
|Income (loss) from operations                                                           |                                       |                              | 8,165  |              |   |              | 1,172  |              |   |              | 5,538  |        |   |   | (12,841 | )       |   |   | 2,034   |        
|Other income (expense):                                                                 |                                       |                              |        |              |   |              |        |              |   |              |        |        |   |   |         |         |   |   |         |        
|                                                                                        | Interest, net                         |                              |        | (1,656       | ) |              |        | 19           |   |              |        | (497   | ) |   |         |        |   |   |         | (2,134  | )
|                                                                                        | Net intercompany interest             |                              |        | (6,476       | ) |              |        | 6,476        |   |              |        |       |   |   |         |        |   |   |         |        |  
|                                                                                        | Other                                 |                              |        | 85           |   |              |        | (143         | ) |              |        | 276    |   |   |         |        |   |   |         | 218     |  
|                                                                                        |                                       |                              |        |              |   |              |        |              |   |              |        |        |   |   |         |         |   |   |         |        
|                                                                                        |                                       |                              | (8,047 | )            |   |              | 6,352  |              |   |              | (221   | )      |   |   |        |         |   |   | (1,916  | )      
|                                                                                        |                                       |                              |        |              |   |              |        |              |   |              |        |        |   |   |         |         |   |   |         |        
|Income (loss) before income taxes and cumulative
    effect of accounting change        |                                       |                              | 118    |              |   |              | 7,524  |              |   |              | 5,317  |        |   |   | (12,841 | )       |   |   | 118     |        
|Income tax benefit                                                                      |                                       |                              | (441   | )            |   |              |       |              |   |              |       |        |   |   |        |         |   |   | (441    | )      
|                                                                                        |                                       |                              |        |              |   |              |        |              |   |              |        |        |   |   |         |         |   |   |         |        
|Income (loss) before cumulative effect of
    accounting change                         |                                       |                              | 559    |              |   |              | 7,524  |              |   |              | 5,317  |        |   |   | (12,841 | )       |   |   | 559     |        
|Cumulative effect of a change in accounting
    principle, net of a tax benefit of $495 |                                       |                              | (961   | )            |   |              |       |              |   |              |       |        |   |   |        |         |   |   | (961    | )      
|                                                                                        |                                       |                              |        |              |   |              |        |              |   |              |        |        |   |   |         |         |   |   |         |        
|Net income (loss)                                                                       |                                       | $                            | (402   | )            |   | $            | 7,524  |              |   | $            | 5,317  |        |   | $ | (12,841 | )       |   | $ | (402    | )      
|                                                                                        |                                       |                              |        |              |   |              |        |              |   |              |        |        |   |   |         |         |   |   |         |        

65



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##### 



aaiPharma Inc.

CONSOLIDATED BALANCE SHEET

(In thousands)


|                                            |                                                              |                                            |        |              |         |              |         |              |         |              |       |       |        |  |         |        |         |   |         |        |         | 
|------------------------------------------- | ------------------------------------------------------------ | ------------------------------------------ | ------ | ------------ | ------- | ------------ | ------- | ------------ | ------- | ------------ | ----- | ----- | ------ |  | ------- | ------ | ------- | - | ------- | ------ | ------- | 
|                                            |                                                              |                                           
|                                            |                                                              | December 31, 2002                         
|                                            |                                                              |                                           
|                                            |                                                              |                                            |        | Non-         |         |             
|                                            |                                                              |                                            |        | Guarantor    |         | Guarantor    |         |             
|                                            |                                                              | Issuer                                     |        | Subsidiaries |         | Subsidiaries |         | Eliminations |         | Consolidated
|                                            |                                                              |                                            |        |              |         |              |         |              |         |             
|ASSETS                                      |                                                              |                                            |        |              |         |              |         |              |         |              |       |       |        |  |         |        |         |   |         |       
|Current assets:                             |                                                              |                                            |        |              |         |              |         |              |         |              |       |       |        |  |         |        |         |   |         |       
|                                            | Cash and cash equivalents                                    |                                            | $      | 5,725        |         |              | $       | 180          |         |              | $     | 627   |        |  | $       |       |         |   | $       | 6,532  |        
|                                            | Accounts receivable, net                                     |                                            |        | 10,104       |         |              |         | 16,758       |         |              |       | 2,605 |        |  |         |       |         |   |         | 29,467 |        
|                                            | Work-in-progress                                             |                                            |        | 4,135        |         |              |         | 2,951        |         |              |       | 4,568 |        |  |         | (1,139 | )       |   |         | 10,515 |        
|                                            | Inventories                                                  |                                            |        | 5,504        |         |              |         | 11,114       |         |              |       | 697   |        |  |         | (311   | )       |   |         | 17,004 |        
|                                            | Prepaid and other current assets                             |                                            |        | 3,782        |         |              |         | 3,642        |         |              |       | 209   |        |  |         |       |         |   |         | 7,633  |        
|                                            |                                                              |                                            |        |              |         |              |         |              |         |              |       |       |        |  |         |        |         |   |         |       
|                                            |                                                              | Total current assets                       |        |              | 29,250  |              |         |              | 34,645  |              |       |       | 8,706  |  |         |        | (1,450  | ) |         |        | 71,151  | 
|Investments in and advances to subsidiaries |                                                              |                                            | 66,061 |              |         |              | (46,202 | )            |         |              |      |       |        |  | (19,859 | )      |         |   |        |       
|Property and equipment, net                 |                                                              |                                            | 42,055 |              |         |              | 7,070   |              |         |              | 4,000 |       |        |  |        |        |         |   | 53,125  |       
|Goodwill, net                               |                                                              |                                            | 624    |              |         |              | 200,644 |              |         |              | 9,524 |       |        |  |        |        |         |   | 210,792 |       
|Intangibles, net                            |                                                              |                                            | 952    |              |         |              | 88,126  |              |         |              |      |       |        |  |        |        |         |   | 89,078  |       
|Other assets                                |                                                              |                                            | 4,514  |              |         |              | 11,569  |              |         |              | 96    |       |        |  |        |        |         |   | 16,179  |       
|                                            |                                                              |                                            |        |              |         |              |         |              |         |              |       |       |        |  |         |        |         |   |         |       
|                                            |                                                              | Total assets                               |        | $            | 143,456 |              |         | $            | 295,852 |              |       | $     | 22,326 |  |         | $      | (21,309 | ) |         | $      | 440,325 | 
|                                            |                                                              |                                            |        |              |         |              |         |              |         |              |       |       |        |  |         |        |         |   |         |       
|LIABILITIES AND STOCKHOLDERS
    EQUITY   
|Current liabilities:                        |                                                              |                                            |        |              |         |              |         |              |         |              |       |       |        |  |         |        |         |   |         |       
|                                            | Current maturities of long-term debt and
    short-term debt |                                            | $      |             |         |              | $       | 5,921        |         |              | $     |      |        |  | $       |       |         |   | $       | 5,921  |        
|                                            | Accounts payable                                             |                                            |        | 4,410        |         |              |         | 11,447       |         |              |       | 1,814 |        |  |         |       |         |   |         | 17,671 |        
|                                            | Customer advances                                            |                                            |        | 7,840        |         |              |         | 5,731        |         |              |       | 2,618 |        |  |         | (1,138 | )       |   |         | 15,051 |        
|                                            | Accrued wages and benefits                                   |                                            |        | 4,922        |         |              |         | 929          |         |              |       | 867   |        |  |         |       |         |   |         | 6,718  |        
|                                            | Interest payable                                             |                                            |        | 285          |         |              |         | 4,947        |         |              |       |      |        |  |         |       |         |   |         | 5,232  |        
|                                            | Other accrued liabilities                                    |                                            |        | 1,244        |         |              |         | 3,379        |         |              |       | (77   | )      |  |         | 655    |         |   |         | 5,201  |        
|                                            |                                                              |                                            |        |              |         |              |         |              |         |              |       |       |        |  |         |        |         |   |         |       
|                                            |                                                              | Total current liabilities                  |        |              | 18,701  |              |         |              | 32,354  |              |       |       | 5,222  |  |         |        | (483    | ) |         |        | 55,794  | 
|Long-term debt, less current portion        |                                                              |                                            | 47,500 |              |         |              | 230,399 |              |         |              |      |       |        |  |        |        |         |   | 277,899 |       
|Other liabilities                           |                                                              |                                            | 7,182  |              |         |              |        |              |         |              |      |       |        |  |        |        |         |   | 7,182   |       
|Investments in and advances to subsidiaries |                                                              |                                            | 68,171 |              |         |              | (72,500 | )            |         |              | 4,984 |       |        |  | (655    | )      |         |   |        |       
|                                            |                                                              | Total stockholders equity                 |        |              | 1,902   |              |         |              | 105,599 |              |       |       | 12,120 |  |         |        | (20,171 | ) |         |        | 99,450  | 
|                                            |                                                              |                                            |        |              |         |              |         |              |         |              |       |       |        |  |         |        |         |   |         |       
|                                            |                                                              | Total liabilities and stockholders equity |        | $            | 143,456 |              |         | $            | 295,852 |              |       | $     | 22,326 |  |         | $      | (21,309 | ) |         | $      | 440,325 | 
|                                            |                                                              |                                            |        |              |         |              |         |              |         |              |       |       |        |  |         |        |         |   |         |       

66



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##### 



aaiPharma Inc.

CONSOLIDATED BALANCE SHEET

(In thousands)


|                                            |                                                              |                                            |        |              |         |              |         |              |        |              |       |       |        |  |         |        |         |   |        |        |         | 
|------------------------------------------- | ------------------------------------------------------------ | ------------------------------------------ | ------ | ------------ | ------- | ------------ | ------- | ------------ | ------ | ------------ | ----- | ----- | ------ |  | ------- | ------ | ------- | - | ------ | ------ | ------- | 
|                                            |                                                              |                                           
|                                            |                                                              | December 31, 2001                         
|                                            |                                                              |                                           
|                                            |                                                              |                                            |        | Non-         |         |             
|                                            |                                                              |                                            |        | Guarantor    |         | Guarantor    |         |             
|                                            |                                                              | Issuer                                     |        | Subsidiaries |         | Subsidiaries |         | Eliminations |        | Consolidated
|                                            |                                                              |                                            |        |              |         |              |         |              |        |             
|ASSETS                                      |                                                              |                                            |        |              |         |              |         |              |        |              |       |       |        |  |         |        |         |   |        |       
|Current assets:                             |                                                              |                                            |        |              |         |              |         |              |        |              |       |       |        |  |         |        |         |   |        |       
|                                            | Cash and cash equivalents                                    |                                            | $      | 5,301        |         |              | $       | 154          |        |              | $     | 916   |        |  | $       |       |         |   | $      | 6,371  |        
|                                            | Accounts receivable, net                                     |                                            |        | 13,189       |         |              |         | 8,415        |        |              |       | 2,690 |        |  |         | 2,300  |         |   |        | 26,594 |        
|                                            | Work-in-progress                                             |                                            |        | 3,871        |         |              |         | 5,099        |        |              |       | 3,794 |        |  |         | (2,300 | )       |   |        | 10,464 |        
|                                            | Inventories                                                  |                                            |        | 2,955        |         |              |         | 5,584        |        |              |       | 518   |        |  |         |       |         |   |        | 9,057  |        
|                                            | Prepaid and other current assets                             |                                            |        | 3,081        |         |              |         | 2,640        |        |              |       | 251   |        |  |         |       |         |   |        | 5,972  |        
|                                            |                                                              |                                            |        |              |         |              |         |              |        |              |       |       |        |  |         |        |         |   |        |       
|                                            |                                                              | Total current assets                       |        |              | 28,397  |              |         |              | 21,892 |              |       |       | 8,169  |  |         |        |        |   |        |        | 58,458  | 
|Investments in and advances to subsidiaries |                                                              |                                            | 66,061 |              |         |              | (46,202 | )            |        |              |      |       |        |  | (19,859 | )      |         |   |       |       
|Property and equipment, net                 |                                                              |                                            | 27,724 |              |         |              | 5,841   |              |        |              | 3,470 |       |        |  |        |        |         |   | 37,035 |       
|Goodwill, net                               |                                                              |                                            | 335    |              |         |              | 40,995  |              |        |              | 8,050 |       |        |  |        |        |         |   | 49,380 |       
|Intangibles, net                            |                                                              |                                            | 736    |              |         |              | 38,388  |              |        |              |      |       |        |  |        |        |         |   | 39,124 |       
|Other assets                                |                                                              |                                            | 7,372  |              |         |              | 4,836   |              |        |              | 81    |       |        |  |        |        |         |   | 12,289 |       
|                                            |                                                              |                                            |        |              |         |              |         |              |        |              |       |       |        |  |         |        |         |   |        |       
|                                            |                                                              | Total assets                               |        | $            | 130,625 |              |         | $            | 65,750 |              |       | $     | 19,770 |  |         | $      | (19,859 | ) |        | $      | 196,286 | 
|                                            |                                                              |                                            |        |              |         |              |         |              |        |              |       |       |        |  |         |        |         |   |        |       
|LIABILITIES AND STOCKHOLDERS
    EQUITY   
|Current liabilities:                        |                                                              |                                            |        |              |         |              |         |              |        |              |       |       |        |  |         |        |         |   |        |       
|                                            | Current maturities of long-term debt and
    short-term debt |                                            | $      |             |         |              | $       | 14           |        |              | $     |      |        |  | $       | (14    | )       |   | $      |       |        
|                                            | Accounts payable                                             |                                            |        | 3,626        |         |              |         | 10,236       |        |              |       | 1,582 |        |  |         |       |         |   |        | 15,444 |        
|                                            | Customer advances                                            |                                            |        | 3,883        |         |              |         | 6,874        |        |              |       | 2,592 |        |  |         |       |         |   |        | 13,349 |        
|                                            | Accrued wages and benefits                                   |                                            |        | 2,040        |         |              |         | 958          |        |              |       | 881   |        |  |         |       |         |   |        | 3,879  |        
|                                            | Interest payable                                             |                                            |        |             |         |              |         | 371          |        |              |       |      |        |  |         |       |         |   |        | 371    |        
|                                            | Other accrued liabilities                                    |                                            |        | 2,821        |         |              |         | 2,201        |        |              |       | 302   |        |  |         | (402   | )       |   |        | 4,922  |        
|                                            |                                                              | Total current liabilities                  |        |              | 12,370  |              |         |              | 20,654 |              |       |       | 5,357  |  |         |        | (416    | ) |        |        | 37,965  | 
|Long-term debt, less current portion        |                                                              |                                            |       |              |         |              | 78,878  |              |        |              |      |       |        |  |        |        |         |   | 78,878 |       
|Other liabilities                           |                                                              |                                            | 224    |              |         |              |        |              |        |              |      |       |        |  |        |        |         |   | 224    |       
|Investments in and advances to subsidiaries |                                                              |                                            | 79,157 |              |         |              | (83,625 | )            |        |              | 4,052 |       |        |  | 416     |        |         |   |       |       
|Redeemable warrants                         |                                                              |                                            | 2,855  |              |         |              |        |              |        |              |      |       |        |  |        |        |         |   | 2,855  |       
|                                            |                                                              | Total stockholders equity                 |        |              | 36,019  |              |         |              | 49,843 |              |       |       | 10,361 |  |         |        | (19,859 | ) |        |        | 76,364  | 
|                                            |                                                              |                                            |        |              |         |              |         |              |        |              |       |       |        |  |         |        |         |   |        |       
|                                            |                                                              | Total liabilities and stockholders equity |        | $            | 130,625 |              |         | $            | 65,750 |              |       | $     | 19,770 |  |         | $      | (19,859 | ) |        | $      | 196,286 | 
|                                            |                                                              |                                            |        |              |         |              |         |              |        |              |       |       |        |  |         |        |         |   |        |       

