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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, 2003 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period fromto Commission File Number 0-21185 aaiPharma Inc. (Exact name of Registrant as specified in its charter)
 Delaware
    
    04-2687849(State or other jurisdiction of
    
    (I.R.S. employerincorporation or organization)
    
    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(b) of the Act: None 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   o   No   þ 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 registrants common stock held by
non-affiliates of the registrant as of June 30, 2003, computed by reference to
the closing price of the common stock on that date was $165,449,708. The number of shares outstanding of registrants common stock as of May 31,
2004 was 28,585,582 shares.




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Explanatory Note We are restating our financial statements for the year ended December 31, 2002
and for the first, second and third quarters of 2002 and 2003. This
restatement is reported in this Annual Report on Form 10-K for the year ended
December 31, 2003 and will be reported in amendments to our Quarterly Reports
on Form 10-Q for the periods ended March 31, 2003, June 30, 2003 and September
30, 2003. This restatement:  
    
    corrects the recognition of revenue for certain
transactions in 2003 that did not satisfy all of the conditions
for revenue recognition contained in SFAS 48 and/or SAB 101,
    
    increases reserves for product returns and makes other
adjustments to our revenue reserves in 2003, and
    
    with respect to 2002 and 2003, changes the accounting for
our major product line acquisitions which had been accounted for
as business combinations to treat such acquisitions as
acquisitions of assets that do not constitute a business. On February 27, 2004, our Board of Directors appointed a committee consisting
of all of the non-employee members of our Board of Directors (the Special
Committee) to conduct an inquiry into unusual sales in our Brethine and
Darvocet product lines during the second half of 2003. King & Spalding LLP, an
independent law firm, and Deloitte & Touche USA LLP, as independent forensic
accountants, were engaged to assist the Special Committee in this inquiry. In connection with the Special Committees inquiry, we determined that certain
matters required material adjustments to the 2003 financial information
included in our February 5, 2004 press release and the financial information
for the periods ended March 31, June 30, and September 30, 2003. The Special
Committees investigation and the adjustments from the Special Committees
inquiry are discussed in greater detail in this report in Item 7. Managements
Discussion and Analysis of Financial Condition and Results of Operations -
Special Committee Investigation. In addition to the accounting treatment adjustments identified in connection
with the Special Committees investigation, we have identified several other
adjustments that affect the 2003 financial information that we had reported on
February 5, 2004. These adjustments include:  
    
    a charge of $15.9 million due to the impairment of our Brethine
intangible asset recorded in the fourth quarter of 2003;
    
    a $4.7 million impairment charge in the fourth quarter of 2003
which represents the entire intangible asset recorded in the third
quarter relating to the acquisition of Darvocet A500;
    
    a $7.3 million increase in our returns reserve for sales of
Brethine and Darvon/Darvocet products in the fourth quarter of 2003;
    
    a $2.7 million increase in our inventory obsolescence reserve
in the fourth quarter of 2003;
    
    a $3.2 million increase in our chargeback reserve for sales in
the fourth quarter of 2003 for our Oramorph product and other products; and
    
    a valuation allowance of $10.0 million as an offset against
our deferred tax asset as of December 31, 2003. In addition to the 2003 adjustments arising in connection with the Special
Committees investigation and the additional adjustments
identified above, we are restating our financial statements for the
year ended December 31, 2002 and for the periods ended March 31, June 30, and
September 30, 2002 and 2003 to treat each of our major product line
acquisitions as acquisitions of assets that do not constitute a business. On
January 14, 2004 and April 26, 2004, we received letters from the SECs
Division of Corporate Finance commenting on, asking questions about, and
seeking 2




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additional disclosure with respect to, certain of our periodic reports.
Following discussions with the Division of Corporate Finance and based on
additional analyses, we have changed our accounting for these transactions from
treating the acquisitions as business combinations to treating them as asset
acquisitions. Accordingly, no portion of the purchase price for these
acquisitions is allocated to goodwill, and the amount previously allocated to
goodwill is instead allocated to the other identifiable acquired assets,
including assets with definite lives. As a result, our direct costs in 2002
are greater than the amount previously reported by $6.8 million due to the
increase in amortization expense resulting from a greater amount of purchase
price being allocated to assets with definite lives, and our directs costs in
2003 are greater than the amount we reported in our February 5, 2004 press
release for 2003 by $9.1 million. As
a result of the foregoing, we have reduced our 2003 net revenue and
diluted earnings
per share by $57.7 million and $2.35, respectively, from the results we
reported in our February 2004 press release. Our 2003 net
revenues and diluted loss per share are $225.0 million and $1.18,
respectively. For more detail on
the adjustments we have made to the 2003 financial information that
we had reported in our February 5, 2004 press release, see the
table included in this report in Item 7. Managements
Discussion and Analysis of Financial Condition and Results of
Operations  Restatement of Previously Issued Financial
Statements and Note 1 of Notes to Consolidated
Financial Statements included elsewhere in this report. In addition, we have reduced our
2002 diluted earnings per share by $0.15 from the results reported in our annual report
on Form 10-K for the year ended December 31, 2002 and are now
reporting diluted earnings per share of $0.46. The financial results
reported in this report have incorporated these adjustments. Until we amend our Quarterly Reports on Form 10-Q for the periods ended March
31, 2003, June 30, 2003 and September 30, 2003, the financial statements and
related financial information contained in such reports should not be relied
upon. In addition, we do not intend to file any amended Annual Report on Form
10-K or Quarterly Report on Form 10-Q for periods affected by the restatements
that ended prior to March 31, 2003, and the financial statements and related
financial information contained in such reports should no longer be relied
upon. All referenced amounts in this report for prior periods and prior period
comparisons reflect the balances and amounts on a restated basis. PART I Item 1. Business The terms we, us, our or aaiPharma 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 3




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We own the following registered and unregistered trademarks: Darvocet,
Darvon®, Darvon-N®, Darvocet-N®, Darvocet A500, Brethine®, ProSorb®,
ProSorb-D, ProSLO, ProSLO II, ProCore®, Oramorph® SR, ProLonic AQ,
Roxanol, Roxicodone®, AzaSan®, aaiPharma®, AAI® and Applied Analytical
Industries®. AzaSan® is a registered trademark owned by us and licensed to
Salix Pharmaceuticals. Unless the context otherwise requires, references in
this document to Darvon are to Darvon® and Darvon-N® collectively and
references to Darvocet are to Darvocet-N® and Darvocet A500. We also reference
trademarks owned by other companies. Prilosec® is a registered trademark of
AstraZeneca AB, Dolophine® is a registered trademark of Eli Lilly and Company,
Allegra-D® is a registered trademark of Aventis Pharmaceuticals Inc.,
Proventil® is a registered trademark of Schering Corporation, Volmax® is a
registered trademark of GlaxoSmithKline, Ultram® is a registered trademark of
Johnson & Johnson, Imuran® is a registered trademark of Prometheus Laboratories
Inc.,M.V.I.® and Aquasol® are registered trademarks owned by Mayne Pharma
(USA) Inc., Duraclon® is a registered trademark owned by Fujisawa Healthcare,
Inc. and licensed to us, Avinza® is a registered trademark owned by Ligand
Pharmaceuticals, Inc., MS Contin® and Oxycontin® are registered trademarks
owned by Purdue Pharma, L.P., Kadian® is a registered trademark owned by
Alpharma Inc., Zemplar® and Calcijex® are registered trademarks owned by Abbott
Laboratories, and Hectorol® is a registered trademark owned by Bone Care
International Inc. All references in this document to any of these terms
lacking the ® or TM symbols are defined terms that reference the products,
technologies or businesses bearing the trademarks with these symbols. Overview Our company was founded in 1979 to provide laboratory services, such as
analytical testing on pharmaceutical compounds, to pharmaceutical companies.
In the 1980s, we increased our service offerings to include clinical trials
material manufacturing, microbiological testing and regulatory and
quality consulting. We
continued expanding our scientific base in the 1990s by adding bioanalytical,
biotechnical, commercial manufacturing and human clinical trials management
capabilities. We offer our clients scientific solutions to their
pharmaceutical development needs. In our history, we have worked with large
and small companies offering a wide range of services across the drug
development continuum. We also used our drug development capacity to work on our own internal product
pipeline. In the 1990s, we helped establish two companies which received
approvals for products we developed. We also entered into various shared-risk
arrangements with companies to bring pharmaceutical products to the market
based on development work we conducted. In 2001, we began pursuing a product acquisition strategy. Between August 2001
and April 2002, we acquired three product lines, which we initially marketed
through a contract sales force. In late 2002, we decided to augment sales of
our products by creating an internal sales and marketing capability. In late
2003, we completed the acquisition of a line of pain products from Elan. This
acquisition opened the hospital channel for promotion of a sophisticated line
of injectable products used to treat pain. These products are mainly used in
hospital settings and the hospital market will be the focus of our
pharmaceutical operations in 2004. We operate through the following businesses:  
    
    Pharmaceuticals Division;
    
    AAI Development Services; and
    
    Research and Development Division. 4




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For information about the revenues, income from operations and total assets of
each segment of our business for each of the last three years, see Note 12 of
Notes to Consolidated Financial Statements included elsewhere in this report. Vision and Strategy of our Company We envision aaiPharma as a science-driven pharmaceutical company focused on
developing medicines that minimize or eliminate pain in patients. The business
model of our company is unique and incorporates significant third party
utilization of our drug development capabilities and our facilities in exchange
for fees and royalties, which we use to offset the overhead costs of our
company and our research and development program. Our company has extensive pharmaceutical development experience and has been
part of the development program on numerous products for major pharmaceutical
companies for over 20 years. We plan to leverage that experience, our own
intellectual properties and our relationships with other pharmaceutical
companies to grow our company by developing our own novel product portfolio and
by acquiring existing products and improving them. We plan to commercialize our own pharmaceuticals in three ways:  
    
    First, we are continuing to build a hospital-based sales
force focused on pain products. This sales force will continue to
consist of highly trained and skilled professional representatives
who work directly for our company. We do not anticipate utilizing
contract sales organizations. Our sales representatives will be
focused on the needs of physicians who treat acute and chronic
pain using a consultative sales approach. We will augment the
sales force with seminars and visits from our pool of scientific
and medical talent resident in our laboratories.
    
    Second, we will seek pharmaceutical partners to sell some
of our products to the wider markets including family practice
physicians. The Company currently has several approved products
and several pipeline products that will benefit from this
co-marketing and/or co-promotion approach. Conversely, we will
seek agreements with pharmaceutical companies to market their
products into the hospital market utilizing our own specialty
sales force.
    
    Third, we intend to license some of our products to other
parties in exchange for fees and royalties and in some cases in
exchange for product rights to their products. International
license agreements for existing and pipeline products are
anticipated along with domestic licenses for products outside of
our therapeutic focus. We plan to focus our research and development efforts toward improved pain
therapeutics, although we will continue a broader research effort in other
therapeutic areas such as gastrointestinal disease and central nervous system
disorders. We will continue to research physical chemical attributes of
various pharmaceuticals and broaden our intellectual property base. Pharmaceuticals Division  Our Product Sales Business The Pharmaceuticals Division markets and commercializes the pharmaceutical
products that we have acquired or developed. In 2004, we made a strategic
decision to refocus our sales force to the hospital and pain clinic markets
following our acquisition of Duraclon, Oramorph SR and a methadone injectable
product. Our sales force is being redesigned to provide experienced and
knowledgeable professionals to sell our complex, highly technical specialty
pharmaceutical products to a sophisticated target market. We believe that this
new, narrower focus will create greater efficiencies for our sales team and
allow us a forum to discuss the clinical benefits of our products. To improve
the selling efforts of our proprietary branded 5




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products, such as the Darvon
and Darvocet brands, and our near term pipeline products, we will seek to
identify and team with a long term marketing alliance partner to market and
sell to primary care physicians. Consistent with our scientific and clinical orientation we will expand our
medical affairs resources to support and improve the clinical application and
utilization of our products to benefit patients. We commercialize products in the pain and critical care therapeutic areas. Our
pain products include both Schedule IV drugs, (Darvon/Darvocet), and Schedule
II products acquired from Elan. Our critical care products are used to treat
chronic kidney dialysis patients (calcitriol), organ rejection in kidney
transplants (azathioprine) and severe asthma (Brethine). We are aware that our
Brethine injectable product is prescribed by doctors for off-label usage to
treat premature labor. Sales and Distribution of Pharmaceutical Products We use an internal sales force to sell our pharmaceutical product lines. As
mentioned above, we are redesigning our sales efforts to reach hospitals and
pain clinics. As of May 12, 2004, we had 75 sales representatives. We have contracted with a
subsidiary of Cardinal Health, Inc. to provide warehousing, distribution,
inventory tracking, customer service, and financial administrative assistance
related to our distribution program, including management of applicable
chargebacks, and accounts receivable collection. On December 26, 2003 we entered into an agreement with a second subsidiary of
Cardinal Health, Inc., effective as of October 1, 2003, to act as our exclusive
distributor of Brethine injectable products in their 10-pack presentation for a
three-year period. Manufacturing Capability We currently manufacture certain high-potency and high-toxicity drug products,
along with controlled substance products, for ourselves and for clients in our
manufacturing facility in Wilmington, North Carolina. Although our
manufacturing generally covers small volume products, 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 and we provide
manufacturing, packaging, and labeling of clinical trial materials. In
addition, we also operate a 48,000-square-foot sterile manufacturing facility in Charleston,
South Carolina where we manufacture sterile, injectable products, including our
methadone hydrochloride product and our Brethine injectable product. Our Pharmaceutical Products We commercialize products in two therapeutic areas, pain management and
critical care. Pain Management Products Roxicodone, Oramorph SR, Roxanol and Duraclon Product Lines.On December 2,
2003, we acquired a line of pain management products, which treat
moderate-to-severe pain (the New Pain Products), and existing inventory from
subsidiaries of Elan Corporation, plc. We acquired these product lines,
inventory and related intangible assets for $102.5 million, exclusive of
transactional costs. These products consist of three brands of Schedule II
(CII) pain products  Roxicodone (oxycodone hydrochloride) tablets, Oramorph
SR (morphine sulfate) sustained-release tablets, and Roxanol (morphine sulfate)
immediate release oral solutions. We also acquired a non-scheduled pain
management product, Duraclon (clonidine hydrochloride) injection, as part of
the same transaction. Schedule II pain products are regulated as controlled
substances 6




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by the U.S. Drug Enforcement Agency. Each of these products, other
than Oramorph SR, is subject to generic competition. Oramorph SR is
subject to substitution by pharmacists in certain states. Supply of Product. The New Pain Products are manufactured and supplied by third
parties. Duraclon is currently purchased on a purchase order basis from
American Pharmaceutical Partners, Inc. Roxicodone, Oramorph SR, and Roxanol
are purchased pursuant to a manufacturing agreement between Roxane
Laboratories, Inc. (Roxane) and Elan Pharma International Limited dated
September 28, 2001 (the Roxane Supply Agreement). We assumed Elan Pharma
International Limiteds rights and obligations under the Roxane Supply
Agreement in connection with the acquisition of the New Pain Products. The
term of the Roxane Supply Agreement expires on September 27, 2006. Roxane
manufactures the applicable New Pain Products in its Columbus, Ohio facility. 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). 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s patent exclusivity
expired in 1973 and Darvon-N and Darvocet-Ns patent exclusivity expired 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. We paid $211.4 million in cash, exclusive of transactional costs, 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 additional royalties for 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 $15.0 million in the applicable calendar quarter. We do 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, as amended, that we have
entered into with Eli Lilly, Eli Lilly agreed to supply specified quantities of
the acquired products and the bulk active ingredient from and after closing for
the then-existing twelve Darvon and Darvocet product presentations (form and
dosage). The supply agreement extends through December 31, 2004. We purchase
these products manufactured by Eli Lilly for a fixed unit cost, 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
is 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. We have acquired all of the product under this agreement
that we will need for 2004, except for the requirements of one product which we
are manufacturing in one of our manufacturing facilities. We intend to
transfer into our facility the manufacturing of all products previously
manufactured by Eli Lilly, except one product which will be manufactured by a
third party. The transfer of this manufacturing, however, is subject to FDA
approval and it is possible that this approval could require significant
expense and time, and it is possible that we might never receive approval. Darvocet A500. We acquired a product which we subsequently branded as Darvocet
A500 from Athlon Pharmaceuticals in July 2003. Due to safety concerns about
the potential for liver toxicity from large doses 7




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of acetaminophen, the FDA
established a recommended 4,000 mg maximum daily dose limit of over-the-counter
acetaminophen for adults. Containing only 500 mg of acetaminophen, compared to
650 mg in Darvocet-N 100, Darvocet A500 taken at the recommended daily dose
provides 1,000 mg less acetaminophen than the FDA limit. Because many patients
continue taking over-the-counter pain relievers
and sleep aids containing acetaminophen in addition to a prescription pain
reliever, Darvocet A500 reduces the likelihood of exceeding the recommended
daily limit for acetaminophen when taken up to six times per day, without
sacrificing analgesic efficacy. We received FDA approval of Darvocet A500 on
September 10, 2003, launched the product in September 2003 and initiated a
national campaign in October 2003. In connection with the acquisition, we entered a three-year services agreement
with Athlon Pharmaceuticals to provide sales support in designated territories
throughout the United States for the Darvocet A500 product. After providing
notice to Athlon of its material breach under this agreement, we terminated
this agreement on June 4, 2004 and have initiated litigation. Supply of Product. Darvocet A500 is manufactured and supplied by Mikart, Inc.
(Mikart). Mikart manufactures Darvocet A500 in its Atlanta, Georgia facility.
We have entered into an agreement with Mikart to supply us with our
requirements for Darvocet A500 for an initial term ending 2013. Thereafter,
the agreement with Mikart will continue for successive one-year renewal terms
unless terminated by either party as set forth in the agreement. The agreement
requires us to make a payment to Mikart if we have not purchased a set amount
of Darvocet A500 by September 2006. We have amended this agreement in 2004 to
allow additional products of ours to be manufactured by Mikart and for these
products to be included in our purchase obligation although we have not yet
agreed on the terms for manufacturing these additional products, including
price. Methadone Hydrochloride Injection. In April 2003, we acquired exclusive rights
to a parenterally administered methadone product, formerly branded as Dolophine
Hydrochloride Injection, from Roxane. This product is indicated for the
treatment of moderate-to-severe pain not responsive to non-narcotic analgesics,
and for use in temporary treatment of opioid dependence in patients unable to
take oral medication. We manufacture this product at our facility in Charleston, South Carolina. Critical Care Products 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, exclusive of transactional costs.
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.
Brethine is approved 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 we do not market or
promote the product 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. IMPAX Laboratories has been marketing a generic version of the oral form of
Brethine since July 2001. Two generic versions of the injectable form of this
drug were approved in 2004. Major branded products competing against Brethine
to treat these ailments include Volmax, Proventil, and branded and generic
forms of albuterol. 8




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Supply of Product.We entered into an interim supply agreement with Novartis
providing for manufacture and packaging of the oral and injectable form of
Brethine for sale by us in the U.S. through December 13, 2004. Under the
supply agreement, we may purchase the products for a fixed unit cost during the
term of the agreement, that was subject to an annual price adjustment on
January 1, 2003 and January 1, 2004 tied to the Consumer Price Index. We have transferred the Brethine manufacturing
processes to our own facility. Calcitriol. On February 13, 2002, we acquired from Aesgen, Inc. the rights to
its calcitriol product, a generic injectable vitamin D nutritional product.
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 royalty
payments for the eight-year period following the first commercial sale of this
product. In 2003, 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. 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 were approved for the sale
of calcitriol until the expiration of this market exclusivity period, after
which time additional generic calcitriol products competing with our calcitriol
product were approved for commercial sale by the FDA. 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. The exclusivity period ended in the second half of 2003. Azathioprine. In 2003, we received FDA approval to market three internally
developed line extensions of additional strengths to our current 50 mg generic
azathioprine tablet product: 25 mg, 75 mg and 100 mg tablets. We began selling
the 75 mg and 100 mg products in the first quarter of 2003. 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. In November 2003, we granted Salix Pharmaceuticals an exclusive
license to market the 25 mg, 75 mg, and 100 mg strengths of AzaSan
(azathioprine) and we licensed our AzaSan trademark to Salix. Under the
agreement with Salix, we receive royalties on net sales. We entered into a
three-year supply agreement with Salix to continue to manufacture these
products and supply all of Salixs needs. We continue to manufacture and sell
our 50 mg azathioprine tablet product as a generic product. M.V.I. and Aquasol. 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 $52.5 million, exclusive of transactional costs, paid at
closing, plus additional consideration described below. Our M.V.I. and Aquasol
product line acquisition agreement was amended on July 22, 2003. As amended,
it provided for two $1.0 million guaranteed payments, which were made in August
2002 and 2003, eliminated a contingent payment of $2.0 million that was
potentially due in August 2003 under the original agreement, and provided for a
future contingent payment of $43.5 million potentially due in August 2004,
depending on the status of certain reformulation activities being carried out
by the seller and regulatory approval of the reformulation by the FDA. The
amount of the $43.5 million contingent payment was to be reduced by $1 million
per month if the conditions for the contingent payment had not occurred by
December 31, 2002. The conditions for the contingent payment were not met by
the required date, so the amount of the contingent payment had decreased by
$12.0 million by the end of December 2003. Such conditions were satisfied in
January and February 2004, fixing the liability at $31.5 million. As of
December 31, 2003, this contingent obligation had not been 9




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recorded as a liability on our consolidated balance sheet and will be recorded in the first
quarter of 2004. Also on July 22, 2003, the M.V.I. supply agreement with the
seller was extended through 2008, subject to early termination rights by us on
six months notice given at any time, and by the supplier on twenty-four months
notice given at any time on or after August 17, 2004. 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. On April 26, 2004, we sold our M.V.I. and Aquasol product lines (the M.V.I.
and Aquasol Sale) to Mayne Pharma (USA) Inc. for $105 million, subject to
adjustments based on inventory levels at closing and other post-closing
obligations. A portion of the closing payment is held in escrow to satisfy our
post-closing obligations under the agreement. At the closing of the
transaction, we paid to AstraZeneca AB the $31.5 million payment due in August
2004, which was discounted to approximately $31.0 million (the M.V.I.
Payment). The M.V.I. Payment represents a payment upon FDA approval of the
reformulated product under the terms of the amended purchase agreement with
AstraZeneca. AAI Development Services  Our Development Services Business AAI Development Services 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 and quality consulting, and manufacturing.
These services generally are provided on a fee-for-service basis. Prior to our transition to a specialty pharmaceutical company, this development
services business was the core of our operations. AAI Development Services
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 activities, to assist in 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 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 stand-alone 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 expanding
our expertise in the key therapeutic area of pain management to further enhance
our products in this area. 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. 10




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Generally, AAI Development Services 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 or for work incurred
to date, 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 Development Services 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 Development Services provides a variety of pharmaceutical services to its
customers, including drug formulation development and small scale
manufacturing, as well as 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 Development Services provides integrated
formulation development services for customers pharmaceutical products to
develop safe and stable products with desired characteristics. AAI Development
Services provides services during each phase of the drug development process,
from new compounds to modifications of existing products. These formulation
development projects may last for a short duration or for several years. Manufacture of Clinical Trial Supplies.AAI Development Services 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 Development Services 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.
Additionally, they have the capacity for controlled substance storage and
handling. AAI Development Services provides its clients with assistance in
scaling up production of clinical supply quantities to commercial quantity
manufacturing and provides small batch commercial manufacturing capabilities. Analytical Services AAI Development Services 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, technical support and
problem solving. Our analytical services include:  
    
    Method development and validation;
    
    Product characterization;
    
    Raw materials and product release testing; and
    
    Stability studies. Biopharmaceutical Services AAI Development Services integrates a Phase I clinical study capability with
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. Our biopharmaceutical services
include: 11




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
    
    Phase I clinical services from our 88-bed Phase I clinical trial
facility located in Research Triangle Park, North Carolina, and a
72-bed facility in Neu-Ulm, Germany;
    
    Microbiological testing;
    
    Bioanalytical testing; and
    
    Biotechnology analysis and synthesis. Phase I to IV Clinical Services AAI Development Services 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. Regulatory and Other Consulting Services AAI Development Services 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 clients vendors and client operations, conducts seminars, provides
training courses, and advises clients on applicable regulatory requirements.
AAI Development Services also assists clients in designing development programs
for new or existing drugs intended to be marketed in the United States and
Europe. Research and Development Division  Our Product Development Business The Research and Development Division provides research and development
expertise that has been leveraged externally for our clients and more recently
internally for our own proprietary product efforts. This division serves as
the foundation for our bridging strategy that allows us to provide integrated
new product planning services by bridging the companys research and
development capabilities with our commercialization efforts. The division has
a unique portfolio of proprietary and licensed drug-delivery technologies
(described below) and intellectual property rights. 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. In addition to product development, the Research and Development Division seeks
to develop proprietary drug-delivery technologies for licensing to our clients.
We also utilize our technical resources and operating capacity for internal
drug and technology development with the objective of marketing new products or
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 that could medically and 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 the medical value while extending the commercial value of a
branded product line. Improved characteristics may include enhancement of
product stability, creation of additional absorption profiles (e.g., quick or
sustained release), higher drug absorption or bioavailability (permitting 12




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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 opportunities for the expansion of a drug
products effective market life. Our currently available technologies include:  
    
    ProCore a patented 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 a technology designed to accelerate absorption rates. It
permits weakly acidic compounds to exhibit a shorter onset of action
relative to conventional dosage forms. The concept is that acidic drugs
with the benefit of the technology form a dispersion pattern upon release
in the stomach that allows for faster and more complete absorption.
ProSorb is a broad-based technology primarily used with liquid or
encapsulated drug products. The application of this technology to
diclofenac, a non-steroidal anti-inflammatory drug, has resulted in our
proprietary ProSorb-D product candidate, which is discussed below.
    
    ProLonic AQ a drug-delivery technology specifically designed to
release an active agent in the colon. This technology can be
incorporated into a tablet, a pellet, or a capsule dosage form and uses
conventional manufacturing equipment and aqueous coating processes. The
advantage represented by this technology is the ability to control the
location and timing of release.
    
    ProSLO and ProSLO II an osmosis technology designed to produce
controlled release product therapy with either a single drug or a
combination of drugs. Osmotic action is the natural movement of an
aqueous solution through a membrane and is used to make oral drug
administration more accurate, precise, and convenient. This technology
allows for an immediate release component in the outside layer of a laser
drilled tablet. This facilitates 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. We own the ProCore, ProSorb, and Prolonic AQ technologies. The ProSLO and
ProSLO II technologies are available for use by us and our clients in the U.S.
through an agreement with Osmotica Corporation. We have entered into a
Cooperative Venture Agreement with Osmotica Corporation to develop, manufacture
and license various new drug products with third party organizations. This
agreement enables us to develop mutually acceptable new drug products or
improve the characteristics of mutually acceptable existing products and
compounds utilizing patents, patent applications and know-how associated with
pharmaceutical formulation technologies for such products. 13




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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. Our Internal Product Development Pipeline We have a number of proprietary pharmaceutical products under development, in
three primary categories:  
    
    chemical compounds or existing active pharmaceutical ingredients where
product line extensions or new product 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 include ProSorb-D;
    
    new active ingredients or compounds that are chemically similar to
currently marketed products with established therapeutic and safety
profiles that offer improved attributes over existing products; and
    
    new active ingredients or chemical entities that fall within our
targeted therapeutic classes. Our product development strategy focuses on products for which we expect some
period of market exclusivity, without competition from generic substitutes or
other third-party products. This exclusivity may come by way of patents or
regulatory exclusivity. We are currently developing the following products: Darvon/Darvocet Line Extension.A line extension with improved product delivery
and therapeutic characteristics eligible for regulatory and patent exclusivity. Brethine Line Extensions.We have received FDA approval of a glass vial form of
an injectable Brethine product, as opposed to the current glass ampoule
presentation. This form improves the safety and convenience of administering
this drug. We are also working towards reducing the aluminum content in this
product. ProSorb-D.ProSorb-D is a softgel capsule that combines diclofenac, an
anti-inflammatory pain medication, with our ProSorb rapid dispersion
technology. This product is for the management of pain. It has recently
completed Phase III clinical trials and we plan to file a New Drug Application,
or NDA, with the FDA in the second half of 2004. Gastrointestinal Product.We are developing a proton pump inhibitor, delivered
in a unique formulation developed by us. The product is in clinical evaluation
with filing planned in the second half of 2004. Fexofenadine/pseudoephedrine.On January 15, 2004, we announced that Aventis
submitted an NDA to the FDA for Allegra-D 24-hour tablets. This is a
fexofenadine/pseudoephedrine formulation developed by us with a patented
extended release drug-delivery technology, ProSLO II. Upon approval by the
FDA, we will receive a milestone payment and royalties on sales of the product. Other Product Candidates.In addition to the specifically identified products
named above, we continue to target additional products to develop. As we
continue our development activities, obtain additional information, and
evaluate our interim results, we may decide to change the scope and direction
of any of our 14




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development programs and projects. This could also change how we
allocate our research and development spending. Notwithstanding the foregoing,
we may not be able to successfully develop, commercialize or license any of the
products discussed in this Form 10-K. We devote significant resources to research and development. For fiscal years
2003, 2002 and 2001, our expenditures on research and development were $21.8
million, $20.9 million and $10.5 million, respectively. 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 enables 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
improving our own internal operational productivity, while helping to maintain
quality. We continue to upgrade and expand our company-wide financial and
operational integrated management information systems. Significant upgrades
have begun and are scheduled to be completed during 2004. Customers Our largest customers are large wholesalers of pharmaceutical products. The
Pharmaceuticals Divisions customers are primarily large well-established
pharmaceutical wholesalers. Cardinal Health, Inc., AmerisourceBergen
Corporation and McKesson Corporation accounted for approximately 16.7%, 15.4%
and 11.6% of our 2003 consolidated net revenues, respectively and 30.8%, 28.4%
and 21.4%, respectively, of our Pharmaceuticals Division net revenues. As is
customary in the pharmaceutical industry, we accept returns of products we have
sold as the products near their expiration date. Significant research and development projects have a defined cycle, and
accordingly, the composition of our customer group in the AAI Development
Services and Research and Development Division areas of our business changes
from year to year. Because of the project nature of engagements in these
business segments, large customers may represent a significant portion of the
business in one period but not subsequent periods. We have experienced
concentration in these areas of our business in the past, and do not believe
that this is unusual for companies which operate in this market. However, we
do not believe that revenues from any large customer of the Research and
Development Division or AAI Development Services are likely to exceed 10% of
our consolidated net revenues in the foreseeable future. Backlog Our order 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. The order backlog does not include anticipated net revenues for work
performed for internal clients or for any variable-priced contracts. During the
course of a project, a client may substantially adjust the requested scope of
services and corresponding adjustments are made. Our order backlog also
includes orders for pharmaceutical products that have been ordered by our
customers, but have not yet been shipped. We believe that our order backlog as of any date is not a meaningful predictor
of future results due to the variability and short duration of many of our
development services contracts. The backlog can also be affected by
adjustments in the scope of contracted projects. At December 31, 2003 and 2002,
our order backlog was approximately $52 million and $57 million, respectively. We do not expect to fill approximately 15




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$10 million of the 2003 amount by
December 31, 2004. Included in the backlog total is $1.3 million for
pharmaceutical products ordered but not yet shipped. 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 small specialty pharmaceutical
companies to large pharmaceutical companies. The following tables illustrate the products that compete with the products we
sell: Our Branded Products Our Products
    
    Competitor's ProductsBrethine (tablet)
    
    VolmaxProventilBranded and generic forms of Albuterol sulfateGeneric terbutaline sulfateBrethine (injectable)
    
    Generic terbutaline injectableOramorph SR
    
    AvinzaKadianMS Contingeneric MS ContinRoxicodone
    
    generic oxycodoneDarvon/Darvocet
    
    generic propoxypheneMethadone injection
    
    injectable hydromorphoneoxymorphonemeperidine
 Our Generic Products Our Products
    
    Competitors' ProductsCalcitriol
    
    Calcijexother generic calcitriol productsAzathioprine
    
    Imuranother generic azathioprine products
 In addition to the competitive products listed above, additional competitive
products may be introduced in the future. 16




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Our AAI Development Services 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. We believe that although there are numerous fee-for-service
competitors in this 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,
manufacture, and sell 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 us 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 addition, we maintain a system for
monitoring product-related complaints for all of our commercial products. 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 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. 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 17




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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 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
applications 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 for our customers, and the
manufacture, development and testing of our New Pain Products, our Darvon and
Darvocet products and our methadone hydrochloride product, 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. 18




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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,
clinical data obtained from studies in humans showing the safety and
effectiveness of the drug for the proposed therapeutic use, and chemistry,
manufacturing, and controls data documenting how the drug is made and
manufacturing operations are controlled. 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 typically blinded from the
physician and 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 (e.g., Darvon and Darvocet) that we have acquired, we
are often able to reference the original NDA 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 federal 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 19




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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 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 any 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
reference listed drug
(i.e., usually 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 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 20




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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 requires 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 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 2003, the Office of the Inspector General of the Department
of Health and Human Services issued a Compliance Program Guidance for
Pharmaceutical Manufacturers 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, 2003, we had approximately 1,300 full-time equivalent
employees, of which 95 hold Ph.D. or M.D. degrees, or the foreign equivalent.
We believe that our relations with our employees are good. None 21




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of our employees in the U.S. are represented by a union. European 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 skilled employees increases at our other operations or
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 United States and selected foreign countries and to
vigorously prosecute patent infringements, as we deem appropriate. We currently
own patents issued by the U.S. Patent and Trademark Office, and have additional
patent applications filed and pending with the U.S. 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 new physical and chemical characteristics of known compounds,
and previously unknown compounds. We
are aggressively pursuing patent infringement against Schwarz Pharma
AG and related companies to protect our rights under
two of our patents with respect to omeprazole. During the first sixteen months
of sales, the defendants in this action received over $1.1 billion in sales
from the product we believe is infringing our patent. The case is currently
scheduled for trial in June 2005. Litigation involves a high degree of
uncertainty as to outcomes and we cannot predict the outcome of our
infringement claims. The defendants have also asserted various counter claims
against us, including violations of antitrust laws. See Item 3. Legal
Proceedings  Patent Litigation for more information on this proceeding. We have a license in the U.S. and some other countries to use the patents,
patent applications, and know-how associated with certain pharmaceutical
formulation technologies for mutually acceptable drug candidates. The ProSLO
and ProSLO II technologies are licensed from Osmotica Corporation. Like our
own formulation technologies mentioned above, these technologies may be used to
develop mutually acceptable new drug products or improve the 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 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
is relevant to the partnership or as required under the arrangement during its
term and so long as our partner agrees to keep those duties confidential. 22




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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 433,000 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
Italy, Japan, Sweden, 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. Primary Operating Facilities ApproximateSquareLocation
    
    Primary Use
    
    Footage
    
    Leased/OwnedWilmington, N.C.
    
    Corporate Headquarters
    
    
    73,000
    
    
    OwnedWilmington, N.C.
    
    Manufacturing/Warehouse/
Office
    
    
    45,200
    
    
    OwnedWilmington, N.C.
    
    Laboratory/Office
    
    
    20,000
    
    
    Leased; lease expires
October 2006Wilmington, N.C.
    
    Laboratory/Office
    
    
    33,000
    
    
    OwnedWilmington, N.C.
    
    Clinical Distribution
Warehouse and Storage for
Stability Studies
    
    
    25,600
    
    
    Leased; lease expires
September 2008Chapel Hill, N.C.
    
    Laboratory/Clinic
    
    
    31,000
    
    
    OwnedNorth Brunswick, N.J.
    
    Laboratory/Office/Warehouse
    
    
    74,600
    
    
    Leased; lease expires
August 2010Shawnee, Kansas
    
    Laboratory/Office/Warehouse
    
    
    31,500
    
    
    Leased; lease expires
December 2005Natick, Mass.
    
    Office
    
    
    44,800
    
    
    Leased; lease expires
March 2007Charleston, S.C.
    