67



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##### 



aaiPharma Inc.

CONSOLIDATED STATEMENT OF CASH FLOWS

(In thousands)


|                                                        |                                                                                                                                  |                                                              |         |              |         |              |          |              |         |              |        |        |        |   |     |         |        |   |          |          |         |  
|------------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------ | ------- | ------------ | ------- | ------------ | -------- | ------------ | ------- | ------------ | ------ | ------ | ------ | - | --- | ------- | ------ | - | -------- | -------- | ------- | -
|                                                        |                                                                                                                                  |                                                             
|                                                        |                                                                                                                                  | Year Ended December 31, 2002                                
|                                                        |                                                                                                                                  |                                                             
|                                                        |                                                                                                                                  |                                                              |         | Non-         |         |             
|                                                        |                                                                                                                                  |                                                              |         | Guarantor    |         | Guarantor    |          |             
|                                                        |                                                                                                                                  | Issuer                                                       |         | Subsidiaries |         | Subsidiaries |          | Eliminations |         | Consolidated
|                                                        |                                                                                                                                  |                                                              |         |              |         |              |          |              |         |             
|Cash flows from operating activities:                   |                                                                                                                                  |                                                              |         |              |         |              |          |              |         |              |        |        |        |   |     |         |        |   |          |         
|                                                        | Income (loss) before extraordinary loss                                                                                          |                                                              | $       | 18,963       |         |              | $        | 59,466       |         |              | $      | (100   | )      |   | $   | (55,676 | )      |   | $        | 22,653   |        
|                                                        | Adjustments to reconcile income
    (loss) before extraordinary loss to net cash provided by
    (used in) operating activities: |                                                              |         |              |         |              |          |              |         |              |        |        |        |   |     |         |        |   |          |          |        
|                                                        |                                                                                                                                  | Depreciation and amortization                                |         |              | 4,743   |              |          |              | 3,830   |              |        |        | 998    |   |     |         |       |   |          |          | 9,571   |  
|                                                        |                                                                                                                                  | Other                                                        |         |              | (9      | )            |          |              | (432    | )            |        |        | 586    |   |     |         |       |   |          |          | 145     |  
|                                                        | Changes in operating assets and liabilities:                                                                                     |                                                              |         |              |         |              |          |              |         |              |        |        |        |   |     |         |        |   |          |          |        
|                                                        |                                                                                                                                  | Trade and other receivables                                  |         |              | 3,085   |              |          |              | (8,342  | )            |        |        | 577    |   |     |         | 2,300  |   |          |          | (2,380  | )
|                                                        |                                                                                                                                  | Work-in-progress                                             |         |              | (264    | )            |          |              | 2,148   |              |        |        | (80    | ) |     |         | (1,161 | ) |          |          | 643     |  
|                                                        |                                                                                                                                  | Inventories                                                  |         |              | (2,549  | )            |          |              | (5,530  | )            |        |        | (85    | ) |     |         | 311    |   |          |          | (7,853  | )
|                                                        |                                                                                                                                  | Prepaid and other assets                                     |         |              | 2,158   |              |          |              | (13,006 | )            |        |        | 87     |   |     |         |       |   |          |          | (10,761 | )
|                                                        |                                                                                                                                  | Accounts payable                                             |         |              | 783     |              |          |              | 1,211   |              |        |        | (57    | ) |     |         |       |   |          |          | 1,937   |  
|                                                        |                                                                                                                                  | Customer advances                                            |         |              | 3,957   |              |          |              | (1,143  | )            |        |        | (449   | ) |     |         | (1,138 | ) |          |          | 1,227   |  
|                                                        |                                                                                                                                  | Interest payable                                             |         |              | 284     |              |          |              | 4,577   |              |        |        |       |   |     |         |       |   |          |          | 4,861   |  
|                                                        |                                                                                                                                  | Accrued wages and benefits and other accrued
    liabilities |         |              | 5,406   |              |          |              | 2,952   |              |        |        | (1,348 | ) |     |         | 1,056  |   |          |          | 8,066   |  
|                                                        |                                                                                                                                  | Intercompany receivables and payables                        |         |              | (68,000 | )            |          |              | 12,771  |              |        |        | 935    |   |     |         | 54,294 |   |          |          |        |  
|                                                        |                                                                                                                                  |                                                              |         |              |         |              |          |              |         |              |        |        |        |   |     |         |        |   |          |         
|Net cash (used in) provided by operating
    activities |                                                                                                                                  |                                                              | (31,443 | )            |         |              | 58,502   |              |         |              | 1,064  |        |        |   | (14 | )       |        |   | 28,109   |         
|                                                        |                                                                                                                                  |                                                              |         |              |         |              |          |              |         |              |        |        |        |   |     |         |        |   |          |         
|Cash flows from investing activities:                   |                                                                                                                                  |                                                              |         |              |         |              |          |              |         |              |        |        |        |   |     |         |        |   |          |         
|                                                        | Purchases of property and equipment                                                                                              |                                                              |         | (4,909       | )       |              |          | (2,070       | )       |              |        | (1,550 | )      |   |     |        |        |   |          | (8,529   | )      
|                                                        | Purchases of property and equipment previously
    leased                                                                        |                                                              |         | (14,145      | )       |              |          |             |         |              |        |       |        |   |     |        |        |   |          | (14,145  | )      
|                                                        | Proceeds from sales of property and equipment                                                                                    |                                                              |         | 127          |         |              |          | 4            |         |              |        |       |        |   |     |        |        |   |          | 131      |        
|                                                        | Acquisitions                                                                                                                     |                                                              |         |             |         |              |          | (211,997     | )       |              |        |       |        |   |     |        |        |   |          | (211,997 | )      
|                                                        | Other                                                                                                                            |                                                              |         | (642         | )       |              |          | 49           |         |              |        |       |        |   |     |        |        |   |          | (593     | )      
|                                                        |                                                                                                                                  |                                                              |         |              |         |              |          |              |         |              |        |        |        |   |     |         |        |   |          |         
|Net cash used in investing activities                   |                                                                                                                                  |                                                              | (19,569 | )            |         |              | (214,014 | )            |         |              | (1,550 | )      |        |   |    |         |        |   | (235,133 | )       
|                                                        |                                                                                                                                  |                                                              |         |              |         |              |          |              |         |              |        |        |        |   |     |         |        |   |          |         
|Cash flows from financing activities:                   |                                                                                                                                  |                                                              |         |              |         |              |          |              |         |              |        |        |        |   |     |         |        |   |          |         
|                                                        | Proceeds from long-term borrowings                                                                                               |                                                              |         | 49,401       |         |              |          | 195,085      |         |              |        |       |        |   |     |        |        |   |          | 244,486  |        
|                                                        | Payments on long-term borrowings                                                                                                 |                                                              |         | (1,900       | )       |              |          | (50,014      | )       |              |        |       |        |   |     | 14      |        |   |          | (51,900  | )      
|                                                        | Proceeds from interest rate swap                                                                                                 |                                                              |         |             |         |              |          | 10,486       |         |              |        |       |        |   |     |        |        |   |          | 10,486   |        

68



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##### 



|                                                         |                          |                              |        |              |  |              |         |              |   |              |      |    |  |   |    |   |  |   |         |       | 
|-------------------------------------------------------- | ------------------------ | ---------------------------- | ------ | ------------ |  | ------------ | ------- | ------------ | - | ------------ | ---- | -- |  | - | -- | - |  | - | ------- | ----- | 
|                                                         |                          |                             
|                                                         |                          | Year Ended December 31, 2002
|                                                         |                          |                             
|                                                         |                          |                              |        | Non-         |  |             
|                                                         |                          |                              |        | Guarantor    |  | Guarantor    |         |             
|                                                         |                          | Issuer                       |        | Subsidiaries |  | Subsidiaries |         | Eliminations |   | Consolidated
|                                                         |                          |                              |        |              |  |              |         |              |   |             
|                                                         | Issuance of common stock |                              |        | 3,243        |  |              |         |             |   |              |      |   |  |   |    |  |  |   |         | 3,243 | 
|                                                         | Other                    |                              |        | 692          |  |              |         | (19          | ) |              |      | 29 |  |   |    |  |  |   |         | 702   | 
|                                                         |                          |                              |        |              |  |              |         |              |   |              |      |    |  |   |    |   |  |   |         |      
|Net cash provided by financing activities                |                          |                              | 51,436 |              |  |              | 155,538 |              |   |              | 29   |    |  |   | 14 |   |  |   | 207,017 |      
|                                                         |                          |                              |        |              |  |              |         |              |   |              |      |    |  |   |    |   |  |   |         |      
|Net increase (decrease) in cash and cash
    equivalents |                          |                              | 424    |              |  |              | 26      |              |   |              | (457 | )  |  |   |   |   |  |   | (7      | )    
|Effect of exchange rate changes on cash                  |                          |                              |       |              |  |              |        |              |   |              | 168  |    |  |   |   |   |  |   | 168     |      
|Cash and cash equivalents, beginning of period           |                          |                              | 5,301  |              |  |              | 154     |              |   |              | 916  |    |  |   |   |   |  |   | 6,371   |      
|                                                         |                          |                              |        |              |  |              |         |              |   |              |      |    |  |   |    |   |  |   |         |      
|Cash and cash equivalents, end of period                 |                          | $                            | 5,725  |              |  | $            | 180     |              |   | $            | 627  |    |  | $ |   |   |  | $ | 6,532   |      
|                                                         |                          |                              |        |              |  |              |         |              |   |              |      |    |  |   |    |   |  |   |         |      

69



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##### 



aaiPharma Inc.

CONSOLIDATED STATEMENT OF CASH FLOWS

(In thousands)


|                                                        |                                                                                              |                                                              |         |              |        |              |         |              |         |              |        |        |       |   |     |         |        |   |         |         |        |  
|------------------------------------------------------- | -------------------------------------------------------------------------------------------- | ------------------------------------------------------------ | ------- | ------------ | ------ | ------------ | ------- | ------------ | ------- | ------------ | ------ | ------ | ----- | - | --- | ------- | ------ | - | ------- | ------- | ------ | -
|                                                        |                                                                                              |                                                             
|                                                        |                                                                                              | Year Ended December 31, 2001                                
|                                                        |                                                                                              |                                                             
|                                                        |                                                                                              |                                                              |         | Non-         |        |             
|                                                        |                                                                                              |                                                              |         | Guarantor    |        | Guarantor    |         |             
|                                                        |                                                                                              | Issuer                                                       |         | Subsidiaries |        | Subsidiaries |         | Eliminations |         | Consolidated
|                                                        |                                                                                              |                                                              |         |              |        |              |         |              |         |             
|Cash flows from operating activities:                   |                                                                                              |                                                              |         |              |        |              |         |              |         |              |        |        |       |   |     |         |        |   |         |        
|                                                        | Net income (loss)                                                                            |                                                              | $       | 5,940        |        |              | $       | 22,371       |         |              | $      | 48     |       |   | $   | (22,419 | )      |   | $       | 5,940   |       
|                                                        | Adjustments to reconcile net income
    (loss) to net cash provided by operating activities: |                                                              |         |              |        |              |         |              |         |              |        |        |       |   |     |         |        |   |         |         |       
|                                                        |                                                                                              | Depreciation and amortization                                |         |              | 3,661  |              |         |              | 2,764   |              |        |        | 1,330 |   |     |         |       |   |         |         | 7,755  |  
|                                                        |                                                                                              | Other                                                        |         |              | 449    |              |         |              | 458     |              |        |        | 358   |   |     |         |       |   |         |         | 1,265  |  
|                                                        | Changes in operating assets and liabilities:                                                 |                                                              |         |              |        |              |         |              |         |              |        |        |       |   |     |         |        |   |         |         |       
|                                                        |                                                                                              | Trade and other receivables                                  |         |              | 4,238  |              |         |              | (6,559  | )            |        |        | (791  | ) |     |         |       |   |         |         | (3,112 | )
|                                                        |                                                                                              | Work-in-progress                                             |         |              | 4,358  |              |         |              | (192    | )            |        |        | 2,336 |   |     |         |       |   |         |         | 6,502  |  
|                                                        |                                                                                              | Inventories                                                  |         |              | (30    | )            |         |              | (5,519  | )            |        |        | 97    |   |     |         |       |   |         |         | (5,452 | )
|                                                        |                                                                                              | Prepaid and other assets                                     |         |              | 3,380  |              |         |              | (5,485  | )            |        |        | (127  | ) |     |         |       |   |         |         | (2,232 | )
|                                                        |                                                                                              | Accounts payable                                             |         |              | (430   | )            |         |              | 6,828   |              |        |        | 275   |   |     |         |       |   |         |         | 6,673  |  
|                                                        |                                                                                              | Customer advances                                            |         |              | 890    |              |         |              | (406    | )            |        |        | 1,038 |   |     |         |       |   |         |         | 1,522  |  
|                                                        |                                                                                              | Interest payable                                             |         |              | (144   | )            |         |              | 371     |              |        |        |      |   |     |         |       |   |         |         | 227    |  
|                                                        |                                                                                              | Accrued wages and benefits and other accrued
    liabilities |         |              | 212    |              |         |              | 1,465   |              |        |        | (12   | ) |     |         | (402   | ) |         |         | 1,263  |  
|                                                        |                                                                                              | Intercompany receivables and payables                        |         |              | (9,099 | )            |         |              | (12,917 | )            |        |        | (819  | ) |     |         | 22,835 |   |         |         |       |  
|                                                        |                                                                                              |                                                              |         |              |        |              |         |              |         |              |        |        |       |   |     |         |        |   |         |        
|Net cash provided by operating activities               |                                                                                              |                                                              | 13,425  |              |        |              | 3,179   |              |         |              | 3,733  |        |       |   | 14  |         |        |   | 20,351  |        
|                                                        |                                                                                              |                                                              |         |              |        |              |         |              |         |              |        |        |       |   |     |         |        |   |         |        
|Cash flows from investing activities:                   |                                                                                              |                                                              |         |              |        |              |         |              |         |              |        |        |       |   |     |         |        |   |         |        
|                                                        | Purchases of property and equipment                                                          |                                                              |         | (174         | )      |              |         | (4,821       | )       |              |        | (1,320 | )     |   |     |        |        |   |         | (6,315  | )     
|                                                        | Proceeds from sales of property and equipment                                                |                                                              |         | 2,792        |        |              |         | 645          |         |              |        | 76     |       |   |     |        |        |   |         | 3,513   |       
|                                                        | Acquisitions                                                                                 |                                                              |         | (983         | )      |              |         | (78,117      | )       |              |        |       |       |   |     |        |        |   |         | (79,100 | )     
|                                                        | Other                                                                                        |                                                              |         | 151          |        |              |         |             |         |              |        |       |       |   |     |        |        |   |         | 151     |       
|                                                        |                                                                                              |                                                              |         |              |        |              |         |              |         |              |        |        |       |   |     |         |        |   |         |        
|Net cash provided by (used in) investing
    activities |                                                                                              |                                                              | 1,786   |              |        |              | (82,293 | )            |         |              | (1,244 | )      |       |   |    |         |        |   | (81,751 | )      
|                                                        |                                                                                              |                                                              |         |              |        |              |         |              |         |              |        |        |       |   |     |         |        |   |         |        
|Cash flows from financing activities:                   |                                                                                              |                                                              |         |              |        |              |         |              |         |              |        |        |       |   |     |         |        |   |         |        
|                                                        | Net payments on short-term debt                                                              |                                                              |         | (14,653      | )      |              |         |             |         |              |        | (1,619 | )     |   |     |        |        |   |         | (16,272 | )     
|                                                        | Proceeds from long-term borrowings                                                           |                                                              |         |             |        |              |         | 78,878       |         |              |        |       |       |   |     |        |        |   |         | 78,878  |       
|                                                        | Payments on long-term borrowings                                                             |                                                              |         | (952         | )      |              |         | (58          | )       |              |        |       |       |   |     | (14     | )      |   |         | (1,024  | )     
|                                                        | Issuance of common stock                                                                     |                                                              |         | 5,123        |        |              |         |             |         |              |        |       |       |   |     |        |        |   |         | 5,123   |       
|                                                        | Other                                                                                        |                                                              |         | (67          | )      |              |         | (49          | )       |              |        | (36    | )     |   |     |        |        |   |         | (152    | )     
|                                                        |                                                                                              |                                                              |         |              |        |              |         |              |         |              |        |        |       |   |     |         |        |   |         |        
|Net cash (used in) provided by financing
    activities |                                                                                              |                                                              | (10,549 | )            |        |              | 78,771  |              |         |              | (1,655 | )      |       |   | (14 | )       |        |   | 66,553  |        

70



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##### 



|                                                         |  |                              |       |              |  |              |      |              |  |              |     |   |  |   |   |  |  |   |       |  
|-------------------------------------------------------- |  | ---------------------------- | ----- | ------------ |  | ------------ | ---- | ------------ |  | ------------ | --- | - |  | - | - |  |  | - | ----- | -
|                                                         |  |                             
|                                                         |  | Year Ended December 31, 2001
|                                                         |  |                             
|                                                         |  |                              |       | Non-         |  |             
|                                                         |  |                              |       | Guarantor    |  | Guarantor    |      |             
|                                                         |  | Issuer                       |       | Subsidiaries |  | Subsidiaries |      | Eliminations |  | Consolidated
|                                                         |  |                              |       |              |  |              |      |              |  |             
|                                                         |  |                              |       |              |  |              |      |              |  |              |     |   |  |   |   |  |  |   |       |  
|Net increase (decrease) in cash and cash
    equivalents |  |                              | 4,662 |              |  |              | (343 | )            |  |              | 834 |   |  |   |  |  |  |   | 5,153 |  
|Effect of exchange rate changes on cash                  |  |                              |      |              |  |              |     |              |  |              | (7  | ) |  |   |  |  |  |   | (7    | )
|Cash and cash equivalents, beginning of year             |  |                              | 639   |              |  |              | 497  |              |  |              | 89  |   |  |   |  |  |  |   | 1,225 |  
|                                                         |  |                              |       |              |  |              |      |              |  |              |     |   |  |   |   |  |  |   |       |  
|Cash and cash equivalents, end of year                   |  | $                            | 5,301 |              |  | $            | 154  |              |  | $            | 916 |   |  | $ |  |  |  | $ | 6,371 |  
|                                                         |  |                              |       |              |  |              |      |              |  |              |     |   |  |   |   |  |  |   |       |  

71



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##### 



aaiPharma Inc.

CONSOLIDATED STATEMENT OF CASH FLOWS

(In thousands)


|                                             |                                                                                              |                                              |                                                              |              |       |              |        |              |     |              |        |        |       |        |   |         |   |        |         |         |       |        |  
|-------------------------------------------- | -------------------------------------------------------------------------------------------- | -------------------------------------------- | ------------------------------------------------------------ | ------------ | ----- | ------------ | ------ | ------------ | --- | ------------ | ------ | ------ | ----- | ------ | - | ------- | - | ------ | ------- | ------- | ----- | ------ | -
|                                             |                                                                                              |                                             
|                                             |                                                                                              | Year Ended December 31, 2000                
|                                             |                                                                                              |                                             
|                                             |                                                                                              |                                              |                                                              | Non-         |       |             
|                                             |                                                                                              |                                              |                                                              | Guarantor    |       | Guarantor    |        |             
|                                             |                                                                                              | Issuer                                       |                                                              | Subsidiaries |       | Subsidiaries |        | Eliminations |     | Consolidated
|                                             |                                                                                              |                                              |                                                              |              |       |              |        |              |     |             
|Cash flows from operating activities:        |                                                                                              |                                              |                                                              |              |       |              |        |              |     |              |        |        |       |        |   |         |   |        |         |        
|                                             | Net income (loss)                                                                            |                                              | $                                                            | 559          |       |              | $      | 7,524        |     |              | $      | 5,317  |       |        | $ | (12,841 | ) |        | $       | 559     |      
|                                             | Adjustments to reconcile net income
    (loss) to net cash provided by operating activities: |                                              |                                                              |              |       |              |        |              |     |              |        |        |       |        |   |         |   |        |         |         |      
|                                             |                                                                                              | Depreciation and amortization                |                                                              |              | 4,892 |              |        |              | 967 |              |        |        | 1,394 |        |   |         |  |        |         |         | 7,253 |       
|                                             |                                                                                              | Other                                        |                                                              |              | 228   |              |        |              | 303 |              |        |        | (68   | )      |   |         |  |        |         |         | 463   |       
|                                             |                                                                                              | Changes in operating assets and liabilities: |                                                              |              |       |              |        |              |     |              |        |        |       |        |   |         |   |        |         |         |       |       
|                                             |                                                                                              |                                              | Trade and other receivables                                  |              |       | 7,287        |        |              |     | 2,838        |        |        |       | (3,407 | ) |         |   |       |         |         |       | 6,718  |  
|                                             |                                                                                              |                                              | Work-in-progress                                             |              |       | (952         | )      |              |     | (1,548       | )      |        |       | 2,200  |   |         |   |       |         |         |       | (300   | )
|                                             |                                                                                              |                                              | Inventories                                                  |              |       | (1,723       | )      |              |     | (16          | )      |        |       | (200   | ) |         |   |       |         |         |       | (1,939 | )
|                                             |                                                                                              |                                              | Prepaid and other assets                                     |              |       | 306          |        |              |     | 944          |        |        |       | 182    |   |         |   |       |         |         |       | 1,432  |  
|                                             |                                                                                              |                                              | Accounts payable                                             |              |       | 894          |        |              |     | 823          |        |        |       | 247    |   |         |   |       |         |         |       | 1,964  |  
|                                             |                                                                                              |                                              | Customer advances                                            |              |       | 2,038        |        |              |     | 1,577        |        |        |       | (672   | ) |         |   |       |         |         |       | 2,943  |  
|                                             |                                                                                              |                                              | Interest payable                                             |              |       | (4           | )      |              |     |             |        |        |       |       |   |         |   |       |         |         |       | (4     | )
|                                             |                                                                                              |                                              | Accrued wages and benefits and other accrued
    liabilities |              |       | (1,523       | )      |              |     | (1,617       | )      |        |       | (1,245 | ) |         |   |       |         |         |       | (4,385 | )
|                                             |                                                                                              |                                              | Intercompany receivables and payables                        |              |       | (5,307       | )      |              |     | (10,245      | )      |        |       | 2,711  |   |         |   | 12,841 |         |         |       |       |  
|                                             |                                                                                              |                                              |                                                              |              |       |              |        |              |     |              |        |        |       |        |   |         |   |        |         |        
|Net cash provided by operating activities    |                                                                                              |                                              | 6,695                                                        |              |       |              | 1,550  |              |     |              | 6,459  |        |       |        |  |         |   |        | 14,704  |        
|                                             |                                                                                              |                                              |                                                              |              |       |              |        |              |     |              |        |        |       |        |   |         |   |        |         |        
|Cash flows from investing activities:        |                                                                                              |                                              |                                                              |              |       |              |        |              |     |              |        |        |       |        |   |         |   |        |         |        
|                                             | Purchases of property and equipment                                                          |                                              |                                                              | (2,114       | )     |              |        | (1,501       | )   |              |        | (971   | )     |        |   |        |   |        |         | (4,586  | )    
|                                             | Proceeds from sales of property and equipment                                                |                                              |                                                              |             |       |              |        | 18           |     |              |        | 289    |       |        |   |        |   |        |         | 307     |      
|                                             | Other                                                                                        |                                              |                                                              | (258         | )     |              |        |             |     |              |        | 592    |       |        |   |        |   |        |         | 334     |      
|                                             |                                                                                              |                                              |                                                              |              |       |              |        |              |     |              |        |        |       |        |   |         |   |        |         |        
|Net cash used in investing activities        |                                                                                              |                                              | (2,372                                                       | )            |       |              | (1,483 | )            |     |              | (90    | )      |       |        |  |         |   |        | (3,945  | )      
|                                             |                                                                                              |                                              |                                                              |              |       |              |        |              |     |              |        |        |       |        |   |         |   |        |         |        
|Cash flows from financing activities:        |                                                                                              |                                              |                                                              |              |       |              |        |              |     |              |        |        |       |        |   |         |   |        |         |        
|                                             | Net payments on short-term debt                                                              |                                              |                                                              | (4,075       | )     |              |        |             |     |              |        | (6,580 | )     |        |   |        |   |        |         | (10,655 | )    
|                                             | Payments on long-term borrowings                                                             |                                              |                                                              | (610         | )     |              |        | (63          | )   |              |        |       |       |        |   |        |   |        |         | (673    | )    
|                                             | Issuance of common stock                                                                     |                                              |                                                              | 405          |       |              |        |             |     |              |        |       |       |        |   |        |   |        |         | 405     |      
|                                             | Other                                                                                        |                                              |                                                              | (592         | )     |              |        | (12          | )   |              |        | 27     |       |        |   |        |   |        |         | (577    | )    
|                                             |                                                                                              |                                              |                                                              |              |       |              |        |              |     |              |        |        |       |        |   |         |   |        |         |        
|Net cash used in financing activities        |                                                                                              |                                              | (4,872                                                       | )            |       |              | (75    | )            |     |              | (6,553 | )      |       |        |  |         |   |        | (11,500 | )      
|                                             |                                                                                              |                                              |                                                              |              |       |              |        |              |     |              |        |        |       |        |   |         |   |        |         |        
|Net decrease in cash and cash equivalents    |                                                                                              |                                              | (549                                                         | )            |       |              | (8     | )            |     |              | (184   | )      |       |        |  |         |   |        | (741    | )      
|Effect of exchange rate changes on cash      |                                                                                              |                                              |                                                             |              |       |              |       |              |     |              | (22    | )      |       |        |  |         |   |        | (22     | )      
|Cash and cash equivalents, beginning of year |                                                                                              |                                              | 1,188                                                        |              |       |              | 505    |              |     |              | 295    |        |       |        |  |         |   |        | 1,988   |        
|                                             |                                                                                              |                                              |                                                              |              |       |              |        |              |     |              |        |        |       |        |   |         |   |        |         |        
|Cash and cash equivalents, end of year       |                                                                                              | $                                            | 639                                                          |              |       | $            | 497    |              |     | $            | 89     |        |       | $      |  |         |   | $      | 1,225   |        
|                                             |                                                                                              |                                              |                                                              |              |       |              |        |              |     |              |        |        |       |        |   |         |   |        |         |        