    Sterile Manufacturing/Office
    
    
    48,000
    
    
    Leased; lease expires
July 2011Neu-Ulm, Germany
    
    European Headquarters/
Laboratory/Clinic
    
    
    112,400
    
    
    Leased; lease expires
December 2008
 23




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Item 3. Legal Proceedings We are party to lawsuits and administrative proceedings incidental to the
normal course of our business. Our material legal proceedings are described
below. We cannot predict the outcomes of these matters. However, except as
noted below, 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. Prosecuting and defending
these material legal proceedings, including responding to governmental
inquiries, has resulted, and is expected to continue to result, in a
significant diversion of managements attention and resources and an increase
in professional fees. Government Investigations On August 7, 2003 we received a letter from the staff of the Enforcement
Division of the SEC (the Enforcement Division) requesting voluntary
production of certain documents. We responded to this letter on August 21,
2003 and supplemented our response on August 29, 2003. Independent of the August 7, 2003 inquiry letter, on September 26, 2003,
certain members of our board and management voluntarily met with, and provided
documents to, the staff of the Enforcement Division. As a follow-up to this
September 26, 2003 meeting and as part of the inquiry initiated on August 7,
2003, on October 8, 2003, we received a further request from staff of the
Enforcement Division for voluntary production of certain documents, to which we
responded on October 30, 2003. On January 14, 2004 and April 26, 2004, we received letters from the SECs
Division of Corporate Finance commenting on, asking questions about, and
seeking additional disclosure with respect to certain of our periodic reports.
We have responded to these letters. In April 2004, in connection with an investigation conducted by the United
States Attorneys Office for the Western District of North Carolina (the U.S.
Attorneys Office), we received five federal grand jury subpoenas for document
production and potential testimony related to, among other things, certain
transactions regarding our 2002 and 2003 financial information, the terms,
conditions of employment and compensation arrangements of certain of our senior
management personnel, compensation and incentive arrangements for employees
responsible for the sale of our Brethine, Darvocet, calcitriol, azathioprine
and Darvon Compound products, quantities of the foregoing products in
distribution channels, financial benefits with respect to specified corporate
transactions to our senior management and others, certain loans obtained by us,
extensions of credit, if any, by us to officers or directors, accounting for
sales and returns of our foregoing products, our analysts conference calls on
financial results, internal and external investigations of pharmaceutical
product sales activities, and related matters. We have also been advised that
the SEC has initiated an inquiry into at least the same issues investigated by the
Special Committee. The U.S. Attorneys Office has advised that we may also
receive a subpoena from the SEC. We and the Special Committee have agreed to cooperate fully with the government
investigations, and the Special Committee has agreed to share all results of
its investigation with the SEC and the U.S. Attorneys Office. To that end, two
meetings of our outside counsel with attorneys for the U.S. Attorneys Office
and the SEC have taken place and numerous documents as requested by these
government agencies have been voluntarily produced. We are attempting
to schedule a third meeting with the
U.S. Attorneys Office and the SEC in July in order
to provide additional information related to the Special Committees
investigation to these government agencies. We and the Special Committee
intend to facilitate any interviews of our employees or officers that may be
requested by these government agencies. The Department of Justice, SEC and other government agencies that are
investigating or might commence an investigation of aaiPharma could impose,
based on a claim of fraud, material misstatements, violation of false claims
law or otherwise, civil and/or criminal sanctions, including fines, penalties,
and/or administrative remedies. If any government sanctions are imposed, which
we cannot predict or reasonably estimate at this time, our business, financial
condition, results of operations or cash flows could be materially adversely
affected. These matters have resulted, and are expected to continue to result,
in a significant diversion of managements attention and resources and in
significant professional fees. On January 2, 2004, we received separate letters from the Kentucky Office of
Attorney General and the Florida Office of Attorney General advising that each
was currently investigating allegations regarding our pricing practices related
to our average manufacturer price and best price calculations that are used by
the government to set Medicaid reimbursement rates. Neither letter requested
that we provide any information, and each letter merely requested that we
retain all documents with respect to these calculations pursuant to a newly
adopted federal regulation that would have permitted the destruction of these
documents three years after the applicable prices were reported, except to the
extent we were aware of an ongoing investigation. It is our understanding that
many other pharmaceutical companies received similar letters at that time from
attorneys general in a number of states and that such letters may have been in
response to the new federal regulation that would have otherwise allowed the
destruction of documents reflecting these pricing 24




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calculations. A number of attorneys general, including the Florida and Kentucky attorneys general,
petitioned the U.S. Secretary of Health and Human Services to withdraw the new
regulation. We are not aware of any further developments in these
investigations. Federal Securities and ERISA Litigation We and certain of our current and former officers have been named as defendants
in purported shareholder class action lawsuits alleging violations of federal
securities laws. These lawsuits were filed beginning in February 2004 and are
pending in the U.S. District Court for the Eastern District of North Carolina.
These lawsuits assert claims under Sections 10(b) and 20(a) of the Securities
Exchange Act of 1934 and Rule 10b-5 thereunder on behalf of a class of
purchasers of our common stock during the period from January 31, 2002 through
and including March 1, 2004 (the Class Period). The complaints allege
generally that the defendants knowingly or recklessly made false or misleading
statements during the Class Period concerning our financial condition and that
our financial statements did not present our true financial condition and were
not prepared in accordance with generally accepted accounting principles. The
complaints seek certification as a class action, unspecified compensatory
damages, attorneys fees and costs, and other relief. By order dated April 16,
2004, the district court consolidated the securities lawsuits into one
consolidated action. We expect that the plaintiffs will file a consolidated,
amended complaint later in 2004, to which we will respond in lieu of responding
to the individual complaints. In addition, we, one of our former officers, certain of our employees and
others have been named in a purported class action brought by an aaiPharma
retirement plan participant and beneficiary asserting claims under the Employee
Retirement Income Security Act of 1974, as amended (ERISA) on behalf of a
class of all persons who are or were participants or beneficiaries of the
aaiPharma Inc. Retirement and Savings Plan (the Plan) during the period from
April 24, 2002 to March 31, 2004. The complaint alleges generally that the
defendants breached fiduciary duties owed under ERISA with respect to the
investment of Plan assets in aaiPharma stock by misleading participants and
beneficiaries of the Plan regarding our earnings, prospects, and business
condition. The complaint seeks certification as a class action, unspecified
compensatory damages, attorneys fees and costs, and other relief. This ERISA
lawsuit is pending in U.S. District Court for the Eastern District of North
Carolina. These securities and ERISA lawsuits are at an early stage, and no lead
plaintiff has yet been appointed, nor a consolidated amended complaint served,
in the federal securities litigation. We are not required to file an answer or
motion to dismiss in the federal lawsuits until after service of the
consolidated amended complaint on us and no discovery has yet occurred in these
lawsuits. By, and subject to, the terms of our bylaws, we have certain
obligations to indemnify the current and former officers and employees of the
Company who have been named as defendants in these lawsuits. We have purchased
directors and officers liability insurance (D&O insurance) that may provide
coverage for some or all of these lawsuits and governmental investigations.
There is a risk, however, that some or all of the claims or expenses will not
be covered by such policies; or that, even if covered, our ultimate liability
will exceed the available insurance. Although we intend to vigorously pursue
all defenses available in these lawsuits, an adverse determination in these
lawsuits or an inability to obtain payment under our D&O insurance policies for
litigation and indemnification costs and any damages ultimately borne by us as
a result of these lawsuits and investigations could have a material adverse
effect on our business, financial condition, results of operations or cash
flows. Patent Litigation We are a party to a number of legal actions with generic drug companies. We
are involved in four lawsuits centered on our omeprazole-related patents,
including one lawsuit brought by us against an alleged infringer of our patents
and three lawsuits which were brought by third parties against us and are
currently essentially inactive. Omeprazole is the active ingredient found in
Prilosec, a drug sold by AstraZeneca. 25




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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 U.S. District Court
for the Southern District of New York in July 2001 and November 2001. The
plaintiffs in these cases have challenged 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 of these cases against us are in early stages of litigation. However,
while these plaintiffs have sought approval from the FDA to market a generic
form of Prilosec, no such FDA approval has, as of March 14, 2004, been granted
to them. In addition, these plaintiffs omeprazole product has been found in
separate litigation to infringe certain patents of AstraZeneca and the
infringement findings have been upheld on appeal. These lawsuits are
essentially inactive at this time. Only limited discovery has occurred in
these lawsuits and no additional discovery is currently being sought. No date
has been set for trial. In the event that these lawsuits again become active,
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 against us in
August 2001 by Andrx Pharmaceuticals, Inc. in the U.S. District Court for the
Southern District of New York. Andrx has
challenged the validity of three of our omeprazole patents and has also sought
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
has sought injunctive relief and unspecified treble damages. We have denied the
substantive allegations made by Andrx. This case is in an early stage of litigation. While Andrx has received FDA
approval for its generic omeprazole product, 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, which
findings have been upheld on appeal. No date has been set for trial. No
discovery is currently being sought. We have filed a motion to dismiss the
litigation on various grounds and Andrx has objected to our motion. The
lawsuit is essentially inactive at this time. As of June 1, 2004, the judge
has not decided our motion to dismiss the litigation. 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, together with the other named
defendants, KUDCO) in the U.S. District Court for the Southern District of New
York. KUDCO has a generic omeprazole product with final FDA marketing
approval, was found not to infringe the AstraZeneca patents in the separate
AstraZeneca patent litigation, and is currently selling its generic substitute
for Prilosec in the U.S. marketplace. We initially brought the lawsuit under our U.S. Patent No. 6,268,385.
Following the collection of additional information concerning KUDCOs
commercially marketed product, we sought leave of the court to file an amended
complaint, adding additional claims of infringement and contributory
infringement under our U.S. Patent No. 6,326,384 and joining as defendants
Schwarz Pharma Manufacturing Inc. and Schwarz Pharma USA Holdings Inc. These
two patents include, among other claims, claims directed to compositions and
methods wherein certain characteristics of solid state omeprazole are
essentially the same in formulated drug product as in its active ingredient. In September 2003, the judge granted us leave to file the first amended
complaint adding our second patent and the additional KUDCO affiliates to the
lawsuit. Following initial discovery, we sought leave of the 26




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court to file a second amended complaint, adding Kremers Urban Inc., another KUDCO affiliate,
to the lawsuit. On February 26, 2004, the judge granted us leave to file the
second amended complaint, adding Kremers Urban Inc. to the lawsuit. KUDCO has filed its answer to our complaint, denying our claims, asserting
various affirmative defenses to our claims, and asserting counterclaims of
patent invalidity, product non-infringement and antitrust violations under
federal and state antitrust laws. KUDCO is also contesting the personal
jurisdiction of the court over all of the defendants in this lawsuit other than
Kremers Urban Development Co., Kremers Urban Inc. and Schwarz Pharma Inc.
Motions on the jurisdictional issues are pending before the court. We have
denied the substantive allegations made by KUDCO in its counterclaims. Substantial discovery of both sides documents and of defendants product
samples has occurred in the lawsuit, although both sides asserted numerous
discovery deficiencies against the other in the lawsuit. On February 26, 2004,
the judge assigned the discovery disputes to a federal magistrate for
resolution. Discovery is continuing at this time. The parties previously had
agreed to the commencement of the trial in January 2005 but have recently moved
the trial date to June 2005. We have previously indicated to KUDCO a willingness to grant a license under
our omeprazole patents for an appropriate royalty. In the absence of KUDCO taking a royalty-bearing license, we are seeking
damages equal to a reasonable royalty on all infringing sales by the KUDCO
defendants since commercial launch of their generic substitute for Prilosec on
December 9, 2002 through the date of a judicial decision in the litigation, and
a permanent injunction on subsequent sales thereafter (unless KUDCO takes a
license), among other remedies, in the event that we ultimately prevail in the
litigation. The KUDCO defendants have publicly confirmed sales of their generic
omeprazole product during the first sixteen months after launch of their
product of approximately $1.1 billion. In the absence of a license, we intend
to vigorously prosecute the case, defend our 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 and, while currently stayed by
the judge in the KUDCO litigation, it is possible that the defendants
antitrust counterclaims will ultimately be allowed to proceed and be litigated
and, if adversely found, a material adverse effect on our consolidated
financial statements, results of operations or cash flow could result. In cases where we have initiated an action, we intend to prosecute our claims
to the full extent of our rights under the law. In cases where we are named
defendants, we intend to vigorously pursue all defenses available. Contract Sales Force Litigation On April 15, 2004, we filed a lawsuit against Athlon Pharmaceuticals, Inc.
seeking a declaratory judgment that we were entitled to terminate the Service
Agreement (the Athlon Service Agreement) dated July 16, 2003, as amended,
between us and Athlon as well as damages and injunctive relief for material
breaches of the Athlon Service Agreement by Athlon. The Athlon Service
Agreement incorporated the terms and conditions pursuant to which
representatives of Athlon would promote the sale of our Darvocet A500 product
to physicians. We initially paid Athlon $3,350,000 to build its sales force to
promote the sale of our Darvocet A500, and the terms of the Athlon Service
Agreement would require us to pay Athlon an additional $1,200,000 each month
for such services for the contract period of 36 months, commencing in October
2003, subject to Athlons compliance with certain representations, warranties
and covenants, some of which are described below. 27




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The lawsuit asserts that Athlon has materially breached the Athlon Service
Agreement in several ways, including failure to: (i) provide the required
number of sales representatives during our launch of Darvocet A500 commencing
in October 2003, (ii) use its best efforts to promote Darvocet A500 at the
targeted levels of first and second pharmaceutical details to physicians, (iii)
perform the services to the best of its ability, as contractually required, and
(iv) require its sales representatives to perform the contracted services, as
required, in a professional manner consistent with industry standards and in
conformance with that level of care and skill ordinarily exercised by
professional contract sales organizations in similar circumstances. The lawsuit
also asserts that Athlon breached its representation and warranty that it would
perform, and would require its sales representatives to perform, the contracted
services in substantially the same manner that it would promote Athlons own
products. Athlon has asserted several counterclaims, including breach of an implied
covenant of good faith in fair dealing and anticipatory breach of the contract.
We have filed a reply denying these allegations. On June 4, 2004, we sent a notice of termination of the Athlon Service
Agreement to Athlon. We also informed Athlon of our intent to amend the
lawsuit to assert the defense of fraud in the inducement in the formation of
the agreement on the part of Athlon and other claims. We intend to prosecute our claims, and defend against the counterclaims made by
Athlon in connection with the referenced lawsuit or related litigation, to the
full extent permitted by law. Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to our stockholders during the fourth quarter of
2003. 28




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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 National
Market under the symbol AAII, is listed below by quarter for the years ended
December 31, 2003 and 2002: QuarterFirst
    
    Second
    
    Third
    
    Fourth2003:High
    
    $
    21.90
    
    
    $
    20.10
    
    
    $
    22.22
    
    
    $
    25.85Low
    
    $
    8.15
    
    
    $
    8.62
    
    
    $
    15.99
    
    
    $
    16.682002:High
    
    $
    23.96
    
    
    $
    25.35
    
    
    $
    14.36
    
    
    $
    11.51Low
    
    $
    14.09
    
    
    $
    11.73
    
    
    $
    7.68
    
    
    $
    6.54
 The foregoing prices have been adjusted for the three-for-two common stock
split, effected through a stock dividend, paid on March 10, 2003. We estimate there were approximately 5,450 holders of record for our common
stock as of March 31, 2004. No cash dividends were declared during 2003 or
2002, and our senior secured credit facilities prohibit us from paying cash
dividends. We received notice on March 30, 2004 from the NASDAQ National Market that, due
to the delay in filing of our Form 10-K for the fiscal year ended December 31,
2003, we were not in compliance with certain NASDAQ marketplace rules and that
our common stock would be subject to delisting at the opening of business on
April 8, 2004, unless we requested a hearing pursuant to NASDAQ rules. We
requested and participated in a hearing before a NASDAQ listing qualifications
panel on April 29, 2004 in which we committed to filing this Report on Form
10-K on or before June 15, 2004 and to file amended quarterly reports on Form
10-Q for each of the three quarters of 2003, and our quarterly report on Form
10-Q for the period ended March 31, 2004, on or before June 30, 2004. We have
not received notification of the outcome of the delisting hearing. On May 18,
2004, we received notice from the NASDAQ National Market that we were
delinquent in the filing of our Form 10-Q for the period ended March 31, 2004. 29




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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(as2003
    
    restated)
    
    2001
    
    2000
    
    1999(in thousands, except per share amounts)Statement of Operations Data:Net revenues
    
    $
    224,977
    
    
    $
    230,510
    
    
    $
    141,073
    
    
    $
    104,245
    
    
    $
    102,175Direct costs (excluding depreciation
and royalty expense)
    
    
    114,837
    
    
    
    90,697
    
    
    
    67,197
    
    
    
    47,642
    
    
    
    52,611Selling
    
    
    39,534
    
    
    
    23,077
    
    
    
    13,749
    
    
    
    11,652
    
    
    
    11,945General and administrative
    
    
    40,463
    
    
    
    40,109
    
    
    
    26,538
    
    
    
    23,773
    
    
    
    21,992Research and development
    
    
    21,788
    
    
    
    20,853
    
    
    
    10,482
    
    
    
    11,891
    
    
    
    10,760Depreciation
    
    
    7,973
    
    
    
    7,156
    
    
    
    7,755
    
    
    
    7,253
    
    
    
    7,249Royalty expense
    
    
    1,095
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Intangible asset impairment
    
    
    20,600
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Direct pharmaceutical start-up costs
    
    
    
    
    
    
    
    
    
    
    2,123
    
    
    
    
    
    
    
    Transaction, integration and
restructuring costs (1)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,400Income (loss) from operations
    
    
    (21,313
    )
    
    
    48,618
    
    
    
    13,229
    
    
    
    2,034
    
    
    
    (8,782
    )Other expense, net
    
    
    (15,892
    )
    
    
    (26,958
    )
    
    
    (4,090
    )
    
    
    (1,916
    )
    
    
    (1,409
    )Income (loss) before income taxes and
cumulative effect of accounting
change
    
    
    (37,205
    )
    
    
    21,660
    
    
    
    9,139
    
    
    
    118
    
    
    
    (10,191
    )Provision for (benefit from) income
Taxes
    
    
    (4,502
    )
    
    
    8,542
    
    
    
    3,199
    
    
    
    (441
    )
    
    
    (2,278
    )Income (loss) before cumulative effect
of accounting change
    
    
    (32,703
    )
    
    
    13,118
    
    
    
    5,940
    
    
    
    559
    
    
    
    (7,913
    )Cumulative effect of a change in
accounting principle, net of a tax
benefit of $495
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (961
    )
    
    
    Net income (loss)
    
    $
    (32,703
    )
    
    $
    13,118
    
    
    $
    5,940
    
    
    $
    (402
    )
    
    $
    (7,913
    )Basic earnings (loss) per share (2)
    
    $
    (1.18
    )
    
    $
    0.48
    
    
    $
    0.22
    
    
    $
    (0.02
    )
    
    $
    (0.31
    )Weighted average shares outstanding
    
    
    27,730
    
    
    
    27,348
    
    
    
    26,691
    
    
    
    26,232
    
    
    
    25,806Diluted earnings (loss) per share (2)
    
    $
    (1.18
    )
    
    $
    0.46
    
    
    $
    0.22
    
    
    $
    (0.02
    )
    
    $
    (0.31
    )Weighted average shares outstanding
    
    
    27,730
    
    
    
    28,359
    
    
    
    27,462
    
    
    
    26,657
    
    
    
    25,806
 30




---



##### 



As of December 31,20022003
    
    (as restated)
    
    2001
    
    2000
    
    1999(in thousands)Balance Sheet Data:Cash and cash equivalents
    
    $
    8,785
    
    
    $
    6,532
    
    
    $
    6,371
    
    
    $
    1,225
    
    
    $
    1,988Working capital
    
    
    (12,960
    )
    
    
    15,357
    
    
    
    20,493
    
    
    
    10,558
    
    
    
    6,507Property and equipment, net
    
    
    57,236
    
    
    
    53,125
    
    
    
    37,035
    
    
    
    42,161
    
    
    
    45,026Total assets
    
    
    534,597
    
    
    
    433,502
    
    
    
    196,286
    
    
    
    112,151
    
    
    
    123,558Long-term debt, less current portion
    
    
    338,844
    
    
    
    277,899
    
    
    
    78,878
    
    
    
    509
    
    
    
    962Redeemable warrants
    
    
    
    
    
    
    
    
    
    
    2,855
    
    
    
    
    
    
    
    Total stockholders equity
    
    
    74,723
    
    
    
    95,254
    
    
    
    76,364
    
    
    
    65,721
    
    
    
    66,558
  (1)
    
    In connection with our merger with Medical & Technical Research
Associates, Inc., we recorded a $6.4 million unusual item in 1999.(2)
    
    All share and per share amounts have been restated to reflect the
March 2003 three-for-two stock split for each period presented as if it
had occurred at the beginning of the period. 31




---



##### 



Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations The Company is restating its financial statements for the first, second and
third quarters of both 2002 and 2003 and for the year 2002 (the Restatement). The
Restatement is reported in this Annual Report on Form 10-K for the year ended
December 31, 2003 and will be reported in amendments to our Quarterly Reports
on Form 10-Q for the periods ended March 31, 2003, June 30, 2003 and September
30, 2003. 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 policies relating to revenue recognition, intangible
assets, inventories and income taxes. These policies are summarized below under
Critical Accounting Policies. Overview We are a science-based specialty pharmaceutical company with over twenty-four
years experience in drug development. In 2003 and 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 three-for-two 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 each period presented as if it had occurred at
the beginning of the period. Pharmaceuticals Division  Our Product Sales Business Our product sales business unit commercializes 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 our various brand names as well as certain generic products. In
2003, we began selling the following products: Product
    
    MonthCalcitriol
    
    MarchAzathioprine
    
    MarchDarvocet A500
    
    SeptemberRoxicodone
    
    DecemberOramorph SR
    
    DecemberRoxanol
    
    DecemberDuraclon
    
    December
 The principal costs of this business include manufacturing costs, either
internally or under agreements with third-party manufacturers, selling expense
of our sales force, payments in connection with a contract sales force and
general and administrative costs of our business unit management team. Our
product sales business unit also includes the commercial manufacturing of low
volume products marketed and sold by other pharmaceutical companies. During
2003, net revenues from product sales were $122.0 million, or 54% of our
consolidated net revenues. 32




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##### 



Our results of operations can be influenced by the timing of purchases made by
our customers and the magnitude of the inventories of our products that our
customers desire to maintain. 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, as described in more detail below, there
may be some volatility of our pharmaceutical product revenues in future periods
due to the timing of our customers purchasing decisions. AAI Development Services  Our Development Services Business Our development services business unit, AAI Development Services, 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. During
2003, net revenues of our development services business unit were $86.5
million, or 38% of our consolidated net revenues. Research and Development Division  Our Product Development Business Our product development business unit, our Research and Development Division,
uses our research and development expertise and capabilities to enhance and
develop new drug-delivery technologies and improve existing pharmaceutical
products. We also 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. During 2003, net revenues of our product development business unit
were $16.5 million, or 7% of our consolidated net revenues. Product Acquisitions Roxicodone, Oramorph SR, Roxanol and Duraclon Product Lines. On December 2,
2003, we acquired a line of pain management products, which treat
moderate-to-severe pain, (the New Pain Products) and existing inventory from
subsidiaries of Elan Corporation, plc. in an asset purchase. We acquired these
product lines and related intangible assets for $102.5 million, exclusive of
transactional costs. To finance this acquisition, which included $5.1 million
of inventory, we used the proceeds from our then-existing senior term loan
credit facility, as described in -Liquidity and Capital Resources. As part
of this transaction, we recorded a $1.5 million pretax loss for the early
extinguishment of debt related to the write-off of financing fees associated 33




---



##### 



with a term loan refinanced in connection with the acquisition. The New Pain
Products 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 tangible and intangible assets. Based on this
allocation, approximately $98 million of intangible assets have been recorded and will be
amortized over 20 years. Darvocet A500. We acquired a product, which we subsequently launched as
Darvocet A500, from Athlon Pharmaceuticals in July 2003 for a cash closing
payment and royalties based on the sales of this product and other defined
propoxyphene and acetaminophen products we subsequently developed or acquired.
Due to safety concerns about the potential for liver toxicity from large doses
of acetaminophen, the FDA established a 4,000 mg maximum daily dose for adults.
Containing only 500 mg of acetaminophen, compared to 650 mg in Darvocet-N 100,
new Darvocet A500 taken at the daily dose, provides 1,000 mg less acetaminophen
than the FDA limit. Because many patients continue taking over-the-counter
pain relievers and sleep aids containing acetaminophen in addition to a
prescription pain reliever, Darvocet A500 reduces the likelihood of exceeding
the recommended daily limit for acetaminophen when taken up to six times per
day, without sacrificing analgesic efficacy. We received FDA approval of
Darvocet A500 on September 10, 2003, and launched the product nationally in
early October 2003. We recorded a $4.7 million acquisition cost as an
intangible asset. We performed an impairment analysis using an
updated sales forecast as of December 31, 2003
and have written off the entire value of the intangible asset. We also entered a three-year services agreement with Athlon Pharmaceuticals to
provide sales support in designated territories throughout the United States
for the Darvocet A500 product. Athlon received a fixed monthly fee of $1.2
million for the sales support services, and was entitled to potential milestone
payments based on the sales of this product and other defined propoxyphene and
acetaminophen products we subsequently developed or acquired. This agreement
was effective October 1, 2003 and has a stated term of 36 months. We have
initiated legal proceedings against Athlon and have terminated this agreement.
See Liquidity and Capital ResourcesCommitments and Contingencies and Note
11 of Notes to Consolidated Financial Statements included elsewhere in this
report. Darvon and Darvocet Product Lines. On March 28, 2002, we acquired the U.S.
rights to the Darvon and Darvocet branded product lines, which treat
mild-to-moderate pain, and existing inventory from Eli Lilly. We acquired
these product lines and related intangible assets for $211.4 million, exclusive
of transactional costs. To finance this acquisition, which included $1.8
million of inventory, we used the proceeds from our then-existing senior
secured credit facilities and senior subordinated notes, as described in
"-Liquidity and Capital Resources. The Darvon and Darvocet 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 tangible and intangible identifiable assets. 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, exclusive of transactional costs, 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 have allocated the purchase price to acquired tangible and
intangible identifiable assets. 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 $52.5 million, exclusive of transactional costs,
paid at closing, plus additional consideration described below. We funded this
purchase price with increased borrowings under our then-existing senior credit
facilities. Our M.V.I. and Aquasol product line acquisition agreement was
amended on July 22, 2003. As amended, it provided for two $1.0 million
guaranteed payments, which were made in August 2002 and 2003, eliminated a
contingent payment of $2.0 million that was potentially due in August 2003
under the original agreement, and provided for a future 34




---



##### 



contingent payment of $43.5 million potentially due in August 2004, depending on the status of
certain reformulation activities being carried out by the seller and regulatory
approval of the reformulation by the
FDA. The amount of the $43.5 million contingent payment was to be reduced by
$1 million per month if the conditions for the contingent payment had not
occurred by December 31, 2002. The conditions for the contingent payment were
not met by the required date, so the amount of the contingent payment had
decreased by $12.0 million by the end of December 2003. Such conditions were
satisfied in January and February 2004, fixing the liability at $31.5 million.
As of December 31, 2003, this contingent obligation had not been recorded as a
liability on our consolidated balance sheet and will be recorded in the first
quarter of 2004. Also on July 22, 2003, the M.V.I. supply agreement with the
seller was extended through 2008, subject to early termination rights by us on
six months notice given at any time, and by the supplier on twenty-four months
notice given at any time on or after August 17, 2004. The M.V.I. and Aquasol
product lines did not have separable assets and liabilities associated with
them other than inventory, therefore we have allocated the remaining purchase
price to acquired identifiable intangible assets. Product Disposition On April 26, 2004, we sold our M.V.I. and Aquasol product business to Mayne
Pharma for $105 million, subject to adjustments based on inventory levels at
closing and other post-closing obligations. A portion of the closing payment
is held in escrow to satisfy our post-closing obligations under the agreement.
In addition, we are entitled to royalties on sales levels, above specified
thresholds, of the M.V.I. line extension product that does not contain vitamin
K, which we developed. At the closing of the transaction, we paid to
AstraZeneca AB the $31.5 million payment due in August 2004, which was
discounted to approximately $31.0 million. This payment represents a deferred
purchase price payment for the original acquisition of the M.V.I. product
business from AstraZeneca. Restatement of Previously Issued Financial Statements We are restating our financial statements for the first, second and third
quarters of both 2002 and 2003 and for the year 2002. The
restatements are reported in
this Annual Report on Form 10-K for the year ended December 31, 2003 and will
be reported in amendments to our Quarterly Reports on Form 10-Q for the
quarterly periods ended March 31, 2003, June 30, 2003 and September 30, 2003.
The restatements correct the Companys revenue recognition of certain
transactions, including specific product sales in 2003, that did not satisfy
all of the conditions for recognition of revenue under SFAS 48 and/or SAB 101,
increase reserves for product returns and record other
adjustments to our revenue reserves for 2003, and reflects a different
accounting treatment for our acquired products. On February 27, 2004, our Board of Directors appointed a committee consisting
of all of the non-employee members of our Board of Directors (the Special
Committee) to conduct an inquiry into unusual sales in our Brethine and
Darvocet product lines and other matters during the second half of 2003. King &
Spalding LLP, an independent law firm, and Deloitte & Touche USA LLP, as
independent forensic accountants, were engaged to assist the Special Committee
in this inquiry. In connection with the Special Committees inquiry, we determined that certain
matters required a material adjustment to the 2003 financial information
included in our February 5, 2004 press release and the financial information
for the period ended September 30, 2003 included in our quarterly report on
Form 10-Q for that period. On March 30, 2004, we also announced that material
adjustments may be required to the 2003 financial information included in our
previous Form 10-Q reports filed in 2003 for the periods ended March 31, and
June 30, 2003. We have determined that these reports on Form 10-Q will also
require material adjustments. 35




---



##### 



In addition to the accounting treatment adjustments identified in connection
with the Special Committees investigation, we have identified other
adjustments that affect the 2003 financial information that we had reported in
our February 5, 2004 press release. These adjustments include:  
    
    a charge of $15.9 million due to the impairment of our Brethine
intangible asset recorded in the fourth quarter of 2003;
    
    a $4.7 million impairment charge in the fourth quarter of 2003
which represents the entire intangible asset recorded in the third
quarter relating to the acquisition of Darvocet A500;
    
    a $7.3 million increase in our returns reserve for sales of
Brethine and Darvon/Darvocet products in the fourth quarter of 2003;
    
    a $2.7 million increase in our inventory obsolescence reserve
in the fourth quarter of 2003;
    
    a $3.2 million increase in our chargeback reserve for sales in
the fourth quarter of 2003 for our Oramorph product; and
    
    a valuation allowance of $10.0 million as an offset
against our deferred tax asset as of December 31, 2003. In addition to the 2003 adjustments arising in connection with the Special
Committees investigation and the additional adjustments
identified above, we are restating our financial statements for the
year ended December 31, 2002 and for the periods ended March 31, June 30, and
September 30, 2002 and 2003 to treat each of our major product line
acquisitions as acquisitions of assets that do not constitute a business. On
January 14, 2004 and April 26, 2004, we received letters from the SECs
Division of Corporate Finance commenting on, asking questions about, and
seeking additional disclosure with respect to certain of our periodic reports.
Following these discussions with the Division of Corporate Finance and based on
additional analyses, we have changed the accounting treatment used from
treating the acquisitions as business combinations to treating them as asset
acquisitions. Accordingly, no portion of the purchase price for these
acquisitions is allocated to goodwill, and the amount previously allocated to
goodwill is instead allocated to the other identifiable acquired assets,
including assets with definite lives. As a result, our direct costs in 2002
are greater than the amount previously reported by $6.8 million due to the
increase in amortization expense resulting from a greater amount of purchase
price being allocated to assets with definite lives, and our directs costs in
2003 are greater than the amount we reported in our February 5, 2004 press
release for 2003 by $9.1 million. We
have reduced the net revenue and diluted earnings per share by $57.7 million and
$2.35, respectively, from the results reported in our February 5, 2004 press
release as a result of the identified adjustments. The financial results
reported in this Form 10-K have incorporated these adjustments. The following table summarizes the adjustments we have made to the financial information for the year ended
December 31, 2003 that we had reported in our February 5,
2004 press release. We will also make significant adjustments to the
financial information reported in our quarterly reports on
Form 10-Q for the first three quarters of 2003. Adjustments from the Special Committees investigation are discussed in
"Special Committee Investigation. Revenue
    
    Pre-Tax Income
    
    Net Income$ in millions, except
per share dataConsignment Sale / Reversal of Revenue:Calcitriol (A)
    
    $
    (1.6
    )
    
    $
    (1.0
    )
    
    $
    (0.6
    )AzaSan 75mg
and 100 mg (A)
    
    
    (0.4
    )
    
    
    (0.4
    )
    
    
    (0.3
    )Darvocet
A500 (A)
    
    
    (9.0
    )
    
    
    (8.1
    )
    
    
    (4.9
    )Calcitriol
(Puerto Rican wholesaler) (B)
    
    
    (4.5
    )
    
    
    (4.5
    )
    
    
    (2.7
    )Brethine
(new wholesaler) (C)
    
    
    (20.6
    )
    
    
    (17.9
    )
    
    
    (10.8
    )Return Reserves:Brethine
(second-tier wholesaler) (D)
    
    
    (6.8
    )
    
    
    (6.8
    )
    
    
    (4.1
    )Darvocet N
100 (E)
    
    
    (4.3
    )
    
    
    (4.3
    )
    
    
    (2.6
    )Brethine (10 and 100 count)
    
    
    (3.5
    )
    
    
    (3.5
    )
    
    
    (2.1
    )Darvon/Darvocet
    
    
    (3.8
    )
    
    
    (3.8
    )
    
    
    (2.3
    )Chargeback Reserves:Oramorph and other products
    
    
    (3.2
    )
    
    
    (3.2
    )
    
    
    (1.9
    )Inventory
Obsolescence:Darvocet A500 (F)
    
    
    
    
    
    
    (3.0
    )
    
    
    (1.8
    )Brethine (C)
    
    
    
    
    
    
    (1.2
    )
    
    
    (0.7
    )Other products
    
    
    
    
    
    
    (2.7
    )
    
    
    (1.6
    )Impairment of Intangible Assets:Brethine
    
    
    
    
    
    
    (15.9
    )
    
    
    (9.8
    )Darvocet
A500 (F)
    
    
    
    
    
    
    (4.4
    )
    
    
    (2.7
    )Other intangible assets
    
    
    
    
    
    
    (0.8
    )
    
    
    (0.5
    )Change in Accounting for Product Acquisitions:Amortization
    
    
    
    
    
    
    (9.1
    )
    
    
    (5.6
    )Taxes:Change in tax rate
    
    
    
    
    
    
    
    
    
    
    (2.0
    )Deferred tax allowance
    
    
    
    
    
    
    
    
    
    
    (10.0
    )Total Adjustments
    
    
    ($57.7
    )
    
    
    ($90.6
    )
    
    
    ($67.0
    )Fully Diluted EPS
    
    
    
    
    
    
    
    
    
    $
    (2.35
    )
 (A) See numbered
paragraph (1) under - Special
Committee Investigation below. The restatement of first quarter
revenues for our calcitriol        and AzaSan products, and the restatement
of third quarter revenues for our Darvocet A500 product, each of which will be
reflected in our        restated report on Form 10-Q for that quarter,
will be significant.
(B) See numbered paragraph (3) under - Special Committee
Investigation below.
(C) See numbered paragraph (4) under - Special
Committee Investigation below.
(D) See numbered paragraph (5) under - Special
Committee Investigation below.
(E) See numbered paragraph (6) under - Special Committee Investigation below.
(F) These numbers are net of amortization. See numbered
paragraph (2) under - Special Committee Investigation below. 2003 Financial Summary Our 2003 net revenues from pharmaceutical products were $122.0 million, $6.4
million less than our 2002 net revenues. Our net revenues were affected
positively by the December 2003 acquisition of the New Pain Products from Elan.
These products contributed $14.5 million to our 2003 net sales. In addition,
we recognized $3.0 million from net revenues associated with products we
launched in 2003. The net revenues generated by our principal product line,
the Darvon/Darvocet family of products, were essentially flat year over year,
although on an annualized basis product sales declined. The principal reasons
for the decline in net revenues were a decline in the net revenues recorded for
our Brethine line and, to a lesser extent, a decline in the net revenues of our
M.V.I. product line. Our Brethine product line experienced unusually high
product returns in the second half of 2003 which resulted in part from an
unanticipated market dynamic when we discontinued selling Brethine injectable
in its 100 count presentation. After discontinuing sales of the 100 count containers, wholesalers began returning the 100 count
containers rather than depleting their inventories. Additional reserves recorded by us in the
fourth quarter of 2003 to cover additional returns of Brethine injectable 100 count 36




---



##### 



further reduced our net revenues. In addition, sales of the M.V.I.
product line were also significantly down from the previous year. We sold this
product line to Mayne Pharma (USA) in April 2004. Our
liquidity in 2004 will be affected significantly by 2003 product sales. In 2003, we sold
products to wholesalers on terms permitting the return of the product within
six months if not resold by the wholesaler, including approximately $9 million
of launch quantity Darvocet A500 sold in the second half of 2003. In addition,
during the second half of 2003, we sold $20.5 million of Brethine injectable
product to a specialty wholesaler and $10.4 million of our Darvocet N-100, 500
count bottles, to repackagers that resulted in wholesaler channel inventory
levels significantly exceeding our target levels. For more detail
about our revenue recognition accounting policy, including the
establishment of our revenue reserves, see  Critical
Accounting Policies; Revenue Recognition. In addition to the special
return rights granted to wholesalers on certain of our products, each of our
products may be returned to us near the expiration date of the product. If the
wholesalers exercise their rights of return for these or other products, the
issuance of either a credit on future sales or a cash payment resulting from
such returns could have a material effect on our liquidity in 2004. In
addition, we are accounting for the shipments made to the specialty wholesaler
under the consignment model. We have received payment for these
shipments but will only record revenue when the wholesaler sells the
product.
Thus, we will record revenue in 2004 on the Brethine injectable product sold to
this specialty wholesaler in 2003 for which we will not receive any additional
cash payments. Finally, to the extent that wholesaler channel inventories of
our products exceed appropriate levels, our sales of these products in
subsequent periods may be adversely affected. The Development Services Division experienced modest growth in net revenues
over 2002 while we increased the use of this divisions capabilities to develop
both line extensions and new products for our Pharmaceuticals Division. Our
Development Services Division provided over 86,000 hours of service in
furthering the line extension efforts on our product line, as well as assisting
in the transfer of manufacturing from third parties to our own facilities.
These hours are reflected as expenses under research and development. We continue to invest both money and Development Services Division capacity to
our internal research and development efforts. In 2003, our research and
development expense was $21.8 million as we furthered the development of
products in our internal pipeline and expanded our intellectual properties
portfolio. We received $16.5 million of royalties in 2003 as a result of past
Research and Development Division efforts. Our Research and Development
program yielded one regulatory approval for three dosage strengths of one
product in 2003. We launched the product in the first quarter and subsequently
licensed the product to a third party in the fourth quarter. Our intellectual
property portfolio increased in 2003 when we received 10 newly issued United
States patents and filed an additional 10 patent applications with the U.S.
Patent and Trademark Office. We also continue to pursue our patent litigation
claims against several parties, see Note 11 of Notes to Consolidated Financial
Statements included elsewhere in this report. On August 5, 2003, we entered into a merger agreement with CIMA LABS INC.
(CIMA). The completion of the merger was subject to several conditions and
contained customary termination rights by each party in the event of higher
unsolicited offers by a third party. During the fourth quarter of 2003, we
announced the termination of our merger agreement by CIMA in light of a
competing offer for CIMA by a third party. As a result, we received an $11.5
million termination fee from CIMA, as provided in the terminated merger
agreement, against which $5.9 million of merger-related fees and expenses were
applied. The net amount of $5.6 million is recorded as other income on our
consolidated statement of operations. In 1994, we organized Endeavor Pharmaceuticals, Inc. (Endeavor) with several
investors to fund the development of hormone pharmaceutical products, initially
focusing on several generic hormone products already under development by us.
Based on subsequent investments by other investors, our interest, assuming
conversion, had been reduced to approximately 10% of the fully diluted common
equity of Endeavor. In the fourth quarter of 2003, Endeavor sold substantially all of its
assets to a third party. As part of this transaction, we 37




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recorded a pretax gain of $1.8 million for the sale of our investment in Endeavor. This gain is
included in other income on our consolidated statement of operations. As of
December 31, 2003, we no longer had any investment in Endeavor. For additional
information on our investment in Endeavor, see Note 8 of Notes to Consolidated
Financial Statements included elsewhere in this report. Special Committee Investigation On February 27, 2004 during the regularly scheduled meeting of the Companys
full Board of Directors, the Board appointed a Special Committee of all
non-employee directors to conduct an inquiry into unusual sales in our Brethine
and Darvocet product lines during the second half of 2003. The Board of
Directors requested the inquiry after receiving information during the meeting
that certain large sales transactions involving these product lines could
negatively impact 2004 sales. That same day, the Special Committee retained
King & Spalding LLP, an independent law firm, to assist in its inquiry. During
the week of March 1, 2004, King & Spalding, in turn, retained Deloitte & Touche
USA LLP, an independent accounting firm, as forensic auditors to assist in the
inquiry. Under the direction of the Special Committee, King & Spalding and
Deloitte & Touche began work on the inquiry immediately. Before the opening of trading on March 1, 2004, the first business day after
the appointment of the Special Committee, the Board of Directors announced the
appointment of the Special Committee and withdrew the Companys previously
announced earnings guidance for the first quarter and full year of 2004. The
Board of Directors also announced that, depending on the results of the
inquiry, adjustments to the Companys 2003 financial results, which were
previously announced in a February 5, 2004 press release and reported in
Quarterly Reports on Form 10-Q for the first three fiscal quarters of 2003,
might be necessary. The Special Committee, with the assistance of counsel and accounting experts,
conducted an extensive investigation that consisted of a review of over
1,000,000 pages of documents and the interview of over 35 aaiPharma employees,
officers, directors and other parties. During the course of the inquiry, the
Special Committees scope expanded beyond its initial charge to include
activities affecting the recognition of revenue in 2003, and other matters. In
a press release issued on April 27, 2004, the Company identified financial
adjustments relating to the recognition of revenue on certain transactions in
2003, and announced that it expected the reduction of revenue recognized for
2003 to be a material amount. As described in more detail below, as a result of the inquiry we have
determined that we must amend our quarterly reports on Form 10-Q for each of
the first three quarters of 2003 to restate our financial statements for the
first three quarters of 2003 to reflect revised accounting and revenue
recognition. These adjustments to our previously reported 2003 financial
information relate to the following transactions identified during the Special
Committees inquiry: (1) In connection with our new product launches in 2003 of calcitriol,
AzaSan 75 mg and 100 mg, Darvon Compound 32, and Darvocet A500, initial launch
quantities of these products were sold pursuant to guaranteed sale conditions
under which we agreed to accept returned product six months after the date of
purchase, if not resold by then. Revenue was recognized for these sales upon
shipment without the establishment of any special reserves to account for these
return rights. Because these launches were into new markets or were products
with which we did not have applicable or analogous historical experience, and
because most of the sales for these products had returns provisions
inconsistent with our normal returns provisions, we have concluded that we did
not have the ability to reasonably estimate returns, and that revenue for these
sales should not have been recognized until all of the conditions of SFAS 48
were met. Since all of the conditions of SFAS 48 had not been met for these sales of
calcitriol, AzaSan 75mg and 100mg, and Darvocet A500 products, revenue will be
recorded as if the sales were consignments. Calcitriol revenues have been
reduced by $1.6 million, AzaSan revenues have been reduced by $0.4 million and 38




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Darvocet A500 revenues have been reduced by $9.0 million. Under the
consignment model, upon shipment of product we invoice the wholesaler, record
deferred revenue at gross invoice sales price and classify the inventory held
by the wholesalers as consignment inventory at our cost of such inventory. We
will recognize revenue (net of discounts, rebates, sales allowances and
accruals for returns) when the consignment inventory is sold by the
wholesalers, as quantified using data from the wholesalers and other
third-party information sources. We will continue to recognize revenue on
these products on this basis until such time as we develop sufficient
historical experience on which to reasonably estimate returns and all other
conditions under SFAS 48 are met. With respect to Darvon Compound 32, sales of
this product were not material and specific returns reserves for this product were established in
2003 in connection with our decision to voluntarily withdraw this product from
the market. (2) In July 2003, we acquired a product that we subsequently marketed as
Darvocet A500. In connection with this acquisition, we entered into a purchase
agreement to acquire the rights to this product for a cash closing payment and
an obligation to make royalty payments based on sales of this product and any
subsequently developed or acquired defined propoxyphene and acetaminophen
products. At that time, we also entered into a service agreement with the
seller providing for a contract sales force to co-promote this product. We
made an upfront cash payment when this service agreement was executed and were
obligated to make additional monthly payments for 36 months once the product
was commercially launched (which occurred in October 2003) and potential
milestone incentive payments based on the sales of this product and any
subsequently developed or acquired defined propoxyphene and acetaminophen
products. On June 4, 2004 we sent a notice of termination of the
Athlon Service Agreement to Athlon and we have initiated litigation
against Athlon with respect thereto. See Item 3. Legal
Proceedings  Contract Sales Force Litigation. In the 2003 financial statements included in our Form 10-Q for the period ended
September 30, 2003, we recorded an intangible asset in the amount of the
closing payment with a definite life of 18.5 years. We have re-evaluated our
allocation of values associated with the concurrent agreements discussed above
and, with the assistance of third-party valuation consultants, have determined
the fair value of the intangible asset acquired as of the date of the
acquisition to be greater than the closing date payment. Accordingly, we have
re-allocated a portion of the value associated with the service agreement to
the purchase price of the intangible asset. Our adjusted financial statements
for the third quarter of 2003 reflect an intangible asset of $4.7 million. Our business plan for our Darvocet line extensions, including Darvocet A500,
was based in part on the belief that these products would not be subject to immediate
competition from generic products, although they would be subject to potential
generic competition. We have learned, however, that in some jurisdictions
pharmacists may fill prescriptions written for Darvocet A500 with generic
products that, though not recognized by the FDA as therapeutically equivalent
to Darvocet A500, may be deemed by the pharmacist to be therapeutically
equivalent. It is our understanding that a pharmacists profit margin on these
generic products generally exceeds the pharmacists profit margin on Darvocet
A500. As described above, we have also initiated litigation with
respect to the performance of the contract sales force in
co-promoting this product. These factors may have accounted for lower revenues from Darvocet A500
than we had initially estimated. In March and April of 2004, we began to receive significant return requests for
Darvocet A500 product sold under the guaranteed sale conditions noted above.
We subsequently contacted our wholesaler customers and utilized actual
inventory levels, in conjunction with third-party prescription data, to
re-evaluate our forecasted sales of the product. This identified a potential
impairment of the acquired Darvocet A500 intangible asset recorded in the third quarter 2003.
We conducted a review for impairment in accordance with SFAS 142 and SFAS 121,
Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets
to Be Disposed Of, and have recorded an impairment loss for the full amount of
this intangible asset, $4.7 million, in the fourth quarter 2003. In addition,
we have re-evaluated and reserved $3.0 million for potential inventory
obsolescence for quantities of the Darvocet A500 product on hand and in the
distribution channel in excess of estimated demand. 39




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(3) We recorded approximately $4.65 million in revenue in the third
quarter of 2003 for the sale of calcitriol product to a Puerto Rican wholesaler
that we have concluded should be reversed in the period in which it was
originally recorded. Our adjusted financial statements for the third quarter
of 2003 have reserved for substantially the full amount of the resulting
inventory, as a substantial amount has been returned and we do not expect the
remainder of this inventory to be sold. (4) There were substantial sales transactions at the end of the third and
fourth quarters of 2003 with a new wholesaler of our Brethine product resulting
in wholesaler channel inventory levels significantly exceeding our target
levels. We also continued to sell Brethine product during the fourth quarter
of 2003 to our established wholesaler customers, further adding to channel
inventory levels. The specialty wholesaler
was expected to open new distribution channels, for which we have
concluded we did not have the ability to reasonably estimate returns, and all
conditions of SFAS 48 were not met. In addition, sales of other products to
this new wholesaler during the third quarter of 2003 appear to have been on
special terms that do not satisfy the conditions of SFAS 48. We had recorded
revenue for these sales upon shipment of the products. The net revenues for these sales to the new specialty wholesaler of $12.3
million of Brethine and $3.9 million of other products in the third quarter of
2003 and $8.3 million of Brethine in the fourth quarter of 2003 have been
reversed in the respective periods they were originally recorded. Revenue will
be recognized as sales meet the criteria of SFAS 48. In addition, the
significant increase in inventory levels in the channel due to transactions
with this new wholesaler caused us to re-evaluate our overall reserves for our
Brethine products. As a result of our analyses, we have increased our
inventory obsolescence reserves by $1.2 million for specific inventory not
expected to sell through before product expiration. (5) There were significant returns in the first quarter of 2004 from a
second-tier wholesaler of our Brethine products that were inconsistent with our
historical returns experience. The bulk of these products was initially sold
by us during the first half of 2003 and was acquired by the second-tier
wholesaler in purchases from us and from one of our principal wholesalers.
Based on our knowledge regarding the market factors affecting these requested
returns, we now believe that this inventory was purchased by the wholesaler for
a particular opportunity that did not materialize. A specific returns reserve of $6.8 million, which included $3.3 million in the
first quarter, $2.6 million in the second quarter and $0.9 million in the third
quarter, has been recorded for these sales and for the related inventory in our
restated 2003 financial statements. (6) There were sales transactions in the fourth quarter of 2003 of our
Darvocet-N 100 500-count bottle product to repackagers resulting in channel
inventory levels significantly exceeding our target levels. Due to the level of inventory that existed in the market, we performed
additional procedures to determine whether there might be higher than
anticipated returns due to future expiration of product. This review included
direct communication with the repackager that had purchased the greatest volume
of this product during the fourth quarter to understand estimated usage
compared to inventory levels. Based on this review, we have concluded these
sales met the conditions of SFAS 48 for recognition, but we have increased our
returns reserve by $4.3 million to adequately cover potential product expiry
concerns. In April 2004, in connection with their audit of the Companys consolidated
financial statements for the year ended December 31, 2003, the Companys
independent auditors identified and communicated to
the Company and the Audit Committee two material weaknesses (as defined under
standards established by the American Institute of Certified Public
Accountants) relating to our accounting and public financial reporting of
significant matters and to its initial recording and management review and
oversight of certain accounting matters. In addition, at that time,
the independent auditors identified 40




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and communicated to the Company and the Audit Committee a
reportable condition (as defined under standards established by the American
Institute of Certified Public Accountants) relating to our internal controls
over our financial reporting for investments. As a result of the information developed during the Special Committees review,
we identified a number of deficiencies in our systems of internal accounting
controls. The internal control deficiencies related to, among other things, a
lack of adequate policies on revenue recognition, and a lack of sufficient
control processes and procedures to effectively monitor and manage wholesaler
inventory levels, to ensure adequate contract approval oversight, and to ensure
effective communication among sales, marketing, finance and legal staff
regarding the terms and conditions of new product launches. We have also
concluded that we did not have an adequate demand-based budgeting approach, and with respect to
the sales of pharmaceutical products, our finance and accounting personnel
lacked adequate training on the application of revenue recognition principles
and the establishment of product return reserves. We determined that we need to dedicate additional attention and resources to
develop formal revenue recognition protocols and training programs, to
implement appropriate contract approval policies and financial reporting
structures and processes, and to ensure that the company has qualified
employees overseeing compliance with applicable accounting principles,
securities laws and regulations. Our new management has undertaken a
substantial process to improve our existing policies, processes and personnel.
In March of 2004, Dr. Sancilio, the Companys Executive Chairman and Chief
Scientific Officer, replaced Dr. Tabbiner as Chief Executive Officer, and
Gregory F. Rayburn was appointed Interim Chief Operating Officer. In April
2004, Timothy R. Wright was appointed President of the Companys
Pharmaceuticals Products Division. Gina Gutzeit was appointed as Interim Chief
Financial Officer in May 2004. Significant Development Agreement We have a development agreement with a customer that provides for us to receive
contingent periodic royalties 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 customer is a major
pharmaceutical company with net assets in excess of $2.0 billion. 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 our customers sales of the product, and have recognized
development services revenue related to the product life cycle management
project. Product development revenues from this agreement were $13.0 million in
2003, $16.9 million in 2002 and $14.9 million in 2001. We recognized no
research and development expense in 2003, 2002 and 2001 associated with the
payments we received in those years. The expense of our work associated with
these revenues was recognized primarily in 1997 through 1999. We do not
anticipate incurring significant expense associated with the product
development revenues under this agreement in future periods. Development
services revenues associated with this agreement were $2.7 million in 2003,
$4.7 million in 2002 and $6.3 million in 2001. 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$1.0 million in
2003, $0.7 million in 2002 and $2.3 million in 2001. Accordingly, for our
development services business unit, we have recognized no expense associated
with the development services revenue arising under this agreement, as this
expense was recognized by our product development business unit. We
are entitled to receive these periodic royalties based on
sales of the customers product only if we make available exclusively to our
customer our product development and reformulation services with respect to a
limited group of drugs that include the customers product. This obligation
does not 41




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prevent us from engaging in these development and reformulation
activities for products that we may develop for ourselves. As we remain available to provide the customer with these services on this
basis in a calendar quarter, we will be entitled to royalties based on the
level of sales over a prior monthly period of the product. 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 royalties in three consecutive quarters, with, for example, the
amount of the royalties in the first quarter being based on product sales in the
first month. However, if we do not
continue to provide these development and reformulation services on the
exclusive basis described above in any quarter, we will not be entitled to
the royalties 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 reformulation services on an exclusive basis. Accordingly, we do not recognize product
development revenues under this agreement in any quarter until we have
satisfied the exclusivity requirement for that quarter. 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 2001, 2002 and 2003 the project was
at the minimum contractual levels. The customer is obligated to continue the
project at the minimum level in 2004, which is approximately $0.7 million. In April 2004, we entered into an agreement to receive a prepayment of amounts
that would otherwise be paid to us quarterly through the second quarter of
2005. These payments would have aggregated $15.4 million. Our agreement to
receive a prepayment of these amounts applied a 5% per annum discount from the
date the payment would otherwise be due to the date paid. In April 2004, we
received approximately $15.0 million in gross proceeds from prepayments made
pursuant to this agreement. We do not anticipate that we will receive further
material payments in connection with this significant development agreement in
the future. Our obligations under the significant development agreement with
respect to the prepaid amounts continue through the second quarter of 2005, and
we will recognize revenue associated with the prepayment as we satisfy these
contractual obligations during this period. 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 31,20022003
    
    (as restated)
    
    2001Net revenues:Product sales
    
    $
    122,021
    
    
    
    54
    %
    
    $
    128,462
    
    
    
    56
    %
    
    $
    27,448
    
    
    
    19
    %Product development
    
    
    16,468
    
    
    
    7
    
    
    
    19,610
    
    
    
    9
    
    
    
    20,426
    
    
    
    14Development services
    
    
    86,488
    
    
    
    39
    
    
    
    82,438
    
    
    
    35
    
    
    
    93,199
    
    
    
    67$
    224,977
    
    
    
    100
    %
    
    $
    230,510
    
    
    
    100
    %
    
    $
    141,073
    
    
    
    100
    %Direct costs (excluding depreciation
and royalty expense)
    
    $
    114,837
    
    
    
    51
    %
    
    $
    90,697
    
    
    
    39
    %
    
    $
    67,197
    
    
    
    48
    %Selling
    
    
    39,534
    
    
    
    18
    
    
    
    23,077
    
    
    
    10
    
    
    
    13,749
    
    
    
    10General and administrative
    
    
    40,463
    
    
    
    18
    
    
    
    40,109
    
    
    
    17
    
    
    
    26,538
    
    
    
    19
 42




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Years Ended December 31,20022003
    
    (as restated)
    
    2001Research and development
    
    
    21,788
    
    
    
    10
    
    
    
    20,853
    
    
    
    9
    
    
    
    10,482
    
    
    
    7Depreciation
    
    
    7,973
    
    
    
    4
    
    
    
    7,156
    
    
    
    3
    
    
    
    7,755
    
    
    
    5Royalty expense
    
    
    1,095
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Intangible asset impairment
    
    
    20,600
    
    
    
    9
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Direct pharmaceutical start-up costs
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,123
    
    
    
    2Income (loss) from operations
    
    
    (21,313
    )
    
    
    (9
    )
    
    
    48,618
    
    
    
    21
    
    
    
    13,229
    
    
    
    9Interest expense, net
    
    
    21,078
    
    
    
    9
    
    
    
    19,366
    
    
    
    8
    
    
    
    3,646
    
    
    
    3Loss from extinguishment of debt
    
    
    (1,511
    )
    
    
    (1
    )
    
    
    (8,053
    )
    
    
    (3
    )
    
    
    
    
    
    
    Other income (expense), net
    
    
    6,697
    
    
    
    3
    
    
    
    461
    
    
    
    
    
    
    
    (444
    )
    
    
    Provision for (benefit from) income
taxes
    
    
    (4,502
    )
    
    
    (2
    )
    
    
    8,542
    
    
    
    4
    
    
    
    3,199
    
    
    
    2Net income (loss)
    
    
    (32,703
    )
    
    
    (15
    )
    
    
    13,118
    
    
    
    6
    
    
    
    5,940
    
    
    
    4
 Year Ended December 31, 2003 Compared to Year Ended December 31, 2002 Our consolidated net revenues for the year ended December 31, 2003 decreased 2%
to $225.0 million, from $230.5 million in 2002. The decrease is attributable to
lower net revenues recorded from the sale of our pharmaceutical products and,
to a lesser extent, a reduction in product development revenues associated with
our significant development contract. Net revenues from product sales decreased to $122.0 million in 2003, from
$128.5 million in 2002. The decrease in net revenues is attributable to
reduced net sales at our Brethine line and, to a lesser extent,
reduced net sales of our M.V.I. line. These
reduced sales were mitigated in 2003 by the introduction
of several new products, including the New Pain Products acquired from Elan in
December 2003, our Darvocet A500 line extension introduced in September 2003
and our calcitriol injection product introduced in March 2003. These new
product offerings contributed an aggregate of $17.4 million to 2003 net
revenue, of which $14.5 million was attributable to sales of the New Pain
Products. In addition, price increases, primarily related to our Brethine
injectable product and Darvon and Darvocet product lines, accounted
for $9.5 million of our 2003 net revenue. Net revenues from commercial manufacturing of
products marketed by other pharmaceutical companies, which are included in
product sales, contributed $2.8 million and $4.1 million to net revenues from
product sales in 2003 and 2002, respectively. Net revenues from product development decreased 16% in 2003 to $16.5 million,
or 7% of net revenues, from $19.6 million, or 9% of net revenues, in 2002,
primarily due to lower revenues related to our significant development
agreement in 2003 and to third-party licensing payments which we had previously
deferred and were amortized into revenue in 2002 and prior years. No
previously deferred revenues were recognized in 2003. Net revenues from our development services business increased 5% in 2003 to
$86.5 million, from $82.4 million in 2002. This increase was principally
attributable to higher demand for our European bioanalytical and clinical
services and our U.S. analytical capabilities, partially offset by lower
fee-for-service revenues from lower demand for our clinical manufacturing and
formulations services and under our significant development agreement. 43




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Direct costs (excluding depreciation and royalty expense) increased $24.1
million, or 27%, to $114.8 million in 2003, from $90.7 million in 2002. This
increase in direct cost dollars resulted from higher product costs of $8.8
million, increased inventory reserves of $11.2 million related to estimated
reserves for excess wholesaler inventories in excess of anticipated demand in
2003 and increased amortization expense of $3.0 million related to product
rights for acquired products. Direct costs as a percentage of net revenues
increased to 51% in 2003 from 39% in 2002. Selling expenses increased 71% in 2003 to $39.5 million, or 18% of net
revenues, from $23.1 million, or 10% of net revenues, in 2002. This increase
is primarily due to expenses incurred by our product sales business associated
with developing our product sales force and marketing and promoting our new
products. As of December 31, 2003, our pharmaceutical sales force was
approximately 200, including 105 outside sales professionals added in October 2003 under an agreement with Athlon
Pharmaceuticals, from whom we acquired our Darvocet A500 product, as compared
to 50 sales professionals at December 31, 2002. In 2004, we have reviewed the
performance of the Athlon sales force performance and have terminated the
contract. General and administrative costs increased 1% in 2003 to $40.5 million, or 18%
of net revenues, from $40.1 million, or 17% of net revenues, in 2002. This
increase was primarily due to additions to our corporate infrastructure to
accommodate the expansion of our overall business, expenses related to the
management build-up for our product sales business and increased product
related insurance costs, partially offset by lower legal fees and employee
benefit related expenses.During 2003, we incurred legal fees and expenses in
our ongoing omeprazole patent litigation against Schwarz Pharma Inc., Schwarz
Pharma AG, Kremers Urban Development Co., and certain affiliates. We
anticipate that we will continue to incur legal fees and expenses in connection
with this litigation in 2004, as well as other litigation and investigations.
See Item 3. Legal Proceedings for additional information regarding this
litigation and other pending litigation that may significantly increase our
legal expenses in 2004. Research and development expenses increased 4% in 2003 to $21.8 million from
$20.9 million in 2002. These amounts represented 10% of net revenues in 2003
and 9% of net revenues in 2002. We incurred significant project spending in
2003 related to our ProSorb-D pain management product and development work on
line extensions for our pain management and critical care products. We target
annual research and development expenses to be approximately 8% to 10% of our
estimated net revenues. Royalty expenses in 2003 were $1.1 million. We accrue royalties based on
revenues generated by certain acquired products, including our Darvocet A500
product and our calcitriol product. These royalty expenses will continue in
2004. No similar royalty expenses were incurred in 2002. In December 2003, we recorded a $15.9 million charge due to the impairment of
an intangible asset associated with our acquired Brethine product. The
then-anticipated introduction of generic competition for this product (which
subsequently occurred in May 2004) affected our future anticipated revenues,
which negatively impacted the carrying value of the acquired intangible assets.
We also recorded a $4.7 million write down of the full amount of the
intangibles assets related to the Darvocet A500 product we acquired in 2003.
In March and April of 2004, we experienced significant requests for returns of
Darvocet A500. We re-evaluated our sales forecast for Darvocet A500 and
identified a potential impairment of the asset. As a result of the impairment
analysis, we determined that the asset needed to be written-off. The consolidated loss from operations was $21.3 million in 2003, compared to
consolidated income from operations of $48.6 million in 2002. This decrease
was primarily due to the lower product sales and product development revenues
in 2003, increased product-related costs and the intangible asset impairment
charges. 44




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Income from operations for our product sales business in 2003 was $2.5 million,
compared to $66.9 million in 2002. This decrease resulted from the combination
of reduced net sales, increases in our reserves for product returns, increased
sales costs associated with the launch of Darvocet A500, and the intangible
asset impairment recorded in the fourth quarter. Income from operations for our product development business was $16.5 million
in 2003, compared to income from operations of $19.6 million in 2002. This
change resulted from the decreased revenues from our significant development
agreement. Income from operations for our development services business was $1.0 million
in 2003, compared to $0.6 million in 2002. This increase is primarily due to
increased margins in our bioanalytical and analytical businesses in 2003. The
increase in revenues was the primary reason for the higher operating margins
achieved in 2003. Unallocated corporate expenses increased in 2003 to $19.0 million, or 8% of net
revenues, from $17.1 million, or 7% of net revenues, in 2002. This higher
level was due to additions to our corporate infrastructure to accommodate the
expansion of our overall business. Net interest expense increased to $21.1 million in 2003, from $19.4 million in
2002. This $1.7 million increase is primarily attributable to the borrowings
that funded our product line acquisitions in December 2003 and March 2002,
partially offset by debt repayments and lower interest rates on our variable
rate debt. Losses from the extinguishment of debt of $1.5 million and $8.1 million were
recorded in 2003 and 2002, respectively. These losses resulted from the
write-off of deferred financing and other costs due to the refinancing of our
term loan facility in December 2003 in connection with our New Pain Products
acquisition and the refinancing of our prior debt facilities in March 2002
related to our Darvon and Darvocet acquisition. Other income in 2003 includes $5.6 million related to the termination fee, net
of expenses, received from CIMA, and the $1.8 million gain from the sale of our
investment in Endeavor. We recorded a tax benefit of $4.5 million in 2003, based on an effective tax
rate of 39%, offset by a valuation allowance of $10.0 million because it is
more likely than not that some portion of the deferred tax asset will not be
realized. Our effective tax for 2002 was 39%. 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,
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 are 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, which increased from
$14.9 million in 2001 to $16.9 million in 2002. 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 45




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internal resources from external revenue-producing projects to research and development projects
relating to our own pharmaceutical products, both current and future. This
redeployment of resources was a strategic decision we made to expand our
proprietary product development pipeline through the increased use of our
development services (fee-for-service) segments core competencies. This
strategy has allowed us to better control project flow at lower costs. Direct costs (excluding depreciation expense) increased $23.5 million, or 35%,
to $90.7 million in 2002, from $67.2 million in 2001. This increase in direct
cost dollars resulted from the increase in revenue in 2002 and amortization
expense of $9.2 million related to product rights for acquired products.
Direct costs as a percentage of net revenues decreased to 39% in 2002 from 48%
in 2001. This favorable change was primarily the result of the change in the
mix of revenues in 2002, with product revenues increasing to 56% of total
revenues from 20% in 2001. Selling expenses increased 68% in 2002 to $23.1 million, from $13.7 million in
2001. This increase was principally due to additional selling expenses
incurred by our product sales business associated with marketing and promoting
our entire product line, maintaining and enhancing our relationships with
distributors, 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. 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. 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 $48.6 million in 2002, or $35.4 million
higher than the prior year, and was due to the expansion of our product sales
business. Income from operations for our product sales business was $66.9 million in
2002, compared to $7.7 million in the prior year. This increase was
attributable to the revenues and gross margin generated from our product line
acquisitions, partially offset by the product rights amortization expense of
$9.2 million. Income from operations for our product development business was $19.6 million
in 2002, compared to $20.4 million in 2001. This change resulted from the
decreased revenues under our significant development agreement, as discussed
above. Our expenses associated with the development work performed under this
agreement were recognized as incurred, primarily in 1997 through 1999. No
significant expense was associated with the product development revenues
recognized in 2002, 2001 or 2000. 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 was primarily due to the decline in development services
revenue, as described above. 46




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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 was primarily attributable to the net borrowings that
funded our product line acquisitions. A loss from the extinguishment of debt of $8.1 million was recorded in 2002.
This loss was due to the write-off of deferred financing and other costs
related to our prior debt facilities that were refinanced in March 2002. We recorded a tax provision of $8.5 million in 2002, based on an effective tax
rate of 39%. This rate was approximately equal to the statutory rate. Our
effective tax rate for 2001 was 35%, which reflected the utilization of tax
loss-carry forwards generated by our European operations. Liquidity and Capital Resources Historically, we have funded our business with cash flows provided by
operations and proceeds from borrowings. Net cash flow provided by operating
activities in 2003 was $38.4 million, up from $31.0 million in 2002. This
increase was primarily due to the significant increase in deferred revenues on
products accounted for under a consignment model, partially offset by negative
cashflow changes in deferred tax assets arising from temporary differences
between the tax and accounting treatment of the deferred revenues. Net cash used in investing activities was $114.3 million in 2003. This
included $102.5 million primarily related to our acquisition of the New Pain
Products. Capital expenditures were $11.9 million during 2003. Capital assets
purchased during 2003 were primarily related to setting up and transferring the
production for acquired products, purchases of information technology hardware
and software and upgrading and replacing laboratory equipment. Net cash provided by financing activities during 2003 was $78.0 million,
primarily representing net proceeds of $160.0 million in additional borrowings
under the term loan facility we entered into in December 2003, as described
below, $8.8 million of cash proceeds from the exercise of stock options and
$1.7 million related to the unamortized proceeds from the sales of our interest
rate swap, partially offset by the repayment of $93.5 million of borrowings
under the then-existing revolving credit facility and the prior term loan
credit facility. These repayments included $50.0 million from the proceeds of
the term loan we entered into in December 2003. The additional repayments were
funded by cash from operations as part of our program to aggressively pay down
our then-existing credit facility. These prepayments of our term loan
indebtedness reduced our liquidity. Net cash flow provided by operating activities in 2002 was $31.0 million, an
increase of $10.6 million from 2001. This change was primarily related to
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 acquisition. Net cash used in
investing activities was $235.1 million in 2002, which included $211.4 million
related to our Darvon and Darvocet acquisition, $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., and capital expenditures of $8.5 million. Net
cash provided by financing activities during 2002 was $204.2 million, primarily
representing net proceeds of $244.5 million in additional 47




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borrowings under our debt facilities, $10.5 million related to the unamortized proceeds from the
sales of our interest rate swap 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 operating activities, 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 M.V.I. and Brethine product line
acquisitions and $5.1 million of cash proceeds from the exercise of stock
options, offset by repayments under our then-existing revolving credit facility
of $16.3 million. Senior Credit Facilities On March 28, 2002, we acquired the U.S. rights to the Darvon and Darvocet
branded product lines and existing inventory from Eli Lilly and Company for
$211.4 million in cash. In connection with the acquisition, we entered into
$175 million of senior credit facilities, issued $175 million of senior
subordinated 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 consisted of a $75 million
five-year revolving credit facility and a $100 million five-year term loan
facility. The term loan facility amortized over the full five-year term. The
senior facilities were subsequently reduced due to repayments made under the
term loan facility. In December 2003, we repaid the remaining term loan
facility of $40 million and entered into a new $160 million term loan facility.
As part of this transaction, we recorded a $1.5 million pretax loss for the
early extinguishment of debt related to the write-off of financing fees
associated with the original term loan. These term loan and revolving credit
facilities provided for variable interest rates based on LIBOR or an alternate
base rate, at our option. On December 31, 2003, 30-day LIBOR was 1.12%. As a result of our failure to timely file our annual report on Form 10-K for
the year ended December 31, 2003, among other matters, we were in default under
the December 2003 term loan and revolving credit facilities. On April 23,
2004, we refinanced these facilities with a portion of the proceeds from the
M.V.I. and Aquasol Sale and with $140 million of senior credit facilities with
a syndicate of lenders, Silver Point Finance LLC (Silver Point) as collateral
agent, and Bank of America, N.A., as administrative agent. Our new senior
credit facilities consist of a two-year, $125 million senior secured term loan
facility (which was fully drawn at closing) and a two-year, $15 million senior
secured revolving credit facility, of which the full amount was available for
borrowing on June 9, 2004. The outstanding loans under our new senior credit
facilities are payable in full on the two-year anniversary date of the closing
of the facilities. Our new senior credit facilities are
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. Subject to exceptions set forth in the definitive
documentation, loans under our new senior credit facilities are also required
to be prepaid with a negotiated percentage of:  
    
    excess cash flow, as defined;
    
    non-ordinary course assets sales;
    
    net proceeds from the sale of subordinated indebtedness;
    
    net proceeds from the issuance of equity issuances; and
    
    extraordinary receipts, as defined. 48




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Optional reductions in revolving credit commitments and optional prepayments of
term loans are subject to a prepayment fee equal to 3% for the first 9 months
of the term of the facilities, 1.5% for the subsequent 9 months of such term,
and 0.75% for the next 3 months of such term (with no prepayment penalty
payable for the last 3 months of the term). Outstanding loans under the
facilities bear interest at a rate per annum equal to a defined LIBOR rate
(with a floor of 2%), plus 6.25%, or a defined reference rate (with a floor of
4%), plus 5.25%, in each case payable monthly in arrears. An additional 1% per
annum unused line fee is payable on unused revolving credit commitments,
payable quarterly in arrears. The proceeds of the loans were used, together with the net cash proceeds from
the M.V.I. and Aquasol Sale, to (i) fund payment of termination obligations
with respect to the our interest rate hedging agreement (discussed below), (ii)
refinance our then-existing senior credit facilities, (iii) fund the April 2004
interest payment due on our 11% senior subordinated notes due 2010, (iv)
provide for ongoing working capital and general corporate needs, and (v) pay for fees, costs and expenses in connection
with the new senior credit facilities and other corporate transactions. Our new senior credit facilities include customary representations and
warranties and customary affirmative and negative covenants, including
limitations on liens, indebtedness, fundamental transactions, dispositions of
assets, changes in the nature of our business, investments, acquisitions,
capital and operating leases, capital expenditures, dividends, redemptions or
other acquisitions of capital stock, redemptions or prepayments of other debt,
transactions with affiliates, issuances of capital stock, modifications of
indebtedness, organizational documents and other agreements, and retention of
excess cash. The facilities also provided for financial covenants, including a
minimum fixed charge ratio, a maximum senior debt to trailing twelve-month
EBITDA ratio, and a covenant requiring a certain level of cash or revolver
availability. Our new senior credit facilities include a covenant requiring us
to file with the Securities and Exchange Commission by September 30, 2004 our
annual report on Form 10-K for the year ended December 31, 2003 and other
periodic reports then required to be filed under the Securities Exchange Act of
1934. Events of default under the facilities include, among others, nonpayment
of principal, interest or fees, violations of covenants, inaccuracy of
representations and warranties, a cross-default to our 11% senior subordinated
notes due 2010 and other material indebtedness, bankruptcy events, and a change
in control. Subordinated Notes Due 2010 In March 2002, we issued $175 million of senior subordinated unsecured notes
due 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 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 not in compliance
with certain of these covenants at December 31, 2003, however defaults under
these covenants have been subsequently waived. On March 31, 2004, the lenders under our then-existing credit agreement, which
was then in default as described above, exercised their right to block us from
making the interest payment to holders of our senior subordinated notes due on
April 1, 2004. Accordingly, we did not make that interest payment on April 1,
2004. In addition, our failure to timely file our annual report on Form 10-K
for the year ended December 31, 2003 constituted a default under the indenture
governing the senior subordinated notes. 49




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On April 20, 2004, we completed a solicitation seeking the consent from holders
of our senior subordinated notes to approve a refinancing or replacement of our
then existing the credit facilities with our new senior credit facilities and
certain amendments to, and waivers under, the indenture governing the senior
subordinated notes to, among other things:  
    
    grant a lien to secure our obligations under the senior
subordinated notes, which lien is junior to the liens securing our
new senior credit facilities but covers the same collateral;
    
    increase the interest rate of the senior subordinated from 11%
per annum to 11.5% per annum effective April 1, 2004;
    
    suspend our obligation under the indenture to file periodic
reports with the SEC until the earlier of the date that our annual report on
Form 10-K for the year ended December 31, 2003 is filed with the
SEC or September 30, 2004, and suspend our obligation under the
indenture to furnish annual written statements of our
accountants until the fifth day after the earlier of the date that
our annual report on Form 10-K for the year ended
December 31, 2003 is filed with the SEC and September 30,
2004;
    
    further limit our ability to grant liens to secure certain
obligations unless the liens are subordinate to the liens securing
the senior subordinated notes or are otherwise permitted under the
indenture; and
    
    limit our ability to incur up to $10 million of indebtedness,
and to grant liens to secure that amount of indebtedness, not
otherwise specifically permitted by the indenture, until our annual
report on Form 10-K for the year ended December 31, 2003 is filed
with the SEC or unless the indebtedness is incurred to fund an
interest payment with respect to the senior subordinated debt. Following the completion of this consent solicitation, we entered into a
supplemental indenture to affect these amendments and waivers and made the
interest payments that had been due on April 1, 2004, together with default
interest. We made interest payments on the senior subordinated notes of $9.6 million in
October 2003 and $9.7 million in April 2004. The April 2004 interest payment
was offset by approximately $1.7 million received under our interest rate
hedging agreement, described below. Interest Rate Hedging Agreement Concurrently with the issuance of our senior subordinated notes, we entered
into an interest rate hedging agreement to effectively convert interest expense
on a portion of the 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 February 27, 2003, and again on June 23, 2003, we sold the then
outstanding hedging agreement for $2.3 million and $3.7 million, respectively,
and replaced it with a similar interest rate hedging agreement. The amounts we
received, less the interest benefits earned through the dates of sale, have
been recorded as premiums to the carrying amount of the notes and are being
amortized into interest income over their remaining life. This amortization
will be approximately $2.0 million annually. At December 31, 2003, we had an
interest rate hedging agreement in place covering $150 million of the notes, at
a rate of 6-month LIBOR plus 7.41%. On December 31, 2003, 6-month LIBOR was
1.22%, giving us an estimated all-in rate of 8.63%. The terms of the interest
rate hedging agreements, other than the base rate, were identical and were
perfectly matched with the terms of the related hedged instrument. Our obligations under the interest rate hedging agreement were secured by
collateral under our then-existing senior credit facilities. 50




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As a condition to establishing our new senior credit facilities, we terminated
the interest rate hedging agreement in April 2004. Our termination obligations
under the interest rate hedging agreement were approximately $9.4 million,
which amount was paid upon termination of that agreement. Income Tax Refunds Income tax refunds will be a source of near-term liquidity. We anticipate
receiving $4.5 million due on our 2003 tax filing and $0.5 million for the
amended 2002 tax filing. Commitments and Contingencies As discussed above, the conditions for the M.V.I. and Aquasol contingent
payment were not satisfied by the required date, so that the potential $43.5
million contingent payment had decreased by $12.0 million by December 31, 2003.
Such conditions were met in January and February 2004, fixing the liability at
$31.5 million. As of December 31, 2003, this contingent obligation had not
been recorded as a liability on our consolidated balance sheet and was recorded
in the first quarter of 2004. We discharged this obligation in April 2004. 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. At December 31, 2003 these contingent payment obligations, including
the contingent payments due in connection with the acquisition of the M.V.I.
and Aquasol product lines, had not been recorded as a liability on our
consolidated balance sheet. On August 7, 2003 we received a
letter from the staff of the Enforcement Division requesting voluntary
production of certain documents. We responded to this letter on August 21,
2003 and supplemented our response on August 29, 2003. Independent of the August 7, 2003 inquiry letter, on September 26, 2003,
certain members of our board and management voluntarily met with, and provided
documents to, the staff of the Enforcement Division. As a follow-up to this
September 26, 2003 meeting and as part of the inquiry initiated on August 7,
2003, on October 8, 2003, we received a further request from staff of the
Enforcement Division for voluntary production of certain documents, to which we
responded on October 30, 2003. On January 14, 2004 and April 26, 2004, we received letters from the SECs
Division of Corporate Finance commenting on, asking questions about, and
seeking additional disclosure with respect to certain of our periodic reports.
We have responded to these letters. In April 2004, in connection with an
investigation conducted by the U.S. Attorneys Office, we received five federal grand jury subpoenas for document
production and potential testimony related to, among other things, certain
transactions regarding our 2002 and 2003 financial information, the terms,
conditions of employment and compensation arrangements of certain of our senior
management personnel, compensation and incentive arrangements for employees
responsible for the sale of our Brethine, Darvocet, calcitriol, azathioprine
and Darvon Compound products, quantities of the foregoing products in
distribution channels, financial benefits with respect to specified corporate
transactions to our senior management and others, certain loans obtained by us,
extensions of credit, if any, by us to officers or directors, accounting for
sales and returns of our foregoing products, our analysts conference calls on
financial results, internal and external investigations of pharmaceutical
product sales activities, and related matters. We have also been advised that
the SEC has initiated an inquiry into at least the same issues investigated by the
Special Committee. The U.S. Attorneys Office has advised that we may also
receive a subpoena from the SEC. We and the Special Committee have agreed to cooperate fully with the government
investigations, and the Special Committee has agreed to share all results of
its investigation with the SEC and the U.S. Attorneys Office. To that end, two
meetings of our outside counsel with attorneys for the U.S. Attorneys Office
and the SEC have taken place and numerous documents as requested by these
government agencies have been voluntarily produced. We are attempting
to schedule a third meeting with the
U.S. Attorneys Office and the SEC in July in order
to provide additional information related to the Special Committees
investigation to these government agencies. We and the Special Committee
intend to facilitate any interviews of our employees or officers that may be
requested by these government agencies. The Department of Justice, SEC and other government agencies that are
investigating or might commence an investigation of aaiPharma could impose,
based on a claim of fraud, material misstatements, violation of false claims
law or otherwise, civil and/or criminal sanctions, including fines, penalties,
and/or administrative remedies. If any government sanctions are imposed, which
we cannot predict or reasonably estimate at this time, our business, financial
condition, results of operations or cash flows could be materially adversely
affected. These matters have resulted, and are expected to continue to result,
in a significant diversion of managements attention and resources and in
significant professional fees. On January 2, 2004, we received separate letters from the Kentucky Office of
Attorney General and the Florida Office of Attorney General advising that each
was currently investigating allegations regarding our pricing practices related
to our average manufacturer price and best price calculations that are used by
the government to set Medicaid reimbursement rates. Neither letter requested
that we provide any information, and each letter merely requested that we
retain all documents with respect to these calculations pursuant to a newly
adopted federal regulation that would have permitted the destruction of these
documents three years after the applicable prices were reported, except to the
extent we were aware of an ongoing investigation. It is our understanding that
many other pharmaceutical companies received similar letters at that time from
attorneys general in a number of states and that such letters may have been in
response to the new federal regulation that would have otherwise allowed the
destruction of documents reflecting these pricing calculations. A number of
attorneys general, including the Florida and Kentucky attorneys general,
petitioned the U.S. Secretary of Health and Human Services to withdraw the new
regulation. We are not aware of any further developments in these
investigations. 51




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We and certain of our officers have been named as defendants in purported
shareholder class action lawsuits alleging violations of federal securities
laws. These lawsuits were filed beginning in February 2004 and are pending in
the U.S. District Court for the Eastern District of North Carolina. These
lawsuits assert claims under Sections 10(b) and 20(a) of the Securities
Exchange Act of 1934 and Rule 10b-5 thereunder on behalf of a class of
purchasers of our common stock during the period from January 31, 2002 through
and including March 1, 2004. The complaints allege generally that the
defendants knowingly or recklessly made false or misleading statements during
the Class Period concerning our financial condition and that our financial
statements did not present our true financial condition and were not prepared
in accordance with generally accepted accounting principles. The complaints
seek certification as a class action, unspecified compensatory damages,
attorneys fees and costs, and other relief. By order dated April 16, 2004,
the district court consolidated the securities lawsuits into one consolidated
action. We expect that the plaintiffs will file a consolidated, amended
complaint later in 2004, to which we will respond in lieu of responding to the
individual complaints. In addition, we, one of our former officers, certain of our employees and
others have been named in a purported class action brought by an aaiPharma
retirement plan participant and beneficiary asserting claims under ERISA on
behalf of a class of all persons who are or were participants or beneficiaries
of the aaiPharma Inc. Retirement and Savings Plan during the period from April
24, 2002 to March 31, 2004. The complaint, which is pending in
the U.S. District Court for the Eastern District of North Carolina, alleges generally that the
defendants breached fiduciary duties owed under ERISA with respect to the
investment of Plan assets in aaiPharma stock by misleading participants and
beneficiaries of the Plan regarding our earnings, prospects, and business
condition. The complaint seeks certification as a class action, unspecified
compensatory damages, attorneys fees and costs, and other relief. These securities and ERISA lawsuits are at an early stage, and no lead
plaintiff has yet been appointed, nor a consolidated amended complaint served,
in the federal securities litigation. We are not required to file an answer or
motion to dismiss in the federal lawsuits until after service of the
consolidated amended complaint on us and no discovery has yet occurred in these
lawsuits. By, and subject to, the terms of our bylaws, we have certain
obligations to indemnify the current and former officers of the Company who
have been named as defendants in these lawsuits. We have purchased directors
and officers liability insurance that may provide coverage for some or all of
these lawsuits and governmental investigations. There is a risk, however, that
some or all of the claims or expenses will not be covered by such policies; or
that, even if covered, our ultimate liability will exceed the available
insurance. Although we intend to vigorously pursue all defenses available in
these lawsuits, an adverse determination in these lawsuits or an inability to
obtain payment under our D&O insurance policies for litigation and
indemnification costs and any damages ultimately borne by us as a result of
these lawsuits and investigations could have a material adverse effect on our
business, financial condition, results of operations or cash flows. We are a party to a number of legal actions with generic drug companies. We
are involved in four lawsuits centered on our omeprazole-related patents,
including one lawsuit brought by us against an alleged infringer of our patents
and three lawsuits which were brought by third parties against us and are
currently essentially inactive. Omeprazole is the active ingredient found in
Prilosec, a drug sold by AstraZeneca. Two omeprazole-related cases have been filed against us by Dr. Reddys
Laboratories Ltd. and Dr. Reddys Laboratories, Inc. in the U.S. District Court
for the Southern District of New York in July 2001 and November 2001. The
plaintiffs in these cases have challenged 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. 52




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##### 



Both of these cases against us are in early stages of litigation. However,
while these plaintiffs have sought approval from the FDA to market a generic
form of Prilosec, no such FDA approval has, as of March 14, 2004, been granted
to them. In addition, these plaintiffs omeprazole product has been found in
separate litigation to infringe certain patents of AstraZeneca and the
infringement findings have been upheld on appeal. These lawsuits are
essentially inactive at this time. Only limited discovery has occurred in
these lawsuits and no additional discovery is currently being sought. No date
has been set for trial. In the event that these lawsuits again become active,
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 against us in
August 2001 by Andrx Pharmaceuticals, Inc. in the U.S. District Court for the
Southern District of New York. Andrx has challenged the validity of three of
our omeprazole patents and has also sought 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 has sought injunctive relief and
unspecified treble damages. We have denied the substantive allegations made by
Andrx. This case is in an early stage of litigation. While Andrx has received FDA
approval for its generic omeprazole product, 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, which
findings have been upheld on appeal. No date has been set for trial. No
discovery is currently being sought. We have filed a motion to dismiss the
litigation on various grounds and Andrx has objected to our motion. The
lawsuit is essentially inactive at this time. As of June 1, 2004, the judge
has not decided our motion to dismiss the litigation. 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, together with the other named defendants, KUDCO) in
the U.S. District Court for the Southern District of New York. KUDCO has a
generic omeprazole product with final FDA marketing approval, was found not to
infringe the AstraZeneca patents in the separate AstraZeneca patent litigation,
and is currently selling its generic substitute for Prilosec in the U.S.
marketplace. Discovery is continuing at this time. The parties previously had agreed to the
commencement of the trial in January 2005 but have recently moved the trial
date to June 2005. In cases where we have initiated an action, we intend to prosecute our claims
to the full extent of our rights under the law. In cases where we are named
defendants, we intend to vigorously pursue all defenses available. In 2003, we entered a three-year services agreement with Athlon Pharmaceuticals
to provide sales support in designated territories throughout the United States
for the Darvocet A500 product. As of December 31, 2003, future minimum
payments due under this agreement were: $14.4 million2004; $14.4
million2005; $10.8 million2006; and zerothereafter. Subsequent to the
commercial launch of Darvocet A500 in October 2003, issues have arisen with
respect to the level of performance by this contract sales force. We have
commenced legal action against Athlon alleging breach of our agreement and
seeking a declaratory judgment that we are entitled to terminate this agreement
and injunctive relief and damages and have terminated this agreement. We may
not be successful in this action. Athlon has asserted several counterclaims,
including breach of an implied covenant of good faith in fair dealing and
anticipatory breach of the contract. We have filed a reply denying these
allegations. 53