72



---



##### 





|        |                                                                                         
|------- | ----------------------------------------------------------------------------------------
|Item 9. | Changes in and Disagreements with Accountants
    on Accounting and Financial Disclosure

None.

PART III



|         |                                                       
|-------- | ------------------------------------------------------
|Item 10. | Directors and Executive Officers of the
    Registrant

Our directors and executive officers and certain
biographical information about each of these individuals are set
forth below:

|                             |  |     |    |          |  |                                                                                             
|---------------------------- |  | --- | -- | -------- |  | --------------------------------------------------------------------------------------------
|Name                         |  | Age |    | Position
|                             |  |     |    |         
|Frederick D. Sancilio, Ph.D. |  |     | 53 |          |  | Executive Chairman of the Board and Chief
    Scientific Officer                            
|Philip S. Tabbiner, D.B.A.   |  |     | 47 |          |  | President and Chief Executive Officer and Director                                          
|Gregory S. Bentley           |  |     | 53 |          |  | Executive Vice President and General Counsel                                                
|William L. Ginna, Jr.        |  |     | 50 |          |  | Executive Vice President and Chief Financial
    Officer                                    
|David M. Hurley              |  |     | 43 |          |  | Executive Vice President of aaiPharma and
    President of Pharmaceuticals Division         
|Vijay Aggarwal, Ph.D.        |  |     | 54 |          |  | Executive Vice President of aaiPharma and
    President of AAI International                
|George E. Van Lear, Ph.D.    |  |     | 62 |          |  | Executive Vice President of aaiPharma and
    President of Research and Development Division
|John D. Hogan                |  |     | 42 |          |  | Vice President of aaiPharma, Principal Accounting
    Officer and Controller                
|William H. Underwood         |  |     | 55 |          |  | Executive Vice President and Director                                                       
|John E. Avery                |  |     | 74 |          |  | Director                                                                                    
|Joseph H. Gleberman          |  |     | 45 |          |  | Director                                                                                    
|Kurt M. Landgraf             |  |     | 56 |          |  | Director                                                                                    
|James G. Martin, Ph.D.       |  |     | 67 |          |  | Director                                                                                    
|Richard G. Morrison, Ph.D.   |  |     | 66 |          |  | Director                                                                                    
|John M. Ryan                 |  |     | 58 |          |  | Director                                                                                    
|James L. Waters              |  |     | 77 |          |  | Director                                                                                    

Frederick D. Sancilio,
Ph.D.has been a Director since 1979,
and is currently Executive Chairman of the Board of Directors
and Chief Scientific Officer of aaiPharma. Before founding
aaiPharma in 1979, Dr. Sancilios experience in the
pharmaceutical industry included various positions with
Burroughs-Wellcome Co., Schering-Plough Corporation, and
Hoffmann-LaRoche, Inc. Dr. Sancilio served as the Chairman
of the Board of Directors and Chief Executive Officer of
aaiPharma since the Company was founded until July 1, 2002,
when he was appointed to his current position.

Philip S. Tabbiner,
D.B.A.was elected a director in
August 2002 and has served as President and Chief Executive
Officer of aaiPharma since July 2002, having previously served
as Executive Vice President of aaiPharma and President of NeoSan
Pharmaceuticals from November 2000 to January 2002. Prior to
joining aaiPharma, Dr. Tabbiner held various positions in
the pharmaceutical industry over a twenty-year career.
Dr. Tabbiner served from December 1998 to November 2000 as
a Senior Vice President at Bayer Diagnostics, Bayer Corporation,
a manufacturer of medical instruments, and as President of
International at Chiron Diagnostics, a manufacturer of medical
instruments, from 1997 until Bayer acquired Chiron Diagnostics
in 1998. Prior to joining Chiron Diagnostics, Dr. Tabbiner
served from 1995 to 1997 as Vice President of Worldwide Sales
and Marketing at the Dupont Merck Pharmaceutical
Company  Radiopharm Division.

73



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##### 



Gregory S. Bentleyhas served as Executive Vice President and General Counsel of
aaiPharma since June 1999. Mr. Bentley served as Secretary
of aaiPharma from June 1999 to April 2002. Prior to joining
aaiPharma, Mr. Bentley served from 1994 to 1999 as Vice
President, Regulatory and Quality for Siemens Medical Systems,
Inc., a leading medical device company and a subsidiary of
Siemens Corporation. Prior to joining Siemens Corporation as
Associate General Counsel in 1986, Mr. Bentley practiced
law with the law firm of Shearman & Sterling in New York.

William L. Ginna,
Jr.has served as Executive Vice
President and Chief Financial Officer of aaiPharma since
February 2000. Prior to joining aaiPharma, Mr. Ginna served
from 1995 to 1999 as Vice President and Chief Financial Officer
for London International Group, a medical and consumer products
distributor. Mr. Ginna, a Certified Public Accountant, also
spent ten years with Athlone Industries, Inc., a listed New York
Stock Exchange manufacturer of specialty steels and consumer
products, where he most recently served as Vice President and
Controller.

David M. Hurleyhas
served as Executive Vice President of aaiPharma and President of
our Pharmaceuticals Division since February 2002. Prior to
joining aaiPharma, Mr. Hurley served from June 2000 to
January 2002 as Chief Executive Officer of HealthNexis, a
healthcare exchange company. Prior to joining HealthNexis,
Mr. Hurley held executive level positions from 1994 to 2000
at two subsidiary companies of Novartis Corporation, serving
from December 1998 to June 2000 as President, Chief Executive
Officer, and as a Director of Geneva Pharmaceuticals, Inc., a
specialty pharmaceutical company, and as President, Chief
Executive Officer, and as a Director from December 1997 to
December 1998 and as Executive Vice President from November 1994
to December 1997 at Novartis Nutrition Corporation, a medical
nutrition company.

Vijay Aggarwal,
Ph.D.has served as Executive Vice
President of aaiPharma and as President of AAI International
since April 2002. Prior to joining aaiPharma, Dr. Aggarwal
served from August 1999 to January 2001 as the President of the
Quest Diagnostic Ventures division of Quest Diagnostics Inc., a
provider of diagnostic testing, information and services. From
1985 to 1999, Dr. Aggarwal served in various positions at
Smithkline Beecham Clinical Laboratories, Inc., an independent
clinical laboratory, including as the Vice President and
Director of US Laboratories from July 1998 to August 1999 and as
the Vice President and Director of Managed Care from 1994 to
1998.

George E. Van Lear,
Ph.D.has served as Executive Vice
President of aaiPharma and as President of aaiResearch since
June 2000, having previously worked for aaiPharma in the
1980s. Dr. Van Lear has over 30 years of
experience in the pharmaceutical industry, most recently serving
as President of Senetek PLC, a biotech company, from April 1999
to June 2000 and as Vice President of Research and Development
from 1996 to 1999 at DPT Technologies, Inc, a healthcare company.

John D. Hoganhas
served as Controller and Principal Accounting Officer of
aaiPharma since May 2000 and Vice President of aaiPharma since
April 2002. Prior to joining aaiPharma, Mr. Hogan served
from November 1998 to May 2000 as the Controller of SSL
Americas, a manufacturer and distributor of consumer healthcare
products, medical products and household and industrial gloves.
Mr. Hogan also worked for Salant Corporation, a company
that designs, produces, imports, and markets menswear apparel
products, having served as the Director of Budgeting, Financial
Analysis and SEC Reporting from August 1992 to November 1998 and
as the Assistant Controller from May 1990 to August 1992.

William H. Underwoodis a Director and Executive Vice President  Corporate
Development of aaiPharma. He has served as a Director since
1996, as Chief Operating Officer from 1995 to 1997, as Executive
Vice President since 1992, and as Vice President from 1986 to
1992. Mr. Underwood held various positions in the
pharmaceutical and cosmetic industries prior to joining
aaiPharma in 1986, including Director of Quality Assurance and
Director of Manufacturing at Mary Kay Cosmetics, Inc. and Group
Leader of Bacteriological Quality Control at Burroughs-Wellcome
Co.

John E. Averyjoined
the Board of Directors of aaiPharma in 2000. Mr. Avery is a
retired senior executive of Johnson & Johnson, a leading
multinational healthcare products company, having served as
Company Group Chairman of all operations in Latin America and
the Caribbean. Mr. Avery served from

74



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##### 



1993 to 1996 as Chairman of each of the Americas
Society and the Council of the Americas, each a nonprofit
organization.


Joseph H. Glebermanjoined the Board of Directors of aaiPharma in 1995.
Mr. Gleberman has been employed by Goldman, Sachs &
Co., an investment-banking firm, since 1982, serving as Managing
Director since 1996 and as a Partner since 1990.
Mr. Gleberman serves as a director of BackWeb Technologies
Ltd., Berry Plastics Corporation, IPC Acquisition Corp. and MCG
Capital Corporation.

Kurt M. Landgrafjoined the Board of Directors of aaiPharma in September 2001.
Mr. Landgraf has served since August 2000 as the President
and Chief Executive Officer of the Educational and Testing
Service in Princeton, New Jersey, the worlds largest
private educational testing and measurement organization. He
served in various positions at E.I. Dupont de Nemours Company
and its affiliates from 1980 until 2000, including Chairman and
Chief Executive Officer of Dupont Pharmaceuticals Company from
January 2000 to May 2000, Executive Vice President and Chief
Operating Officer from April 1998 to August 2000, Executive Vice
President from November 1997 to April 1998, and Chief Financial
Officer from December 1996 to October 1997 of E.I. Dupont de
Nemours and Company. Mr. Landgraf serves as a director of
IKON Office Solutions, Inc. and NDC Health Corporation.

James G. Martin,
Ph.D.joined the Board of Directors of
aaiPharma in 1999. Dr. Martin has served since 1995 as
Corporate Vice President and since 1993 as Chairman of the
Research Development Board of Carolinas HealthCare System, a
regional healthcare system. Prior to joining Carolinas
HealthCare, Dr. Martin served as Governor of the State of
North Carolina from 1984 to 1992. Dr. Martin also serves as
a director of Duke Energy Corporation, Palomar Medical
Technologies, Inc., and Family Dollar Stores, Inc.

Richard G. Morrison,
Ph.D.joined the Board of Directors of
aaiPharma in 1999. Prior to his retirement in May 2001,
Dr. Morrison was an Adjunct Professor of Business at the
Cameron School of Business, University of North Carolina at
Wilmington for over six years. Dr. Morrison also has more
than 30 years of pharmaceutical industry experience,
recently acting as a private consultant for medium-sized
international pharmaceutical businesses, and having served as
General Manager and President of Eli Lillys operations in
Venezuela, Mexico and Brazil.