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In addition, in 2003, we entered into a multi-year supply agreement for
Darvocet A500. As of December 31, 2003, the minimum guaranteed purchase
requirement remaining under this agreement was $12.9 million. We have amended
this agreement to allow additional products of ours to be manufactured by the
party to this supply agreement and for these products to count against our
minimum purchase obligation, though we have not established any terms,
including pricing, with respect to the manufacture of these additional
products. The following schedule summarizes contractual obligations and commitments at
December 31, 2003 (in thousands): One Year
    
    Over ThreeLess Than
    
    Through
    
    Through
    
    Over FiveOne Year
    
    Three Years
    
    Five Years
    
    Years
    
    TotalLong-term debt
    
    $
    4,000
    
    
    $
    40,000
    
    
    $
    120,000
    
    
    $
    175,000
    
    
    $
    339,000Operating leases
    
    
    7,654
    
    
    
    11,401
    
    
    
    9,177
    
    
    
    7,257
    
    
    
    35,489Sales support commitments
    
    
    14,400
    
    
    
    25,200
    
    
    
    
    
    
    
    
    
    
    
    39,600Capital lease obligations
    
    
    323
    
    
    
    408
    
    
    
    
    
    
    
    
    
    
    
    731Purchase commitments
    
    
    28,846
    
    
    
    8,600
    
    
    
    
    
    
    
    
    
    
    
    37,446$
    55,223
    
    
    $
    85,609
    
    
    $
    129,177
    
    
    $
    182,257
    
    
    $
    452,266
 Our purchase commitments are primarily related to outstanding orders and
commitments with suppliers to purchase finished goods related to our
pharmaceutical products. Our liquidity needs increased during 2003, and our annual net interest expense
may exceed $28 million in 2004. We have an interest payment on the senior
subordinated notes of $10.1 million due in October 2004. We and certain of our current and former officers and employees have been named
as defendants in multiple purported class action lawsuits commenced by
stockholders and participants in our employee benefit plans beginning in
February 2004 alleging violations of federal securities and pension laws. In
addition, in April 2004, we received subpoenas for document production and
potential testimony issued by a grand jury of the U.S. District Court for the
Western District of North Carolina related to 2002 and 2003 financial
information and other matters. We have also been advised by the Office of the
United States Attorney for the Western District of North Carolina that we may
receive a subpoena from the SEC. Our legal and other related costs in
connection with these proceedings will further increase our liquidity needs in
2004. We will incur substantial non-ordinary cash expenses in 2004, resulting from
the cost of consultants, such as FTI Consulting and other professional
consultants performing services related to the Special Committees
investigation. In addition, we will continue to incur significant professional
fees related to the government investigations, class action lawsuits and other
litigation. On March 31, 2004, each of Moodys Investors Service and Standard & Poors
Ratings Services announced that it had lowered our corporate credit rating:
Moodys to Caa2 from B2 and Standard & Poors to CCC from B+. At the same time,
Moodys lowered its rating of our senior subordinated notes to Ca from Caa1 and
our senior unsecured issuer rating to Caa3 from B3. Standard & Poors lowered
its senior secured debt rating to CCC+ from BB-, and its subordinated debt
rating to CC from B-. These actions may negatively affect our ability to raise
necessary capital through debt securities or other debt instruments on
acceptable terms, or at all. 54




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Analysis of Liquidity We believe, subject to the conditions and contingencies described above, that
our cash flow from operations, and borrowing capacity under our new senior
credit facilities will be adequate to meet our needs for working capital and
anticipated capital expenditures. We are exploring the sale of certain
non-revenue generating assets to supplement our cash flow and to facilitate the
availability of cash to coincide with anticipated cash needs. Sales of assets
above specific thresholds will require the consent of the lenders under our
senior credit facilities. If results of operations do not meet our forecasts, our actual cash flow from
operations may be less than we anticipate. In addition, in those circumstances
covenant violations under our senior credit facilities could
occur. The financial covenants in the senior credit facility include a maximum
senior debt to EBITDA (as defined) leverage ratio of 2.40x for 2004, which
declines on a scheduled basis in quarterly periods thereafter, and a minimum
EBITDA to fixed charges ratio of 1.15x for 2004, which escalates in increments
in each quarterly period thereafter. The financial covenants also require a
minimum of $16,000,000 of Consolidated Net Operating Cash Flow (as defined) for
the periods from (i) April 23, 2004 through May 29, 2004 (with a cure of any
default if the $16,000,000 figure is achieved from April 23, 2004 through June
10, 2004), and (ii) April 23, 2004 through June 30, 2004 (with a cure of any
default if the $16,000,000 figure is achieved from April 23, 2004 through July
14, 2004). The senior credit facilities also require a minimum level of
unrestricted cash and/or availability under the revolving credit portion of the
facilities, after taking into account reductions for certain overdue trade
payables. The covenant levels under our senior credit facilities were set
based upon our then-current forecasts, and we can give no assurance that our
actual results of operations will be consistent with these forecasts. If we violate covenants under our senior credit facilities, we would seek
waivers and amendments from our lenders, but we can give no assurance that any
such necessary waivers and amendments would be available at all or on
acceptable terms. If we were unable to obtain a waiver of future covenant
violations, the lenders would be entitled to require immediate repayment of all
amounts outstanding under the senior credit facilities. An acceleration of
outstanding amounts under the senior credit facilities would also cause a
default under, and could permit acceleration of, our senior subordinated notes
due 2010. In the event of one or more such defaults, the Company may seek
additional sources of financing or access to the capital market, although there
can be no assurance that either source will be available on terms acceptable to
us or at all. Impact of Recent Events on 2004 Results Recent developments will have a significant impact on our results of operations
in 2004 and future periods. As a result of the refinancing of our senior
credit facilities in April 2004, we will record an expense of approximately
$6.2 million in the second quarter of 2004. The M.V.I. and Aquasol Sale
resulted in a significant gain that we will record in the second quarter of
2004. As noted above, we believe that as of December 31, 2003, wholesaler inventory
levels of our Brethine injectable and Darvocet N-100 products exceeded target
levels. These wholesaler inventory levels may adversely affect our sales of
these products in 2004 until wholesaler inventories decline to appropriate
levels. The recent approvals of generic versions of our Brethine injectable
product will further reduce sales of this product. In addition, although
Darvocet A500 is not subject to competition of products approved by the FDA as
generic versions of Darvocet A500, the substitution by pharmacists in some
jurisdictions of generic versions of Darvocet N-100 or other similar products
for prescriptions written for Darvocet A500, is likely to result in sales of
this product being below our initial expectations. As a result, sales of this
line extension product may not materially stem the current trend of declining
unit sales of our Darvon/Darvocet products. 55




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As a result of our acquisition of the New Pain Products in December 2003, our
amortization of acquired product intangible assets, a component of direct costs
of product sales, will increase by approximately $4.5 million in 2004 compared
to 2003, absent any product line acquisitions or subsequent product line sales
in 2004. The M.V.I. and Aquasol Sale, completed in April 2004, will not affect
amortization of acquired product rights in 2004 because the intangible assets
associated with the M.V.I. and Aquasol product line had indefinite lives.
Expenses for professional fees will be materially greater in 2004 than 2003 as
a result of fees paid to our consultants, including FTI Consulting, the
expenses associated with the Special Committees investigation, fees and
expenses related to the solicitation of consents from holders of our senior
subordinated notes, which was completed in April 2004, and fees and expenses
related to pending litigation, including the pending federal securities
litigation, and governmental investigations. Based in part on the matters described above, we anticipate that the Company
will report a loss for each of the first two quarters of 2004. Management Changes On February 12, 2004, we announced that David Hurley, our Chief Operating
Officer, was leaving aaiPharma, effective immediately. On March 29, 2004, we announced that Dr. Frederick D. Sancilio, the founder of
our company and our Executive Chairman and Chief Scientific Officer, would
replace Dr. Philip S. Tabbiner as our Chief Executive Officer. Dr. Tabbiner
also resigned from our board of directors to take a consulting position with
aaiPharma for fifteen months to facilitate this transition. On May 11, 2004, we announced that William L. Ginna, Jr., our Chief Financial
Officer, had left the Company. Mr. Ginna has taken a consulting position with
aaiPharma for twelve months to assist the Company when needed. In March 2004, we appointed Gregory F. Rayburn, a senior managing partner at
FTI Consulting, to the position of interim Chief Operating Officer. In May
2004, we appointed Gina Gutzeit, a senior managing partner at FTI Consulting,
to the position of interim Chief Financial Officer. Critical Accounting Policies Revenue Recognition We recognize revenue in accordance with the Securities and Exchange
Commissions Staff Accounting Bulletin No. 101, Revenue Recognition in
Financial Statements as amended by Staff Accounting Bulletin No. 104
(together, SAB 101) and Statement of Financial Accounting Standards No. 48
Revenue Recognition When Right of Return Exists (FAS 48). SAB 101 states
that revenue should not be recognized until it is realized or realizable and
earned. Revenue is realized or realizable and earned when all of the following
criteria are met: (1) persuasive evidence of an arrangement exists; (2)
delivery has occurred or services have been rendered; (3) the sellers price to
the buyer is fixed and determinable; and (4) collectibility is reasonably
assured. FAS 48 states that revenue from sales transactions where the buyer
has the right to return the product shall be recognized at the time of sale
only if (1) the sellers price to the buyer is substantially fixed or
determinable at the date of sale, (2) the buyer has paid the seller, or the
buyer is obligated to pay the seller and the obligation is not contingent on
resale of the product, (3) the buyers obligation to the seller would not be
changed in the event of theft or physical destruction or damage of the product,
(4) the buyer acquiring the product for resale has economic substance apart
from that provided by the seller, (5) the seller does not have significant
obligations for future performance to directly bring about resale of the
product by the buyer, and (6) the amount of future returns can be reasonably
estimated. 56




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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. The following table sets forth our gross revenues and the amount of dilution to
revenues resulting from allowances for customer credits, including discounts,
rebates, chargebacks, product returns and other allowances for each of 2003,
2002 and 2001: Years Ended December 31,20022003
    
    (as restated)
    
    2001(in thousands)Gross revenues
    
    $
    327,282
    
    
    $
    283,914
    
    
    $
    150,115Allowance for customer credits
    
    
    102,305
    
    
    
    53,404
    
    
    
    9,042Net revenues
    
    $
    224,977
    
    

    $
    230,510
    
    
    $
    141,073
 Net revenues are reported for our three operating segments, which are product
sales, development services and product development. Product Sales.We recognize revenues for product sales at the time title and
risk of loss are transferred to the customer, and the other criteria of SAB 101
and FAS 48 are satisfied. Product shipping and handling costs are included in
cost of sales. We accept returns of products near their expiration date. At the time we recognize revenue from product sales, we record an adjustment,
or decrease, to revenue for estimated chargebacks, rebates, discounts and
returns. Revenue reserves are established on a product-by-product basis.
These revenue reductions are established by management as its best estimate at
the time of sale based on each products historical experience adjusted to
reflect known changes in the factors that impact such reserves. Reserves for
chargebacks, rebates and discounts are established based on the contractual
terms with our customers; analysis of historical levels of discounts,
chargebacks and rebates; communications with customers and purchased
information about the rate of prescriptions being written and the levels of
inventory remaining in the distribution channel as well as our expectations
about the market for each product and anticipated introduction of competitive
products. The reserve for chargebacks is the most significant estimate used in
the recognition of our revenue from product sales. In brief, we have
established contract prices for certain indirect customers that are supplied by
our wholesale customers. A chargeback represents the difference between the
current published wholesale acquisition cost and the indirect customers
contract prices. Prior to 2003, the amount of actual product returns experienced by the Company
had not been significant. As a result, actual returns were charged against
revenue in the period they occurred and aggregate revenue reserves were
evaluated quarterly to determine if they were sufficient to cover estimated
chargebacks, rebates and related allowances, as well as the expected rate of
returns, and adjusted as deemed necessary. In 2003, we began segregating our
products return reserve, which prior thereto we believed was adequately covered
by our aggregate revenue reserves for chargebacks, rebates and related
allowances. We increased the level of detail included in our analyses to
include analyzing inventory in the channel to determine remaining shelf life.
Our returns reserve needs are primarily related to the number of months of
inventory estimated to be in the distribution channel. Levels of inventory in
the distribution channel are monitored and estimated based on information we
purchase from the wholesalers, combined with active discussions between our
sales personnel and the wholesalers we supply. In addition, our actual sales,
returns and chargeback history are used to assess the reasonableness of the
estimated number of months of inventory on hand at our wholesalers. The shelf
life 57




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of products remaining in the distribution channel is estimated based on an
analysis of each lot sold. Each batch has a specific expiration date. A
review of the actual returns history is performed and the run rate of sales out
of the distribution channel is estimated. Estimated product returns reserves
are adjusted based on these reviews. Reserves may also be adjusted to reflect
any significant changes in trends or based upon new information that we believe
may affect the reserve needs. Allowances for new product introductions are
estimated based on our experiences for similar products that we currently
market and are adjusted as deemed necessary based on our experience with each
product. Our reserve analysis also includes a review for the potential
introduction of generic competition and the resulting impact on pricing and
returns reserves. Existing reserves may be adjusted accordingly to reflect our
estimate for any impact these factors may have. We continually monitor our
assumptions with respect to our revenue reserves for product sales and modify
them if necessary. In 2003, we initially recorded net revenues from the sale of newly launched
products at the time of shipment to wholesalers. We have subsequently determined, however,
that not all of the conditions for recognition of revenue specified by SFAS 48
were met. In addition, we have determined that sales of our Brethine product
to a specialty wholesaler did not satisfy the condition of SFAS 48 for the
sales of these products. The new product launches and the sale of Brethine to
a specialty wholesaler have been recorded under the consignment model. Under
the consignment model, we do not recognize revenue upon shipment of
product to wholesalers,
but instead invoice the wholesaler, record deferred revenue at gross invoice
sales price and classify the inventory held by the wholesaler as consignment
inventory at our cost of such inventory. We recognize revenue when such
inventory is sold through to the wholesalers customers, on a first-in
first-out (FIFO) basis. Product Development.Product development revenues consist of royalty revenues
and licensing fees. We recognize royalty revenues as earned based on sales of
the underlying products. Each of our licensing agreements is reviewed to
determine the appropriate revenue recognition treatment under SAB 101.
Revenues from upfront licensing fees are deferred and amortized over the term
of the associated agreement or as ongoing services are performed. Revenues
resulting from achieving certain milestones stipulated in our agreements are
recognized when the specific milestone is achieved. Milestones are based upon
the occurrence of a substantive element specified in the contract or as a
measure of substantive progress towards completion under the contract. Development Services.We recognize the majority of our development services
revenues from fee-for-service contracts on a proportional performance basis as
the work is performed. This is based on the ratio of actual direct costs
incurred to total estimated direct contract costs, which is the best indicator
of performance of these contract obligations. This ratio is multiplied by the
estimated contract value to determine the revenue to be recognized. The
proportional performance method requires us to estimate total expected revenue,
costs and profitability of the contract. These estimates are reviewed
periodically and, if these estimates change or actual results differ from
expected results, an adjustment is recorded in the period in which they become
reasonably estimable. These adjustments could have a material effect on our
results of operations. Historically, there have not been significant variations
between contract estimates and actual costs incurred which were not recoverable
from clients. Changes in the scope of work generally result in an amendment to
contract pricing terms. Amended contract amounts are not included in net
revenues until earned and realization is assured. We also recognize revenue 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. Clients generally may terminate services at any time, however the
majority of our contracts contain provisions that require payment for all
services rendered to date, even those services that have not yet been billed.
We perform ongoing credit evaluations of our customers and maintain reserves
for potential uncollectible accounts. Actual losses from uncollectible
accounts have been minimal. 58




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Intangibles Assets When we acquire the rights to manufacture and sell a product, we record the
aggregate purchase price, along with the value of the product related
liabilities we assume, as intangible assets. We use the assistance of valuation
consultants to help us allocate the purchase price to the fair value of the
various intangible assets we have acquired. Then, we must estimate the economic
useful life of each of these intangible assets in order to amortize their cost
as an expense in our statement of operations over the estimated economic useful
life of the related asset. The factors that drive the actual economic useful
life of a pharmaceutical product are inherently uncertain, and include
physician loyalty and prescribing patterns, competition by products prescribed
for similar indications, future introductions of competing products not yet FDA
approved, the impact of promotional efforts and many other issues. We use all
of these factors in initially estimating the economic useful lives of our
products, and we also continuously monitor these factors for indications of
appropriate revisions. In assessing the recoverability of our intangible assets, we must make
assumptions regarding estimated undiscounted future cash flows and other
factors. If the estimated undiscounted future cash flows do not exceed the
carrying value of the intangible assets we must determine the fair value of the
intangible assets. If the fair value of the intangible assets is less than its
carrying value, an impairment loss will be recognized in an amount equal to the
difference. If these estimates or their related assumptions change in the
future, we may be required to record impairment changes for these assets. In
addition, material adjustments to our forecasted revenues from the sales of any
of our acquired product lines including Brethine and Darvocet may require us to
employ different assumptions with respect to our estimated cash flows. We
review intangible assets for impairment at least annually and whenever events
or changes in circumstances indicate that the carrying amount of an asset may
not be recoverable. If we determine that an intangible asset is impaired, a
non-cash impairment charge would be recognized. 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 SFAS 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. Our goodwill and intangible assets consist of the following: December 31,December 31,
    
    20022003
    
    (as restated)(in thousands)Goodwill, net
    
    $
    13,361
    
    
    $
    11,378Intangible assets, net:Definite-lived
    
    $
    320,530
    
    
    $
    241,018Indefinite-lived
    
    
    51,017
    
    
    
    51,017371,547
    
    
    
    292,035Less accumulated amortization
    
    
    (20,232
    )
    
    
    (10,366
    )$
    351,315
    
    
    $
    281,669
 59




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##### 



On a periodic basis, or as otherwise required, 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. Set forth in the table below are the details of the purchase price allocations
for of our all major product line acquisitions since the beginning of 2001.
The table lists the assets, the value allocated to each asset, how the value
was determined, and the useful life assigned to each asset. In these
acquisitions, the only tangible assets acquired were inventory and
marketing/promotional materials, which were valued based on internal analyses
and data provided by the sellers. Inventory obtained at time of acquisition
was valued at the estimated selling price less the cost of disposal and a
reasonable selling profit. Marketing/promotional materials received were
generally outdated and in limited quantities, so no material value was assigned
to them in the purchase price allocations. We engaged third-party valuation
consultants to assist in purchase price allocations, including identification of intangible assets,
recommendations of fair value of intangible assets, and determination of
expected lives of those assets. Intangible assets that arose from contractual
or legal rights and other intangible assets that were separable, as provided in
paragraph 39 of SFAS 141, were identified. Among the assets that were
considered for recognition were trademarks, Internet domain names,
non-competition agreements, customer lists, backlogs, customer contracts and
non-contractual relationships, licensing and royalty agreements, supply
contracts, employment contracts, patented and unpatented technology, and trade
secrets. The third-party valuation consultants reviewed pertinent facts and recommended
for each asset the appropriate generally accepted valuation approach and
methodology from among the cost, market, and income approaches. Where
possible, a valuation derived using an alternative valuation approach or
methodology was presented and used by management to evaluate the reasonableness
of the recommended fair value. ValueIdentifiable Assets
    
    (in millions)
    
    How Valued
    
    Useful LifeM.V.I. and Aquasol(as restated)Total purchase price,
including transaction fees
    
    $
    54.7Allocation of purchase price:Inventory
    
    $
    3.7
    
    
    Estimated Selling Price Less Cost of Disposal and a Reasonable Selling Profit
    
    N/ATrademarks
    
    
    27.3
    
    
    Income Approach
Discounted Cash Flow Method
    
    IndefiniteDeveloped Technology
    
    
    23.7
    
    
    Income Approach
Discounted Cash Flow Method
    
    IndefiniteTotal
    
    $
    54.7
 60




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##### 



ValueIdentifiable Assets
    
    (millions)
    
    How Valued
    
    Useful LifeBrethine(as
restated)Total purchase price,
including transaction fees
    
    $
    26.6Allocation of purchase price:Trademarks-Existing
    
    $
    11.3
    
    
    Income Approach
Discounted Cash Flow Method
    
    20 yearsTrademarks-Reformulated
    
    
    9.4
    
    
    Income Approach
Discounted Cash Flow Method
    
    20 yearsDeveloped Technology
    
    
    5.9
    
    
    Income Approach
Discounted Cash Flow Method
    
    20 yearsTotal
    
    $
    26.6Darvon/Darvocet(as restated)Total purchase price,including transaction fees
    
    $
    212.6Allocation of purchase price:Inventory
    
    $
    1.7
    
    
    Estimated Selling Price Less
Cost of Disposal and a
Reasonable Selling Profit
    
    N/ATrademarks-Existing
    
    
    80.3
    
    
    Income Approach
Discounted Cash Flow Method
    
    20 yearsTrademarks-Reformulated
    
    
    50.3
    
    
    Income Approach
Discounted Cash Flow Method
    
    20 yearsDeveloped Technology
    
    
    80.3
    
    
    Income Approach
Discounted Cash Flow Method
    
    20 yearsTotal
    
    $
    212.6
 61




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ValueIdentifiable Assets
    
    (in millions)
    
    How Valued
    
    Useful LifeElan Pain PortfolioTotal purchase price,
including transaction fees
    
    $
    103.4Allocation of purchase price:Inventory
    
    $
    5.1
    
    
    Estimated Selling Price Less
Cost of Disposal and a
Reasonable Selling Profit
    
    N/ATrademarks
    
    
    49.1
    
    
    Income Approach
Discounted Cash Flow Method
    
    20 yearsDeveloped Technology
    
    
    49.2
    
    
    Income Approach
Discounted Cash Flow Method
    
    20 yearsTotal
    
    $
    103.4
 Inventories Our inventories are valued at the lower of cost (determined on a first-in,
first-out basis) or market. We review our inventory for short dated or
slow-moving product and inventory commitments under supply agreements based on
projections of future demand and market conditions. For inventory so
identified, we estimate market value or net sales value based on current
realization trends. If the projected net realizable value is less than cost, on
a product basis, we provide a reserve to reflect the lower value of that
inventory. We recognize inventory losses at the time such losses are evident
rather than at the time products are actually sold. We also maintain supply
agreements with some of our vendors which contain minimum purchase
requirements. We estimate future inventory requirements based on current
trends. If our estimated future inventory requirements exceed estimated
shipments to our customers, we record a charge in direct costs. If we over- or
under-estimate the amount of inventory that will not be sold prior to
expiration, there may be a material adverse impact on our consolidated
financial condition and results of operations. Income Taxes Income taxes are provided for under the liability method. This approach
requires the recognition of deferred tax assets and liabilities for the
expected future tax consequences of differences between the tax basis of assets
or liabilities and their carrying amounts in the consolidated financial
statements. A valuation allowance is provided for deferred tax assets if it is
more likely than not that these items will either expire before we are able to
realize their benefit or if future deductibility is uncertain. Developing the
provision for income taxes requires significant judgment and expertise in
federal and state income tax laws, regulations and strategies, including the
determination of deferred tax assets and liabilities and, if necessary, any
valuation allowances that may be required for deferred tax assets. Our
judgments and tax strategies are subject to audit by various taxing
authorities. While we believe we have provided adequately for our income tax
liabilities in our consolidated financial statements, adverse determinations by
these taxing authorities could have a material adverse effect on our
consolidated financial condition and results of operations. Research and Development Arrangements Research and development expense was 10% of our net revenues in 2003, and we
expect research and development activities to account for between 8% and 10% of
budgeted annual net revenues in 2004. The following product development table
identifies, for each of our major development programs in 2003, the 62




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stage of development at December 31, 2003 of the lead product or products in each
program, research and development spending on each program in 2003, cumulative
research and development spending on each program from inception through
December 31, 2003, 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. CumulativeProgram
    
    Estimated2003
    
    R&D
    
    AdditionalStage of
    
    Program
    
    Spending
    
    R&D
    
    EstimatedMajor Development
    
    Development for
    
    R&D
    
    Through
    
    Spending to
    
    Year ofProgram (and Lead
    
    Lead Products in
    
    Spending
    
    December 31,
    
    Complete
    
    Completion ofProducts)
    
    Program
    
    (1)
    
    2003
    
    Lead Products
    
    Lead Products(dollars in millions)Products:Pain Management
    
    
    
    $
    12.2
    
    
    $
    27.6(Darvocet line
extension)
    
    Pre-clinical
    
    
    
    
    
    
    
    
    
    $
    2.1
    
    
    
    2005(ProSorb-D)
    
    Phase III
    
    
    
    
    
    
    
    
    
    
    4.5
    
    
    
    2005Gastrointestinal
    
    
    
    
    4.2
    
    
    
    16.3(GI-1)
    
    Phase I
    
    
    
    
    
    
    
    
    
    
    4.9
    
    
    
    2006Critical Care
    
    
    
    
    2.6
    
    
    
    5.2(Brethine line extension)
    
    SNDA filed in June 2003 (2)
    
    
    
    
    
    
    
    
    
    
    0.1
    
    
    
    2004Other
    
    n/a
    
    
    3.0
    
    
    
    n/a
    
    
    
    n/a
    
    
    
    n/aTechnologies:Drug Delivery
    
    
    
    
    0.2
    
    
    
    13.9(Fexofenadine/Pseudoephedrine)
    
    NDA filed in December 2003 (3)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2004$
    22.2
  (1)
    
    Includes an allocation of $5.8 million of indirect costs, primarily
management and administrative overhead and facilities costs, based on
direct research and development costs in 2003. In addition, this includes
an allocation of $0.4 million reported as depreciation in our consolidated
statement of operations.(2)
    
    Approved in 2004; awaiting commercialization.(3)
    
    This product is being developed for a customer pursuant to a development
agreement. The customer filed the NDA. 63




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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 and
Forward-Looking Statements. 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 $0.6 million in 2003, $1.1 million in 2002 and $0.2 million in 2001.
We had no related accounts receivable at December 31, 2003 and $0.3 million at
December 31, 2002. In December 2003, Endeavor sold substantially all of its
assets to a third party. As part of this transaction, we recorded a gain of
$1.8 million for the sale of our investment in Endeavor. This gain is included
in other income on the consolidated statement of operations. Endeavor filed
articles of dissolution in December 2003 with the Delaware Secretary of State. 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, including Dr. Sancilio, beneficially own common
equity of Aesgen. In the aggregate they own approximately 15% of Aesgens fully
diluted common equity. In October 2001, we agreed to provide development
services to Aesgen, through AAI Development Services, at our standard rates in exchange for
$1.1 million of Aesgen convertible preferred stock. Through December 31, 2003,
we had performed $580,000 of services under this agreement. At December 31,
2003, we held convertible preferred shares of Aesgen that represented 10.0% of
Aesgens fully diluted common equity, which included 5.4% earned through
December 31, 2003, for services performed under this agreement. We do not
anticipate performing any additional services for Aesgen under this agreement. 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,
2003, the book value of these assets was zero. In February 2002, we purchased a generic calcitriol product from Aesgen for
payment of $1.0 million in cash and additional contingent milestone payments of
up to $1.5 million. In 2003, the prerequisite for payment of an additional
$500,000 of such contingent milestones occurred and such payment was made to
Aesgen, while 64




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the prerequisites for payment of the remaining $1.0 million were
not met and no further payment of this amount is owed by us. Under this
agreement, we are obligated to pay royalty payments for the eight-year period
following the first commercial sale of this product. In 2003, we expensed
royalties related to Aesgen of $0.6 million. Of this amount, none was payable
at December 31, 2003. We recognized net revenues of zero, $494,000 and $86,000 from Aesgen for the
years ended December 31, 2003, 2002 and 2001, respectively. We had no related
accounts receivable or work-in-progress at December 31, 2002 or 2001. See 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 2003, we adopted Statement of Financial Accounting Standards No. 145,
Rescission of FASB Statements 4, 44, and 64, Amendment of FASB Statement No.
13, and Technical Corrections (SFAS 145). SFAS 145 no longer requires
companies to report gains or losses associated with the extinguishment of debt
as a component of extraordinary gains or losses, net of tax. In addition, any
extraordinary gains or losses on extinguishment of debt in prior periods
presented would require reclassification. As required by SFAS 145, the
extraordinary loss recognized in the year ended December 31, 2002 of
approximately $8.1 million ($5.3 million net of tax) to record the write-off of
deferred financing and other costs related to its prior debt facilities has
been reclassified to other expense. Statement of Financial Accounting Standards No. 146, Accounting for Costs
Associated with Exit or Disposal Activities (SFAS 146), requires that a
liability for costs associated with an exit or disposal activity be recognized
when the liability is incurred rather than when a commitment to an exit plan is
made. SFAS 146 is effective for exit or disposal activities that are initiated
after December 31, 2002. Adoption of this statement did not have a material
effect on our financial position or results of operations. In January 2003, the Financial Accounting Standards Board issued FASB
Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46).
FIN 46, as amended, requires that variable interest entities be consolidated by
the primary beneficiary of the entity if certain criteria are met. FIN 46 is
effective immediately for all variable interest entities created or acquired
after January 31, 2003. For variable interest entities created or acquired
prior to February 1, 2003, the provisions of FIN 46 became effective for us
during the fourth quarter of 2003. Based upon our review, we have not
identified any entity that would require consolidation. Provided that we are
not the primary beneficiary, the maximum exposure to losses related to any
entity that may be determined to be a variable interest entity is limited to
the carrying amount of the investment in the entity. We do not believe the other recently issued, but not yet effective, accounting
standards will have a material impact on the Company. 65




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Risk Factors and Forward Looking Statements Risks Related to our Financial Condition. We have substantial future cash needs and potential cash needs and we cannot
assure you that we will be successful in generating or otherwise obtaining the
funds necessary to meet those needs. We estimate that we have sufficient cash, liquid resources and realizable
assets and investments to meet our near-term liquidity requirements. In making
this estimate, we have not assumed any material payments in connection with our
pending litigations in the near term, other than anticipated professional fees.
Any material adverse legal judgments, fines, penalties or settlements arising
from our pending litigations or investigations could require us to obtain
additional funds. Although we expect to incur a loss in each of the first two
quarters of 2004, in making our liquidity estimates, we have also assumed a
certain level of operating performance. Our future operating performance will
be affected by the factors discussed in this report and other factors, many of
which are beyond our control. If our future operating performance is less than
anticipated, we could be required to increase cash flow by selling
assets and/or reducing staffing levels to improve liquidity. We
cannot assure you that we would be able to sell assets or
commercially reasonable terms, or at all, or that reductions in our
staffing levels would alleviate short-term liquidity issues or would
not be disruptive to our business. We could also be required to
obtain additional funds. As described
below, certain events, including our inability to incur additional indebtedness
under the restrictive covenants contained in our existing debt instruments,
have materially adversely affected our financial flexibility, including our
ability to access external sources of capital to finance our business. If our
estimates are incorrect and we are required to obtain additional funds, we
cannot assure you that we would be able to obtain those funds on commercially
reasonable terms, or at all, which would have a material adverse effect on our
business, financial condition, results of operations and liquidity. Our substantial indebtedness may severely limit cash flow available for our
operations and could impair our ability to service debt or obtain additional
financing if necessary. We are highly leveraged. As of May 31, 2004, we have outstanding $125 million
in senior term loans and letters of credit of approximately $280,000, as well
as a senior revolving credit facility in the amount of $15 million. In addition
we have $175 million of our senior subordinated notes outstanding. We have
granted a first-priority lien on substantially all of our current and future
property, including our intellectual property to secure our obligations with
respect to our senior credit facilities and a second-priority lien on the same
collateral to secure our subordinated notes. The substantial amount of payments on our outstanding debt and other payment
obligations could, among other things:  
    
    limit our ability to obtain additional financing and acquire additional products,
    
    limit our flexibility in planning for, or reacting to, changes in our business and the industry,
    
    place us at a competitive disadvantage relative to our competitors with less debt,
    
    render us more vulnerable to general adverse economic and industry conditions, and
    
    require us to dedicate a substantial portion of our cash flow to service our debt. Our ability to make future payments on, and, if necessary, to refinance our
debt, will depend on our ability to generate cash in the future, which may be
influenced by general economic, business, financial, competitive, legislative,
regulatory and other factors beyond our control. We cannot assure you that our
business will generate sufficient cash flow from operations or that future
borrowings will be available in an amount sufficient to enable us to repay our
debt on or before maturity. We may need to refinance all or a 66




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portion of our debt on or before maturity. We cannot assure you that we would be able to
refinance any of our debt on commercially reasonable terms or at all. Our near term liquidity and cash flow may be significantly affected by returns
of product sold in 2003. In 2003, we sold products to wholesalers on terms permitting the return of the
product within six months if not then resold by the wholesaler, including
approximately $9 million of launch quantity Darvocet A500 sold in the second
half of 2003. In addition, during the second half of 2003, we sold $21 million
of Brethine injectable to a specialty wholesaler and $10.4 million of our
Darvocet-N 100, 500 count bottles, to repackagers that resulted in wholesaler
channel inventory levels significantly exceeding our target levels. In
addition to the special return rights granted in product launches, each of our
products may be returned to us near the expiration date of the product. If the
wholesalers exercise their rights of return for these or other products, the
issuance of either a credit on future sales or cash payment resulting from such
returns could have a material effect on our liquidity in 2004. In addition, we
are accounting for the shipments made to the specialty wholesaler under the
consignment model. We received payment for these shipments in 2003. Thus,
although we may record revenue in 2004 on the Brethine injectable product we
sold in 2003, we will not receive any additional cash payments. Finally, to
the extent that wholesaler channel inventories of our products exceed
appropriate levels, as discussed above, our sales of those products in
subsequent periods, and thus our cash flow, may be adversely affected. Our reduced corporate credit ratings may impair our ability to effect future
refinancings of our indebtedness or increase the expense of replacement
indebtedness. On March 31, 2004, Moodys and Standard & Poors each announced reductions in
our corporate credit ratings. These reductions of our credit ratings could
adversely affect our ability to effect a future refinancing of our indebtedness
or increase the cost of implementing any other debt financing. Our failure to timely file our Annual Report on Form 10-K for the fiscal year
ended December 31, 2003 could result in the delisting of our common stock on
the NASDAQ Stock Market. We received notice on March 30, 2004 from the NASDAQ Stock Market that, due to
the delay in filing of our Form 10-K for the fiscal year ended December 31,
2003, we are not in compliance with certain NASDAQ marketplace rules and that
our common stock would be subject to delisting at the opening of business on
April 8, 2004, unless we request a hearing pursuant to NASDAQ rules. We
requested and participated in a hearing before NASDAQ on April 29, 2004 in
which we committed to filing this Report on Form 10-K on or before June 15,
2004 and to file amended quarterly Reports on Form 10-Q for each of the three
quarters of 2003 on or before June 30, 2004. On May 18, 2004 we received notice
from the NASDAQ Stock Market that we were delinquent in filing our Quarterly
Report on Form 10-Q for the first quarter of 2004. Even if we meet our
commitments to file the periodic reports, the NASDAQ may still act to delist
our stock from the NASDAQ Stock Market. Thereafter, our common stock would not
be eligible for trading on any national securities exchange or the OTC Bulletin
Board. If our common stock is no longer traded through a market system, it may not be liquid and we may be unable to obtain
future equity financing, or use our common stock as consideration for mergers
or other business combinations. We have and in the near term will continue to incur significant professional
fees which may materially negatively affect our cash flow. We have incurred, and in the near term will continue to incur, significant
professional fees in connection with the Special Committees inquiry and in
connection with pending litigation and governmental investigations. Our
professional fees on a number of the matters, including the securities and
ERISA 67




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litigation and governmental investigations, may extend for several years.
These significant professional fees may materially negatively affect our
results of operations and cash flow. Customer concerns with respect to our liquidity and pending governmental
investigations and litigation could make it difficult for us to obtain and
retain long-term fee-for-service projects. Some customers and potential customers of our AAI Development Services Division
have expressed concern with respect to issues regarding our liquidity and
pending governmental investigations and litigation in deciding whether to place
long-term fee-for-service projects with us. If we are unsuccessful
in overcoming these concerns, we may fail to obtain new long
term fee-for-service projects, which would have a material adverse effect on
our results of operations, financial condition and cash flow. Risks Relating to Pending Governmental Investigations and Lawsuits An adverse judgment in the securities and ERISA litigation in which we and
certain current and former executive officers, employees and directors are
defendants could have a material adverse effect on our results of operations
and liquidity. We and certain of our officers have been named as defendants in purported
shareholder class action lawsuits alleging violations of federal securities
laws. These lawsuits were filed beginning in February 2004 and are pending in
the U.S. District Court for the Eastern District of North Carolina. These
lawsuits assert claims under Sections 10(b) and 20(a) of the Securities
Exchange Act of 1934 and Rule 10b-5 thereunder on behalf of a class of
purchasers of our common stock during the period from January 31, 2002 through
and including March 1, 2004. The complaints allege generally that the
defendants knowingly or recklessly made false or misleading statements during
the Class Period concerning our financial condition and that our financial
statements did not present our true financial condition and were not prepared
in accordance with generally accepted accounting principles. The complaints
seek certification as a class action, unspecified compensatory damages,
attorneys fees and costs, and other relief. By order dated April 16, 2004,
the district court consolidated the securities lawsuits into one consolidated
action. We expect that the plaintiffs will file a consolidated, amended
complaint later in 2004, to which we will respond in lieu of responding to the
individual complaints. In addition, we, one of our former officers, certain of our employees and
others have been named in a purported class action brought by an aaiPharma
retirement plan participant and beneficiary asserting claims under ERISA on
behalf of a class of all persons who are or were participants or beneficiaries
of the aaiPharma Inc. Retirement and Savings Plan during the period from April
24, 2002 to March 31, 2004. The complaint alleges generally that the
defendants breached fiduciary duties owed under ERISA with respect to the
investment of Plan assets in aaiPharma stock by misleading participants and
beneficiaries of the Plan regarding our earnings, prospects, and business
condition. The complaint seeks certification as a class action, unspecified
compensatory damages, attorneys fees and costs, and other relief. These securities and ERISA lawsuits are at an early stage, and no lead
plaintiff has yet been appointed, nor a consolidated amended complaint served,
in the federal securities litigation. We are not required to file an answer or
motion to dismiss in the federal lawsuits until after service of the
consolidated amended complaint on us and no discovery has yet occurred in these
lawsuits. By, and subject to, the terms of our bylaws, we have certain
obligations to indemnify the current and former officers and employees of the
Company who have been named as defendants in these lawsuits. We have purchased
D&O insurance that may provide coverage for some or all of these lawsuits and
governmental investigations. There is a risk, however, that some or all of the
claims or expenses will not be covered by such policies; or that, even if
covered, our ultimate liability will exceed the available insurance. Although
we intend to vigorously pursue 68




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all defenses available in these lawsuits, an
adverse determination in these lawsuits or an inability to obtain payment under
our D&O insurance policies for litigation and indemnification costs and any
damages ultimately borne by us as a result of these lawsuits and investigations
could have a material adverse effect on our business, financial condition,
results of operations or cash flows. An adverse outcome with respect to investigations of aaiPharma that are being
conducted by the SEC and the U.S. Attorneys Office could have a material
adverse effect on our results of operations and liquidity. On August 7, 2003 we received a
letter from the staff of the Enforcement Division requesting voluntary
production of certain documents. We responded to this letter on August 21,
2003 and supplemented our response on August 29, 2003. Independent of the August 7, 2003 inquiry letter, on September 26, 2003,
certain members of our board and management voluntarily met with, and provided
documents to, the staff of the Enforcement Division. As a follow-up to this
September 26, 2003 meeting and as part of the inquiry initiated on August 7,
2003, on October 8, 2003, we received a further request from staff of the
Enforcement Division for voluntary production of certain documents, to which we
responded on October 30, 2003. On January 14, 2004 and April 26, 2004, we received letters from the SECs
Division of Corporate Finance commenting on, asking questions about, and
seeking additional disclosure with respect to certain of our periodic reports.
We have responded to these letters. In April 2004, in connection with an
investigation conducted by the U.S. Attorneys Office, we received five federal grand jury subpoenas for document
production and potential testimony related to, among other things, certain
transactions regarding our 2002 and 2003 financial information, the terms,
conditions of employment and compensation arrangements of certain of our senior
management personnel, compensation and incentive arrangements for employees
responsible for the sale of our Brethine, Darvocet, calcitriol, azathioprine
and Darvon Compound products, quantities of the foregoing products in
distribution channels, financial benefits with respect to specified corporate
transactions to our senior management and others, certain loans obtained by us,
extensions of credit, if any, by us to officers or directors, accounting for
sales and returns of our foregoing products, our analysts conference calls on
financial results, internal and external investigations of pharmaceutical
product sales activities, and related matters. We have also been advised that
the SEC has initiated an inquiry into at least the same issues investigated by the
Special Committee. The U.S. Attorneys Office has advised that we may also
receive a subpoena from the SEC. We and the Special Committee have agreed to cooperate fully with the government
investigations, and the Special Committee has agreed to share all results of
its investigation with the SEC and the U.S. Attorneys Office. To that end, two
meetings of our outside counsel with attorneys for the U.S. Attorneys Office
and the SEC have taken place and numerous documents as requested by these
government agencies have been voluntarily produced. We are attempting
to schedule a third meeting with the
U.S. Attorneys Office and the SEC in July in order
to provide additional information related to the Special Committees
investigation to these government agencies. We and the Special Committee
intend to facilitate any interviews of our employees or officers that may be
requested by these government agencies. The Department of Justice, SEC and other government agencies that are
investigating or might commence an investigation of aaiPharma could impose,
based on a claim of fraud, material misstatements, violation of false claims
law or otherwise, civil and/or criminal sanctions, including fines, penalties,
and/or administrative remedies. If any government sanctions are imposed, which
we cannot predict or reasonably estimate at this time, our business, financial
condition, results of operations or cash flows could be materially adversely
affected. These matters have resulted, and are expected to continue to result,
in a significant diversion of managements attention and resources and in
significant professional fees. In addition, there may be additional governmental investigations pending of
which we are not yet aware. We have certain obligations to indemnify our officers and directors, and we may
not have sufficient insurance coverage available for this purpose. We may be
forced to pay these indemnification costs directly, and we may not be able to
maintain existing levels of coverage, which could make it difficult to attract
or retain qualified directors and officers. Our bylaws require that we indemnify our directors and officers under specified
circumstances. Although we have purchased D&O liability insurance for our
directors and officers to fund a portion of these obligations, if our insurance
carriers should deny coverage, or if the indemnification costs exceed the
insurance coverage, we may be forced to bear some or all of these
indemnification costs directly, which could be substantial and may have an
adverse effect on our business, financial condition, results of operations and
cash flows. If the cost of this insurance increases significantly, or if this
insurance becomes unavailable, we may not be able to maintain or increase our
levels of insurance coverage for our directors and officers, which could make
it difficult to attract or retain qualified directors and officers. 69




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As a result of our announcement regarding unusual sales of certain products and
the initiation of an inquiry by the Special Committee, and the increased
scrutiny of financial disclosure generally, investor confidence and the
confidence of our lenders in us has suffered and could suffer further. The
results of our investigations and any subsequent adjustments to our financial
statements could have such effect and further materially and adversely affect
the trading price of our securities and our ability to access the capital
markets and increase our litigation risks. As a result of our announcement regarding unusual sales of certain products and
the appointment of the Special Committee to investigate such sales, and the
increased scrutiny of our financial disclosures generally, investor confidence
and the confidence of our lenders in us has suffered and could suffer further.
The U.S. Attorneys Office and the SEC are scrutinizing our financial reporting
practices with respect to such unusual sales. The results of the Special
Committees investigation and the material modifications to our 2002 and 2003
financial results as included in this Annual Report on Form 10-K may further
adversely affect confidence in us and further materially and adversely affect
the trading price of our securities and our ability to access capital markets
and increases our litigation risks. The institution of further litigation and
government investigations could also have a material adverse impact on us. The circumstances surrounding our Special Committee investigation, pending
litigation and governmental investigations and adjustments to our financial
statements could make it difficult for us to hire and retain key personnel. The investigation by our Special Committee, investigations by the SEC and/or
the U.S. Attorneys Office and pending securities and ERISA class actions and
other litigation, and recent announced changes to our management team, have
created substantial uncertainty regarding our ability to focus on our business
operations and remain competitive with other companies in our industry.
Because of this uncertainty, we may have difficulty motivating and retaining
key personnel or replacing key personnel who leave aaiPharma. In addition, due
to the recent substantial declines in the price of our common stock, the
exercise price of outstanding employee stock options substantially exceeds the
trading price of our common stock. The loss in value of these stock options may
affect our ability to retain our key employees, which could seriously harm our
ability to generate revenue, manage day-to-day operations, and deliver our
products and services. Risks Related to Our Business Our internal controls have been inadequate and could adversely affect our
financial condition and ability to carry out our business plan. We have determined that unusual, significant sales of our Brethine injectable
and Darvocet N-100 products occurred during the second half of 2003, and that
certain wholesalers were given a right to return quantities
of new products that we launched in 2003 to the extent that they had not sold
the new products within a specified time. We have also become aware of
opportunities for an employee or group of employees to take actions to
circumvent our internal controls. Thus, we are undertaking a thorough review
of our internal control structure with the assistance of our independent
auditors who have identified material weaknesses in and a reportable condition
with respect to our internal controls. In addition, we may have to commit
substantial resources, including time from our management team, to improve our
internal controls which may negatively affect our ability to implement our
business plan. Further, a control system, no matter how well designed and
operated, can provide only reasonable, not absolute, assurance that the control
systems objectives will be met. Because of the inherent limitations in all
control systems, no system of controls can provide absolute assurance that all
control issues and instances of fraud, if any, within our company have been
detected. The design of any system of controls is based in part upon certain
assumptions about the likelihood of future events, and we cannot assure you
that any design will succeed in achieving its stated 70




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goals under all potential
future conditions. A failure of our controls and procedures to detect error or
fraud could seriously harm our business and results of operations. We may have overpaid for our branded product lines that may not produce
sufficient cash flow to repay indebtedness incurred in connection with the
acquisition or to provide an acceptable rate of return on our investment. We have increased our net revenues through a series of acquisitions of branded
products. The acquisition prices that we paid were based upon many factors,
including our analysis of sales history, forecasted sales, competition, and our
judgment with respect to marketing potential, brand strength and product
improvement opportunities. The revenues we derive from any of these product
lines may be lower than amounts we expected when we acquired these product
lines. We funded our acquisitions of M.V.I., Brethine, Darvon, Darvocet,
Oramorph SR, Roxanol, and Roxicodone by borrowings under predecessor senior
credit facilities, and the net proceeds from our sale of the senior
subordinated notes. We may have overpaid for our branded product lines that may
not produce sufficient cash flow to repay indebtedness incurred in connection
with the acquisition or to provide an acceptable rate of return on our
investment. Our branded products are subject to generic competition and increased generic
substitution for our branded products may result in a decrease in our revenues
and materially affect our liquidity. Our branded products are subject to generic competition. In 2004, the Food and
Drug Administration approved generic versions of our Roxicodone and Brethine
injectable products. There is no proprietary protection for most of the branded
pharmaceutical products that we sell, and as a result our branded
pharmaceutical products are or may become subject to competition from generic
substitutes. In May 2004, a generic version of injectable Brethine was
introduced. If our competitors can supply significant amounts of the
generic product to the market, our
revenues from sales of Brethine injectable product may be substantially
reduced. In addition, given levels of inventory of this product in the
distribution channel, our cash flows from sales of this product may be
negatively affected and we may experience significant returns of this product
which could materially adversely affect our liquidity. Generic substitutes for
our branded products, which may be precisely identical to our branded products,
are sold by competitors at significantly lower prices. If consumers and
physicians do not believe that our branded products have greater benefits than
their generic equivalents, they may elect generic equivalents or other
substitute products in lieu of our branded products, which may result in
decreased revenues for our branded products. In addition, any further increase
in the amount of generic and other competition against any one or more of our
products could further lower prices and unit sales. In addition, pressures to
reduce pharmaceutical costs, including from third-party payers such as health
maintenance organizations, or HMOs, and health insurers, may result in
physicians or pharmacies increasingly using generic substitutes. State and
federal legislation, and decisions by state and federal government agencies
with the power to determine or influence purchasing decisions on products sold
to government agencies or through government funded programs, may be enacted or
made that would adversely affect purchases of branded pharmaceutical products.
Such legislation or government agency
decisions may more broadly mandate substitution of generic products for
prescriptions written for branded products, establish preferred or exclusionary
product lists that favor generic products, or otherwise establish or influence
product purchases. Competition from generic products or additional legislation
or regulatory developments favoring generic products, creating preferred or
exclusionary product lists, or establishing or influencing purchasing decisions
could cause our sales of branded products to decrease and could have a material
adverse effect on our business, financial condition, and results of operations. 71




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A small number of customers account for a large portion of our sales and the
loss of one of them, or changes in their purchasing or payment patterns or inventories,
could result in reduced sales or adversely impact our financial performance. We are heavily dependent on sales of our products to three large national
wholesalers, McKesson Corporation, Cardinal Health Inc., and AmerisourceBergen
Corporation, which then resell our products out of their inventories to
pharmacies and other indirect customers for use in meeting ultimate
prescription demand. Our results of operations, including, in particular,
product sales revenue, may vary from quarter to quarter due to buying
and payment patterns
and inventories of our wholesalers. In the event wholesalers with whom we do
business determine to limit their purchases of our inventory or
withhold payments from us, sales of our
products or our cash flows could be materially adversely affected. For example, in advance of an
anticipated price increase, many of our customers may order pharmaceutical
products in larger than normal quantities. The ordering of excess quantities in
any quarter could cause sales of some of our branded pharmaceutical products to
be lower in subsequent quarters than they would have been otherwise. We believe
that excess sales of our Brethine injectable and Darvocet N-100 products during the
second half of 2003 will significantly reduce our sales of these products in
2004. The small number of wholesale drug distributors, consolidation in this
industry or financial difficulties of these distributors could result in the
combination or elimination of warehouses, which could temporarily increase
returns of our products or, as a result of distributors reducing inventory
levels, delay the purchase of our products. We
do not anticipate receiving further material payments in connection
with our significant development agreement in the future, and we may
be unable to replace this revenue stream. We
have a significant development agreement under which we received
product development revenues of $13.0 million in 2003,
$16.9 million in 2002 and $14.9 million in 2001 and
development services revenues of $2.7 million in 2003,
$4.7 million in 2002 and $6.3 million in 2001. During this
time period, we recorded research and development expenses of
$1.0 million in 2003, $0.7 million in 2002 and
$2.3 million in 2001 related to this agreement. In April 2004,
we entered into an agreement to receive a prepayment of amounts that
would otherwise be paid to us quarterly through the second quarter of
2005 under this significant development agreement. These payments
would have aggregated $15.4 million, and in April 2004 we
received approximately $15.0 million in gross proceeds from the
prepayment. We do not anticipate that we will receive further
material payments in connection with this significant development
agreement in the future. If we are unable to replace this revenue
stream, our results of operations and cash flows may be materially
adversely affected. We are dependent on third parties for the manufacture of our products, for
critical raw materials and services. We are dependent on third parties for certain essential business functions, and
problems with these third-party arrangements could materially adversely affect
our ability to manufacture and sell products and our business, financial
condition, and results of operations. We are dependent on third parties for the manufacture of most of our
proprietary products. Our manufacturing dependence upon third parties may
adversely affect our profit margins and our ability to deliver our products on
a timely and competitive basis. If we are unable to retain or replace
third-party manufacturers on commercially acceptable terms, we may not be able
to distribute our products as planned. If we encounter delays or difficulties
with contract manufacturers in producing or packaging our products, the
distribution, marketing and subsequent sales of these products would be
adversely affected, and we may have to seek alternative sources of supply, lose
sales or abandon or divest a product line on unsatisfactory terms. We may be
unable to enter into alternative supply arrangements at commercially acceptable
rates on a timely basis, if at all. The manufacturers that we utilize may not
be able to provide us with sufficient quantities of our products, and the
products supplied to us may not meet our specifications. Moreover, failure of
our contract manufacturers to follow good manufacturing practices as mandated
by the FDA, could suspend or halt manufacturing at these sites. Additionally,
modifications, enhancements, or changes in manufacturing sites of approved
products are subject to FDA approval that we may or may not be able to obtain
and that may be subject to a lengthy application process. After expiration of our existing third-party supply contracts, our
manufacturing costs for those products supplied under these contracts could be
higher and any transfer of manufacturing of these products, including any
transfer to our own or new third-party manufacturing facilities, may cause us
to incur significant manufacturing start-up costs. Our third-party supply
contracts are scheduled to expire beginning over the next few years, and we may be unable to renew agreements with our
current suppliers since in a number of cases our suppliers are companies from
whom we acquired our branded products and the supply agreements were entered
into in connection with the purchase of the branded product line. Additionally,
any change of the manufacturing site of any of these products would require FDA
approval of the new 72




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manufacturing facility. FDA approval, however, is not
within our control, and we may not receive the necessary approval within our
anticipated time schedule, if at all. We are also dependent on third parties for the supply of critical raw materials
and packaging supplies. Sales of our products will be dependent on our ability
to obtain FDA-approved supplies of raw materials, including active and inactive
pharmaceutical ingredients, and packaging materials, at commercially acceptable
prices and terms, in time to satisfy critical product development, testing,
analytical and manufacturing activities, customer contracts, or our development
plans. The FDA must approve the supply source of many ingredients for our
products. The qualification of a new supply source could delay the manufacture
of the drug involved. Arrangements with our foreign suppliers are subject to
certain additional risks, including the availability of governmental
clearances, export duties, political instability, currency fluctuations, and
restrictions on the transfer of funds. Any constraints on the supply of raw
materials could materially and adversely affect our business, financial
condition, and results of operations. We use, and are dependent on, a contract distribution program for warehousing
of our branded products. We have contracted with a national pharmaceutical
product distribution company to provide warehousing, product distribution,
inventory tracking, customer service and financial administrative assistance
related to our product distribution program. We are dependent on the
capabilities of this third party to distribute our products effectively. We do
not have extensive experience performing these functions ourselves and may
suffer significant disruption if in the future we have to perform these
functions or find alternative providers. Our new products and line extensions, including Darvocet A500 may not produce
revenues sufficient to justify the cost of acquiring or developing these
products or our related direct costs and selling expense. Our business plan for our Darvocet line extensions, including Darvocet A500,
was based on the belief that these products would not be subject to immediate
competition from generic products, although they would be subject to potential
generic competition. In some jurisdictions, however, pharmacists may fill
prescriptions written for Darvocet A500 and similar Darvocet line extension
products with generic products that, though not recognized by the FDA as
therapeutically equivalent to the Darvocet products, may be deemed by the
pharmacist to be therapeutically equivalent to those products. It is our
understanding that a pharmacists profit margin on these generic products
generally exceeds the pharmacists profit margin on our branded Darvocet line
extension products. These factors may result in lower revenues from these
Darvocet line extensions than we had internally estimated. We have written off
the full amount of the Darvocet A-500 assets we acquired in July 2003 because
we do not anticipate additional material income from this product. Our new
products and line extensions may not produce revenues sufficient to justify our
cost of acquiring or developing these products or our direct costs and selling
expense. If we cannot sell our Darvocet A500 and other products in amounts greater than
our minimum purchase requirements under our supply agreement, our results of
operations and cash flows may be adversely affected. Our original supply agreement for Darvocet A500 requires us to purchase certain
minimum levels of this product over the initial three-year period of this
agreement, subject to specified terms and conditions. We amended the agreement
to allow other products manufactured by the third party on our behalf to count
towards this minimum requirement, but have not yet agreed upon the terms for
manufacturing these additional products, including price. If sales of our
products do not significantly increase from current rates or we are unable to
transfer the manufacturing of additional products to the third party in a
timely manner, we may incur losses in connection with the purchase commitments
under the supply agreement. In the event
we incur losses in connection with the purchase commitments under the supply
agreements, there may be a material adverse effect upon our results of
operations and cash flows. 73




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Because we have a limited number of product lines, a material adverse change in
any one of our product lines could materially adversely affect our results of
operations and cash flows. Our success is largely dependent upon a limited number of key product lines,
which means that any unfavorable developments with respect to any one product
line could materially adversely affect us. Sales of our branded product lines,
particularly Darvon, Darvocet, and Brethine, represent a significant portion of
our total revenues. The divestiture of our M.V.I. business reduced the number
of key product lines that we sell. Accordingly, any factor adversely affecting
sales of any of these products, such as the recent introduction of generic
competitors of our injectable Brethine and Roxicodone products, could have a
material adverse effect on our business, financial condition, and results of
operations. In addition, any perceived problems with these products, such as
any problem with their safety or efficacy, could have a similar material
adverse effect. We may incur substantial expense to develop products that we never successfully
commercialize. We incur substantial research and development expenses, and other expenses,
attempting to develop new or improved products or product line extensions. The
products or line extensions to which we devote operational and financial
resources could be commercial failures. Successful commercialization of
products and product line extensions requires accurate anticipation of market
and customer acceptance of particular products, customers needs, the sale of
competitive products, and emerging technological trends, among other things.
Additionally, for successful product development, we must complete many complex
formulation and analytical testing requirements and obtain regulatory approvals
from the FDA and other regulatory agencies. When developed, new or
reformulated drugs may not exhibit desired characteristics or may not be
accepted by the marketplace. Complications can also arise during production
scale-up. Our products and line extensions may encounter unexpected,
unresolvable patent conflicts, or may not have enforceable intellectual
property rights. Delays or problems also may arise from internal conflicts for
resource availability, personnel errors or equipment failures. If we incur
significant expenses for a product or line extension that we do not
successfully develop and commercialize, there could be a material adverse
effect on our business, financial condition and results of operations. Introductions by us of line extensions of our existing products may require
that we make unexpected changes in our estimates for future product returns and
reserves for obsolete inventory which would adversely affect our operating
results. Part of our business strategy includes the introduction of line extensions of
our existing products to create marketing advantages and extend the life cycles
of our product lines. From time to time, we may seek to introduce line
extensions on an expedited basis, even though there are significant levels of
inventories of product which may be rendered obsolete or otherwise adversely
affected by the line extension. This may require us to increase our estimate
for returns of product on hand at wholesalers, which are recorded as a
reduction of our net revenues, and increase our reserve for our inventory which
is recorded as a direct cost. Accordingly, the introduction of line extensions
may adversely affect our operating results. There is a risk that we may incur additional charges for intangible asset
impairment. When we acquire the rights to manufacture and sell a product, we record the
aggregate purchase price, along with the value of the product related
liabilities we assume, as intangible assets. We use the assistance of valuation
consultants to help us allocate the purchase price to the fair value of the
various intangible assets we have acquired. Then, we must determine if the
asset has an indefinite life or a definite life and estimate the economic
useful life of each of the definite-lived intangible assets in order to
amortize their cost as an expense in our statement of operations over the
estimated economic useful life of the related asset. The
factors that drive the actual economic useful life of a pharmaceutical product
are inherently uncertain, and include physician loyalty and prescribing
patterns, competition by products prescribed for similar 74




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indications, future
introductions of competing products not yet FDA approved, the impact of
promotional efforts and many other issues. We use all of these factors in
initially estimating the economic useful lives of our products, and we also
continuously monitor these factors for indications of appropriate revisions. In assessing the recoverability of our intangible assets, we must make
assumptions regarding estimated undiscounted future cash flows and other
factors. If the estimated undiscounted future cash flows do not exceed the
carrying value of the intangible assets we must determine the fair value of the
intangible assets. If the fair value of the intangible assets is less than its
carrying value, an impairment loss will be recognized in an amount equal to the
difference. If these estimates or their related assumptions change in the
future, we may be required to record impairment changes for these assets. In
addition, material adjustments to our forecasted revenues from the sales of any
of our acquired product lines including Brethine and Darvocet may require us to
employ different assumptions with respect to our estimated cash flows. We
review intangible assets for impairment at least annually and whenever events
or changes in circumstances indicate that the carrying amount of an asset may
not be recoverable. If we determine that an intangible asset is impaired, a
non-cash impairment charge would be recognized. As circumstances after an acquisition can change, the value of intangible
assets may not be realized by us. If we determine that impairment has
occurred, we would be required to write-off the impaired portion of the
unamortized intangible assets, which could have a material adverse effect on
our results of operations in the period in which the write-off occurs. In
addition, in the event of a sale of any of our assets, we cannot be certain
that our recorded value of such intangible assets would be recovered. We may be unable to secure or enforce adequate intellectual property rights to
protect the new products or technologies we develop, and our existing
intellectual property rights may not be adequate to protect us or provide us
with a competitive advantage. Our ability to successfully commercialize new products or technologies is
dependent upon our ability to secure and enforce strong intellectual property
rights, generally patents, and we may be unable to do so. To obtain patent
protection, we must be able to successfully persuade the U.S. Patent and
Trademark Office and its foreign counterparts to issue patents on a timely
basis and possibly in the face of third-party challenges. Even if we are
granted a patent, our rights may later be challenged or circumvented by third
parties. The issuance of a patent is not conclusive as to its validity or
enforceability. Litigation to enforce our patents generally will involve
substantial professional fees and costs and may ultimately prove to be
unsuccessful. In addition, we may receive notices from third parties regarding
patent claims against us or our subsidiaries. Any such claims, with or without
merit, could be time-consuming to defend, result in costly litigation, divert
our managements attention and resources, and cause us to incur significant
expenses or, in the event of adverse decisions, significant damages owed to the
patent owner. In addition, any potential intellectual property litigation
could require that we stop selling our products, obtain a license from the
owner to sell or use the relevant intellectual property, which we may not be
able to obtain on favorable terms, if at all, or modify our products to avoid
using the relevant intellectual property. In the event of a successful claim
of infringement against us, our business, financial condition and results of
operations could be materially and adversely affected. Additionally, we also rely on trade secrets and other unprotected proprietary
knowledge, which we generally seek to protect by confidentiality,
non-disclosure and assignment of invention agreements with our employees,
consultants, licensees and other companies. These agreements, however, may be
breached or may not be enforceable, or we may not have adequate remedies for a
breach by the other party. Additionally, our trade secrets may become known by
our competitors. Parties to those agreements may claim rights to intellectual
property arising out of their work. The disclosure or misappropriation of our
intellectual property for any of these reasons could materially and adversely
affect our business, financial condition or results of operations. 75




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We may be unable to obtain government approval for our products or comply with
government regulations relating to our business. The commercialization of pharmaceutical products is subject to extensive
federal, state and local regulation in the United States and similar foreign
regulation. We do not know the extent to which we may be affected by
legislative and other regulatory actions and developments concerning various
aspects of our operations, our products and the health care field generally.
We do not know what effect changes in governmental regulation and other actions
or decisions by governmental agencies may have on our business in the future.
Any changes could require changes to manufacturing methods or facilities,
pharmaceutical importation, expanded or different labeling, new approvals, the
recall, replacement or discontinuance of certain products, additional record
keeping, price or purchase controls or limitations, and expanded documentation
of the properties of certain products and scientific substantiation. Any
regulatory changes could have a material adverse effect on our business,
financial condition and results of operations or our competitive position. The
manufacturing, processing, formulation, packaging, labeling, distribution,
importation, pricing, reimbursement and advertising of our products, and
disposal of waste products arising from these activities, are also subject to
regulation by the U.S. Drug Enforcement Administration, the Federal Trade
Commission, the U.S. Consumer Product Safety Commission, the U.S. Department of
Agriculture, the Occupational Safety and Health Administration, the U.S.
Environmental Protection Agency, the U.S. Customs Service and the Centers for
Medicare and Medicaid Services, as well as state, local and foreign
governments. We will be required to obtain approval from the FDA based upon pre-clinical
testing, clinical trials showing safety and effectiveness, chemistry and
manufacturing control data, and other data and information before marketing
most drug products. The generation of the required data is regulated by the FDA
and can be time-consuming and expensive, and the results might not justify
approval. Our FDA product filings may not be approved in a timely manner, if
at all, and we may be unable to meet other regulatory requirements for our
products. Pharmaceutical products also must be distributed, sampled,
advertised and promoted in accordance with FDA requirements. Even if we are
successful in obtaining all required pre-marketing approvals, post-marketing
requirements and any failure on our part to comply with other regulations could
result in suspension or limitation of approvals or commercial activities
pertaining to affected products. The FDA could also require reformulation of
products during the post-marketing stage. All of our drugs must be manufactured in conformity with current Good
Manufacturing Practice regulations, as interpreted and enforced by the FDA, and
drug products subject to an FDA-approved application must be manufactured,
processed, packaged, held and labeled in accordance with information contained
in the application. Additionally, modifications, enhancements or changes in
manufacturing sites of approved products are, in many circumstances, subject to
FDA approval, which may be subject to a lengthy application process or which we
may be unable to obtain. 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,
and operations at these facilities could be interrupted or halted if such
inspections are unsatisfactory. Failure to comply with FDA or other governmental regulations can result in
fines, unanticipated compliance expenditures, recall or seizure of products,
total or partial suspension of production or distribution, suspension of the
FDAs review of our product applications, 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, if compliance is
deficient in any significant way, it could have a material adverse effect on
us. Most of our suppliers are subject to similar regulations and periodic
inspections. 76




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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. 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 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 bill 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. While we
have internal policies and practices requiring compliance with the health care
fraud and abuse laws and false claims laws, it is possible that some 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. On January 2, 2004, we received separate letters from the Kentucky Office of
Attorney General and the Florida Office of Attorney General advising that each
was currently investigating allegations regarding our pricing practices related
to our average manufacturer price and best price calculations that are used by
the government to set Medicaid reimbursement rates. Neither letter requested
that we provide any information, and each letter merely requested that we
retain all documents with respect to these calculations pursuant to a newly
adopted federal regulation that would have permitted the destruction of these
documents three years after the applicable prices were reported, except to the
extent we were aware of an ongoing investigation. It is our understanding that
many other pharmaceutical companies received similar letters at that time from
attorneys general in a number of states and that such letters may have been in
response to the new federal regulation that would have otherwise allowed the
destruction of documents reflecting these pricing calculations. A number of
attorneys general, including the Florida and Kentucky attorneys general,
petitioned the U.S. Secretary of Health and Human Services to withdraw the new
regulation. We are not aware of any further developments in these
investigations. Additionally, our business involves the controlled storage, use and disposal of
hazardous or highly potent materials. We are subject to numerous environmental
laws and regulations in the jurisdictions in which we operate. 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. In the event of an accident, we could be held liable to
governmental authorities or private parties for any damages that result, and
the liability could exceed our resources. In addition, we could be held liable
for costs associated with contamination of properties currently or formerly
occupied by us, or at other parties disposal sites where we dispose or have
disposed of hazardous wastes, even though this contamination may have been
caused by third parties or the disposal may have complied with the regulatory
requirements then in place. Current or future environmental laws and
regulations, or adverse changes in the way current laws and regulations are
interpreted or enforced, may materially adversely affect our business,
financial condition and results of operations. We maintain liability insurance
for some environmental risks that our management believes to be appropriate and
in accordance with industry practice. However, we may incur liabilities beyond
the limits or outside the coverage of our insurance and may not be able to
maintain insurance on acceptable terms. 77




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In connection with our activities outside the U.S., we are subject to foreign
regulatory requirements governing the testing, approval, manufacture, labeling,
marketing and sale of pharmaceutical products. These requirements vary from
country to country. Even if 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. Clinical
studies conducted outside of any particular country may not be accepted by that
country, and the approval of a pharmaceutical product in one country does not
assure that the product will be approved in another country. In addition,
regulatory agency approval of pricing is required in many countries and may be
required for our marketing of any drug in those countries. Product liability claims or product recalls could harm our business, financial
condition and results of operations. We face an inherent business risk of exposure to product liability claims in
the event that the use of our products or products that we manufacture for
others is alleged to have resulted in adverse effects. Such risks will exist
even with respect to those products that receive regulatory approval for
commercial sale. While we will take what we believe are appropriate
precautions, we may not be able to avoid significant product liability
exposure. Although we maintain product liability insurance, this insurance may
not be sufficient to cover all potential claims against us or involving our
products or products manufactured for others. Also, adequate insurance
coverage may not be available in the future at acceptable costs, if at all.
When we acquire or develop new products, we cannot assure that additional
liability insurance coverage for these new products will be available on
acceptable terms, if at all. The assertion of this type of claim could have a
material adverse affect on our business, financial condition and results of
operations. Product recalls may be issued at our discretion or at the
discretion of government agencies or others having regulatory
authority for pharmaceutical product sales. Recalls could have a material
adverse effect on our business, financial condition and results of operations. We are vulnerable to pressures from third-party payers. Our commercial success in product sales will depend on patients being
reimbursed by third-party health care payers, such as government and private
health insurers and managed care organizations. Third-party payers are
increasingly challenging the pricing of medical products and services. For
example, third-party payers strenuously discourage use of branded products when
generic substitutes are available, although they may prefer established branded
products over more expensive newer products for the same indication. As a
result, reimbursement may not be available to enable us to maintain price
levels sufficient to realize an appropriate return on our investment in product
acquisition and development. If adequate reimbursement levels are not
provided, our business, financial condition and results of operations could be
materially and adversely affected. The market for our products may also be limited by other actions of third-party
payers. For example, many managed health care organizations are now limiting
the pharmaceutical products that are on their lists of approved drugs. The
resulting competition among pharmaceutical companies to place their products on
these formulary lists has created a trend of downward pricing pressure in the
industry. In addition, many managed care organizations are pursuing various
ways to reduce pharmaceutical costs and are considering formulary contracts
primarily with those pharmaceutical companies that can offer a broad line of
products for a given class of therapy or disease, which we cannot do. Our
products may not be included on the approved drug list of managed care
organizations, and downward pricing pressures in the industry generally could
materially and adversely impact our business, financial condition and results
of operations. 78




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New legislation or regulatory proposals may adversely affect our revenues. A number of legislative proposals aimed at reducing the costs of medical
products and services have been enacted or proposed. For example, certain
state governments have enacted legislation that seeks to reduce the price paid
by the Medicaid program for prescription drugs. In Florida and Michigan,
pharmaceutical companies that sell drugs reimbursed under state Medicaid
programs are now required to offer rebates in addition to the existing rebates
mandated by Federal law in order for their prescription drugs to be placed on
the states preferred list of drugs eligible for Medicaid reimbursement. A
number of states are considering additional legislation and other measures that
would, if enacted, further adversely affect revenues from the sale of branded
drugs, for example, through limits on the purchase of branded drugs by state
institutions and restrictions on reimbursement for branded drugs in programs
subject to state jurisdiction. In addition, in 2000, Congress directed the FDA to adopt regulations allowing
the reimportation of approved drugs originally manufactured in the United
States back into the United States from other countries where the drugs were
sold at a lower price. Although the Secretary of Health and Human Services has
refused to implement this directive, in July 2003 the House of Representatives
passed a similar bill that does not require the Secretary of Health and Human
Services to act. The reimportation bills have not yet resulted in any new laws
or regulations; however, these and other initiatives could decrease the price
we receive for our products. For most of our branded products, we own only the
U.S. distribution rights, while others own the rights to distribute these
products outside the United States. Accordingly, sales of our products in the
United States could be adversely affected by the importation of equivalent
products that are manufactured by others and are available outside the United
States. Changes in the Medicare, Medicaid or similar governmental programs or the
amounts paid by those programs for our services may adversely affect our
earnings. These programs are highly regulated and subject to frequent and
substantial changes and cost containment measures. In recent years, changes in
these programs have limited and reduced reimbursement to providers. The
Medicare Prescription Drug, Improvement and Modernization Act of 2003, creates
a new, voluntary prescription drug benefit under the Social Security Act, which
we refer to as Medicare Drug Benefit. Beginning in 2006, Medicare
beneficiaries entitled to Part A or enrolled in Part B, as well as certain
other Medicare enrollees, will be eligible for the Medicare Drug Benefit.
Regulations implementing the Medicare Drug Benefit have not yet been published,
and the Medicare Drug Act requires that the Federal Trade Commission conduct a
study and make recommendations regarding additional legislation that may be
needed concerning the Medicare Drug Benefit. We are unable at this time to
predict or estimate the financial impact of this new legislation.
Additionally, several large pharmaceutical companies have recently adopted
discount plans for the elderly. Our business, financial condition and results
of operations could be materially and adversely affected if recently
established or future legislative or regulatory programs that are designed to
reduce the costs of medical products and services are effective or require
consumers to use generic substitutes or other alternatives for our branded
products. Our stock price is volatile, which could result in substantial losses for
investors purchasing shares. Our operating results may fluctuate from quarter to quarter and from year to
year, causing our stock price to fluctuate. The market price of our common
stock will be affected by our ability to meet analysts and investors
expectations. Failure to meet these expectations, even slightly, could cause
the market price of our common stock to fall significantly. The market prices
for securities of drug delivery, biotechnology and pharmaceutical companies
historically, and our stock in particular, have been highly volatile and may be
highly volatile in the future. Other factors that could materially adversely
affect our stock price include: 79




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##### 




    
    demand by consumers for our products and the products we produces for others;
    
    the prices that we can obtain for such products;
    
    the level of product and price competition;
    
    competitive new product introductions, including generic competition;
    
    distributors and wholesalers ordering patterns;
    
    levels of our products in the distribution channels;
    
    the outcome and costs of litigation brought by and against us;
    
    timely success in product development and regulatory approvals for
new products and line extensions;
    
    actions by the FDA in connection with submissions related to our
products or those of our competitors;
    
    other governmental regulations and actions affecting our products or those of our competitors;
    
    third-party payer decisions and actions affecting our products or those of our competitors;
    
    developments in patent or other proprietary rights owned by us or others;
    
    our manufacturing efficiency and capacity and the ability of our
product and raw material suppliers to supply us with conforming products
and materials on a timely and regulatory compliant basis;
    
    our ability to control costs;
    
    fluctuations in our operating results;
    
    the number and profitability of new services agreements that we enter into;
    
    the number and timing of product development milestones that we
achieve under third-party agreements and other contracts with customers;
    
    the level of spending on research and development by us and by the
pharmaceutical industry as a whole;
    
    announcements of technological collaborations, innovations or new
products by us or our competitors;
    
    public concern as to the safety of our products or the products we manufacture for others;
    
    the results of pre-clinical testing and clinical studies or trials by us or our competitors;
    
    decisions by our pharmaceutical company partners relating to the
products incorporating our technologies; and
    
    general economic and market conditions. Our business is subject to changing regulation of corporate governance and
public disclosure that has increased both our costs and the risk of
noncompliance. Because our common stock is publicly traded, we are subject to certain rules
and regulations of federal, state and financial market exchange entities
charged with the protection of investors and the oversight of companies whose
securities are publicly traded. These entities, including the Public Company
Accounting Oversight Board, the SEC and NASDAQ, have recently issued new
requirements and regulations and continue developing additional regulations and
requirements in response to recent corporate scandals and laws enacted by
Congress, most notably the Sarbanes-Oxley Act of 2002. Our efforts to comply
with these new regulations have resulted in, and are likely to continue
resulting in, increased general and administrative expenses and diversion of
management time and attention from revenue-generating activities to compliance
activities. In particular, our efforts to prepare to comply with Section 404 of the
Sarbanes-Oxley Act and related regulations regarding our managements required
assessment of our internal control over financial reporting and our independent
auditors attestation of that assessment has required, and continues to
require, the commitment of significant financial and managerial resources. In
part to prepare for compliance with Section 404, as well as to generally
improve our internal control environment, we have undertaken 80




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substantial measures, including, among other things, costly projects to centralize both our
accounting and information technology systems. These projects, which represent both
operational and compliance risks, require significant resources and must be
completed in a timely manner in order to enable us to comply with the Section
404 requirements. Although management believes that ongoing efforts to improve
our internal control over financial reporting will enable management to provide
the required report, and our independent auditors to provide the required
attestation, under Section 404 as of December 31, 2004, we can give no
assurance that such efforts will be completed on a timely and successful basis
to enable our management and independent auditors to provide the required
report and attestation. Moreover, because the new and changed laws, regulations and standards are
subject to varying interpretations in many cases due to their lack of
specificity, their application in practice may evolve over time as new guidance
is provided by regulatory and governing bodies. This evolution may result in
continuing uncertainty regarding compliance matters and additional costs
necessitated by ongoing revisions to our disclosure and governance practices. Cautionary Statement Regarding Forward-Looking Statements This document contains forward-looking statements within the meaning of the
safe harbor provisions of the Private Securities Litigation Reform Act of
1995. Words such as estimate, project, intend, anticipate, believe
and similar expressions are intended to identify forward-looking statements.
The forward-looking statements contained in this document include statements
about future financial and operating results, including the anticipated
financial condition, results of operations, business strategies, operating
efficiencies, competitive positions, growth opportunities for existing
products, plans and objectives of management and markets for our common stock.
These statements are based on the current expectations and beliefs of our
management and are subject to a number of factors and uncertainties, including
the matters noted above, that could cause actual results to differ materially
from those described in the forward-looking statements. These statements are
not guarantees of future performance, involve certain risks, uncertainties and
assumptions that are difficult to predict, and are based upon assumptions as to
future events that may not prove accurate. Therefore, actual outcomes and
results may differ materially from what is expressed in the forward-looking
statement. In any forward-looking statement in which we express an expectation
or belief as to future results, that expectation or belief is expressed in good
faith and believed to have a reasonable basis, but there can be no assurance
that the statement or expectation or belief will result or be achieved or
accomplished. Additional risks and uncertainties pertaining to the following
factors, among others, could cause actual results to differ materially from
those described in the forward-looking statements:  
    
    demand by consumers for our products and the products we produces for others;
    
    the prices that we can obtain for such products;
    
    the level of product and price competition;
    
    competitive new product introductions, including generic competition;
    
    distributors and wholesalers ordering patterns;
    
    levels of our products in the distribution channels;
    
    the outcome and costs of governmental investigation;
    
    the outcome and costs of litigation brought by and against us;
    
    timely success in product development and regulatory approvals for
new products and line extensions;
    
    actions by the FDA in connection with submissions related to our
products or those of our competitors;
    
    other governmental regulations and actions affecting our products or those of our competitors; 81




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##### 




    
    third-party payer decisions and actions affecting our products or those of our competitors;
    
    developments in patent or other proprietary rights owned by us or others; and
    
    the other factors discussed in - Risks Factors and Forward-Looking Statements. We do not undertake any obligation to (and expressly disclaim any obligation
to) update or alter our forward-looking statements, whether as a result of new
information, future events or otherwise. 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 our risk from foreign exchange movement, we may use local debt
to fund our foreign operations. If foreign exchange rates were to increase by
10%, our operating results would have been lower by $100,000 in 2003 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 $1.0 million. 82




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##### 



Item 8. Financial Statements and Supplementary Data Report of Independent Registered Public Accounting Firm Board of Directors and Stockholders
aaiPharma Inc. We have audited the accompanying consolidated balance sheets of aaiPharma Inc.
and subsidiaries as of December 31, 2003 and 2002, 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,
2003. 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 the standards of the Public Company
Accounting Oversight Board (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 financial statements referred to above present fairly, in
all material respects, the consolidated financial position of aaiPharma Inc.
and subsidiaries at December 31, 2003 and 2002, and the consolidated results of
their operations and their cash flows for each of the three years in the period
ended December 31, 2003, in conformity with U.S. generally accepted accounting
principles. 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. /s/ Ernst & Young LLP Raleigh, North Carolina
May 14, 2004 83




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##### 



aaiPharma Inc.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts) Years Ended December 31,20022003
    
    (as restated)
    
    2001Net revenues:Product sales
    
    $
    122,021
    
    
    $
    128,462
    
    
    $
    27,448Product development
    
    
    16,468
    
    
    
    19,610
    
    
    
    20,426Development services (includes related party net
revenues of $630, $1,556 and $323)
    
    
    86,488
    
    
    
    82,438
    
    
    
    93,199224,977
    
    
    
    230,510
    
    
    
    141,073Operating costs and expenses:Direct costs (excluding depreciation and royalty expense):Product sales (includes acquired product rights
amortization of $12,273, $9,239, and $0)
    
    
    62,970
    
    
    
    41,884
    
    
    
    13,337Development services
    
    
    51,867
    
    
    
    48,813
    
    
    
    53,860Total direct costs
    
    
    114,837
    
    
    
    90,697
    
    
    
    67,197Selling
    
    
    39,534
    
    
    
    23,077
    
    
    
    13,749General and administrative
    
    
    40,463
    
    
    
    40,109
    
    
    
    26,538Research and development
    
    
    21,788
    
    
    
    20,853
    
    
    
    10,482Depreciation
    
    
    7,973
    
    
    
    7,156
    
    
    
    7,755Royalty expense
    
    
    1,095
    
    
    
    
    
    
    
    Intangible asset impairment
    
    
    20,600
    
    
    
    
    
    
    
    Direct pharmaceutical start-up costs
    
    
    
    
    
    
    
    
    
    
    2,123Total operating costs and expenses
    
    
    246,290
    
    
    
    181,892
    
    
    
    127,844(Loss) income from operations
    
    
    (21,313
    )
    
    
    48,618
    
    
    
    13,229Other income (expense), net:Interest, net
    
    
    (21,078
    )
    
    
    (19,366
    )
    
    
    (3,646
    )Loss from extinguishment of debt
    
    
    (1,511
    )
    