John M. Ryanjoined
the Board of Directors of aaiPharma in 1996. Mr. Ryan
serves as Managing Partner of Ryan Partners, a business advisory
and venture capital firm he founded in July 1996 and as Vice
President of Cetek Corporation, a drug discovery company. Prior
to founding Ryan Partners, Mr. Ryan served as a Partner of
Coopers & Lybrand, LLP (now PricewaterhouseCoopers LLP), an
accounting firm, with which he was associated from 1972 to 1996.
Mr. Ryan has served as a director of numerous private
companies and as an officer and director of several
not-for-profit corporations.

James L. Watersjoined the Board of Directors of aaiPharma in 1981. Since 1980,
Mr. Waters has been a private investor in numerous
companies. He is president of Cetek Corporation, a drug
discovery company, Secretary of Trans-Tek, Inc., an instrument
measurement company, and the founder of Waters Associates, Inc.,
now known as Waters Corporation, a scientific instrumentation
manufacturer.

Section 16(a) Beneficial Ownership
Reporting Compliance

Section 16(a) of the Securities Exchange Act
of 1934 (the Exchange Act) requires the
Companys officers and directors, as well as any holders of
more than 10% of the Companys Common Stock, to file with
the Securities Exchange Commission certain reports of ownership
and changes in ownership of Common Stock and other equity
securities of the Company. Based solely on review of such
reports and certain representations furnished to it, the Company
believes that during the fiscal year ended December 31,
2002, all officers and directors complied with all applicable
Section 16(a) filing requirements except Frederick D.
Sancilio submitted two late reports for four acquisition
transactions by his spouse for their children that occurred in
fiscal years 1999 and 2001 and John Hogan submitted one late
report for one acquisition transaction.

75



---



##### 



Item 11.     Executive
Compensation

The following Summary Compensation Table sets
forth all compensation awarded to, earned by or paid for
services rendered to the Company in all capacities in 2002 by:
(i) the Companys chief executive officer and
(ii) the Companys next four most highly compensated
employees who were serving as executive officers on
December 31, 2002 (collectively, the Named Executive
Officers):

Summary Compensation Table

|                                |                            |      |      |                     |  |              |         |              |  |                              |         |            |  |                 |           |    |   |  |           |   |  |  |         |         |  |  |       |          |  
|------------------------------- | -------------------------- | ---- | ---- | ------------------- |  | ------------ | ------- | ------------ |  | ---------------------------- | ------- | ---------- |  | --------------- | --------- | -- | - |  | --------- | - |  |  | ------- | ------- |  |  | ----- | -------- | -
|                                |                            |      |      |                     |  |              |         |              |  |                             
|                                |                            |      |      |                     |  |              |         |              |  | Long Term Compensation Award
|                                |                            |      |      |                     |  |             
|                                |                            |      |      | Annual Compensation |  |              |         | Securities   |  |                             
|                                |                            |      |      |                     |  | Restricted   |         | Underlying   |  |                             
|Name and                        |                            |      |      |                     |  | Other Annual |         | Stock        |  | Options/                     |         | All Other 
|Principal Position              |                            | Year |      | Salary($)(1)        |  | Bonus($)(2)  |         | Compensation |  | Awards($)                    |         | SARs(#)(3) |  | Compensation($)
|                                |                            |      |      |                     |  |              |         |              |  |                              |         |            |  |                
|Frederick D. Sancilio, Ph.D.(4) |                            |      | 2002 |                     |  |              | 407,115 |              |  |                              | 287,000 |            |  |                 | 58,499(5  | )  |   |  | 0         |   |  |  | 82,500  |         |  |  | 0     |         
|                                | Executive Chairman and     |      |      | 2001                |  |              |         | 400,000      |  |                              |         | 0          |  |                 |           | (6 | ) |  |           | 0 |  |  |         | 67,500  |  |  |       | 0        |  
|                                | Chief Scientific Officer   |      |      | 2000                |  |              |         | 400,000      |  |                              |         | 24,000     |  |                 |           | (6 | ) |  |           | 0 |  |  |         | 67,500  |  |  |       | 0        |  
|Phillip S. Tabbiner, D.B.A.(7)  |                            |      | 2002 |                     |  |              | 397,942 |              |  |                              | 260,750 |            |  |                 | (6        | )  |   |  | 418,000(8 | ) |  |  | 168,000 |         |  |  | 0     |         
|                                | President &                |      |      | 2001                |  |              |         | 285,000      |  |                              |         | 0          |  |                 |           | (6 | ) |  |           | 0 |  |  |         | 12,000  |  |  |       | 65,160(9 | )
|                                | Chief Executive Officer    |      |      | 2000                |  |              |         | 30,692       |  |                              |         | 0          |  |                 |           | (6 | ) |  |           | 0 |  |  |         | 120,000 |  |  |       | 0        |  
|David M. Hurley (10)            |                            |      | 2002 |                     |  |              | 309,615 |              |  |                              | 160,000 |            |  |                 | (6        | )  |   |  | 0         |   |  |  | 300,000 |         |  |  | 0     |         
|                                | Executive Vice President   |      |      | 2001                |  |              |         |             |  |                              |         |           |  |                 |           |   |   |  |           |  |  |  |         |        |  |  |       |         |  
|                                |                            |      |      | 2000                |  |              |         |             |  |                              |         |           |  |                 |           |   |   |  |           |  |  |  |         |        |  |  |       |         |  
|William L. Ginna, Jr.(11)       |                            |      | 2002 |                     |  |              | 260,000 |              |  |                              | 122,050 |            |  |                 | 30,000(12 | )  |   |  | 0         |   |  |  | 187,500 |         |  |  | 3,000 |         
|                                | Executive Vice President & |      |      | 2001                |  |              |         | 209,750      |  |                              |         | 0          |  |                 |           | (6 | ) |  |           | 0 |  |  |         | 0       |  |  |       | 3,000    |  
|                                | Chief Financial Officer    |      |      | 2000                |  |              |         | 180,000      |  |                              |         | 33,000     |  |                 |           | (6 | ) |  |           | 0 |  |  |         | 112,500 |  |  |       | 14,498(9 | )
|Gregory S. Bentley              |                            |      | 2002 |                     |  |              | 225,000 |              |  |                              | 182,750 |            |  |                 | (6        | )  |   |  | 0         |   |  |  | 75,000  |         |  |  | 3,000 |         
|                                | Executive Vice President & |      |      | 2001                |  |              |         | 184,750      |  |                              |         | 0          |  |                 |           | (6 | ) |  |           | 0 |  |  |         | 0       |  |  |       | 3,000    |  
|                                | General Counsel            |      |      | 2000                |  |              |         | 175,000      |  |                              |         | 19,250     |  |                 |           | (6 | ) |  |           | 0 |  |  |         | 45,000  |  |  |       | 3,000    |  
|William H. Underwood            |                            |      | 2002 |                     |  |              | 202,800 |              |  |                              | 95,840  |            |  |                 | (6        | )  |   |  | 0         |   |  |  | 37,500  |         |  |  | 0     |         
|                                | Executive Vice President   |      |      | 2001                |  |              |         | 191,769      |  |                              |         | 0          |  |                 |           | (6 | ) |  |           | 0 |  |  |         | 0       |  |  |       | 1,005    |  
|                                |                            |      | 2000 |                     |  |              | 165,000 |              |  |                              | 0       |            |  |                 | (6        | )  |   |  | 0         |   |  |  | 37,500  |         |  |  | 2,438 |         



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Includes salary amounts deferred pursuant to the
    Companys 401(k) plan.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   
|(2) | Includes discretionary bonuses granted in March
    2002 to the following executives in the following amounts:
    Dr. Sancilio, $140,000; Dr. Tabbiner, $99,750;
    Mr. Ginna, $75,250; Mr. Bentley, $66,500; and
    Mr. Underwood, $35,000. The bonuses were paid in April
    2002, unless the executive elected to defer receipt of the bonus
    until the future. If the deferral election was made, the
    executive received 100% of the bonus in January 2003 and will
    receive an additional 100% of the bonus in January 2004, unless
    the deferring executive voluntarily leaves our employment prior
    to the payment date. Dr. Sancilio, Dr. Tabbiner,
    Mr. Ginna, and Mr. Bentley each elected to defer the
    bonus payment.
|   
|(3) | Share amounts have been adjusted to reflect the
    3-for-2 stock split effected by a stock dividend paid on
    March 10, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   
|(4) | Dr. Sancilio served as our Chief Executive
    Officer until July 1, 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   
|(5) | Such amounts include $24,414 for reimbursement
    for non-business use of the Companys aircraft and $20,946
    for reimbursement for accounting fees and club memberships
    pursuant to Dr. Sancilios employment agreement with
    the Company.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   
|(6) | Amounts received do not exceed the lesser of
    $50,000 or 10% of salary.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   
|(7) | Dr. Tabbiner commenced employment with the
    Company on November 15, 2000.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|   
|(8) | The aggregate value of the restricted shares at
    December 31, 2002 was $350,500. These shares will vest on
    August 2, 2005 and the shares have a right to dividends
    declared by the Company.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   
|(9) | Relocation expense reimbursement.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          



|     |                                                                         
|---- | ------------------------------------------------------------------------
|(10) | Mr. Hurley commenced employment with us on
    February 4, 2002.        
|    
|(11) | Mr. Ginna commenced employment with the
    Company on February 1, 2000.
|    
|(12) | Includes reimbursement of $24,000 for a country
    club membership.    

76



---



##### 



The following table sets forth certain
information with respect to options granted during 2002,
adjusted for the 3-for-2 stock split, to the executive officers
named in the Summary Compensation Table:

Stock Option Grants in 2002

Individual Grants

|                             |  |               |         |                  |  |          |     |            |  |                        |       |        |  |  |         |  |  |  |           |  |  |  |           | 
|---------------------------- |  | ------------- | ------- | ---------------- |  | -------- | --- | ---------- |  | ---------------------- | ----- | ------ |  |  | ------- |  |  |  | --------- |  |  |  | --------- | 
|                             |  |               |         |                  |  |          |     |            |  |                       
|                             |  |               |         |                  |  |          |     |            |  | Potential Realizable  
|                             |  |               |         |                  |  |          |     |            |  | Value at Assumed      
|                             |  | Number of     |         | Percent of Total |  |          |     |            |  | Annual Rates of Stock 
|                             |  | Securities    |         | Options/SARs     |  |          |     |            |  | Price Appreciation for
|                             |  | Underlying    |         | Granted to       |  | Exercise |     |            |  | Option Term(1)        
|Name and                     |  | Options       |         | Employees in     |  | Price    |     | Expiration |  |                       
|Principal Position           |  | Granted(#)(2) |         | Fiscal Year      |  | ($/Sh)   |     | Date       |  | 5%($)                  |       | 10%($)
|                             |  |               |         |                  |  |          |     |            |  |                        |       |       
|Frederick D. Sancilio, Ph.D. |  |               | 52,500  |                  |  |          | 2.0 | %          |  |                        | 16.29 |        |  |  | 1/13/12 |  |  |  | 411,026   |  |  |  | 1,160,882 | 
|                             |  |               | 30,000  |                  |  |          | 1.1 | %          |  |                        | 14.73 |        |  |  | 5/17/12 |  |  |  | 212,447   |  |  |  | 600,026   | 
|Philip S. Tabbiner, D.B.A    |  |               | 40,500  |                  |  |          | 1.5 | %          |  |                        | 14.81 |        |  |  | 1/13/12 |  |  |  | 377,044   |  |  |  | 955,504   | 
|                             |  |               | 15,000  |                  |  |          | 0.6 | %          |  |                        | 19.38 |        |  |  | 4/26/12 |  |  |  | 182,788   |  |  |  | 463,221   | 
|                             |  |               | 37,500  |                  |  |          | 1.4 | %          |  |                        | 14.96 |        |  |  | 5/10/12 |  |  |  | 352,731   |  |  |  | 893,890   | 
|                             |  |               | 75,000  |                  |  |          | 2.8 | %          |  |                        | 11.45 |        |  |  | 8/2/12  |  |  |  | 539,749   |  |  |  | 1,367,829 | 
|David M. Hurley              |  |               | 37,500  |                  |  |          | 1.4 | %          |  |                        | 14.96 |        |  |  | 5/10/12 |  |  |  | 352,731   |  |  |  | 893,890   | 
|                             |  |               | 120,000 |                  |  |          | 4.5 | %          |  |                        | 11.71 |        |  |  | 7/25/12 |  |  |  | 883,722   |  |  |  | 2,239,527 | 
|                             |  |               | 142,500 |                  |  |          | 5.4 | %          |  |                        | 11.45 |        |  |  | 8/2/12  |  |  |  | 1,025,522 |  |  |  | 2,598,876 | 
|William L. Ginna, Jr.        |  |               | 45,000  |                  |  |          | 1.7 | %          |  |                        | 14.81 |        |  |  | 1/13/12 |  |  |  | 418,938   |  |  |  | 1,061,670 | 
|                             |  |               | 15,000  |                  |  |          | 0.6 | %          |  |                        | 14.96 |        |  |  | 5/10/12 |  |  |  | 141,093   |  |  |  | 357,556   | 
|                             |  |               | 127,500 |                  |  |          | 4.8 | %          |  |                        | 11.45 |        |  |  | 8/2/12  |  |  |  | 917,573   |  |  |  | 2,325,310 | 
|Gregory S. Bentley           |  |               | 45,000  |                  |  |          | 1.7 | %          |  |                        | 14.81 |        |  |  | 1/13/12 |  |  |  | 418,938   |  |  |  | 1,061,670 | 
|                             |  |               | 15,000  |                  |  |          | 0.6 | %          |  |                        | 14.96 |        |  |  | 5/10/12 |  |  |  | 141,093   |  |  |  | 357,556   | 
|                             |  |               | 15,000  |                  |  |          | 0.6 | %          |  |                        | 10.76 |        |  |  | 8/23/12 |  |  |  | 101,472   |  |  |  | 257,150   | 
|William H. Underwood         |  |               | 22,500  |                  |  |          | 0.9 | %          |  |                        | 14.81 |        |  |  | 1/13/12 |  |  |  | 209,469   |  |  |  | 530,835   | 
|                             |  |               | 15,000  |                  |  |          | 0.6 | %          |  |                        | 14.96 |        |  |  | 5/10/12 |  |  |  | 141,093   |  |  |  | 357,556   | 



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Potential realizable value is based on an
    assumption that the price of the Common Stock appreciates at the
    annual rate shown (compounded annually) from the date of grant
    until the end of the ten-year option term. The numbers are
    calculated based on the requirements promulgated by the
    Securities and Exchange Commission and do not reflect the
    Companys estimate of future stock price growth.
|   
|(2) | The options vest in one-third increments at each
    of the first, second, and third anniversaries of the grant date
    except that the options expiring on August 2, 2012 vest on
    the seventh anniversary of the grant date, August 2, 2002,
    but may vest sooner if certain financial targets are met.                                                                                                               

The following table sets forth certain
information with respect to the number of shares underlying
unexercised options adjusted for the 3-for-2 stock split, and
the value of unexercised options held at fiscal year end by the
Named Executive Officers:

Aggregated 2002 Year-End Option
Values

|                             |  |                        |                |                          |  |  |                 | 
|---------------------------- |  | ---------------------- | -------------- | ------------------------ |  |  | --------------- | 
|                             |  | Number of Securities   |                |                         
|                             |  | Underlying Unexercised |                | Value of Unexercised    
|                             |  | Options                |                | In-the-Money Options    
|                             |  | at Fiscal Year-End(#)  |                | At Fiscal Year-End($)(1)
|Name and                     |  | Exercisable/           |                | Exercisable/            
|Principal Position           |  | Unexercisable          |                | Unexercisable           
|                             |  |                        |                |                         
|Frederick D. Sancilio, Ph.D. |  |                        | 67,455/150,045 |                          |  |  | 222,150/152,295 | 
|Philip S. Tabbiner, D.B.A    |  |                        | 85,200/214,800 |                          |  |  | 300,432/154,768 | 
|David M. Hurley              |  |                        | 0/300,000      |                          |  |  | 0/0             | 

77



---



##### 



|                      |  |                        |                |                          |  |  |                 | 
|--------------------- |  | ---------------------- | -------------- | ------------------------ |  |  | --------------- | 
|                      |  | Number of Securities   |                |                         
|                      |  | Underlying Unexercised |                | Value of Unexercised    
|                      |  | Options                |                | In-the-Money Options    
|                      |  | at Fiscal Year-End(#)  |                | At Fiscal Year-End($)(1)
|Name and              |  | Exercisable/           |                | Exercisable/            
|Principal Position    |  | Unexercisable          |                | Unexercisable           
|                      |  |                        |                |                         
|William L. Ginna, Jr. |  |                        | 74,961/225,039 |                          |  |  | 256,146/128,334 | 
|Gregory S. Bentley    |  |                        | 89,970/90,030  |                          |  |  | 310,299/68,116  | 
|William H. Underwood  |  |                        | 114,497/62,024 |                          |  |  | 206,176/70,045  | 

Equity Compensation Plan Information

The following table sets forth the aggregate
number of options issued and available for issuance as of
December 31, 2002 and the weighted average exercise price
of the outstanding options, in each case, adjusted for the
3-for-2 stock split:

|                                                               |  |                   |           |                   |  |               |       |  |  |  |           | 
|-------------------------------------------------------------- |  | ----------------- | --------- | ----------------- |  | ------------- | ----- |  |  |  | --------- | 
|                                                               |  | Number of         |           |                   |  |              
|                                                               |  | Securities to be  |           |                   |  | Number of    
|                                                               |  | Issued Upon       |           | Weighted Average  |  | Securities   
|                                                               |  | Exercise of       |           | Exercise Price of |  | Remaining    
|                                                               |  | Outstanding       |           | Outstanding       |  | Available for
|                                                               |  | Options, Warrants |           | Options, Warrants |  | Future       
|Plan Category                                                  |  | and Rights        |           | and Rights        |  | Issuance     
|                                                               |  |                   |           |                   |  |              
|Equity compensation plans approved by security
    holders     |  |                   | 5,408,973 |                   |  | $             | 10.71 |  |  |  | 1,321,517 | 
|Equity compensation plans not approved by
    security holders |  |                   |          |                   |  |               |      |  |  |  |          | 
|Total                                                          |  |                   | 5,408,973 |                   |  |               | 10.71 |  |  |  | 1,321,517 | 

Employment and Compensation
Agreement

On November 17, 1995, the Company entered
into an employment agreement with Dr. Frederick D. Sancilio. The
employment agreement renews automatically for successive
one-year periods unless either party notifies the other party of
an intention not to extend the term. Dr. Sancilio currently
serves as aaiPharmas Executive Chairman of the Board and
Chief Scientific Officer. Prior to July 2002, he served as
Chairman of the Board of Directors and Chief Executive Officer.
The Company is required under this agreement to use best efforts
to cause Dr. Sancilio to be elected to the Companys
board of directors, the boards of directors of any of affiliated
corporations on which Dr. Sancilio served on
November 17, 1995, and the board of directors of any
majority-owned subsidiary of aaiPharma acquired after
November 17, 1995.

Dr. Sancilios annual salary was
increased from $400,000 to $440,000 effective January 1,
2002. The salary paid to Dr. Sancilio may be increased but
not reduced by the board of directors without
Dr. Sancilios approval. In July 2002,
Dr. Sancilios salary was adjusted to $400,000 to
reflect his new role as Executive Chairman and Chief Scientific
Officer. The employment agreement provides that
Dr. Sancilio will be eligible to receive bonus compensation
of up to 50% of his annual salary if the Company attains
performance objectives set jointly by the board of directors and
Dr. Sancilio. In addition, Dr. Sancilio is eligible to
participate in the Companys employee benefit plans made
available generally to executive officers and any other
aaiPharma compensation or incentive plans, to receive an
automobile allowance, and to receive other perquisites not to
exceed, in the aggregate, $35,000 per year.

The employment agreement permits the Company to
terminate Dr. Sancilios employment at any time, with
or without cause. However, if the Company terminates
Dr. Sancilios employment without cause or if
Dr. Sancilio terminates his employment within 90 days
after a constructive discharge, Dr. Sancilio would
be entitled to receive payments aggregating three times his then
current annual salary. These payments would be made in monthly
installments over two years, during which time Dr. Sancilio
would continue to receive his medical and life insurance
benefits. Under the employment agreement, a constructive
discharge includes, among other things, the removal of Dr.
Sancilio from the positions of Chairman of the Board, a
reduction in

78



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Dr. Sancilios responsibilities, or the
relocation of the Companys principal executive offices by
more than 30 miles from its current location. The
employment agreement requires Dr. Sancilio to refrain from
certain activities in competition with aaiPharma for a period of
two years after the termination of his employment for any reason.


All of the Companys executive officers have
entered into agreements with the Company wherein they will be
entitled to a one-year salary if they are terminated without
cause. Besides Dr. Sancilio, no other executive officer of
the Company has an employment contract with aaiPharma.

Item 12.     Security
Ownership of Certain Beneficial Owners and Management

The following table sets forth certain
information known to the Company with respect to beneficial
ownership of the Companys Common Stock as of
March 12, 2003 by (i) each stockholder known by the
Company to be the beneficial owner of more than 5% of the
Companys Common Stock, (ii) each director,
(iii) each executive officer named in the Summary
Compensation Table and (iv) all executive officers and
directors as a group.

|                                                                 |  |                    |            |            |  |  |      |  
|---------------------------------------------------------------- |  | ------------------ | ---------- | ---------- |  |  | ---- | -
|                                                                 |  | Number of Shares   |            | Percent of
|                                                                 |  | Beneficially Owned |            | Shares    
|Name of Beneficial Owner                                         |  | (1)                |            | (2)       
|                                                                 |  |                    |            |           
|Frederick D. Sancilio, Ph.D. (3)(4)                              |  |                    | 6,220,622  |            |  |  | 22.4 | %
|Brown Capital Management, Inc. (5)                               |  |                    | 4,871,001  |            |  |  | 17.7 | %
|The Goldman Sachs Group, L.P. (6)                                |  |                    | 3,415,248  |            |  |  | 12.4 | %
|James L. Waters (7)                                              |  |                    | 3,172,549  |            |  |  | 11.5 | %
|Lazard Freres & Co. LLC (8)                                      |  |                    | 1,883,715  |            |  |  | 6.8  | %
|Royce Associates, LLC (9)                                        |  |                    | 1,440,600  |            |  |  | 5.2  | %
|John E. Avery                                                    |  |                    | 105,000    |            |  |  | *    |  
|Joseph H. Gleberman (10)                                         |  |                    | 0          |            |  |  |     |  
|Kurt M. Landgraf                                                 |  |                    | 34,650     |            |  |  | *    |  
|James G. Martin, Ph.D.                                           |  |                    | 90,749     |            |  |  | *    |  
|Richard Morrison, Ph.D.                                          |  |                    | 82,499     |            |  |  | *    |  
|John M. Ryan                                                     |  |                    | 101,502    |            |  |  | *    |  
|William H. Underwood (11)                                        |  |                    | 317,470    |            |  |  | 1.1  | %
|Phillip S. Tabbiner, D.B.A.                                      |  |                    | 157,451    |            |  |  | *    |  
|Gregory S. Bentley                                               |  |                    | 132,452    |            |  |  | *    |  
|William L. Ginna, Jr.                                            |  |                    | 112,444    |            |  |  | *    |  
|David M. Hurley                                                  |  |                    | 0          |            |  |  |     |  
|All executive officers and directors as a group
    (15 persons) |  |                    | 10,766,022 |            |  |  | 37.5 | %



---



|  |             
|- | ------------
|* | Less than 1%



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Unless otherwise indicated below, the persons and
    entities named in the table have sole voting and sole investment
    power with respect to all shares beneficially owned, subject to
    community property laws where applicable. Information in the
    table reflects options granted under the Companys 1995
    Stock Option Plan, 1996 Stock Option Plans, 1997 Stock Option
    Plan and the 2000 Non Employee Director Stock Option Plan to the
    extent such options are or become exercisable within
    60 days. Accordingly, the totals for the following
    executive officers and directors and all executive officers and
    directors as a group includes the following shares represented
    by options: Mr. Ryan, 100,000 shares; Mr. Underwood,
    138,987 shares; Dr. Martin, 88,499 shares;
    Dr. Morrison, 82,499 shares; Mr. Bentley, 109,952
    shares; Dr. Sancilio, 107,455 shares; Mr. Waters, 0
    shares; Mr. Avery, 75,000 shares; Mr. Landgraf, 34,650
    shares; Mr. Ginna, 112,444 shares; Dr. Tabbiner,
    116,201 shares; and all executive officers and directors as a
    group, 1,091,748 shares. The shares in the table reflect the
    three-for-two stock dividend that was distributed March 10,
    2003 to shareholders of record on February 19, 2003.
|   
|(2) | These calculations are based on an aggregate of
    27,608,540 shares issued and outstanding as of March 12,
    2003, which reflects the impact of the three-for-two stock
    dividend. Options to purchase                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          