    
    (8,053
    )
    
    
    Other income (expense), net
    
    
    6,697
    
    
    
    461
    
    
    
    (444
    )(15,892
    )
    
    
    (26,958
    )
    
    
    (4,090
    )(Loss) income before income taxes
    
    
    (37,205
    )
    
    
    21,660
    
    
    
    9,139(Benefit from) provision for income taxes
    
    
    (4,502
    )
    
    
    8,542
    
    
    
    3,199Net (loss) income
    
    $
    (32,703
    )
    
    $
    13,118
    
    
    $
    5,940Basic (loss) earnings per share
    
    $
    (1.18
    )
    
    $
    0.48
    
    
    $
    0.22Weighted average shares outstanding
    
    
    27,730
    
    
    
    27,348
    
    
    
    26,691Diluted (loss) earnings per share
    
    $
    (1.18
    )
    
    $
    0.46
    
    
    $
    0.22Weighted average shares outstanding
    
    
    27,730
    
    
    
    28,359
    
    
    
    27,462
 The accompanying notes are an integral part of these financial statements. 84




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##### 



aaiPharma Inc.
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data) December 31,20022003
    
    (as restated)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    8,785
    
    
    $
    6,532Accounts receivable, net
    
    
    32,614
    
    
    
    29,467Work-in-progress
    
    
    12,503
    
    
    
    10,515Inventories, net
    
    
    14,693
    
    
    
    17,004Deferred tax assets
    
    
    19,184
    
    
    
    1,271Prepaid and other current assets
    
    
    10,398
    
    
    
    6,362Total current assets
    
    
    98,177
    
    
    
    71,151Property and equipment, net
    
    
    57,236
    
    
    
    53,125Goodwill, net
    
    
    13,361
    
    
    
    11,378Intangible assets, net
    
    
    351,315
    
    
    
    281,669Other assets
    
    
    14,508
    
    
    
    16,179Total assets
    
    $
    534,597
    
    
    $
    433,502LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Current maturities of long-term debt
    
    $
    4,000
    
    
    $
    5,921Accounts payable
    
    
    21,879
    
    
    
    17,671Customer advances
    
    
    17,630
    
    
    
    15,051Accrued wages and benefits
    
    
    5,320
    
    
    
    6,718Interest payable
    
    
    5,511
    
    
    
    5,232Deferred product revenue
    
    
    45,664
    
    
    
    Other accrued liabilities
    
    
    11,133
    
    
    
    5,201Total current liabilities
    
    
    111,137
    
    
    
    55,794Long-term debt, less current portion
    
    
    338,844
    
    
    
    277,899Deferred tax liability
    
    
    2,246
    
    
    
    3,840Other liabilities
    
    
    7,647
    
    
    
    715Commitments and contingencies
    
    
    
    
    
    
    Stockholders equity:Preferred stock, $ .001 par value; 5 million
shares authorized, none outstanding in 2003 or 2002
    
    
    
    
    
    
    Common stock, $.001 par value; 100 million
shares authorized, 28,221,983 outstanding - 2003;
27,502,709 outstanding - 2002
    
    
    28
    
    
    
    27Paid-in capital
    
    
    88,049
    
    
    
    79,049Retained (deficit) earnings
    
    
    (16,307
    )
    
    
    16,396Accumulated other comprehensive income (loss)
    
    
    3,197
    
    
    
    (218
    )Deferred compensation
    
    
    (244
    )
    
    
    Total stockholders equity
    
    
    74,723
    
    
    
    95,254Total liabilities and stockholders equity
    
    $
    534,597
    
    
    $
    433,502
 The accompanying notes are an integral part of these financial statements. 85




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##### 



aaiPharma Inc.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands) Years Ended December 31,20022003
    
    (as restated)
    
    2001Cash flows from operating activities:Net (loss) income
    
    $
    (32,703
    )
    
    $
    13,118
    
    
    $
    5,940Adjustments to reconcile net (loss) income to
net cash provided by operating civilities:Depreciation and amortization
    
    
    20,246
    
    
    
    16,395
    
    
    
    7,755Intangible asset impairment
    
    
    20,600
    
    
    
    
    
    
    
    Write-off of deferred financing and other costs
    
    
    1,511
    
    
    
    8,053
    
    
    
    Other
    
    
    434
    
    
    
    145
    
    
    
    1,265Changes in operating assets and liabilities:Accounts receivable, net
    
    
    (2,632
    )
    
    
    (2,380
    )
    
    
    (3,112
    )Work-in-progress
    
    
    (1,085
    )
    
    
    643
    
    
    
    6,502Inventories, net
    
    
    2,449
    
    
    
    (7,853
    )
    
    
    (5,452
    )Deferred tax assets
    
    
    (17,913
    )
    
    
    (352
    )
    
    
    2,597Prepaid and other assets
    
    
    (5,687
    )
    
    
    (10,409
    )
    
    
    (4,829
    )Accounts payable
    
    
    3,849
    
    
    
    1,937
    
    
    
    6,673Customer advances
    
    
    2,062
    
    
    
    1,227
    
    
    
    1,522Interest payable
    
    
    279
    
    
    
    4,861
    
    
    
    227Deferred revenue
    
    
    45,664
    
    
    
    
    
    
    
    Accrued wages and benefits and other accrued liabilities
    
    
    1,278
    
    
    
    5,580
    
    
    
    1,263Net cash provided by operating activities
    
    
    38,352
    
    
    
    30,965
    
    
    
    20,351Cash flows from investing activities:Purchases of property and equipment
    
    
    (11,910
    )
    
    
    (8,529
    )
    
    
    (6,315
    )Purchase of property and equipment previously leased
    
    
    
    
    
    
    (14,145
    )
    
    
    Proceeds from sales of property and equipment
    
    
    606
    
    
    
    131
    
    
    
    3,513Acquisitions of product rights and other intangibles
    
    
    (102,464
    )
    
    
    (211,997
    )
    
    
    (79,100
    )Other
    
    
    (502
    )
    
    
    (593
    )
    
    
    151Net cash used in investing activities
    
    
    (114,270
    )
    
    
    (235,133
    )
    
    
    (81,751
    )Cash flows from financing activities:Net payments on short-term debt
    
    
    
    
    
    
    
    
    
    
    (16,272
    )Proceeds from long-term borrowings
    
    
    160,000
    
    
    
    244,486
    
    
    
    78,878Payments on long-term borrowings
    
    
    (93,500
    )
    
    
    (51,900
    )
    
    
    (1,024
    )Proceeds from interest rate swaps, net
    
    
    1,703
    
    
    
    10,486
    
    
    
    Proceeds from stock option exercises
    
    
    8,757
    
    
    
    3,243
    
    
    
    5,123Other
    
    
    1,086
    
    
    
    (2,153
    )
    
    
    (152
    )Net cash provided by financing activities
    
    
    78,046
    
    
    
    204,162
    
    
    
    66,553Net increase (decrease) in cash and cash equivalents
    
    
    2,128
    
    
    
    (6
    )
    
    
    5,153Effect of exchange rate changes on cash
    
    
    125
    
    
    
    167
    
    
    
    (7
    )Cash and cash equivalents, beginning of year
    
    
    6,532
    
    
    
    6,371
    
    
    
    1,225Cash and cash equivalents, end of year
    
    $
    8,785
    
    
    $
    6,532
    
    
    $
    6,371Supplemental information, cash paid for:Interest
    
    $
    24,012
    
    
    $
    16,835
    
    
    $
    2,719Income taxes
    
    $
    7,248
    
    
    $
    1,346
    
    
    $
    370
 The accompanying notes are an integral part of these financial statements. 86




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##### 



aaiPharma Inc.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY (DEFICIT)
(In thousands) Common Stock
    
    Paid-in
    
    RetainedEarnings(Accumulated
    
    AccumulatedOtherComprehensive
    
    DeferredCompensationandShares
    
    Amount
    
    Capital
    
    Deficit)
    
    Income (Loss)
    
    Other
    
    TotalBalance, December 31, 2000
    
    
    26,447
    
    
    $
    27
    
    
    $
    70,352
    
    
    $
    (2,662
    )
    
    $
    (1,974
    )
    
    $
    (22
    )
    
    $
    65,721Stock options exercised
    
    
    549
    
    
    
    
    
    
    
    4,872
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,872Currency translation adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (672
    )
    
    
    
    
    
    
    (672
    )Realized loss on investments
reclassified into earnings
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    481
    
    
    
    
    
    
    
    481Payments on stock subscriptions
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    22
    
    
    
    22Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,940
    
    
    
    
    
    
    
    
    
    
    
    5,940Balance, December 31, 2001
    
    
    26,996
    
    
    
    27
    
    
    
    75,224
    
    
    
    3,278
    
    
    
    (2,165
    )
    
    
    
    
    
    
    76,364Stock options exercised
    
    
    507
    
    
    
    
    
    
    
    3,825
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,825Currency translation adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,837
    
    
    
    
    
    
    
    1,837Realized loss on investments
reclassified into earnings
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    110
    
    
    
    
    
    
    
    110Net income (as restated)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    13,118
    
    
    
    
    
    
    
    
    
    
    
    13,118Balance, December 31, 2002 (as
restated)
    
    
    27,503
    
    
    
    27
    
    
    
    79,049
    
    
    
    16,396
    
    
    
    (218
    )
    
    
    
    
    
    
    95,254Stock options exercised
    
    
    719
    
    
    
    1
    
    
    
    8,582
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    8,583Currency translation adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,415
    
    
    
    
    
    
    
    3,415Issuance of restricted stock
award
    
    
    
    
    
    
    
    
    
    
    418
    
    
    
    
    
    
    
    
    
    
    
    (418
    )
    
    
    Amortization of deferred
compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    174
    
    
    
    174Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (32,703
    )
    
    
    
    
    
    
    
    
    
    
    (32,703
    )Balance, December 31, 2003
    
    $
    28,222
    
    
    $
    28
    
    
    $
    88,049
    
    
    $
    (16,307
    )
    
    $
    3,197
    
    
    $
    (244
    )
    
    $
    74,723
 The accompanying notes are an integral part of these financial statements. 87




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##### 



aaiPharma Inc.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(In thousands) Years Ended December 31,20022003
    
    (as restated)
    
    2001Net (loss) income
    
    $
    (32,703
    )
    
    $
    13,118
    
    
    $
    5,940Currency translation adjustments
    
    
    3,415
    
    
    
    1,837
    
    
    
    (672
    )Realized loss on investments reclassified into
earnings from other comprehensive income
    
    
    
    
    
    
    110
    
    
    
    481Comprehensive (loss) income
    
    $
    (29,288
    )
    
    $
    15,065
    
    
    $
    5,749
 The accompanying notes are an integral part of these financial statements. 88




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##### 



aaiPharma Inc.
Notes to Consolidated Financial Statements
December 31, 2003 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 acquires or develops. The Company also
has a comprehensive range of pharmaceutical development capabilities primarily
in the United States and Europe. In 2003 and 2002, the majority of the
Companys net revenues came from the sale of commercial pharmaceutical
products. Prior to 2002, the majority of the Companys net revenues were earned
in its 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 years consolidated financial
statements have been reclassified to conform to the December 31, 2003
presentation. On January 30, 2003, aaiPharmas Board of Directors approved a three-for-two
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 each period presented
as if it had occurred at the beginning of the period. Restatement of Previously Issued Financial Statements The Company has restated its consolidated statements of operations, cash flows,
stockholders equity and comprehensive income for the year ended December 31,
2002 and its consolidated balance sheet as of December 31, 2002. In addition,
the restatement affects the first, second and third quarters of 2002 and 2003.
The restated amounts for these quarters are presented in Note 13. The
restatement does not affect periods prior to 2002. The restatement corrects
the Companys accounting treatment of certain transactions that did not satisfy
all of the conditions of SFAS 48 or were subsequently deemed to involve
subjective determinations for which the Company has determined alternative
accounting treatments should be used. Set forth below are the restatement
adjustments included in the restatement of the previously issued financial
statements for the year ended December 31, 2002. The following table presents the impact of the restatement adjustments
described below on net income for the year ended December 31, 2002: 89




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##### 



Net Income for theYear EndedDecember 31, 2002As previously reported
    
    $
    17,314Intangible asset amortization
    
    
    (6,823
    )Provision for income taxes
    
    
    2,627As restated
    
    $
    13,118
 The adjustments to restate the 2002 and 2003 quarterly periods relate to the
following: (i) for 2003, the correction of the Companys revenue recognition of certain
transactions, including specific product sales in 2003, that did not satisfy
all of the conditions for recognition of revenue under SFAS 48 and/or SAB 101,
as well as significant increases in reserves for product returns and other
adjustments to the Companys revenue and product inventory reserves, and (ii) for 2002 and 2003 a change
in the accounting treatment used with respect
to the Companys product line acquisitions from accounting for the acquisitions as
business combinations to recording such transactions as asset acquisitions.
Accordingly the Company adjusted the related allocations to reverse the
recording of goodwill and allocate all amounts specifically to identifiable
tangible and intangible assets (see note 2). The following table presents the impact of the restatement adjustments on the
Companys previously reported results for the year ended December 31, 2002 on a
condensed basis: Year EndedDecember 31, 2002AsPreviously
    
    AsReported
    
    RestatedStatement of operations:Net revenues
    
    $
    230,510
    
    

    $
    230,510Total costs and expenses
    
    
    213,196
    
    
    
    217,392Net income
    
    $
    17,314
    
    
    $
    13,118Basic earnings per share
    
    $
    0.63
    
    
    $
    0.48Diluted earnings per share
    
    $
    0.61
    
    
    $
    0.46
 90




---



##### 



December 31, 2002AsPreviously
    
    AsReported
    
    Restated(In thousands)Balance sheet:ASSETSCurrent assets:Cash and cash equivalents
    
    $
    6,532
    
    
    $
    6,532Accounts receivable, net
    
    
    29,467
    
    
    
    29,467Other current assets
    
    
    35,152
    
    
    
    35,152Total current assets
    
    
    71,151
    
    
    
    71,151Other assets
    
    
    369,174
    
    
    
    362,351Total assets
    
    $
    440,325
    
    
    $
    433,502LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities
    
    $
    55,794
    
    
    $
    55,794Long-term debt, less current portion
    
    
    277,899
    
    
    
    277,899Other liabilities
    
    
    7,182
    
    
    
    4,555Stockholders equity
    
    
    99,450
    
    
    
    95,254Total liabilities and stockholders equity
    
    $
    440,325
    
    
    $
    433,502
 Subsequent Events NASDAQ Delisting The Company received notice on March 30, 2004 from the NASDAQ Stock Market
that, due to the delay in filing of its Form 10-K for the fiscal year ended
December 31, 2003, the Company is not in compliance with certain NASDAQ
marketplace rules and that its common stock would be subject to delisting at
the opening of business on April 8, 2004, unless the Company request a hearing
pursuant to NASDAQ rules. The Company requested and participated in a hearing
before NASDAQ on April 29, 2004 in which it committed to filing this Report on
Form 10-K on or before June 15, 2004 and to file amended quarterly Reports on
Form 10-Q for each of the three quarters of 2003 on or before June 30, 2004.
The Company has not received notification of the outcome of the delisting
hearing. On May 18, 2004, the Company received notice from the NASDAQ Stock
Market that the Company was delinquent on the filing of its Form 10-Q for the
period ended March 31, 2004. Credit Ratings Downgrade On March 31, 2004, each of Moodys Investors Service and Standard & Poors
Ratings Services announced that it had lowered the Companys corporate credit
rating: Moodys to Caa2 from B2 and Standard & Poors to CCC from B+. At the
same time, Moodys lowered its rating of aaiPharmas senior subordinated notes
to Ca from Caa1 and aaiPharmas senior unsecured issuer rating to Caa3 from
B3. Standard & Poors lowered its senior secured debt rating to CCC+ from BB-,
and its subordinated debt rating to CC from B-. 91




---



##### 



Senior Credit Agreement and Indenture Defaults aaiPharma did not file its Annual Report on Form 10-K for the year ended
December 31, 2003 (the 2003 Form 10-K) in the time required by the federal
securities laws. This failure to file the 2003 Form 10-K constituted an event
of default under its former senior credit agreement, dated as of March 28, 2002
(as amended, the Credit Agreement), with Bank of America, N.A. as
administrative agent (in such capacity, the Administrative Agent). Due to
this and other events of default under the Credit Agreement, the Company was
advised by the Administrative Agent that the Company was not permitted to make
any borrowings under the $100 million revolving credit facility portion of the
Credit Agreement. On April 23, 2004, aaiPharma refinanced the Credit Agreement with $140 million
of senior credit facilities with a syndicate of lenders, Silver Point Finance
LLC as collateral agent, and Bank of America, N.A., as administrative agent
(the Restructured Facility). The Restructured Facility consists of a
two-year, $125 million senior secured term loan facility (which was fully drawn
at closing) and a two-year, $15 million senior secured revolving credit
facility. M.V.I. and Aquasol Sale On April 26, 2004, the Company sold its M.V.I. and Aquasol product lines to
Mayne Pharma (USA) Inc. for $105 million, subject to adjustments based on
inventory levels at closing and other post-closing obligations (the M.V.I. and
Aquasol Sale). A portion of the closing payment is held in escrow to satisfy
post-closing obligations under the agreement. At the closing of the
transaction, the Company paid to AstraZeneca AB the $31.5 million payment due
in August 2004 (see Note 2), which was discounted to approximately $31.0
million as a result of the early payment (the M.V.I. Payment). Royalties Receivable The Company entered into a definitive agreement to receive a prepayment of
certain royalties receivable (the Accelerated Royalties), that would
otherwise have been paid to it quarterly through the second quarter
of 2005 pursuant to the development agreement discussed below under
Revenue Recognition  Product Development.
These royalties would have aggregated $15.4 million. The agreement to receive a
prepayment of these royalties discounted the Accelerated Royalties by 5% per
annum from the date originally due to the advance payment date. The Company
received approximately $15.0 million in gross proceeds from the Accelerated
Royalties in April 2004. Termination of Interest Rate Hedging Obligation At December 31, 2003 aaiPharma was a party to an interest rate hedging
agreement to effect a swap of its fixed interest rate on a notional amount of
the Companys 11% senior subordinated notes (the Notes, see Note 6) to a
floating interest rate. The Company terminated the interest rate hedging
agreement. The Companys termination obligations under this interest rate
hedging agreement were approximately $9.4 million, which were paid in full on
April 26, 2004. Governmental Investigations and Litigation In April 2004, the Company received subpoenas for document production and
potential testimony issued by a grand jury of the U.S. District Court for the
Western District of North Carolina related primarily to 2002 and 2003 financial
information, certain loans obtained by it, extensions of credit, and other
information. The Company has also been advised by the Office of the United
States Attorney for the Western District of North Carolina that it may receive
a subpoena from the Securities and Exchange Commission (SEC). In addition,
the Company and certain of its current and former officers and employees have
been named as defendants in multiple purported class action lawsuits commenced
by stockholders and retirement plan participants beginning in February 2004
alleging violations of federal securities laws and ERISA. 92




---



##### 



Revenue Recognition The Company recognizes revenue in accordance with the SECs Staff Accounting
Bulletin No. 101, Revenue Recognition in Financial Statements as amended by
Staff Accounting Bulletin No. 104 (together, SAB 101), and FASB Statement No.
48 Revenue Recognition When Right of Return Exists (SFAS 48). SAB 101
states that revenue should not be recognized until it is realized or realizable
and earned. Revenue is realized or realizable and earned when all of the
following criteria are met: (1) persuasive evidence of an arrangement exists;
(2) delivery has occurred or services have been rendered; (3) the sellers
price to the buyer is fixed and determinable; and (4) collectibility is
reasonably assured. SFAS 48 states that revenue from sales transactions where
the buyer has the right to return the product shall be recognized at the time
of sale only if (1) the sellers price to the buyer is substantially fixed or
determinable at the date of sale, (2) the buyer has paid the seller, or the
buyer is obligated to pay the seller and the obligation is not contingent on
resale of the product, (3) the buyers obligation to the seller would not be
changed in the event of theft or physical destruction or damage of the product,
(4) the buyer acquiring the product for resale has economic substance apart
from that provided by the seller, (5) the seller does not have significant
obligations for future performance to directly bring about resale of the
product by the buyer, and (6) the amount of future returns can be reasonably
estimated. Net Revenues The Companys net revenues represent the Companys total revenues less
allowances for customer credits, including estimated discounts, rebates,
chargebacks, product returns and non-research and development expenses
reimbursed by customers. Net revenues are reported for the Companys three operating segments, which are
product sales, development services and product development. Product Sales The Company recognizes revenues for product sales at the time title and risk of
loss are transferred to the customer, and the other criteria of SAB 101 and
SFAS 48 are satisfied, which is generally at the time products are shipped.
Product shipping and handling costs are included in product cost of goods sold.
Products are sold to pharmaceutical wholesalers, the largest three of which
account for approximately 81% and 88% of the Companys sales revenues for the
years ended December 31, 2003 and 2002, respectively. At the time gross
revenue is recognized from product sales, an adjustment, or decrease, to
revenue for estimated chargebacks, rebates, discounts and returns is also
recorded. These revenue reserves are determined on a product-by-product basis.
Revenue reserves are established by management as its best estimate at the
time of sale based on each products historical experience adjusted to reflect
known changes in the factors that impact such reserves. Reserves for
chargebacks, rebates and related allowances are established based on the
contractual terms with customers; analysis of historical levels of discounts,
chargebacks and rebates; communications with customers and purchased
information about the rate of prescriptions being written and the levels of
inventory remaining in the distribution channel as well as expectations about
the market for each product and anticipated introduction of competitive
products. The reserve for chargebacks is the most significant estimate used in
the recognition of revenue from product sales. Contract prices are established
for certain indirect customers that are supplied by the Companys wholesale
customers. A chargeback represents the difference between the current
published wholesale acquisition cost and the indirect customers contract
price. If the actual amount of cash discounts taken, chargebacks, rebates and
expired product returns differ from the amounts estimated by management,
material differences may result from the amount of revenue the Company
recognizes from product sales. 93




---



##### 



In the case of shipments made to wholesalers that do not meet the revenue
recognition criteria of SFAS 48, and SAB 101, such shipments are accounted for
using the consignment model. Product shipments accounted for under the
consignment model currently include the Companys new product launches in 2003
and product shipments through a new specialty distributor, which began in the
third quarter of 2003. Under the consignment model, the Company does not
recognize revenue upon shipment of product. For these product sales, the
Company invoices the wholesaler, records deferred revenue at gross invoice
sales price, and classifies the inventory held by the wholesaler as consigned
inventory at the Companys cost of goods for such inventory. The Company
recognizes revenue on consigned inventory when such inventory is sold through
to the wholesalers customers, on a first-in first-out (FIFO) basis. The
Companys estimates of inventory at the wholesalers and deferred revenue on
consigned inventory are based on (1) the projected prescription demand-based
sales for its products, (2) the Companys analysis of third-party information,
including information obtained from certain wholesalers with respect to their
inventory levels and sell-through to customers and third-party market research
data, and (3) the Companys internal product sales information. The Companys
estimates are subject to the inherent limitations of estimates that rely on
third-party data, as certain third-party information was itself in the form of
estimates, and reflect other limitations. The Companys sales and revenue
recognition for such consigned inventory reflect the Companys estimates of
actual product sold through to the wholesale customer. As of December 31, 2003,
deferred product revenues under the consignment model were $45.7 million. Prior to 2003, the amount of actual product returns experienced by the Company
had not been significant. As a result, actual returns were charged against
revenue in the period they occurred and aggregate revenue reserves were
evaluated quarterly to determine if they were sufficient to cover estimated
chargebacks, rebates and related allowances, as well as the expected rate of
returns, and adjusted as deemed necessary. In 2003, the Company began
segregating the Companys products return reserve, which prior thereto the
Company believed was adequately covered by the Companys aggregate revenue
reserves for chargebacks, rebates and related allowances. The Company
increased the level of detail included in the Companys analyses to include
analyzing inventory in the channel to determine remaining shelf life. The
Companys returns reserve needs are primarily related to the number of months
of inventory estimated to be in the distribution channel. Levels of inventory
in the distribution channel are monitored and estimated based on information
the Company purchases from the wholesalers, combined with active discussions
between the Companys sales personnel and the wholesalers to which the Company
supplies. In addition, the Companys actual sales, returns and chargeback
history are used to assess the reasonableness of the estimated number of months
of inventory on hand at the Companys wholesalers. The shelf life of products
remaining in the distribution channel is estimated based on an analysis of each
lot sold. Each batch has a specific expiration date. A review of the actual
returns history is performed and the run rate of sales out of the distribution
channel is estimated. Estimated product returns reserves are adjusted based on
these reviews. Reserves may also be adjusted to reflect any significant
changes in trends or based upon new information that the Company believes may
affect the reserve needs. Allowances for new product introductions are
estimated based on the Companys experiences for similar products that the
Company currently markets and are adjusted as deemed necessary based on the
Companys experience with each product. The Companys reserve analysis also
includes a review for the potential introduction of generic competition and the
resulting impact on pricing and returns reserves. Existing reserves may be
adjusted accordingly to reflect the Companys estimate for any impact these
factors may have. aaiPharma continually monitors its assumptions with respect
to the Companys revenue reserves for product sales and modifies them if
necessary. 94




---



##### 



Product Development The majority of the product development segments revenues consist of
licensing, milestone and royalty payments from the Companys proprietary
technology. The provisions for licensing, milestone and royalty payments
included in contracts are related to the occurrence of specific identifiable
events. Each of the licensing agreements is reviewed to determine the
appropriate revenue recognition treatment under SAB 101 and EITF 00-21 Revenue
Arrangements with Multiple Deliverable Arrangements. The Company recognizes
revenues from licensing fees over the estimated life of the agreement to which
the licensing fees relate or when the commitment to perform services under the
agreement has been fulfilled. Milestone payments are recognized as revenue
when the milestone has been achieved, the performance obligation has been met
and collection of the milestone-related revenue to be recognized is probable.
The Company recognizes recurring royalties revenue in the period in which the
related product sales occur or, in the case of the development
agreement discussed below, in the period the matching contractual
obligation is performed. The Company has a development agreement with a customer that provides for it to
receive contingent periodic royalties and obligates the customer to use the Company on a fee-for-service basis for a
product life cycle management project related to the product. The customer is
a major pharmaceutical company with net assets in excess of $2.0 billion. The
development agreement relates to a product with respect to which the Company
has licensed intellectual property that it developed in the past. The Company
has recognized product development revenues under this agreement for the
periodic payments based on its customers sales of the product, and have
recognized development services revenue related to the product life cycle
management project. Product development revenues from this agreement were $13.0
million in 2003, $16.9 million in 2002 and $14.9 million in 2001. The Company
recognized no research and development expense in 2003, 2002 and 2001
associated with the payments it received in those years. The expense of its
work associated with these revenues was recognized primarily in 1997 through
1999. The Company does 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 $2.7 million
in 2003, $4.7 million in 2002 and $6.3 million in 2001. Because of the research
and development nature of its 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, the Company has recorded its
costs incurred in this project as research and development expense$1.0
million in 2003, $0.7 million in 2002 and $2.3 million in 2001. Accordingly,
for its development services business unit, the Company has recognized no
expense associated with the development services revenue arising under this
agreement, as this expense was recognized by its product development business
unit. The
Company is entitled to receive these periodic royalties based on sales of
the customers product only if it makes available exclusively to its customer
its product development and reformulation services with respect to a limited
group of drugs that include the customers product. This obligation does not
prevent the Company from engaging in these development and reformulation
activities for products that it may develop for itself. As the Company remains available to provide the customer with these services on
this basis in a calendar quarter, it will be entitled to royalties based on the
level of sales over a prior monthly period of the product. 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, the Company
would be entitled to royalties in three consecutive quarters, with, for
example, the amount of the royalties in the first quarter being based on product
sales in the first month. However, if it does
not continue to provide these development and reformulation services on the
exclusive basis described above in any quarter, it will not be entitled to
the royalties for that quarter and all subsequent quarters. Under the agreement,
the Company has the right, at any time, to terminate its obligation to provide
the development and reformulation services on an 95




---



##### 



exclusive basis. Accordingly, the Company does not recognize product
development revenues under this agreement in any quarter until it has satisfied
the exclusivity requirement for that quarter. Development Services The Company recognizes the majority of its development services revenues from
fee-for-service contracts on a proportional performance basis as the work is
performed. To measure performance, the Company compares actual direct costs
incurred to estimated total contract direct costs, which is the best indicator
of performance of the contract obligations as the costs directly relate to the
labor hours incurred to perform the service. This ratio is multiplied by the
estimated contract value to determine the revenue to be recognized. The
proportional performance method requires an estimate of total expected revenue
and at no time under this method are costs deferred. These estimates are
reviewed periodically and, if these estimates change or actual results differ
from expected results, an adjustment is recorded in the period in which they
become reasonably estimable. These adjustments could have a material effect on
the Companys results of operations. Historically, there have not been
significant variations between contract estimates and actual costs incurred.
Changes in the scope of work generally result in an amendment to contract
pricing terms. Amended contract amounts are not included in net revenues until
signed change orders are executed, revenue is earned and realization is
assured. The Company also recognizes revenue 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. The majority of the Companys arrangements with customers are not
multiple-element arrangements. However, due to the proprietary nature of
product formulations, the Company has entered into a limited number of
multiple-element arrangements related to product development activity. During
2003, the Company adopted EITF 00-21 and has applied its criteria to such
arrangements in determining the separability of elements and timing of revenue
recognition under SAB 101. Provisions for losses on contracts, if any, are recognized when
identified. Clients generally may terminate services at any time. However,
the majority of contracts contain provisions that require payment for all
services rendered to date, even those services that had not yet been billed.
In the specific cases where these termination provisions are not specifically
defined in the contract, the Company ensures that the future billing milestones
are achievable and within the Companys control prior to recognition of revenue
under such arrangements The
following table sets forth the Companys gross revenues and the amount of dilution to
revenues resulting from revenue reserves such as allowances for customer
credits, including discounts, rebates, chargebacks, product returns and other
allowances for each of 2003, 2002 and 2001: Years Ended December 31,20022003
    
    (as restated)
    
    2001(in thousands)Gross revenues
    
    $
    327,282
    
    
    $
    283,914
    
    
    $
    150,115Allowance for customer credits
    
    
    102,305
    
    
    
    53,404
    
    
    
    9,042Net revenues
    
    $
    224,977
    
    
    $
    230,510
    
    
    $
    141,073
 Income Taxes 96




---



##### 



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. This approach
requires the recognition of deferred tax assets and liabilities for the
expected future tax consequences of differences between the tax basis of assets
or liabilities and their carrying amounts in the consolidated financial
statements. A valuation allowance is provided for deferred tax assets if it is
more likely than not that these items will either expire before the
Company is able to
realize their benefit or if future deductibility is uncertain. Developing the
provision for income taxes requires significant judgment and expertise in
federal and state income tax laws, regulations and strategies, including the
determination of deferred tax assets and liabilities and, if necessary, any
valuation allowances that may be required for deferred tax assets. The
Companys judgments and tax strategies are subject to audit by various taxing
authorities. While the Company believes that it has provided adequately for its
income tax liabilities in its consolidated financial statements, adverse
determinations by these taxing authorities could have a material adverse effect
on the Companys consolidated financial condition and results of operations. Research and Development Costs The Company engages in numerous research and development (R&D) projects with
the objective of growth and utilization of its 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 $8.0 million, $4.5
million and $0.9 million for the years ended December 31, 2003, 2002 and 2001,
respectively. (Loss) Earnings per Share Basic (loss) earnings per share is based on the weighted average number of
common shares outstanding during the year. Diluted (loss) earnings per share is
computed assuming that the actual weighted average number of common shares
outstanding was increased by the exercise of stock options issued to employees
and members of the Companys Board of Directors under the treasury stock
method. The diluted per share amounts reflect a change in the number of shares
outstanding (the denominator) to include the options as if they were
exercised and converted to shares and issued, unless their inclusion would be
anti-dilutive. In 2003, 2002 and 2001, 1,890,548, 2,296,001 and 824,378
options were excluded as they were anti-dilutive. In each year presented, the
net (loss) income (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 per share computations: 97




---



##### 



Years Ended December 31,20022003
    
    (as restated)
    
    2001(In thousands)Basic earnings per share:Weighted average number of shares
    
    
    27,730
    
    
    
    27,348
    
    
    
    26,691Effect of dilutive securities:Stock options
    
    
    
    
    
    
    1,011
    
    
    
    771Diluted earnings per share:Adjusted weighted average number of shares
and assumed conversions
    
    
    27,730
    
    
    
    28,359
    
    
    
    27,462
 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. At December 31,
2003, approximately 29% of the accounts receivable balance represented amounts
due from one customer. At December 31, 2002, approximately 18% and 17%,
respectively, of the accounts receivable balance 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. In 2003, three customers accounted for approximately 17%, 15% and 12%,
respectively, of the Companys revenues 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 2001. 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. 98




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##### 



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. 142, Goodwill and Other Intangible Assets
(SFAS 142), the Company ceased amortization of goodwill as of January 1,
2002. In accordance with the Statement of Financial Accounting Standards No.
141, Business Combinations (SFAS 141), 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, 2003
and 2002, 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, 2002 to December 31, 2003
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, 2003 and 2002, the amounts of accumulated amortization of
identifiable intangibles were approximately $20.2 million and $10.4 million,
respectively. The changes in the carrying value of goodwill which is entirely in the
Development Services operating segment for the year ended December 31, 2003 are
as follows: Balance atDecember 31,
    
    
    
    
    
    Foreign
    
    Balance at2002
    
    
    
    
    
    Currency
    
    December 31,(as restated)
    
    Additions
    
    Translation
    
    2003(in thousands)Development services
    
    $
    11,378
    
    
    $
    100
    
    
    $
    1,883
    
    
    $
    13,361
 99




---



##### 



The changes in identifiable intangible assets for the years ended December 31,
2003 and 2002 are as follows: Balance at
    
    
    
    
    
    
    
    
    
    
    
    
    
    Balance atJanuary 1,
    
    
    
    
    
    Amortization
    
    Asset
    
    December 31,
    
    Amortizable2003
    
    Additions
    
    Expense
    
    Impairment
    
    2003
    
    Life(in thousands)Indefinite-lived intangibles
    
    $
    51,017
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    51,017
    
    
    IndefiniteTrademarks, technology and
license agreements
    
    
    230,652
    
    
    
    103,670
    
    
    
    (12,620
    )
    
    
    (21,404
    )
    
    
    300,298
    
    
    3  20 years$
    281,669
    
    
    $
    103,670
    
    
    $
    (12,620
    )
    
    $
    (21,404
    )
    
    $
    351,315
 Balance at
    
    
    
    
    
    
    
    
    
    Balance atJanuary 1,
    
    
    
    
    
    Amortization
    
    December 31,
    
    Amortizable2002
    
    Additions
    
    Expense
    
    2002
    
    Life(as restated, in thousands)Indefinite-lived intangibles
    
    $
    51,017
    
    
    $
    
    
    
    $
    
    
    
    $
    51,017
    
    
    IndefiniteTrademarks, technology and
license agreements
    
    
    27,824
    
    
    
    212,349
    
    
    
    (9,521
    )
    
    
    230,652
    
    
    3 - 20 years$
    78,841
    
    
    $
    212,349
    
    
    $
    (9,521
    )
    
    $
    281,669
 The total intangible asset amortization expense for the year ended December 31,
2003, was $12.6 million, of which $12.3 million is product related and is
included in direct costs and $0.3 million, which is included in depreciation
and amortization expenses. Amortization expense for the next five years is
estimated to be approximately $19 million per year. In December 2001, the Company acquired the Brethine product line, as further
discussed in Note 2. In early 2004, generic versions of this product were
approved by the FDA. In December 2003, the Company performed an analysis of
the carrying value of the intangible assets associated with the product, based
on discounted cash flows using its updated assumptions, and determined that
they were impaired. The Company recorded an impairment charge of $15.9
million. In July 2003, the Company acquired the rights to a product marketed under the
Darvocet A500 brand name. The Company initially valued these rights at $4.7
million, and recorded such value as an intangible asset to be amortized over
its estimated useful life. As a result of a delay in market acceptance of the
Darvocet A500 product and other changes in market condition for these products,
the Company evaluated the intangible asset carrying value at December 31, 2003.
Based on a discounted cash flows analysis of this intangible as of December
31, 2003, the Company determined that the value was fully impaired and wrote
off the unamortized balance of $4.7 million as intangible asset impairment on
the consolidated statements of operations. 100




---



##### 



On a periodic basis, or as otherwise required, 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 are
written-off in the period in which such determination is made. The Company has
changed its annual test date from December 31st to October 1st for testing
whether goodwill is impaired. This change is both preferable and allowed in
that choosing the 1st day of the 4th quarter allows adequate time to perform
the first step of the test and, if necessary, the second step of the test while
still providing time to report the impact of the test in the Companys periodic
filings. The Company will test goodwill for impairment as of October 1st of
each fiscal year, or more frequently should circumstances change or events
occur that would more likely than not reduce the fair value of a reporting unit
below its carrying amount, as provided for in SFAS No. 142. 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 used an interest rate hedging agreement to modify its fixed rate
obligation under the Notes to a variable rate obligation, thereby adjusting the
interest rate to the current market rate and ensuring that the hedged notional
amount of 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 133), to
account for its interest rate swap using hedge accounting treatment. As of
December 31, 2003, the Company had outstanding one interest rate hedging
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 hedging agreement,
designated as a fair value hedge, qualifies for treatment under the short-cut
method of measuring effectiveness. Under the provisions of SFAS 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 hedging agreement. This interest rate hedging
agreement was terminated in April 2004. Impact of Recently Issued Accounting Standards In 2003, the Company adopted Statement of Financial Accounting Standards No.
145, Rescission of FASB Statements 4, 44, and 64, Amendment of FASB Statement
No. 13, and Technical Corrections (SFAS 145). SFAS 145 no longer requires
companies to report gains or losses associated with the extinguishment of debt
as a component of extraordinary gains or losses, net of tax. In addition, any
extraordinary gains or losses on extinguishment of debt in prior periods
presented would require reclassification. As required by SFAS 145, the
extraordinary loss recognized in the year ended December 31, 2002 of
approximately $8.1 million ($5.3 million net of tax) to record the write-off of
deferred financing and other costs related to its prior debt facilities has
been reclassified to other expense. 101




---



##### 



Statement of Financial Accounting Standards No. 146, Accounting for Costs
Associated with Exit or Disposal Activities (SFAS 146), requires that a
liability for costs associated with an exit or disposal activity be recognized
when the liability is incurred rather than when a commitment to an exit plan is
made. SFAS 146 is effective for exit or disposal activities that are initiated
after December 31, 2002. Adoption of this statement did not have a material
effect on its financial position or results of operations. In January 2003, the FASB issued Interpretation No. 46 (FIN 46),
Consolidation of Variable Interest Entities. FIN 46 requires an investor
with a majority of the variable interests (primary beneficiary) in a variable
interest entity (VIE) to consolidate the entity and also requires majority and
significant variable interest investors to provide certain disclosures. A VIE
is an entity in which the voting equity investors do not have a controlling
interest, or the equity investment at risk is insufficient to finance the
entitys activities without receiving additional subordinated financial support
from other parties. Effective December 2003, the FASB issued Staff Position
FIN 46R that defers the application of FIN 46 to interests in potential VIEs if
the VIE was created prior to February 1 2003 and the company has not issued
financial statements reporting interests in VIEs in accordance with FIN 46
until the end of periods ending after March 15, 2004. The Company adopted FIN
46 in fiscal 2003 and the adoption did not have a significant impact
on the Companys
consolidated financial position, results of operations or cash flows. Other recently issued, but not yet effective, accounting standards will not
have a material impact on the Company. Employee Stock-Based Compensation The Company follows Accounting Principles Board Opinion No. 25, Accounting for
Stock Issued to Employees (APB 25) and related Interpretations in accounting
for its employee stock options as permitted by Statement of Financial
Accounting Standards No. 123 Accounting for Stock-Based Compensation (SFAS
123) and makes the pro forma disclosures required by SFAS 123, as amended by
SFAS 148, Accounting for Stock-Based Compensation-Transition and Disclosure. 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 31,2003
    
    2002
    
    2001Expected dividend yield
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    0.0
    %Risk-free interest rate
    
    
    3.0
    %
    
    
    3.8
    %
    
    
    4.6
    %Expected volatility
    
    
    116.0
    %
    
    
    113.0
    %
    
    
    120.0
    %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 on a straight-line basis over the vesting
period. The grant date Black-Scholes weighted average fair value of options
issued at market price was $13.19, $11.49 and $8.90 per share for 2003, 2002
and 2001, 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 2003 or 2001. 102




---



##### 



The Company applies APB 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 stock
option 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 123, the
Companys net (loss) income and earnings (loss) per share would have been
changed to the pro forma amounts indicated below. Pro forma compensation
expense under SFAS 123 is based on the single award method recorded on a
straight-line basis. Years Ended December 31,2003
    
    2002
    
    2001(as restated)(In thousands, except per share data)Net (loss) income, as reported
    