79



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|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    | shares held by a person that are exercisable or
    become exercisable within the 60-day period are deemed to be
    outstanding for the purpose of calculating the percentage of
    outstanding shares owned by that person but are not deemed to be
    outstanding for the purpose of calculating the percentage owned
    by any other person.                                                                                                                                                                                                                                                                                                                                                                                                                                    
|   
|(3) | Dr. Sancilios address is 1001 North
    Highway 1, suite 308, Jupiter, Florida 33477.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   
|(4) | Includes 2,325 shares owned by
    Dr. Sancilios children.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   
|(5) | Based on Schedule 13G filed by Brown Capital
    Management, Inc. with the Securities and Exchange Commission
    dated February 5, 2003. The address of Brown Capital
    Management, Inc. is 1201 N. Calvert Street, Baltimore, Maryland
    21202. This Schedule 13G indicates that Brown Capital
    Management, Inc. has sole dispositive power for 4,871,001 shares
    and sole voting power for 3,959,820 shares.                                                                                                                                                                                                                                                                                                                                                              
|   
|(6) | Goldman, Sachs & Co. (GS) is an
    indirect wholly-owned subsidiary of The Goldman Sachs Group,
    Inc. (GSG). GS, a NASD member, is an investment
    banking firm that regularly performs services such as acting as
    a financial advisor and serving as principal or agent in the
    purchase and sale of securities. GSG and GS may be deemed to own
    beneficially and indirectly in the aggregate 3,415,248 shares of
    the Companys Common Stock through certain investment
    partnerships of which affiliates of GS and GSG are the general
    partner, managing general partner or managing partner. GS is the
    investment manager of one or more of the investment
    partnerships. The address of GS is 85 Broad Street, New York,
    New York 10004.
|   
|(7) | Includes 640,135 shares of Common Stock
    beneficially owned by Mr. Waterss spouse.
    Mr. Waterss address is 47 New York Avenue,
    Framingham, Massachusetts 01701.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   
|(8) | Based on Schedule 13G filed by Lazard Freres
    & Co. LLC with the Securities and Exchange Commission dated
    February 14, 2003. The address of Lazard Freres & Co.
    LLC is 30 Rockefeller Plaza, 59th Floor, New York, NY 10020.
    This Schedule 13G indicates that Lazard Freres & Co.
    LLC has sole dispositive power for 1,883,715 shares and sole
    voting power for 1,759,365 shares.                                                                                                                                                                                                                                                                                                                                                                               
|   
|(9) | Based on Schedule 13G filed by Royce &
    Associates, LLC with the Securities and Exchange Commission
    dated January 31, 2003. The address of Royce &
    Associates, LLC is 1414 Avenue of Americas, New York, NY 10019.
    This Schedule 13G indicates that Royce & Associates,
    LLC has sole dispositive power for 1,440,600 shares and sole
    voting power for 1,440,600 shares.                                                                                                                                                                                                                                                                                                                                                                                         



|     |                                                                                                                                                                                                                                                                                                                                                                                                    
|---- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(10) | Mr. Gleberman, a managing director of
    Goldman, Sachs & Co., disclaims beneficial ownership of the
    3,415,248 shares which may be deemed beneficially owned by GSG
    as described in note (6) above. Mr. Gleberman, a
    managing director of GS, disclaims beneficial ownership of the
    securities reported herein except to the extent of his pecuniary
    interest therein, if any.
|    
|(11) | Includes 1,387 shares beneficially owned by
    Mr. Underwoods children.                                                                                                                                                                                                                                                                                                                          

Item 13.     Certain
Relationships and Related Transactions

We have certain relationships, and have engaged
in transactions, with related parties. These transactions may
raise conflicts of interest and, although we do not have a
formal policy to address conflicts of interest, we evaluate
relationships and transactions involving conflicts of interest
on a case by case basis.

In November 1995, GS Capital Partners II, L.P.,
G.S. Capital Partners II Offshore, L.P., Bridge Street Fund
1995, L.P., Stone Street Fund, L.P., and Goldman Sachs & Co.
Verwaltungs GmbH, each an investment partnership managed by an
affiliate of The Goldman Sachs Group Ltd., purchased shares of
preferred stock of aaiPharma. All outstanding shares of
preferred stock were converted into aaiPharma common stock in
conjunction with our public offering of common stock in
September 1996. These Goldman Sachs investment partnerships own
3,415,248 shares of our common stock. Pursuant to a stockholder
agreement entered into in connection with their 1995 investment,
the Goldman Sachs investment partnerships have the right to
designate one member of our board of directors for so long as
they and their affiliates (which include Goldman,
Sachs & Co.) beneficially own 10% or more of the
outstanding shares of our common stock. Pursuant to the

80



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stockholders agreement, Joseph Gleberman, a
managing director of Goldman, Sachs & Co., serves as one of
our directors.


In connection with the 1995 investment, we agreed
that so long as the Goldman Sachs investment partnerships
beneficially own 5% or more of the outstanding shares of our
common stock, we will retain Goldman, Sachs & Co. or an
affiliate to perform all investment banking services for us for
which an investment banking firm is retained, and to serve as
managing underwriter of any offering of our capital stock on
customary terms, consistent with an arms-length
transaction. If we cannot agree to the terms of an engagement
with Goldman, Sachs & Co. or their affiliates after good
faith discussions, the agreement permits us to engage any other
investment banking firm. However, Goldman, Sachs & Co. would
be entitled to serve as co-managing underwriter in any
underwritten offering of our capital stock.

In addition, in that 1995 investment transaction,
we granted to the Goldman Sachs investment partnerships, and
other stockholders including Frederick Sancilio, James Waters
and William Underwood, all current directors of aaiPharma,
rights to cause us to register for sale the shares of common
stock they beneficially owned at that time.

In 1994, as part of our internal development
program, we organized Endeavor Pharmaceuticals, Inc. to continue
development of products that we had been developing on our own.
We assigned our rights to these products to Endeavor in return
for approximately 47% of Endeavors fully diluted equity.
We also entered into a contract with Endeavor to continue
product development and clinical supply manufacture and granted
to Endeavor, under certain circumstances, the first right to
purchase additional proprietary hormone pharmaceutical products
that we develop. Although this contract terminated in April
2001, Endeavors right to purchase internally developed
hormone products that we develop survives through April 2004. As
the result of subsequent investment in Endeavor by third
parties, including the Goldman Sachs investment partnerships,
our ownership interest in Endeavor has been diluted to
approximately 13% of the common stock of Endeavor outstanding on
a fully diluted basis at December 31, 2002. At
December 31, 2002, the Goldman Sachs investment
partnerships beneficially owned approximately 13.9% of
Endeavors common stock on a fully diluted basis, while we
owned 13.2%, Dr. Frederick D. Sancilio owned 0.8% and the
Waters Foundation, an affiliate of James L. Waters, one of our
directors, owned 0.6%. Pursuant to an agreement among the
Endeavor stockholders, we have the right to designate one of the
eight members of Endeavors board of directors.
Dr. Sancilio currently serves as our designee on
Endeavors board.

Pursuant to our product development and supply
agreements with Endeavor, we had net sales to Endeavor of
approximately $1.1 million in 2002, $0.2 million in 2001 and
$0.7 million in 2000. These amounts were charged at our
commercial rates similar to those charged to other clients. We
had approximately $292,000 and $79,000 in related accounts
receivable from Endeavor at December 31, 2002 and 2001,
respectively. In February 2000, we purchased product rights to
an estradiol product and validated manufacturing equipment from
Endeavor as consideration for reducing Endeavors
outstanding receivable and work-in-progress balances. Endeavor
assigned to us the rights to this estradiol product, a generic
version of estradiol approved by the FDA, and the related
commercialization contract between Endeavor and a third party.
Under the commercialization agreement, we will be entitled to
certain minimum royalties if the third party manufactures and
distributes estradiol. Endeavor also sold a piece of
manufacturing equipment and related accessories to us. As
consideration for these product and contract rights and
equipment, we agreed to reduce Endeavors outstanding
receivable balance from approximately $2.9 million, including
work-in-progress, to $950,000. The terms of this transaction
resulted from negotiations between Endeavor and us. We believe
this transaction was fair to us based on our estimate of the
value of the outstanding receivable and work-in-process balances
we reduced compared to the value of the rights and equipment we
acquired.

We organized Aesgen, Inc. with an affiliate of
the Mayo Clinic in 1994 and funded it in 1995 with an affiliate
of the Mayo Clinic, MOVA Pharmaceutical Corporation and certain
other investors. Our initial common stock investment in Aesgen
was distributed to our shareholders prior to our initial public
offering in 1996. As a result, our directors and executive
officers beneficially own the following percentages of the fully
diluted common equity of Aesgen as of December 31, 2002:
Dr. Sancilio, 4.1%, Mr. Waters, 5.0% and
Mr. Underwood, 0.3%. In addition, the Goldman Sachs
investment partnerships own 1.8% of the fully diluted

81



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common equity of Aesgen as of December 31,
2002. In January 2001, the terms of the non-convertible,
redeemable preferred stock we received in connection with our
1995 investment in Aesgen were amended to make that class of
stock convertible into Aesgen common stock. In October 2001 we
agreed to provide development services to Aesgen, through AAI
International, in exchange for up to $1.1 million of Aesgen
convertible preferred stock. Through December 31, 2002, the
Company had performed $580,000 of services under the agreement
but had not been issued any shares of convertible preferred
stock. As of December 31, 2002, we owned approximately
10.0% of the common equity of Aesgen on a fully diluted basis.
If all $1.1 million of services are performed, we expect to own
14.2% of Aesgens common equity on a fully diluted basis.


At the time of our 1995 investment in Aesgen, we
entered into a development agreement with Aesgen. Under this
agreement, we had the right to provide product development and
support services to Aesgen with respect to the generic drugs
being developed by Aesgen, provided that our fees for such
services were comparable to those of a competitor. In addition,
we were obligated not to develop for our own account or for any
other person, any formulation of the generic products then under
development by Aesgen. In 1996, we sold to Aesgen marketing
rights to a pharmaceutical product that we were developing.
Under the agreement, Aesgen paid a license fee and will pay
additional royalties upon marketing the product. In December
2001 we agreed to purchase from Aesgen a number of generic
product development projects including the rights to associated
abbreviated new drug applications that have been filed with or
approved by the FDA. In exchange for the rights to these
products, we agreed to terminate the 1995 development agreement
and the 1996 license agreement with Aesgen described above, and
to release Aesgen from any and all liabilities owed to us under
these contracts, including approximately $0.7 million of work in
progress and accounts receivable. Furthermore, as a result of
this transaction, we will have the right to receive royalties
that were formerly payable to Aesgen by MOVA Pharmaceutical
Corporation with respect to the abbreviated new drug
applications we acquired from Aesgen. The terms of this
transaction resulted from negotiations between Aesgen and us. We
believe this transaction was fair to us.

In February 2002, we purchased a proprietary
product from Aesgen for payments of $1.0 million in cash and
additional contingent milestone payments of up to $1.5 million.
Recently, the prerequisite for payment of an additional $500,000
of such contingent milestones occurred and such payment was made
to Aesgen, while the prerequisites for payment of the remaining
$1.0 million were not met and no further payment of this amount
is potentially owed by the Company. We intend to market this
product as an extension of the Aquasol product line. Under this
agreement, we are obligated to pay royalty payments equal to 30%
of the net revenues of the product acquired from Aesgen, less
costs incurred in its manufacture and marketing, for the
eight-year period following the first commercial sale of this
product.

We recognized net revenues of approximately
$494,000, $86,000 and $100,000 from Aesgen in 2002, 2001, and
2000, respectively and we had no accounts receivable or
work-in-progress at December 31, 2002 or 2001.

Mr. Waters and Dr. Sancilio have agreed
to sell us up to a total of 363,807 shares of our common stock
to provide the shares for issuance pursuant to our 1995 Stock
Option Plan. Upon the exercise of a stock option awarded under
the 1995 plan, we are entitled to purchase from them the same
number of shares at the exercise price of the option, $5.57 per
share. As of December 31, 2002, options to acquire 765
shares of our common stock were outstanding under our 1995 Stock
Option Plan. We acquired no shares from Mr. Waters in 2002,
39,198 shares in 2001 for $218,202 and 4,167 shares in 2000 for
$26,336, and we acquired no shares from Dr. Sancilio in
2002, 47,910 shares in 2001 for $266,699 and 5,094 shares in
2000 for $28,356.

Item 14.     Controls
and Procedures

(a) Evaluation of Disclosure Controls and
Procedures aaiPharma Inc.s Executive Chairman,
Chief Executive Officer and Chief Financial Officer have
evaluated the Companys disclosure controls and procedures
as of March 24, 2003, and they concluded that these
controls and procedures are effective.

(b) Changes in Internal Controls 
There are no significant changes in internal controls or in
other factors that could significantly affect these controls
subsequent to March 24, 2003.

82



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##### 





|         |                                                                    
|-------- | -------------------------------------------------------------------
|Item 15. | Exhibits, Financial Statement Schedules and
    Reports on Form 8-K

(a)(1) and (2)  The response to this
portion of Item 15 is submitted as a separate section of
this report and reference is hereby made to Item 8.

(b) During the fourth quarter of 2002, we
furnished the following Form 8-K:



| |   |                                                                                                                                                                                                                                                                         
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | dated December 4, 2002, to file a press
    release reporting a patent infringement lawsuit against Kremers
    Urban Development Co. (KUDCO), Schwarz Pharma Inc., and Schwarz
    Pharma AG alleging patent infringement of one of
    aaiPharmas omeprazole patents.

(c) Exhibits  A list of the
exhibits required to be filed as part of this Report on
Form 10-K is set forth in the
Exhibit Index, which immediately precedes such
exhibits, and is incorporated herein by reference.

(d) FINANCIAL STATEMENT SCHEDULE

Schedules not included herein have been omitted
because they are not applicable or the required information is
shown in the consolidated financial statements or notes thereto.

83



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##### 



SCHEDULE II

aaiPharma Inc.