    $
    (32,703
    )
    
    $
    13,118
    
    
    $
    5,940Deferred compensation amortization, net of tax
    
    
    104
    
    
    
    
    
    
    
    Pro forma stock-based compensation cost, net of tax
    
    
    9,764
    
    
    
    6,520
    
    
    
    2,366Pro forma net income (loss)
    
    
    (42,363
    )
    
    
    6,598
    
    
    
    3,574Earnings (loss) per share:As reported -Basic
    
    $
    (1.18
    )
    
    $
    0.48
    
    
    $
    0.22Diluted
    
    $
    (1.18
    )
    
    $
    0.46
    
    
    $
    0.22Pro forma -Basic
    
    $
    (1.53
    )
    
    $
    0.24
    
    
    $
    0.13Diluted
    
    $
    (1.53
    )
    
    $
    0.23
    
    
    $
    0.13
 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, 2003 and 2002. 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 based on market quotations.
At December 31, 2003 and 2002, the fair market value of the Companys fixed
rate debt 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 revenue reserves and sales allowances,
including reserves for chargebacks, product returns, rebates and related
allowances, an allowance for doubtful accounts, inventory reserves and useful
lives for intangible assets. Actual results could differ from such estimates
and changes in such estimates may have a material affect on amounts reported in
future periods. 103




---



##### 



2. Asset Acquisitions On December 2, 2003, the Company acquired a line of pain management products,
which treat moderate to severe pain, (the New Pain Products) and existing
inventory from subsidiaries of Elan Corporation, plc, in an asset purchase.
The product lines acquired are marketed under the Roxicodone, Oramorph SR,
Roxanol and Duraclon brand names. The Company acquired these product lines and
related intangible assets for $102.5 million, exclusive of transactional costs.
To finance this acquisition, which included $5.1 million of inventory, the
Company used the proceeds from its then-existing senior term loan credit
facility, as described in Note 6. Revenues from the sales of these products are
included in the Companys results of operations beginning on the acquisition
date. The New Pain Products 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. Based on this allocation, $98
million of intangible assets have been identified and will be amortized over 20
years. The following unaudited pro forma consolidated financial information reflects
the results of operations for the years ended December 31, 2003 and 2002 as if
the acquisition of the New Pain Products had occurred at the beginning of the
periods presented. Years Ended December 31,2003
    
    2002(In thousands, except per share data)Net revenues
    
    $
    294,895
    
    
    $
    295,592Direct costs
    
    
    120,498
    
    
    
    98,152
 These pro forma results have been prepared for comparative purposes only and do
not purport to be indicative of what operating results would have been had the
acquisition taken place at the beginning of the period presented. In addition,
these results are not intended to be a projection of future results. On August 5, 2003, aaiPharma and CIMA LABS INC., (CIMA) entered into a merger
agreement. The completion of the merger was subject to several conditions,
including the approval of the merger by the stockholders of CIMA and aaiPharma
and the expiration or termination of the applicable waiting period under the
Hart-Scott-Rodino Antitrust Improvements Act of 1976, and contained customary
termination rights by each party in the event of higher unsolicited offers by a
third party. During the fourth quarter of 2003, the Company announced the
termination of the merger agreement by CIMA in light of a competing offer for
CIMA by a third party. As a result, the Company received an $11.5 million
termination fee from CIMA, as provided in the terminated merger agreement,
against which $5.9 million of merger-related fees and expenses were applied.
The net amount of $5.6 million is included in other income on the consolidated
statements of operations. On March 28, 2002, the Company acquired the U.S. rights to the Darvon and
Darvocet branded product lines, which treat mild-to-moderate pain, and existing
inventory from Eli Lilly and Company, in an asset purchase. The Company
acquired these product lines and related intangible assets for $211.4 million,
exclusive of transactional costs. To finance this acquisition, which included
$1.8 million of inventory, the Company used the proceeds from the then existing
senior secured credit facilities and senior subordinated notes, as described in
Note 6. Revenues from the sales of these products are included in the Companys
results of operations beginning 104




---



##### 



on the acquisition date. The Darvon and Darvocet 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. The
identified intangible assets are amortized over 20 years. 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 an asset
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, exclusive of transactional costs. To finance this acquisition, the
Company used the proceeds from a $25 million term loan, which was refinanced in
March 2002 by a 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, which are being amortized over 20
years. 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 an asset 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 $52.5 million, exclusive of
transactional costs, paid at closing, plus additional consideration described
below. To finance the initial payment for this acquisition, which included
$3.7 million for inventory, the Company used the proceeds from a term loan,
which was refinanced by a senior secured credit facility as described in Note
6. The product line acquisition agreement was amended in July 2003. As
amended, it provided for two $1.0 million guaranteed payments, which were made
in August 2002 and 2003, eliminated a contingent payment of $2.0 million that
was potentially due in August 2003 under the original agreement, and provided
for a future contingent payment of $43.5 million potentially due in August
2004, depending on the status of certain reformulation activities being carried
out by the seller and regulatory approval of the reformulations by the U.S.
Food and Drug Administration (FDA). The amount of the $43.5 million contingent
payment was to be reduced by $1 million per month if the conditions for the
contingent payment had not occurred by December 31, 2002. The amount of the
contingent payment had decreased by $12.0 million by December 31, 2003. Such
conditions were satisfied in January and February 2004, fixing the previously
contingent liability under the amendment at $31.5 million. As a result of the
July 2003 amendment to the original purchase agreement, the Company was
precluded from recognizing this obligation as additional purchase price for the
M.V.I. and Aquasol product line. As of December 31, 2003, this contingent
obligation had not been recorded as a liability on the Companys consolidated balance
sheet and will be recorded as a liability and as an other expense in the first
quarter of 2004. Also in July 2003, the M.V.I. supply agreement with the
seller was extended through 2008, subject to early termination rights by the
Company on six months notice given at any time, and by the supplier on
twenty-four months notice given at any time on or after August 17, 2004.
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 connection with the M.V.I. and Aquasol acquisition, the Company recorded
intangible assets which meet the criteria for having an indefinite life. In
accordance with SFAS 142, these intangible assets are not being 105




---



##### 



amortized but are evaluated for impairment on at least an annual basis. The
intangible assets recorded in connection with this acquisition represent the
trademarks, technology and know-how associated with the product lines. On April 26, 2004, the Company sold the M.V.I. and Aquasol product lines to
Mayne Pharma (USA) Inc., for $105 million subject to certain adjustments based
on inventory levels at closing and other post-closing obligations. A portion
of the closing payment is held in escrow to satisfy the Companys post-closing
obligations under the agreement. At the closing of the transaction, aaiPharma
paid to AstraZeneca AB the $31.5 million payment due in August 2004, which was
discounted to approximately $31.0 million (the M.V.I. Payment). Royalties on
sales levels of the new M.V.I. product formulation above specified thresholds
will be paid to the Company as part of this agreement. 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. No payment was made in 2003.
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 Companys consolidated balance sheets. Set forth in the table below are the details of the purchase price allocations
for each of the Companys major product line acquisitions since the beginning
of 2001. The table lists the assets acquired, the value allocated to each
asset, how the value was determined, and the estimated useful life assigned to
each asset. In these acquisitions, the only tangible assets acquired were
inventory and marketing/promotional materials, which were valued based on
internal analyses and data provided by the sellers. Inventory obtained at time
of acquisition was valued at the estimated selling price less the cost of
disposal and a reasonable selling profit. Marketing/promotional materials
received were generally outdated and in limited quantities; therefore no
material value was assigned in the purchase price allocations. The Company
engaged third-party valuation consultants to assist the Company with its
purchase price allocations, including identification of intangible assets
recommendations of fair value of intangible assets, and determination of
expected lives of those assets. Intangible assets that arose from contractual
or legal rights and other intangible assets that were separable, as discussed
in SFAS 141, were identified. Among the assets that were considered for
recognition were trademarks, Internet domain names, non-competition agreements,
customer lists, backlogs, customer contracts and non-contractual relationships,
licensing and royalty agreements, supply contracts, employment contracts,
patented and unpatented technology, and trade secrets. The third-party valuation consultants reviewed pertinent facts and recommended
for each asset the appropriate generally accepted valuation approach and
methodology from among the cost, market, and income approaches. Where
possible, a valuation derived using an alternative valuation approach or
methodology was presented and used by management to evaluate the reasonableness
of the recommended fair value. 106




---



##### 



ValueIdentifiable Assets
    
    (millions)
    
    How Valued
    
    Useful LifeM.V.I. and Aquasol(as restated):Total purchase price, including transaction fees
    
    $
    54.7Allocation of purchase price:Inventory
    
    $
    3.7
    
    
    Estimated Selling Price Less Cost of Disposal and a Reasonable Selling Profit
    
    N/ATrademarks
    
    
    27.3
    
    
    Income Approach 
Discounted Cash Flow Method
    
    IndefiniteDeveloped Technology
    
    
    23.7
    
    
    Income Approach 
Discounted Cash Flow Method
    
    IndefiniteTotal
    
    $
    54.7Brethine(as restated):Total purchase price, including transaction fees
    
    $
    26.6Allocation of purchase price:Trademarks-Existing
    
    $
    11.3
    
    
    Income Approach 
Discounted Cash Flow Method
    
    20 yearsTrademarks-Reformulated
    
    
    9.4
    
    
    Income Approach 
Discounted Cash Flow Method
    
    20 yearsDeveloped Technology
    
    
    5.9
    
    
    Income Approach 
Discounted Cash Flow Method
    
    20 yearsTotal
    
    $
    26.6
 107




---



##### 



ValueIdentifiable Assets
    
    (millions)
    
    How Valued
    
    Useful LifeDarvon/Darvocet(as restated):Total purchase price, including transaction fees
    
    $
    212.6Allocation of purchase price:Inventory
    
    $
    1.7
    
    
    Estimated Selling Price Less Cost of Disposal and a Reasonable Selling Profit
    
    N/ATrademarks-Existing
    
    
    80.3
    
    
    Income Approach 
Discounted Cash Flow Method
    
    20 yearsTrademarks-Reformulated
    
    
    50.3
    
    
    Income Approach 
Discounted Cash Flow Method
    
    20 yearsDeveloped Technology
    
    
    80.3
    
    
    Income Approach 
Discounted Cash Flow Method
    
    20 yearsTotal
    
    $
    212.6Elan Pain Portfolio:Total purchase price, including transaction fees
    
    $
    103.4Allocation of purchase price:Inventory
    
    $
    5.1
    
    
    Estimated Selling Price Less Cost of Disposal and a Reasonable SellingProfit
    
    N/ATrademarks
    
    
    49.1
    
    
    Income Approach 
Discounted Cash Flow Method
    
    20 yearsDeveloped Technology
    
    
    49.2
    
    
    Income Approach 
Discounted Cash Flow Method
    
    20 yearsTotal
    
    $
    103.4
 108




---



##### 



3. Accounts Receivable, Net The following table presents the components of accounts receivable: December 31,2003
    
    2002(In thousands)Trade
    
    $
    33,448
    
    
    $
    30,843Related parties
    
    
    144
    
    
    
    292Total accounts receivable
    
    
    33,592
    
    
    
    31,135Allowance for doubtful accounts
    
    
    (978
    )
    
    
    (1,668
    )Total accounts receivable, net
    
    $
    32,614
    
    
    $
    29,467
 4. Inventories, Net The following table presents the components of inventories: December 31,2003
    
    2002(In thousands)Finished goods (including consigned inventory of $4,792 in 2003)
    
    $
    18,579
    
    
    $
    11,110Work-in-process
    
    
    1,865
    
    
    
    1,866Raw materials and supplies
    
    
    5,007
    
    
    
    4,749Inventory reserves
    
    
    (10,758
    )
    
    
    (721
    )Total inventories, net
    
    $
    14,693
    
    
    $
    17,004
 5. Property and Equipment, Net The following table presents the components of property and equipment: December 31,2003
    
    2002(In thousands)Land
    
    $
    2,784
    
    
    $
    2,688Buildings and improvements
    
    
    31,446
    
    
    
    29,893Machinery and equipment
    
    
    69,593
    
    
    
    62,814Construction-in-progress
    
    
    8,154
    
    
    
    3,921Cost of property and equipment
    
    
    111,977
    
    
    
    99,316Less accumulated depreciation
    
    
    (54,741
    )
    
    
    (46,191
    )Total property and equipment, net
    
    $
    57,236
    
    
    $
    53,125
 109




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##### 



Depreciation expense was approximately $7.6 million, $6.9 million and $7.0
million for the years ended December 31, 2003, 2002 and 2001, respectively. 6. Debt and Credit Line The following table presents the components of current maturities of
long-term debt: December 31,2003
    
    2002(In thousands)Current maturities of long-term debt
    
    $
    4,000
    
    
    $
    5,921
 The following table presents the components of long-term debt: December 31,2003
    
    2002(In thousands)U.S. bank term loan
    
    $
    156,000
    
    
    $
    50,000U.S. revolving credit facility
    
    
    8,000
    
    
    
    47,50011% senior subordinated notes due 2010, net of original issue discount
    
    
    174,106
    
    
    
    173,963Interest rate swap monetization deferred income
    
    
    12,189
    
    
    
    10,486Fair value of interest rate swap
    
    
    (7,451
    )
    
    
    1,871Less current maturities of long-term debt
    
    
    (4,000
    )
    
    
    (5,921
    )Total long-term debt due after one year
    
    $
    338,844
    
    
    $
    277,899
 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 amortized
over the full five-year term. The senior facilities were subsequently reduced
due to early repayments made under the term loan facility. In December 2003,
the remaining term loan facility of $40 million was repaid and a new term loan
facility was entered into. As part of this transaction, the Company recorded a
$1.5 million loss for the early extinguishment of debt related to the write-off
of financing fees associated with the original term loan. The December 2003
term loan was a $160 million facility which amortized over a six-year term.
The net proceeds from this facility were used to fund the acquisition of the
New Pain Products, as described in Note 2. In December 2003, the revolving
credit facility was amended and increased to $85 million, which was
subsequently increased to $100 million in January 2004. At December 31, 2003,
the Company had unused availability under the revolving credit facility of
$77.0 million. The availability of borrowings under the revolving credit
facility was not limited by a borrowing base. The term loan and revolving
credit facilities provide for variable interest rates based on LIBOR or an
alternate base rate, at the Companys option. On December 31, 2003, 30-day
LIBOR was 1.12%. 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. These senior credit 110




---



##### 



facilities require the payment of certain commitment fees based on the unused
portion of the revolving credit facility and may be prepaid at any time without
a premium. 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. 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 hedging agreement to effectively convert
interest expense on a portion of the 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 February 27, 2003, and again on June 23,
2003, the Company sold the then outstanding interest rate hedging agreement for
$2.3 million and $3.7 million, respectively, and replaced it with a similar
interest rate hedging agreement. The amounts received, less the interest
benefits earned through the dates of sale, have been recorded as premiums to
the carrying amount of the notes and are being amortized into interest income
over their remaining life. At December 31, 2003, the Company had an interest
rate hedging agreement in place covering $150 million of the notes, at a rate
of 6-month LIBOR plus 7.41%. On December 31, 2003, 6-month LIBOR was 1.22%,
giving the Company an estimated all-in rate of 8.63%. The terms of the
interest rate hedging agreements, other than the base rate, were identical and
were perfectly matched with the terms of the related hedged instrument. On
February 27, 2004, 6-month LIBOR was 1.17%. 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 not in
compliance with the covenants at December 31, 2003, see Note 1 for further
discussion. Scheduled maturities of long-term debt as of December 31, 2003, were as follows
(in thousands): 2004
    
    $
    4,0002005
    
    
    16,0002006
    
    
    24,0002007 (including the revolving credit facility)
    
    
    40,0002008
    
    
    40,0002009
    
    
    40,0002010
    
    
    175,000Total
    
    $
    339,000
 As a result of aaiPharmas failure to timely file the Companys annual report
on Form 10-K for the year ended December 31, 2003, among other matters,
aaiPharma was in default of these term loan and revolving credit facilities.
On April 23, 2004, aaiPharma refinanced these facilities with a portion of the
proceeds from the M.V.I. sale and with $140 million of senior credit facilities
with a syndicate of lenders, Silver Point Finance LLC (Silver Point) as
collateral agent, and Bank of America, N.A., as administrative agent. The
Companys 111




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##### 



new senior credit facilities consist of a two-year, $125 million senior secured
term loan facility (which was fully drawn at closing) and a two-year, $15
million senior secured revolving credit facility, of which the entire amount
was available for borrowing at closing. The outstanding loans under the
Companys new senior credit facilities are payable in full on the two-year
anniversary date of the closing of the facilities. The Companys
new senior credit facilities are 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. Subject to exceptions set
forth in the definitive documentation, loans under the Companys new senior
credit facilities are also required to be prepaid with a negotiated percentage
of:  
    
    excess cash flow, as defined;
    
    non-ordinary course assets sales;
    
    net proceeds from the sale of subordinated indebtedness;
    
    net proceeds from the issuance of equity issuances; and
    
    extraordinary receipts, as defined. Optional reductions in revolving credit commitments and optional prepayments of
term loans are subject to a prepayment fee equal to 3% for the first 9 months
of the term of the facilities, 1.5% for the subsequent 9 months of such term,
and 0.75% for the next 3 months of such term (with no prepayment penalty
payable for the last 3 months of the term). Outstanding loans under the
facilities bear interest at a rate per annum equal to a defined LIBOR rate
(with a floor of 2%), plus 6.25%, or a defined reference rate (with a floor of
4%), plus 5.25%, in each case payable monthly in arrears. An additional 1% per
annum unused line fee is payable on unused revolving credit commitments,
payable quarterly in arrears. The proceeds of the loans were used, together with the net cash proceeds from
the sale of the M.V.I. and Aquasol product lines, to (i) fund payment of
termination obligations with respect to the Companys interest rate hedging
agreement (discussed below), (ii) refinance the Companys then-existing senior
credit facilities, (iii) fund the April 2004 interest payment due on the
Companys 11% senior subordinated notes due 2010, (iv) provide for ongoing
working capital and general corporate needs, and (v) pay for fees, costs and
expenses in connection with the new senior credit facilities and other
corporate transactions. The Companys new senior credit facilities include customary representations
and warranties and customary affirmative and negative covenants, including
limitations on liens, indebtedness, fundamental transactions, dispositions of
assets, changes in the nature of the Companys business, investments,
acquisitions, capital and operating leases, capital expenditures, dividends,
redemptions or other acquisitions of capital stock, redemptions or prepayments
of other debt, transactions with affiliates, issuances of capital stock,
modifications of indebtedness, organizational documents and other agreements,
and retention of excess cash. The facilities also provided for financial
covenants, including a minimum fixed charge ratio, a maximum total debt to
trailing twelve-month EBITDA ratio, and a covenant requiring a certain level of
cash or revolver availability. The Companys new senior credit facilities
include a covenant requiring the Company to file with the Securities and
Exchange Commission by September 30, 2004 the Companys annual report on Form
10-K for the year ended December 31, 2003 and other periodic reports then
required to be filed under the Securities Exchange Act of 1934. Events of
default under the facilities include, among others, nonpayment of principal,
interest or fees, violations of covenants, inaccuracy of representations and
warranties, a cross-default to the Companys 11% senior subordinated notes due
2010 and other material indebtedness, bankruptcy events, and a change in
control. On March 31, 2004, the lenders under the Companys then-existing credit
agreement, which was then in default as described above, exercised their right
to block the Company from making the interest payment due 112




---



##### 



on April 1, 2004 to holders of the Companys senior subordinated notes.
Accordingly, aaiPharma did not make that interest payment on April 1, 2004. In
addition, the Companys failure to timely file the Companys annual report on
Form 10-K for the year ended December 31, 2003 constituted a default under the
indenture governing the senior subordinated notes. On April 20, 2004, aaiPharma completed a solicitation seeking the consent from
holders of the Companys senior subordinated notes to approve a refinancing or
replacement of the Companys then-existing credit facilities with the Companys
new senior credit facilities and certain amendments to, and waivers under, the
indenture governing the senior subordinated notes to, among other things:  
    
    grant a lien to secure the Companys obligations under the
senior subordinated notes, which lien is junior to the liens securing
the Companys new senior credit facilities but covers the same
collateral;
    
    increase the interest rate of the senior subordinated from 11%
per annum to 11.5% per annum effective April 1, 2004;
    
    suspend the Companys obligation under the indenture to file
periodic reports with the SEC until the earlier of the date that the
Companys annual report on Form 10-K for the year ended December 31,
2003 is filed with the SEC or September 30, 2004, and suspend
the Companys obligation to furnish annual written statements
of the Companys accountants until the fifth day after the
earlier of the date that the Companys annual report on Form 10-K for the year
ended December 31, 2003 is filed with the SEC and
September 30, 2004;
    
    further limit the Companys ability to grant liens to secure
certain obligations unless the liens are subordinate to the liens
securing the senior subordinated notes or are otherwise permitted
under the indenture; and
    
    limit the Companys ability to incur up to $10 million of
indebtedness, and to grant liens to secure that amount of
indebtedness, not otherwise specifically permitted by the indenture,
until the Companys annual report on Form 10-K for the year ended
December 31, 2003 is filed with the SEC or unless the indebtedness is
incurred to fund an interest payment with respect to the senior
subordinated notes. Following the completion of a consent solicitation, aaiPharma entered into a
supplemental indenture to affect these amendments and waivers and made the
interest payments that had been due on April 1, 2004, together with default
interest. The
Company made interest payments on the senior subordinated notes of
$9.6 million in October 2003 and $9.7 million in April 2004. The April 2004 interest payment
was offset by approximately $1.7 million received under the Companys interest
rate hedging agreement, described above. As a condition to establishing the Companys new senior credit facilities,
aaiPharma terminated the interest rate hedging agreement in April 2004. The
Companys termination obligations under the interest rate hedging agreement
were approximately $9.4 million, which amount was paid upon termination of that
agreement. 7. Stockholders Equity The authorized capital stock of the Company at December 31, 2003 and 2002 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, 2003 or 2002. The Company has reserved 1.0 million shares of
common stock for issuance under the stock option plans at December 31, 2003. 113




---



##### 



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 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. As of December 31, 2003, the Company had
granted 1,160,251 options to certain executives that cliff vest after seven
years. These options, however, have an accelerated vesting provision where
granted options will vest in the following proportions if the Companys share
closing price equals or exceed the following share price for seven consecutive
days: 25%, $22.67; 50%, $34.00; 75%, $45.33; and 100%, $55.67. The combined activity from all plans is presented in the following table: WeightedAverageExerciseShares
    
    PriceOutstanding, December 31, 2000
    
    
    3,561,753
    
    
    $
    6.78Granted
    
    
    857,748
    
    
    
    10.61Exercised
    
    
    (594,024
    )
    
    
    6.43Forfeited
    
    
    (329,499
    )
    
    
    8.11Outstanding, December 31, 2001
    
    
    3,495,978
    
    
    
    7.65Granted
    
    
    3,387,798
    
    
    
    14.24Exercised
    
    
    (512,423
    )
    
    
    6.33Forfeited
    
    
    (962,380
    )
    
    
    14.13Outstanding, December 31, 2002
    
    
    5,408,973
    
    
    
    10.79Granted
    
    
    1,884,755
    
    
    
    15.37Exercised
    
    
    (618,723
    )
    
    
    8.36Forfeited
    
    
    (247,401
    )
    
    
    12.83Outstanding, December 31, 2003
    
    
    6,427,604
    
    
    
    12.28
 Information regarding stock options outstanding and options exercisable at
December 31, 2003 is summarized in the table below: 114




---



##### 



Options Outstanding
    
    Options ExercisableWeightedAverage
    
    Weighted
    
    
    
    
    
    WeightedRemaining
    
    Average
    
    
    
    
    
    AverageShares
    
    Life
    
    Exercise
    
    Shares
    
    ExerciseRange of Exercise Prices
    
    Outstanding
    
    (Years)
    
    Price
    
    Exercisable
    
    Price$4.58 - $9.75
    
    
    1,757,050
    
    
    
    5.93
    
    
    $
    6.97
    
    
    
    1,612,844
    
    
    $
    6.80$9.76 - $12.65
    
    
    1,755,625
    
    
    
    8.43
    
    
    
    11.41
    
    
    
    543,721
    
    
    
    11.38$12.73 - $14.96
    
    
    1,955,019
    
    
    
    8.74
    
    
    
    14.65
    
    
    
    518,667
    
    
    
    14.66$15.11 - $24.56
    
    
    959.910
    
    
    
    9.24
    
    
    
    18.79
    
    
    
    114,816
    
    
    
    19.45$4.58 - $24.56
    
    
    6,427,604
    
    
    
    7.96
    
    
    
    12.28
    
    
    
    2,790,048
    
    
    
    9.67
 At December 31, 2003, 2002 and 2001, exercisable options representing 2.8
million, 1.8 million and 1.4 million shares, respectively, were outstanding. 8. Related Party Transactions Endeavor Pharmaceuticals, Inc. In 1994, aaiPharma organized Endeavor Pharmaceuticals, Inc. (Endeavor) with
several investors to fund the development of hormone pharmaceutical products,
initially focusing on several generic hormone products already under
development by the Company. The Company 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, the Companys interest, assuming conversion, had been reduced
to approximately 10% 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 had been
recorded at zero value since 1995. In the fourth quarter of 2003, Endeavor sold
substantially all of its assets to a third party. As part of this transaction,
the Company recorded a pretax gain of $1.8 million for the sale of its
investment in Endeavor. This gain is included in other income on the
consolidated statements of operations. As of December 31, 2003, the Company no
longer had any investment in Endeavor. The Company had net sales to Endeavor of approximately $0.6 million, $1.1
million and $0.2 million for the years ended December 31, 2003, 2002 and 2001,
respectively. At December 31, 2003, the Company had no related accounts
receivable and at December 31, 2002, the Company had $0.3 million in related
accounts receivable. 115




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##### 



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 January
2001, the terms of the preferred stock owned by the Company were amended to
make that class of stock convertible into Aesgen common stock. 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, 2003, the Company has
performed services under the agreement of $580,000. At December 31, 2003, the
Company held 10% of Aesgens fully diluted common
stock. The Company does
not anticipate performing any additional services for Aesgen under this
agreement. 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. In 2003, 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. Under
this agreement, the Company is obligated to pay royalty payments for the
eight-year period following the first commercial sale of the product. In 2003,
the Company expensed royalties related to this agreement of $0.6 million. Of
this amount, none was payable at December 31, 2003. 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 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 zero, $494,000 and $86,000 from Aesgen for
the years ended December 31, 2003, 2002 and 2001 respectively. The Company had
no related accounts receivable from Aesgen or work-in-progress at December 31,
2003 or 2002. Cetan Technologies, Inc. The Company used Cetan Technologies, Inc. (Cetan), to provide scanning and
indexing services required as part of aaiPharmas regulatory compliance and
record retention policies. Cetans principal stockholders include Dr.
Frederick Sancilio and Mr. James Waters, both directors of aaiPharma. The
Company engaged Cetan to perform these services since 1996 and compensated
Cetan pursuant to written agreements for the services. Cetan also provided
computer validation services to aaiPharma, which were required for compliance
with regulatory requirements. Total payments for scanning and validation
services provided to aaiPharma by Cetan were zero, $7,000 and $4,000 for the
years ended December 31, 2003, 2002 and 2001, respectively. 116




---



##### 



9. Income Taxes The following table presents the components for the (benefit from) provision
for income taxes: Years Ended December 31,2003
    
    2002
    
    2001(as restated)(In thousands)(Loss) income before income taxes:United States
    
    $
    (38,600
    )
    
    $
    21,758
    
    
    $
    9,096Non-U.S.
    
    
    1,395
    
    
    
    (98
    )
    
    
    43(Loss) income before taxes
    
    $
    (37,205
    )
    
    $
    21,660
    
    
    $
    9,139(Benefit from) provision for income taxes:Current:Federal
    
    $
    14,824
    
    
    $
    1,842
    
    
    $
    1,654State
    
    
    67
    
    
    
    219
    
    
    
    1,397Non-U.S.
    
    
    113
    
    
    
    355
    
    
    
    Total current taxes
    
    
    15,004
    
    
    
    2,416
    
    
    
    3,051Deferred:Federal
    
    
    (18,398
    )
    
    
    4,517
    
    
    
    1,067State
    
    
    (1,108
    )
    
    
    1,609
    
    
    
    (919
    )Total deferred taxes
    
    
    (19,506
    )
    
    
    6,126
    
    
    
    148(Benefit from) provision for income taxes
    
    $
    (4,502
    )
    
    $
    8,542
    
    
    $
    3,199
 The following table presents the reconciliation of the (benefit from) provision
for income taxes to the amount computed by applying the U.S. federal statutory
income tax rate: Years Ended December 31,2003
    
    2002
    
    2001(as restated)(In thousands)(Loss) income before income taxes
    
    $
    (37,205
    )
    
    $
    21,660
    
    
    $
    9,139Tax (benefit) expense using U.S. statutory income
tax rate of 35% for 2003 and 2002, and 34% for 2001
    
    $
    (13,022
    )
    
    $
    7,581
    
    
    $
    3,107State income taxes, net
    
    
    (1,972
    )
    
    
    1,141
    
    
    
    (11
    )Permanent items, net
    
    
    1,299
    
    
    
    329
    
    
    
    395Non-U.S. operations, net
    
    
    (1,542
    )
    
    
    (194
    )
    
    
    (53
    )Tax credits
    
    
    (450
    )
    
    
    (677
    )
    
    
    (368
    )Change in deferred tax asset valuation allowance
    
    
    11,185
    
    
    
    362
    
    
    
    129(Benefit from)provision for income taxes
    
    $
    (4,502
    )
    
    $
    8,542
    
    
    $
    3,199
 117




---



##### 



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 prepaid and other current assets, other accrued
liabilities and other long-term liabilities. The following table presents the
Companys deferred tax assets and liabilities: December 31,2003
    
    2002(In thousands)Deferred tax assets, resulting from:Accrued liabilities
    
    $
    1,069
    
    
    $
    1,724Accounts receivable
    
    
    332
    
    
    
    1,493Deferred revenue
    
    
    17,371
    
    
    
    903U.S. net operating loss carryforwards
    
    
    359
    
    
    
    1,811Non-U.S. net operating losses
    
    
    4,196
    
    
    
    2,826Accrued reserves and other
    
    
    18,426
    
    
    
    276Total deferred tax assets
    
    
    41,753
    
    
    
    9,033Deferred tax liabilities, resulting from:Amortization
    
    
    (6,064
    )
    
    
    (3,138
    )Property and equipment
    
    
    (4,555
    )
    
    
    (5,453
    )Total
deferred tax liabilities
    
    
    (10,619
    )
    
    
    (8,591
    )Valuation allowances on tax assets
    
    
    (14,196
    )
    
    
    (3,011
    )Net deferred tax assets (liabilities)
    
    $
    16,938
    
    
    $
    (2,569
    )
 Valuation allowances have been provided for certain assets resulting from
accumulated net operating losses from foreign entities and other deferred tax
assets because FAS 109 requires that deferred tax assets be reduced by a
valuation allowance if it is more likely than not that some portion of the
deferred tax asset will not be realized. As of December 31, 2003, the Company
had no federal net operating losses and $5 million of state net operating loss
carryforwards, expiring in 2005. Undistributed earnings of certain consolidated foreign subsidiaries at December
31, 2003, amounted to $2.9 million. No provision for deferred U.S. income
taxes has been made for these subsidiaries because aaiPharma intends to
permanently reinvest such earnings in those foreign operations. If such
earnings were not permanently reinvested, a deferred tax liability would have
been required. 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 may make profit-sharing contributions at the discretion of the
Board of Directors. The Company expensed $1.1 million, $1.0 million and $0.8
million for the years ended December 31, 2003, 2002 and 2001, respectively, for
this benefit plan, all related to the matching contributions. 118




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##### 



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, 2003, 2002 and 2001 was $7.1 million, $7.0
million and $6.9 million, respectively. As of December 31, 2003, future
minimum rentals due under non-cancelable operating lease agreements with
initial terms of one year or more were: $7.7 million2004; $6.6 million2005;
$4.8 million2006; $4.6 million2007; $4.5 million2008 and $7.3
millionthereafter. As of December 31, 2003, future minimum rentals due under
non-cancelable capital lease agreements with initial terms of one year or more
were: $0.3 million2004; $0.2 million2005; $0.2 million2006; and
zerothereafter. In 2003, the Company entered a three-year services agreement with Athlon
Pharmaceuticals, Inc. (Athlon) to provide sales support in designated
territories throughout the United States for the Darvocet A500 product. As of
December 31, 2003, future minimum payments due under this agreement were: $14.4
million2004; $14.4 million2005; $10.8 million2006; and zerothereafter.
The Company has commenced litigation against Athlon with respect to this
agreement, and terminated this agreement, as described below. The Company also
entered into a multi-year supply agreement for Darvocet A500 with a separate
third party. As of December 31, 2003, the minimum guaranteed purchase
requirement remaining under this agreement was $12.9 million. The Company has
amended this agreement to allow additional Company products to be manufactured
under this supply agreement and for these products to be counted against the
minimum purchase obligation, although the Company and this party have not yet
agreed on the terms for manufacturing these additional products, including
price. In 1995, the Company entered into an employment agreement with Dr. Frederick D.
Sancilio, which was most recently amended in 2003. The employment agreement
renews automatically for successive two-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, Chief
Executive Officer and Chief Scientific Officer. The Board of Directors set Dr.
Sancilios annual salary at $422,000 effective January 1, 2003, which has not
yet been adjusted to reflect his resumption of responsibilities as Chief
Executive Officer in March 2004. Pursuant to the employment agreement, Dr.
Sancilio receives a bonus when aaiPharma receives certain regulatory approvals.
This bonus is in the amount of $250,000 for each new drug application and
$50,000 for each supplemental new drug application or abbreviated new drug
application. Dr. Sancilio was awarded a bonus of $100,000 in March 2003 upon
regulatory approval and commercialization of two products. 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 (as defined in the agreement), 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. The Company is party to lawsuits and administrative proceedings incidental to
the normal course of its business. The Company is also party to, or named as a
defendant in, purported class action lawsuits alleging violations of federal
securities and ERISA laws. On August 7, 2003 the Company received a letter from the staff of the
Enforcement Division of the SEC (the Enforcement Division) requesting
voluntary production of certain documents. The Company responded to this
letter on August 21, 2003 and supplemented its response on August 29, 2003. Independent of the August 7, 2003 inquiry letter, on September 26, 2003,
certain members of the Companys board and management voluntarily met with, and
provided documents to, the staff of the Enforcement Division. As a follow-up
to this September 26, 2003 meeting and as part of the inquiry initiated on
August 7, 2003, on October 8, 2003, the Company received a further request from
staff of the Enforcement Division for voluntary production of certain
documents, to which the Company responded on October 30, 2003. On January 14, 2004 and April 26, 2004, the Company received letters from the
SECs Division of Corporate Finance commenting on, asking questions about, and
seeking additional disclosure with respect to certain of our periodic reports.
The Company has responded to these letters. 119




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##### 



In April 2004, in connection with an investigation conducted by the United
States Attorneys Office for the Western District of North Carolina (the U.S.
Attorneys Office), the Company received five federal grand jury subpoenas for
document production and potential testimony related to, among other things,
certain transactions regarding its 2002 and 2003 financial information, the
terms, conditions of employment and compensation arrangements of certain of its
senior management personnel, compensation and incentive arrangements for
employees responsible for the sale of its Brethine, Darvocet, calcitriol,
azathioprine and Darvon Compound products, quantities of the foregoing products
in distribution channels, financial benefits with respect to specified
corporate transactions to its senior management and others, certain loans
obtained by it, extensions of credit, if any, by it to officers or directors,
accounting for sales and returns of its foregoing products, its analysts
conference calls on financial results, internal and external investigations of
pharmaceutical product sales activities, and related matters. The Company also
been advised that the SEC has initiated an inquiry into at least the same issues
investigated by the Special Committee. The U.S. Attorneys Office has advised
that the Company may also receive a subpoena from the SEC. The Company and the Special Committee have agreed to cooperate fully with the
government investigations, and the Special Committee has agreed to share all
results of its investigation with the SEC and the U.S. Attorneys Office. To
that end, two meetings of outside counsel of the Company with attorneys for the
U.S. Attorneys Office and the SEC have taken place and numerous documents as
requested by these government agencies have been voluntarily
produced. We are attempting to schedule a third
meeting with the U.S. Attorneys Office and the SEC in July in order to provide additional information related to the Special
Committees investigation to these government agencies. The Company and the
Special Committee intend to facilitate any interviews of employees or officers
of the Company that may be requested by these government agencies. The Department of Justice, SEC and other government agencies that are
investigating or might commence an investigation of the Company could impose,
based on a claim of fraud, material misstatements, violation of false claims
law or otherwise, civil and/or criminal sanctions, including fines, penalties,
and/or administrative remedies. If any government sanctions are imposed, which
the Company cannot predict or reasonably estimate at this time, the Companys
business, financial condition, results of operations or cash flows could be
materially adversely affected. These matters have resulted, and are expected to
continue to result, in a significant diversion of managements attention and
resources and in significant professional fees. On January 2, 2004, aaiPharma received separate letters from the Kentucky
Office of Attorney General and the Florida Office of Attorney General advising
that each was currently investigating allegations regarding the Companys
pricing practices related to the Companys average manufacturer price and best
price calculations that are used by the government to set Medicaid
reimbursement rates. Neither letter requested that aaiPharma provide any
information, and each letter merely requested that aaiPharma retain all
documents with respect to these calculations pursuant to a newly adopted
federal regulation that would have permitted the destruction of these documents
three years after the applicable prices were reported, except to the extent
aaiPharma was aware of an ongoing investigation. It is the Companys
understanding that many other pharmaceutical companies received similar letters
at that time from attorneys general in a number of states and that such letters
may have been in response to the new federal regulation that would have
otherwise allowed the destruction of documents reflecting these pricing
calculations. A number of attorneys general, including the Florida and Kentucky
attorneys general, petitioned the U.S. Secretary of Health and Human Services
to withdraw the new regulation. aaiPharma is not aware of any further
developments in these investigations. The Company and certain of its officers have been named as defendants in
purported shareholder class action lawsuits alleging violations of federal
securities laws. These lawsuits were filed beginning in February 2004 120




---



##### 



and are pending in the U.S. District Court for the Eastern District of North
Carolina. These lawsuits assert claims under Sections 10(b) and 20(a) of the
Securities Exchange Act of 1934 and Rule 10b-5 thereunder on behalf of a class
of purchasers of the Companys common stock during the period from January 31, 2002
through and including March 1, 2004 (the Class Period). The complaints
allege generally that the defendants knowingly or recklessly made false or
misleading statements during the Class Period concerning the Companys
financial condition and that the Companys financial statements did not present
its true financial condition and were not prepared in accordance with generally
accepted accounting principles. The complaints seek certification as a class
action, unspecified compensatory damages, attorneys fees and costs, and other
relief. By order dated April 16, 2004, the district court consolidated the
securities lawsuits into one consolidated action. The Company expects that the
plaintiffs will file a consolidated, amended complaint later in 2004, to which
the Company will respond in lieu of responding to the individual complaints. In addition, the Company, one of its former officers, certain of its employees
and others have been named in a purported class action brought by an aaiPharma
retirement plan participant and beneficiary asserting claims under the Employee
Retirement Income Security Act of 1974, as amended (ERISA) on behalf of a
class of all persons who are or were participants or beneficiaries of the
aaiPharma Inc. Retirement and Savings Plan (the Plan) during the period from
April 24, 2002 to March 31, 2004. The complaint alleges generally that the
defendants breached fiduciary duties owed under ERISA with respect to the
investment of Plan assets in aaiPharma stock by misleading participants and
beneficiaries of the Plan regarding the Companys earnings, prospects, and business
condition. The complaint seeks certification as a class action, unspecified
compensatory damages, attorneys fees and costs, and other relief. These securities and ERISA lawsuits are at an early stage. By, and subject to,
the terms of our bylaws, the Company has certain obligations to indemnify the officers
of the Company and others who have been named as defendants in these lawsuits.
The Company has purchased directors and officers liability insurance (D&O insurance)
that may provide coverage for some or all of these lawsuits and governmental
investigations. There is a risk, however, that some or all of the claims or
expenses will not be covered by such policies; or that, even if covered, the Companys
ultimate liability will exceed the available insurance. Although the
Company intends to
vigorously pursue all defenses available in these lawsuits, an adverse
determination in these lawsuits or an inability to obtain payment
under the Companys D&O
insurance policies for litigation and indemnification costs and any damages
ultimately borne by the Company as a result of these lawsuits and investigations could
have a material adverse effect on the Companys business, financial condition, results of
operations or cash flows. On April 15, 2004, the Company filed a lawsuit against Athlon seeking a
declaratory judgment that the Company was entitled to terminate the Service
Agreement (the Athlon Service Agreement) dated July 16, 2003, as amended,
between aaiPharma and Athlon as well as damages and injunctive relief for
material breaches of the Athlon Service Agreement by Athlon. The Athlon
Service Agreement incorporated the terms and conditions pursuant to which
representatives of Athlon would promote the sale of our Darvocet A500 product
to physicians. The Company initially paid Athlon $3,350,000 to build its sales
force to promote the sale of our Darvocet A500, and the terms of the Athlon
Service Agreement would require the Company to pay Athlon an additional
$1,200,000 each month for such services for the contract period of 36 months,
commencing in October 2003, subject to Athlons compliance with certain
representations, warranties and covenants, some of which are described below. The lawsuit asserts that Athlon has materially breached the Athlon Service
Agreement in several ways, including failure to: (i) provide the required
number of sales representatives during our launch of Darvocet 121