VALUATION AND QUALIFYING ACCOUNTS

(In thousands)

|                                |      |            |   |            |  |            |   |             |  |            |   |     |     |  |   |        |      |  |   |       | 
|------------------------------- | ---- | ---------- | - | ---------- |  | ---------- | - | ----------- |  | ---------- | - | --- | --- |  | - | ------ | ---- |  | - | ----- | 
|                                |      |            |   |            |  | Charged to |   |             |  |           
|                                |      | Balance at |   | Charged to |  | Other      |   |             |  | Balance at
|                                |      | Beginning  |   | Costs and  |  | Accounts-  |   | Deductions- |  | End of    
|Description                     |      | of Period  |   | Expenses   |  | Describe   |   | Describe    |  | Period    
|                                |      |            |   |            |  |            |   |             |  |           
|Allowance for doubtful accounts |      |            |   |            |  |            |   |             |  |            |   |     |     |  |   |        |      |  |   |      
|                                | 2000 |            | $ | 3,114      |  |            | $ | 1,713       |  |            | $ |    |     |  | $ | (3,998 | )(1) |  | $ | 829   | 
|                                | 2001 |            |   | 829        |  |            |   | 970         |  |            |   | 268 | (2) |  |   | (1,023 | )(1) |  |   | 1,044 | 
|                                | 2002 |            |   | 1,044      |  |            |   | 1,294       |  |            |   |    |     |  |   | (670   | )(1) |  |   | 1,668 | 



---

|    |                                                                        
|--- | -----------------------------------------------------------------------
|(1) | Represents amounts written off as uncollectible
    accounts receivable
|   
|(2) | Represents allowance on accounts assumed in
    acquisition            

84



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##### 



SIGNATURES

Pursuant to the requirements of Section 13
or 15(d) 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.

|                                                             |  |                                                                            |  |                |  | 
|------------------------------------------------------------ |  | -------------------------------------------------------------------------- |  | -------------- |  | 
|                                                            
|/s/ FREDERICK D. SANCILIO, PH.D.Frederick D. Sancilio, Ph.D. |  | Executive Chairman of the Board, Chief Scientific
    Officer and Director |  | March 24, 2003

Pursuant to the requirements of the Securities
Exchange Act of 1934, this report has been signed below by the
following persons, or in their behalf by their duly appointed
attorney-in-fact, on behalf of the Registrant in the capacities
and on the date indicated.

|                                                             |  |                                                                                       |  |                |  | 
|------------------------------------------------------------ |  | ------------------------------------------------------------------------------------- |  | -------------- |  | 
|                                                             |  |                                                                                       |  |               
|Signatures                                                   |  | Title                                                                                 |  | Date          
|                                                             |  |                                                                                       |  |               
|                                                            
|/s/ FREDERICK D. SANCILIO, PH.D.Frederick D. Sancilio, Ph.D. |  | Executive Chairman of the Board, Chief Scientific
    Officer and Director            |  | March 24, 2003
|                                                            
|/s/ PHILIP S. TABBINER, D.B.A.Philip S. Tabbiner, D.B.A.     |  | President, Chief Executive Officer and
    Director
    (Principal Executive Officer) |  | March 24, 2003
|                                                            
|/s/ WILLIAM L. GINNA, JR.William L. Ginna, Jr.               |  | Executive Vice President and Chief Financial
    Officer                              |  | March 24, 2003
|                                                            
|/s/ JOHN D. HOGANJohn D. Hogan                               |  | Vice President and Controller
    (Principal Accounting Officer)                      |  | March 24, 2003
|                                                            
|/s/ WILLIAM H. UNDERWOODWilliam H. Underwood                 |  | Executive Vice President and Director                                                 |  | March 24, 2003
|                                                            
|/s/ JOHN E. AVERYJohn E. Avery                               |  | Director                                                                              |  | March 24, 2003
|                                                            
|/s/ JOSEPH H. GLEBERMANJoseph H. Gleberman                   |  | Director                                                                              |  | March 24, 2003
|                                                            
|/s/ KURT M. LANDGRAFKurt M. Landgraf                         |  | Director                                                                              |  | March 24, 2003
|                                                            
|/s/ JAMES G. MARTIN, PH.D.James G. Martin, Ph.D.             |  | Director                                                                              |  | March 24, 2003
|                                                            
|/s/ RICHARD G. MORRISON, PH.D.Richard G. Morrison, Ph.D.     |  | Director                                                                              |  | March 24, 2003
|                                                            
|/s/ JOHN M. RYANJohn M. Ryan                                 |  | Director                                                                              |  | March 24, 2003
|                                                            
|/s/ JAMES L. WATERSJames L. Waters                           |  | Director                                                                              |  | March 24, 2003

85



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##### 



aaiPharma Inc.

Exhibit Index

|        |      |             |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|------- | ---- | ----------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |      |            
|Number  |      | Description
|        |      |            
|        | 3.1  |             |  | Amended and Restated Certificate of Incorporation
    of the Company (incorporated by reference to Exhibit 3.1 to
    the Companys Quarterly Report on Form 10-Q for the
    quarter ended September 30, 1996)                                                                                                                                                                                                                                                                                                                                                          
|        | 3.2  |             |  | Amendment to Certificate of Incorporation dated
    May 24, 2000 (incorporated by reference to Exhibit 3.2
    to the Companys Quarterly Report on Form 10-Q for the
    quarter ended June 30, 2000)                                                                                                                                                                                                                                                                                                                                                                   
|        | 3.3  |             |  | Amended By-laws of the Company (incorporated by
    reference to Exhibit 3.3 to the Companys Quarterly
    Report on Form 10-Q for the quarter ended June 30, 2000)                                                                                                                                                                                                                                                                                                                                                                                                     
|        | 4.1  |             |  | Articles Fourth, Seventh, Eleventh and Twelfth of
    the form of Amended and Restated Certificate of Incorporation of
    the Company (included in Exhibit 3.1)                                                                                                                                                                                                                                                                                                                                                                                                         
|        | 4.2  |             |  | Article II of the form of Restated By-laws
    of the Company (included in Exhibit 3.2)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|        | 4.3  |             |  | Specimen Certificate for shares of Common Stock,
    $.001 par value, of the Company (incorporated by reference to
    Exhibit 4.3 to the Companys Registration Statement on
    Form S-1 (Registration No. 333-5535))                                                                                                                                                                                                                                                                                                                                                  
|        | 10.1 |             |  | Employment Agreement dated November 17, 1995
    between the Company and Frederick D. Sancilio (incorporated by
    reference to Exhibit 10.1 to the Companys
    Registration Statement on Form S-1 (Registration
    No. 333-5535))                                                                                                                                                                                                                                                                                                                                   
|        | 10.2 |             |  | Applied Analytical Industries, Inc. 1995 Stock
    Option Plan (incorporated by reference to Exhibit 10.3 to
    the Companys Registration Statement on Form S-1
    (Registration No. 333-5535))                                                                                                                                                                                                                                                                                                                                                                       
|        | 10.3 |             |  | Applied Analytical Industries, Inc. 1997 Stock
    Option Plan, as amended, (incorporated by reference to
    Exhibit 10.11 to the Companys Registration Statement
    on Form S-1 (Registration No. 333-85602))                                                                                                                                                                                                                                                                                                                                                        
|        | 10.4 |             |  | Stockholder Agreement dated as of
    November 17, 1995 among the Company, GS Capital
    Partners II, L.P., GS Capital Partners II Offshore,
    L.P., Goldman, Sachs & Co. Verwaltungs GmbH, Stone Street
    Fund 1995, L.P., Bridge Street Fund 1995, L.P., Noro-Moseley
    Partners III, L.P., Wakefield Group Limited Partnership,
    James L. Waters, Frederick D. Sancilio and the parties listed on
    Schedule 1 thereto (incorporated by reference to
    Exhibit 10.5 to the Companys Registration Statement
    on Form S-1 (Registration No. 333-5535))
|        | 10.5 |             |  | Development Agreement dated as of April 25,
    1994 between the Company and Endeavor Pharmaceuticals Inc.
    (formerly, GenerEst, Inc.) (incorporated by reference to
    Exhibit 10.12 to the Companys Registration Statement
    on Form S-1 (Registration No. 333-5535))                                                                                                                                                                                                                                                                                           
|        | 10.6 |             |  | Underwriting Agreement dated September 19,
    1996 between the Company and Goldman Sachs & Co., Cowen
    & Company and Lehman Brothers, Inc., as representatives of
    the underwriters listed on Schedule 1 thereto (incorporated
    by reference to Exhibit 10.17 to the Companys
    Quarterly Report on Form 10-Q for the quarter ended
    September 30, 1996)                                                                                                                                                                                                 
|        | 10.7 |             |  | Amendment No. 1 to the Employment Agreement
    dated November 17, 1995 between the Company and Frederick
    D. Sancilio (incorporated by reference to Exhibit 10.14 to
    the Companys Quarterly Report on Form 10-Q for the
    quarter ended June 30, 1999)                                                                                                                                                                                                                                                                                                        
|        | 10.8 |             |  | Applied Analytical Industries, Inc. 1996 Stock
    Option Plan, as amended on March 27, 2000 (incorporated by
    reference to Exhibit 10.17 to the Companys Annual
    Report on Form 10-K filed for the year ended
    December 31, 1999)                                                                                                                                                                                                                                                                                                                             
|        | 10.9 |             |  | Asset Purchase Agreement by and between
    AstraZeneca AB and NeoSan Pharmaceuticals Inc. dated as of
    July 25, 2001 (incorporated by reference to the
    Companys Quarterly Report on Form 10-Q for the period
    ended September 30, 2001)                                                                                                                                                                                                                                                                                                                      

86



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##### 



|        |       |             |  |                                                                                                                                                                                                                                                                                                                                                          
|------- | ----- | ----------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |       |            
|Number  |       | Description
|        |       |            
|        | 10.10 |             |  | Interim Supply Agreement dated as of
    August 17, 2001 between NeoSan Pharmaceuticals Inc. and
    AstraZeneca L.P. (incorporated by reference to Exhibit 2.2
    to the Companys Current Report on Form 8-K dated
    August 17, 2001)                                                                                                               
|        | 10.11 |             |  | Asset Purchase Agreement dated as of
    December 13, 2001 between NeoSan Pharmaceuticals Inc.,
    Novartis Pharmaceuticals Corporation and Novartis Corporation
    (incorporated by reference to the Companys Current Report
    on Form 8-K dated August 17, 2001)                                                                                  
|        | 10.12 |             |  | Interim Supply Agreement dated as of
    December 13, 2001 between NeoSan Pharmaceuticals Inc. and
    Novartis Pharmaceuticals Corporation (incorporated by reference
    to the Companys Current Report on Form 8-K dated
    August 17, 2001)                                                                                                        
|        | 10.13 |             |  | Subscription Agreement dated as of
    October 19, 2001 between the Company and Aesgen, Inc.
    (incorporated by reference to the Companys Annual Report
    on Form 10-K for the year ended December 31, 2001)                                                                                                                                        
|        | 10.14 |             |  | Product Sales Agreement dated as of
    December 21, 2001 between the Company and Aesgen, Inc.
    (incorporated by reference to the Companys Annual Report
    on Form 10-K for the year ended December 31, 2001)                                                                                                                                      
|        | 10.15 |             |  | Indenture dated as of March 28, 2002 between
    the Company, certain of its subsidiaries and First Union
    National Bank, as Trustee (incorporated by reference to
    Exhibit 10.8 to the Companys Registration Statement
    on Form S-1 (Registration No. 333-85602))                                                                             
|        | 10.16 |             |  | Registration Rights Agreement dated as of
    March 28, 2002 between the Company, certain of its
    subsidiaries, Banc of America Securities LLC, CIBC World Markets
    Corp. and First Union Securities, Inc. (incorporated by
    reference to Exhibit 10.9 to the Companys
    Registration Statement on Form S-1 (Registration
    No. 333-85602))
|        | 10.17 |             |  | Credit Agreement dated as of March 28, 2002
    between the Company, certain of its subsidiaries, the lenders
    from time to time party thereto, and Bank of America, N.A., as
    administrative agent (incorporated by reference to
    Exhibit 10.11 to the Companys Registration Statement
    on Form S-1 (Registration No. 333-85602))          
|        | 10.18 |             |  | Assignment, Transfer and Assumption Agreement
    dated as of February 18, 2002 between NeoSan
    Pharmaceuticals, Inc. and Eli Lilly and Company (incorporated by
    reference to Exhibit 2.1 to the Companys Amendment
    No. 1 to Current Report on Form 8-K/A dated
    April 12, 2002)                                                          
|        | 10.19 |             |  | Manufacturing Agreement dated as of
    February 18, 2002 between NeoSan Pharmaceuticals, Inc. and
    Eli Lilly and Company (incorporated by reference to
    Exhibit 2.1 to the Companys Amendment No. 1 to
    Current Report on Form 8-K/A dated April 12, 2002)                                                                                    
|        | 10.20 |             |  | aaiPharma Inc. 2000 Stock Option Plan for
    Non-Employee Directors, as amended (incorporated by reference to
    Exhibit 10.6 to the Companys Registration Statement
    on Form S-1 (Registration No. 333-85602))                                                                                                                                    
|        | 21    |             |  | Subsidiaries of aaiPharma Inc.                                                                                                                                                                                                                                                                                                                           
|        | 23    |             |  | Consent of Independent Auditors                                                                                                                                                                                                                                                                                                                          
|        | 99.1  |             |  | Risk Factors                                                                                                                                                                                                                                                                                                                                             
|        | 99.2  |             |  | Certification Pursuant to 18 U.S.C.
    Section 1350, signed by Frederick D. Sancilio, Ph.D.,
    Executive Chairman of the Board, Chief Scientific Officer and
    Director                                                                                                                                                                             
|        | 99.3  |             |  | Certification Pursuant to 18 U.S.C.
    Section 1350, signed by Philip S. Tabbiner, D.B.A.,
    President, Chief Executive Officer and Director (Principal
    Executive Officer)                                                                                                                                                                        
|        | 99.4  |             |  | Certification Pursuant to 18 U.S.C.
    Section 1350, signed by William L. Ginna, Jr., Executive
    Vice President and Chief Financial Officer                                                                                                                                                                                                          

87