---



##### 



A500 commencing in October 2003, (ii) use its best efforts to promote Darvocet
A500 at the targeted levels of first and second pharmaceutical details to
physicians, (iii) perform the services to the best of its ability, as
contractually required; and (iv) require its sales representatives to perform
the contracted services, as required, in a professional manner consistent with
industry standards and in conformance with that level of care and skill
ordinarily exercised by professional contract sales organizations in similar
circumstances. The lawsuit also asserts that Athlon breached its representation
and warranty that it would perform, and would require its sales representatives
to perform, the contracted services in substantially the same manner that it
would promote Athlons own products. Athlon has asserted several counterclaims, including breach of an implied
covenant of good faith in fair dealing and anticipatory breach of the contract.
The Company has filed a reply denying these allegations. On June 4, 2004, the Company sent a notice of termination of the Athlon Service
Agreement to Athlon. The Company also informed Athlon of its intent to amend
the lawsuit to assert the defense of fraud in the inducement in the formation
of the agreement on the part of Athlon and other claims. The
Company intends to prosecute its claims, and defend against the counterclaims made by
Athlon in connection with the referenced lawsuit or related litigation, to the
full extent permitted by law. The Company is a party to a number of legal actions with generic drug
companies. The Company is involved in four lawsuits centered on its
omeprazole-related patents, including one lawsuit brought by the Company
against an alleged infringer of the Companys patents and three lawsuits which
were brought by third parties against the Company and are currently essentially
inactive. Omeprazole is the active ingredient found in Prilosec, a drug sold by
AstraZeneca. Two omeprazole-related cases have been filed against the company by Dr. Reddys
Laboratories Ltd. and Dr. Reddys Laboratories, Inc. in the U.S. District Court
for the Southern District of New York in July 2001 and November 2001. The
plaintiffs in these cases have challenged the validity of five
patents that the Company has 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. The third case involving the Companys omeprazole patents was brought in August
2001 by Andrx Pharmaceuticals, Inc. in the U.S. District Court for the Southern
District of New York. Andrx has challenged the validity of three of the
Companys omeprazole patents and has also sought 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 has sought injunctive relief and
unspecified treble damages. The fourth case involving the omeprazole patents was brought in December 2002,
and subsequently amended, by the Company against Kremers Urban Development Co.,
Schwarz Pharma Inc. and Schwarz Pharma AG (collectively, KUDCO) in the U.S.
District Court for the Southern District of New York. KUDCO has a generic
omeprazole product with final FDA marketing approval, was found not to infringe
the AstraZeneca 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 complaint, denying the Companys claims,
asserting various affirmative defenses to the claims, and asserting
counterclaims of patent invalidity, product 122




---



##### 



non-infringement and antitrust violations under federal and state antitrust
laws. KUDCO is also contesting the personal jurisdiction of the court over all
of the defendants in this lawsuit other than Kremers Urban Development Co. and
Schwarz Pharma Inc. Motions on the jurisdictional issues are pending before
the court. The Company has denied the substantive allegations made by KUDCO in its
counterclaims. The Company has previously indicated to KUDCO a willingness to
grant a license under its omeprazole patents for an appropriate royalty. In
the absence of a license, the Company intends to vigorously prosecute the case,
defend its patent rights and defend against the foregoing defenses and
counterclaims asserted by KUDCO. The Company cannot predict the outcomes of these lawsuits. Future adverse
findings in the above described lawsuits could have a material adverse effect
on its consolidated financial condition, results of operations or cash flows. 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 division, a product
development business, primarily the research and development business unit, and
a development services business, primarily the AAI Development Services
business unit. The product sales business provides for the sales of the
Companys pharmaceutical 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, goodwill amortization, which are not directly
attributable to a business segment. Financial data by segment and geographic
region are as follows: Years Ended December 31,20022003
    
    (as restated)
    
    2001(in thousands)Net revenues:Product sales
    
    $
    122,021
    
    
    $
    128,462
    
    
    $
    27,448Product development
    
    
    16,468
    
    
    
    19,610
    
    
    
    20,426Development services
    
    
    86,488
    
    
    
    82,438
    
    
    
    93,199$
    224,977
    
    
    $
    230,510
    
    
    $
    141,073United States
    
    $
    204,660
    
    
    $
    228,827
    
    
    $
    129,464Germany
    
    
    20,623
    
    
    
    15,520
    
    
    
    15,442Other
    
    
    1,665
    
    
    
    962
    
    
    
    916Less intercompany
    
    
    (1,971
    )
    
    
    (14,799
    )
    
    
    (4,749
    )$
    224,977
    
    
    $
    230,510
    
    
    $
    141,073
 123




---



##### 



Years Ended December 31,20022003
    
    (as restated)
    
    2001(in thousands)Income (loss) from operations:Product sales
    
    $
    2,483
    
    
    $
    66,880
    
    
    $
    7,691Product development
    
    
    16,468
    
    
    
    19,610
    
    
    
    20,426Development services
    
    
    979
    
    
    
    556
    
    
    
    8,92019,930
    
    
    
    87,046
    
    
    
    37,037Research and development expense
    
    
    (22,205
    )
    
    
    (21,279
    )
    
    
    (10,851
    )Corporate
    
    
    (19,038
    )
    
    
    (17,149
    )
    
    
    (12,957
    )$
    (21,313
    )
    
    $
    48,618
    
    
    $
    13,229United States
    
    $
    (22,420
    )
    
    $
    49,020
    
    
    $
    13,095Germany
    
    
    1,150
    
    
    
    (58
    )
    
    
    440Other
    
    
    (43
    )
    
    
    (344
    )
    
    
    (306
    )$
    (21,313
    )
    
    $

    48,618
    
    
    $
    13,229Depreciation and amortization:Product sales
    
    $
    13,161
    
    
    $
    9,945
    
    
    $
    552Development services
    
    
    4,515
    
    
    
    3,903
    
    
    
    4,503Research and development expense
    
    
    416
    
    
    
    425
    
    
    
    369Corporate
    
    
    2,154
    
    
    
    2,122
    
    
    
    2,331$
    20,246
    
    
    $
    16,395
    
    
    $
    7,755Total assets:Product sales
    
    $
    424,452
    
    
    $
    340,773
    
    
    $
    105,541Product development
    
    
    13,062
    
    
    
    6,024
    
    
    
    7,832Development services
    
    
    55,791
    
    
    
    49,952
    
    
    
    55,555Corporate
    
    
    41,292
    
    
    
    36,753
    
    
    
    27,358$
    534,597
    
    
    $
    433,502
    
    
    $
    196,286United States
    
    $
    504,575
    
    
    $
    411,174
    
    
    $
    176,518Germany
    
    
    28,459
    
    
    
    21,167
    
    
    
    18,794Other
    
    
    1,563
    
    
    
    1,161
    
    
    
    974$
    534,597
    
    
    $
    433,502
    
    
    $
    196,286Goodwill, net:Development services
    
    $
    13,361
    
    
    $
    11,378
    
    
    $
    9,663
 124




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##### 



13. Financial Results by Quarter (Unaudited) QuarterFirst
    
    Second
    
    Third
    
    Fourth(In thousands, except per share amounts)As
    
    
    
    
    
    As
    
    
    
    
    
    AsPreviously
    
    As
    
    Previously
    
    As
    
    Previously
    
    As2003
    
    Reported
    
    Restated
    
    Reported
    
    Restated
    
    Reported
    
    RestatedNet revenues
    
    $
    64,030
    
    
    $
    48,987
    
    
    $
    70,751
    
    
    $
    66,096
    
    
    $
    71,012
    
    
    $
    39,700
    
    
    $
    70,194(Loss)
income from operations
    
    
    17,175
    
    
    
    1,575
    
    
    
    17,384
    
    
    
    10,580
    
    
    
    19,104
    
    
    
    (10,337
    )
    
    
    (23,131
    )Net income (loss)
    
    
    7,156
    
    
    
    (2,468
    )
    
    
    7,988
    
    
    
    3,492
    
    
    
    8,928
    
    
    
    (9,392
    )
    
    
    (24,335
    )Basic earnings (loss) per
share
    
    $
    0.26
    
    
    $
    (0.09
    )
    
    $
    0.29
    
    
    $
    0.13
    
    
    $
    0.32
    
    
    $
    (0.34
    )
    
    $
    (0.87
    )Diluted earnings (loss) per
share
    
    
    0.25
    
    
    
    (0.09
    )
    
    
    0.28
    
    
    
    0.12
    
    
    
    0.31
    
    
    
    (0.34
    )
    
    
    (0.87
    )
 QuarterFirst
    
    Second
    
    Third
    
    Fourth(In thousands, except per share amounts)As
    
    
    
    
    
    As
    
    
    
    
    
    As
    
    
    
    
    
    AsPreviously
    
    As
    
    Previously
    
    As
    
    Previously
    
    As
    
    Previously
    
    As2002
    
    Reported
    
    Restated
    
    Reported
    
    Restated
    
    Reported
    
    Restated
    
    Reported
    
    RestatedNet revenues
    
    $
    45,620
    
    
    $
    45,620
    
    
    $
    61,447
    
    
    $
    61,447
    
    
    $
    61,209
    
    
    $
    61,209
    
    
    $
    62,234
    
    
    $
    62,234Income from operations
    
    
    5,059
    
    
    
    4,853
    
    
    
    16,328
    
    
    
    14,123
    
    
    
    17,041
    
    
    
    14,836
    
    
    
    17,014
    
    
    
    14,806Net income (loss)
    
    
    (3,250
    )
    
    
    (3,376
    )
    
    
    6,104
    
    
    
    4,749
    
    
    
    7,104
    
    
    
    5,748
    
    
    
    7,356
    
    
    
    5,997Basic earnings
(loss) per share
    
    $
    (0.12
    )
    
    $
    (0.12
    )
    
    $
    0.22
    
    
    $
    0.17
    
    
    $
    0.26
    
    
    $
    0.21
    
    
    $
    0.27
    
    
    $
    0.22Diluted earnings
(loss) per share
    
    
    (0.12
    )
    
    
    (0.12
    )
    
    
    0.21
    
    
    
    0.17
    
    
    
    0.25
    
    
    
    0.20
    
    
    
    0.26
    
    
    
    0.21
 125




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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. 126




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##### 





The following information presents consolidating statements of operations,
balance sheets and cash flows for the periods and as of the dates indicated:

aaiPharma Inc.
CONSOLIDATING STATEMENT OF OPERATIONS
(In thousands) Year Ended December 31, 2003Non-Guarantor
    
    GuarantorIssuer
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedNet revenues
    
    $
    44,834
    
    
    $
    159,826
    
    
    $
    22,288
    
    
    $
    (1,971
    )
    
    $
    224,977Equity earnings from subsidiaries
    
    
    (16,949
    )
    
    
    
    
    
    
    
    
    
    
    16,949
    
    
    
    Total revenues
    
    
    27,885
    
    
    
    159,826
    
    
    
    22,288
    
    
    
    14,978
    
    
    
    224,977Operating costs and expenses:Direct costs (excluding depreciation and
royalty expense)
    
    
    27,549
    
    
    
    75,090
    
    
    
    13,680
    
    
    
    (1,482
    )
    
    
    114,837Selling
    
    
    6,465
    
    
    
    30,861
    
    
    
    2,208
    
    
    
    
    
    
    
    39,534General and administrative
    
    
    28,595
    
    
    
    7,746
    
    
    
    4,122
    
    
    
    
    
    
    
    40,463Research and development
    
    
    
    
    
    
    21,777
    
    
    
    
    
    
    
    11
    
    
    
    21,788Depreciation
    
    
    5,466
    
    
    
    1,334
    
    
    
    1,173
    
    
    
    
    
    
    
    7,973Royalty expense
    
    
    
    
    
    
    1,095
    
    
    
    
    
    
    
    
    
    
    
    1,095Intangible asset impairment
    
    
    
    
    
    
    20,600
    
    
    
    
    
    
    
    
    
    
    
    20,60068,075
    
    
    
    158,503
    
    
    
    21,183
    
    
    
    (1,471
    )
    
    
    246,290(Loss) income from operations
    
    
    (40,190
    )
    
    
    1,323
    
    
    
    1,105
    
    
    
    16,449
    
    
    
    (21,313
    )Other income (expense):Interest, net
    
    
    (1,654
    )
    
    
    (19,598
    )
    
    
    174
    
    
    
    
    
    
    
    (21,078
    )Net intercompany interest
    
    
    (2,027
    )
    
    
    2,199
    
    
    
    (172
    )
    
    
    
    
    
    
    Other
    
    
    6,636
    
    
    
    (1,468
    )
    
    
    18
    
    
    
    
    
    
    
    5,1862,955
    
    
    
    (18,867
    )
    
    
    20
    
    
    
    
    
    
    
    (15,892
    )(Loss) income before income taxes
    
    
    (37,235
    )
    
    
    (17,544
    )
    
    
    1,125
    
    
    
    16,449
    
    
    
    (37,205
    )(Benefit from) provision for income taxes
    
    
    (4,532
    )
    
    
    30
    
    
    
    
    
    
    
    
    
    
    
    (4,502
    )Net (loss) income
    
    $
    (32,703
    )
    
    $
    (17,574
    )
    
    $
    1,125
    
    
    $
    16,449
    
    
    
    (32,703
    )
 127




---



##### 



aaiPharma Inc.
RESTATED CONSOLIDATING STATEMENT OF OPERATIONS
(In thousands) Year Ended December 31, 2002Non-Guarantor
    
    GuarantorIssuer
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedNet revenues
    
    $
    59,973
    
    
    $
    168,854
    
    
    $
    16,483
    
    
    $
    (14,800
    )
    
    $
    230,510Equity earnings from subsidiaries
    
    
    48,465
    
    
    
    
    
    
    
    
    
    
    
    (48,465
    )
    
    
    Total revenues
    
    
    108,438
    
    
    
    168,854
    
    
    
    16,483
    
    
    
    (63,265
    )
    
    
    230,510Operating costs and expenses:Direct costs (excluding depreciation)
    
    
    38,536
    
    
    
    56,212
    
    
    
    10,438
    
    
    
    (14,489
    )
    
    
    90,697Selling
    
    
    6,348
    
    
    
    14,954
    
    
    
    1,775
    
    
    
    
    
    
    
    23,077General and administrative
    
    
    27,532
    
    
    
    8,900
    
    
    
    3,677
    
    
    
    
    
    
    
    40,109Research and development
    
    
    732
    
    
    
    20,121
    
    
    
    
    
    
    
    
    
    
    
    20,853Depreciation
    
    
    5,153
    
    
    
    1,005
    
    
    
    998
    
    
    
    
    
    
    
    7,15678,301
    
    
    
    101,192
    
    
    
    16,888
    
    
    
    (14,489
    )
    
    
    181,892Income (loss) from operations
    
    
    30,137
    
    
    
    67,662
    
    
    
    (405
    )
    
    
    (48,776
    )
    
    
    48,618Other (expense) incomeInterest, net
    
    
    (1,774
    )
    
    
    (17,602
    )
    
    
    10
    
    
    
    
    
    
    
    (19,366
    )Net intercompany interest
    
    
    (2,292
    )
    
    
    2,494
    
    
    
    (202
    )
    
    
    
    
    
    
    Other
    
    
    (4,215
    )
    
    
    (3,678
    )
    
    
    301
    
    
    
    
    
    
    
    (7,592
    )(8,281
    )
    
    
    (18,786
    )
    
    
    109
    
    
    
    
    
    
    
    (26,958
    )Income (loss) before income taxes
    
    
    21,856
    
    
    
    48,876
    
    
    
    (296
    )
    
    
    (48,776
    )
    
    
    21,660Provision for income taxes
    
    
    8,738
    
    
    
    
    
    
    
    (196
    )
    
    
    
    
    
    
    8,542Net income (loss)
    
    $
    13,118
    
    
    $
    48,876
    
    
    $
    (100
    )
    
    $
    (48,776
    )
    
    $
    13,118
 128




---



##### 



aaiPharma Inc.
CONSOLIDATING STATEMENT OF OPERATIONS
(In thousands) Year Ended December 31, 2001Non-Guarantor
    
    GuarantorIssuer
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedNet revenues
    
    $
    57,842
    
    
    $
    71,622
    
    
    $
    16,357
    
    
    $
    (4,748
    )
    
    $
    141,073Equity earnings from subsidiaries
    
    
    22,419
    
    
    
    
    
    
    
    
    
    
    
    (22,419
    )
    
    
    Total revenues
    
    
    80,261
    
    
    
    71,622
    
    
    
    16,357
    
    
    
    (27,167
    )
    
    
    141,073Operating costs and expenses:Direct costs (excluding depreciation)
    
    
    34,760
    
    
    
    26,979
    
    
    
    10,206
    
    
    
    (4,748
    )
    
    
    67,197Selling
    
    
    7,170
    
    
    
    5,202
    
    
    
    1,377
    
    
    
    
    
    
    
    13,749General and administrative
    
    
    18,742
    
    
    
    4,486
    
    
    
    3,310
    
    
    
    
    
    
    
    26,538Research and development
    
    
    1,757
    
    
    
    8,725
    
    
    
    
    
    
    
    
    
    
    
    10,482Depreciation
    
    
    3,661
    
    
    
    2,764
    
    
    
    1,330
    
    
    
    
    
    
    
    7,755Direct pharmaceutical start-up costs
    
    
    
    
    
    
    2,123
    
    
    
    
    
    
    
    
    
    
    
    2,12366,090
    
    
    
    50,279
    
    
    
    16,223
    
    
    
    (4,748
    )
    
    
    127,844Income (loss) from operations
    
    
    14,171
    
    
    
    21,343
    
    
    
    134
    
    
    
    (22,419
    )
    
    
    13,229Other (expense) income: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
    )
    
    
    9,139Provision for income taxes
    
    
    3,051
    
    
    
    153
    
    
    
    (5
    )
    
    
    
    
    
    
    3,199Net income (loss)
    
    $
    5,940
    
    
    $
    22,371
    
    
    $
    48
    
    
    $
    (22,419
    )
    
    $
    5,940
 129




---



##### 



aaiPharma Inc.
CONSOLIDATING BALANCE SHEET
(In thousands) December 31, 2003Non-Guarantor
    
    GuarantorIssuer
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedASSETSCurrent assets:Cash and cash equivalents
    
    $
    8,161
    
    
    $
    192
    
    
    $
    432
    
    
    $
    
    
    
    $
    8,785Accounts receivable, net
    
    
    11,242
    
    
    
    16,785
    
    
    
    4,587
    
    
    
    
    
    
    
    32,614Work-in-progress
    
    
    3,688
    
    
    
    5,337
    
    
    
    7,793
    
    
    
    (4,315
    )
    
    
    12,503Inventories, net
    
    
    4,588
    
    
    
    8,909
    
    
    
    1,196
    
    
    
    
    
    
    
    14,693Deferred tax assets
    
    
    19,184
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    19,184Prepaid and other current assets
    
    
    1,872
    
    
    
    8,304
    
    
    
    222
    
    
    
    
    
    
    
    10,398Total current assets
    
    
    48,735
    
    
    
    39,527
    
    
    
    14,230
    
    
    
    (4,315
    )
    
    
    98,177Investments in and advances to subsidiaries
    
    
    66,061
    
    
    
    (46,202
    )
    
    
    
    
    
    
    (19,859
    )
    
    
    Property and equipment, net
    
    
    39,011
    
    
    
    13,954
    
    
    
    4,271
    
    
    
    
    
    
    
    57,236Goodwill, net
    
    
    725
    
    
    
    1,229
    
    
    
    11,407
    
    
    
    
    
    
    
    13,361Intangibles, net
    
    
    1,209
    
    
    
    350,106
    
    
    
    
    
    
    
    
    
    
    
    351,315Other assets
    
    
    2,419
    
    
    
    11,974
    
    
    
    115
    
    
    
    
    
    
    
    14,508Total assets
    
    $
    158,160
    
    
    $
    370,588
    
    
    $
    30,023
    
    
    $
    (24,174
    )
    
    $
    534,597LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Current maturities of long-term debt
    
    $
    
    
    
    $
    4,000
    
    
    $
    
    
    
    $
    
    
    
    $
    4,000Accounts payable
    
    
    5,082
    
    
    
    14,292
    
    
    
    2,505
    
    
    
    
    
    
    
    21,879Customer advances
    
    
    6,441
    
    
    
    8,101
    
    
    
    4,807
    
    
    
    (1,719
    )
    
    
    17,630Accrued wages and benefits
    
    
    2,575
    
    
    
    1,517
    
    
    
    1,228
    
    
    
    
    
    
    
    5,320Interest payable
    
    
    7
    
    
    
    5,504
    
    
    
    
    
    
    
    
    
    
    
    5,511Deferred product revenue
    
    
    
    
    
    
    45,664
    
    
    
    
    
    
    
    
    
    
    
    45,664Other accrued liabilities
    
    
    8,640
    
    
    
    4,332
    
    
    
    (448
    )
    
    
    (1,391
    )
    
    
    11,133Total current liabilities
    
    
    22,745
    
    
    
    83,410
    
    
    
    8,092
    
    
    
    (3,110
    )
    
    
    111,137Long-term debt, less current portion
    
    
    8,000
    
    
    
    330,844
    
    
    
    
    
    
    
    
    
    
    
    338,844Other liabilities
    
    
    2,442
    
    
    
    7,451
    
    
    
    
    
    
    
    
    
    
    
    9,893Investments in and advances to subsidiaries
    
    
    127,363
    
    
    
    (133,182
    )
    
    
    6,212
    
    
    
    (393
    )
    
    
    Total stockholders equity
    
    
    (2,390
    )
    
    
    82,065
    
    
    
    15,719
    
    
    
    (20,671
    )
    
    
    74,723Total liabilities and stockholders equity
    
    $
    158,160
    
    
    $
    370,588
    
    
    $
    30,023
    
    
    $
    (24,174
    )
    
    $
    534,597
 130




---



##### 



aaiPharma Inc.
RESTATED CONSOLIDATING BALANCE SHEET
(In thousands) December 31, 2002Non-Guarantor
    
    GuarantorIssuer
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedASSETSCurrent assets:Cash and cash equivalents
    
    $
    5,725
    
    
    $
    180
    
    
    $
    627
    
    
    $
    
    
    
    $
    6,532Accounts receivable, net
    
    
    10,104
    
    
    
    16,758
    
    
    
    2,605
    
    
    
    
    
    
    
    29,467Work-in-progress
    
    
    4,135
    
    
    
    2,951
    
    
    
    4,568
    
    
    
    (1,139
    )
    
    
    10,515Inventories, net
    
    
    5,504
    
    
    
    11,114
    
    
    
    697
    
    
    
    (311
    )
    
    
    17,004Deferred tax assets
    
    
    1,271
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,271Prepaid and other current assets
    
    
    2,511
    
    
    
    3,642
    
    
    
    209
    
    
    
    
    
    
    
    6,362Total current assets
    
    
    29,250
    
    
    
    34,645
    
    
    
    8,706
    
    
    
    (1,450
    )
    
    
    71,151Investments in and advances to subsidiaries
    
    
    66,061
    
    
    
    (46,202
    )
    
    
    
    
    
    
    (19,859
    )
    
    
    Property and equipment, net
    
    
    42,055
    
    
    
    7,070
    
    
    
    4,000
    
    
    
    
    
    
    
    53,125Goodwill, net
    
    
    624
    
    
    
    1,230
    
    
    
    9,524
    
    
    
    
    
    
    
    11,378Intangibles, net
    
    
    952
    
    
    
    280,717
    
    
    
    
    
    
    
    
    
    
    
    281,669Other assets
    
    
    4,514
    
    
    
    11,569
    
    
    
    96
    
    
    
    
    
    
    
    16,179Total assets
    
    $
    143,456
    
    
    $
    289,029
    
    
    $
    22,326
    
    
    $
    (21,309
    )
    
    $
    433,502LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Current maturities of long-term debt
    
    $
    
    
    
    $
    5,921
    
    
    $
    
    
    
    $
    
    
    
    $
    5,921Accounts payable
    
    
    4,410
    
    
    
    11,447
    
    
    
    1,814
    
    
    
    
    
    
    
    17,671Customer advances
    
    
    7,840
    
    
    
    5,731
    
    
    
    2,618
    
    
    
    (1,138
    )
    
    
    15,051Accrued wages and benefits
    
    
    4,922
    
    
    
    929
    
    
    
    867
    
    
    
    
    
    
    
    6,718Interest payable
    
    
    285
    
    
    
    4,947
    
    
    
    
    
    
    
    
    
    
    
    5,232Other accrued liabilities
    
    
    1,244
    
    
    
    3,379
    
    
    
    (77
    )
    
    
    655
    
    
    
    5,201Total current liabilities
    
    
    18,701
    
    
    
    32,354
    
    
    
    5,222
    
    
    
    (483
    )
    
    
    55,794Long-term debt, less current portion
    
    
    47,500
    
    
    
    230,399
    
    
    
    
    
    
    
    
    
    
    
    277,899Other liabilities
    
    
    4,555
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,555Investments in and advances to subsidiaries
    
    
    68,094
    
    
    
    (72,423
    )
    
    
    4,984
    
    
    
    (655
    )
    
    
    Total stockholders equity
    
    
    4,606
    
    
    
    98,699
    
    
    
    12,120
    
    
    
    (20,171
    )
    
    
    95,254Total liabilities and stockholders equity
    
    $
    143,456
    
    
    $
    289,029
    
    
    $
    22,326
    
    
    $
    (21,309
    )
    
    $
    433,502
 131




---



##### 



aaiPharma Inc.
CONSOLIDATING STATEMENT OF CASH FLOWS
(In thousands) Year Ended December 31, 2003Non-Guarantor
    
    GuarantorIssuer
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedCash flows from operating activities:Net (loss) income
    
    $
    (32,703
    )
    
    $
    (17,574
    )
    
    $
    1,125
    
    
    $
    16,449
    
    
    $
    (32,703
    )Adjustments to reconcile net (loss) income to net cash
provided by (used in) operating activities:Depreciation and amortization
    
    
    5,039
    
    
    
    14,034
    
    
    
    1,173
    
    
    
    
    
    
    
    20,246Intangible asset impairment
    
    
    
    
    
    
    20,600
    
    
    
    
    
    
    
    
    
    
    
    20,600Write-off of deferred financing and other costs
    
    
    1,511
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,511Other
    
    
    (151
    )
    
    
    (13
    )
    
    
    598
    
    
    
    
    
    
    
    434Changes in operating assets and liabilities:Accounts receivable, net
    
    
    (1,138
    )
    
    
    (27
    )
    
    
    (1,467
    )
    
    
    
    
    
    
    (2,632
    )Work-in-progress
    
    
    447
    
    
    
    (2,386
    )
    
    
    (2,322
    )
    
    
    3,176
    
    
    
    (1,085
    )Inventories, net
    
    
    916
    
    
    
    2,205
    
    
    
    (361
    )
    
    
    (311
    )
    
    
    2,449Deferred tax assets
    
    
    (17,913
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (17,913
    )Prepaid and other assets
    
    
    1,224
    
    
    
    (6,939
    )
    
    
    28
    
    
    
    
    
    
    
    (5,687
    )Accounts payable
    
    
    673
    
    
    
    2,844
    
    
    
    332
    
    
    
    
    
    
    
    3,849Customer advances
    
    
    (1,399
    )
    
    
    2,370
    
    
    
    1,671
    
    
    
    (580
    )
    
    
    2,062Interest payable
    
    
    (277
    )
    
    
    556
    
    
    
    
    
    
    
    
    
    
    
    279Deferred product revenue
    
    
    
    
    
    
    45,664
    
    
    
    
    
    
    
    
    
    
    
    45,664Accrued wages and benefits and other accrued liabilities
    
    
    2,935
    
    
    
    1,540
    
    
    
    (1,150
    )
    
    
    (2,047
    )
    
    
    1,278Intercompany receivables and payables
    
    
    76,218
    
    
    
    (60,758
    )
    
    
    1,227
    
    
    
    (16,687
    )
    
    
    Net cash provided by (used in) operating activities
    
    
    35,382
    
    
    
    2,116
    
    
    
    854
    
    
    
    
    
    
    
    38,352Cash flows from investing activities:Purchases of property and equipment
    
    
    (2,082
    )
    
    
    (8,654
    )
    
    
    (1,174
    )
    
    
    
    
    
    
    (11,910
    )Proceeds from sales of property and equipment
    
    
    381
    
    
    
    225
    
    
    
    
    
    
    
    
    
    
    
    606Acquisitions of product rights and other intangibles
    
    
    
    
    
    
    (102,464
    )
    
    
    
    
    
    
    
    
    
    
    (102,464
    )Other
    
    
    (502
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (502
    )Net cash used in investing activities
    
    
    (2,203
    )
    
    
    (110,893
    )
    
    
    (1,174
    )
    
    
    
    
    
    
    (114,270
    )Cash flows from financing activities:Proceeds from long-term borrowings
    
    
    
    
    
    
    160,000
    
    
    
    
    
    
    
    
    
    
    
    160,000Payments on long-term borrowings
    
    
    (39,500
    )
    
    
    (54,000
    )
    
    
    
    
    
    
    
    
    
    
    (93,500
    )Proceeds from interest rate swaps, net
    
    
    
    
    
    
    1,703
    
    
    
    
    
    
    
    
    
    
    
    1,703Proceeds from stock option exercises
    
    
    8,757
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    8,757Other
    
    
    
    
    
    
    1,086
    
    
    
    
    
    
    
    
    
    
    
    1,086Net cash (used in) provided by financing activities
    
    
    (30,743
    )
    
    
    108,789
    
    
    
    
    
    
    
    
    
    
    
    78,046Net increase (decrease) in cash and cash equivalents
    
    
    2,436
    
    
    
    12
    
    
    
    (320
    )
    
    
    
    
    
    
    2,128Effect of exchange rate changes on cash
    
    
    
    
    
    
    
    
    
    
    125
    
    
    
    
    
    
    
    125Cash and cash equivalents, beginning of period
    
    
    5,725
    
    
    
    180
    
    
    
    627
    
    
    
    
    
    
    
    6,532Cash and cash equivalents, end of period
    
    $
    8,161
    
    
    $
    192
    
    
    $
    432
    
    
    $
    
    
    
    $
    8,785
 132




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##### 



aaiPharma Inc.
RESTATED CONSOLIDATING STATEMENT OF CASH FLOWS
(In thousands) Year Ended December 31, 2002Non-Guarantor
    
    GuarantorIssuer
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedCash flows from operating activities:Net income (loss)
    
    $
    13,118
    
    
    $
    48,876
    
    
    $
    (100
    )
    
    $
    (48,776
    )
    
    $
    13,118Adjustments to reconcile net income (loss) to
net cash (used in) provided by operating activities:Depreciation and amortization
    
    
    4,743
    
    
    
    10,654
    
    
    
    998
    
    
    
    
    
    
    
    16,395Write-off of deferred financing and other costs
    
    
    
    
    
    
    8,053
    
    
    
    
    
    
    
    
    
    
    
    8,053Other
    
    
    (9
    )
    
    
    (432
    )
    
    
    586
    
    
    
    
    
    
    
    145Changes in operating assets and liabilities:Accounts receivable, net
    
    
    3,085
    
    
    
    (8,342
    )
    
    
    577
    
    
    
    2,300
    
    
    
    (2,380
    )Work-in-progress
    
    
    (264
    )
    
    
    2,148
    
    
    
    (80
    )
    
    
    (1,161
    )
    
    
    643Inventories, net
    
    
    (2,549
    )
    
    
    (5,530
    )
    
    
    (85
    )
    
    
    311
    
    
    
    (7,853
    )Deferred tax assets
    
    
    (352
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (352
    )Prepaid and other assets
    
    
    2,510
    
    
    
    (13,007
    )
    
    
    88
    
    
    
    
    
    
    
    (10,409
    )Accounts payable
    
    
    783
    
    
    
    1,211
    
    
    
    (57
    )
    
    
    
    
    
    
    1,937Customer advances
    
    
    3,957
    
    
    
    (1,143
    )
    
    
    (449
    )
    
    
    (1,138
    )
    
    
    1,227Interest payable
    
    
    284
    
    
    
    4,577
    
    
    
    
    
    
    
    
    
    
    
    4,861Accrued wages and benefits and other accrued liabilities
    
    
    5,634
    
    
    
    238
    
    
    
    (1,348
    )
    
    
    1,056
    
    
    
    5,580Intercompany receivables and payables
    
    
    (59,528
    )
    
    

    11,199
    
    
    
    935
    
    
    
    47,394
    
    
    
    Net cash (used in) provided by operating activities
    
    
    (28,588
    )
    
    
    58,502
    
    
    
    1,065
    
    
    
    (14
    )
    
    
    30,965Cash 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
    
    
    
    
    
    
    
    
    
    
    
    131Acquisitions of product rights and other intangibles
    
    
    
    
    
    
    (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
    
    
    
    
    
    
    
    
    
    
    
    244,486Payments on long-term borrowings
    
    
    (1,900
    )
    
    
    (50,014
    )
    
    
    
    
    
    
    14
    
    
    
    (51,900
    )Proceeds from interest rate swaps, net
    
    
    
    
    
    
    10,486
    
    
    
    
    
    
    
    
    
    
    
    10,486Proceeds from stock option exercises
    
    
    3,243
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,243Other
    
    
    (2,163
    )
    
    
    (19
    )
    
    
    29
    
    
    
    
    
    
    
    (2,153
    )Net cash provided by financing activities
    
    
    48,581
    
    
    
    155,538
    
    
    
    29
    
    
    
    14
    
    
    
    204,162Net increase (decrease) in cash and cash equivalents
    
    
    424
    
    
    
    26
    
    
    
    (456
    )
    
    
    
    
    
    
    (6
    )Effect of exchange rate changes on cash
    
    
    
    
    
    
    
    
    
    
    167
    
    
    
    
    
    
    
    167Cash and cash equivalents, beginning of period
    
    
    5,301
    
    
    
    154
    
    
    
    916
    
    
    
    
    
    
    
    6,371Cash and cash equivalents, end of period
    
    $
    5,725
    
    
    $
    180
    
    
    $
    627
    
    
    $
    
    
    
    $
    6,532
 133




---



##### 



aaiPharma Inc.
CONSOLIDATING STATEMENT OF CASH FLOWS
(In thousands) Year Ended December 31,
2001Non-Guarantor
    
    GuarantorIssuer
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedCash flows from operating activities:Net income (loss)
    
    $
    5,940
    
    
    $
    22,371
    
    
    $
    48
    
    
    $
    (22,419
    )
    
    $
    5,940Adjustments to reconcile net income (loss) to net cash
provided by operating activities:Depreciation and amortization
    
    
    3,661
    
    
    
    2,764
    
    
    
    1,330
    
    
    
    
    
    
    
    7,755Other
    
    
    449
    
    
    
    458
    
    
    
    358
    
    
    
    
    
    
    
    1,265Changes in operating assets and liabilities:Accounts receivable, net
    
    
    4,238
    
    
    
    (6,559
    )
    
    
    (791
    )
    
    
    
    
    
    
    (3,112
    )Work-in-progress
    
    
    4,358
    
    
    
    (192
    )
    
    
    2,336
    
    
    
    
    
    
    
    6,502Inventories, net
    
    
    (30
    )
    
    
    (5,519
    )
    
    
    97
    
    
    
    
    
    
    
    (5,452
    )Deferred tax assets
    
    
    2,597
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,597Prepaid and other assets
    
    
    783
    
    
    
    (5,485
    )
    
    
    (127
    )
    
    
    
    
    
    
    (4,829
    )Accounts payable
    
    
    (430
    )
    
    
    6,828
    
    
    
    275
    
    
    
    
    
    
    
    6,673Customer advances
    
    
    890
    
    
    
    (406
    )
    
    
    1,038
    
    
    
    
    
    
    
    1,522Interest payable
    
    
    (144
    )
    
    
    371
    
    
    
    
    
    
    
    
    
    
    
    227Accrued wages and benefits and other accrued liabilities
    
    
    212
    
    
    
    1,465
    
    
    
    (12
    )
    
    
    (402
    )
    
    
    1,263Intercompany receivables and payables
    
    
    (9,099
    )
    
    
    (12,917
    )
    
    
    (819
    )
    
    
    22,835
    
    
    
    Net cash provided by operating activities
    
    
    13,425
    
    
    
    3,179
    
    
    
    3,733
    
    
    
    14
    
    
    
    20,351Cash 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
    
    
    
    
    
    
    
    3,513Acquisitions of product rights and other intangibles
    
    
    (983
    )
    
    
    (78,117
    )
    
    
    
    
    
    
    
    
    
    
    (79,100
    )Other
    
    
    151
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    151Net 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
    
    
    
    
    
    
    
    
    
    
    
    78,878Payments on long-term borrowings
    
    
    (952
    )
    
    
    (58
    )
    
    
    
    
    
    
    (14
    )
    
    
    (1,024
    )Proceeds from stock option exercises
    
    
    5,123
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,123Other
    
    
    (67
    )
    
    
    (49
    )
    
    
    (36
    )
    
    
    
    
    
    
    (152
    )Net cash (used in) provided by financing activities
    
    
    (10,549
    )
    
    
    78,771
    
    
    
    (1,655
    )
    
    
    (14
    )
    
    
    66,553Net increase (decrease) in cash and cash equivalents
    
    
    4,662
    
    
    
    (343
    )
    
    
    834
    
    
    
    
    
    
    
    5,153Effect of exchange rate changes on cash
    
    
    
    
    
    
    
    
    
    
    (7
    )
    
    
    
    
    
    
    (7
    )Cash and cash equivalents, beginning of year
    
    
    639
    
    
    
    497
    
    
    
    89
    
    
    
    
    
    
    
    1,225Cash and cash equivalents, end of year
    
    $
    5,301
    
    
    $
    154
    
    
    $
    916
    
    
    $
    
    
    
    $
    6,371
 134




---



##### 



Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Item 9A. Disclosure Controls and Procedures The Company has carried out an evaluation, under the supervision and with the
participation of its newly appointed Chief Executive Officer and interim Chief
Financial Officer, pursuant to Rule 13a-15 promulgated under the Securities
Exchange Act of 1934, as amended, of the effectiveness of the design and
operation of its disclosure controls and procedures as of December 31, 2003,
the end of the period covered by this Annual Report on Form 10-K. Disclosure
controls and procedures are to be designed to ensure that material information
the Company must disclose in its reports filed or submitted under the
Securities Exchange Act of 1934 is recorded, processed, summarized and reported
on a timely basis. As a result of that review, our Chief Executive Officer and
interim Chief Financial Officer have concluded that, as of such date, the
Companys disclosure controls and procedures were not adequate. The internal control deficiencies related to, among other things, a lack of
adequate policies with respect to revenue recognition, and a lack of sufficient
control processes and procedures to effectively monitor and manage wholesaler
inventory levels, to ensure adequate contract-approval oversight, and to ensure
effective and timely communication among sales, marketing, finance and legal
staff regarding the terms and conditions of certain transactions, including new
product launches. Also, with respect to the sales of pharmaceutical products,
the Companys finance and accounting personnel lacked adequate training on the
application of revenue recognition principles and the establishment of product
return reserves. In addition, in April 2004, in connection with their audit of the Companys
consolidated financial statements for the year ended December 31, 2003, the
Companys independent auditors identified and communicated to the Company and
the Audit Committee two material weaknesses (as defined under standards
established by the American Institute of Certified Public Accountants) relating
to the Companys accounting and public financial reporting of significant
matters and to its initial recording and management review and oversight of
certain accounting matters. The material weaknesses were with respect to the
calculation and procedures for the analysis of revenue reserves for product
sales and lack of procedures for timely communications from the Legal
Department and operating divisions to the Finance Department impairing the
ability to properly evaluate the accounting treatment for certain transactions
the Company had entered into and assess the impact of such transactions in a
timely manner. In addition, at that time, the Companys independent auditors
identified and communicated to the Company and the Audit Committee a
reportable condition (as defined under standards established by the American
Institute of Certified Public Accountants) relating to the Companys internal
controls over its financial reporting for investments. The reportable
condition identified the Companys failure to perform a formal review of its
investments and timely to record patents or trademarks or to timely analyze
the patents and trademarks for usefulness and possible impairment. In view of the fact that the financial information presented in this annual
report was prepared 135




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##### 



in the absence of adequate internal controls over financial reporting, the
Company devoted a significant amount of time and resources to the analysis of
the financial information and documentation underlying the financial statements
contained in this annual report, including the related interim financial
statements, resulting in the restatement of certain interim financial
statements. In particular, the Company reviewed significant product sales
transactions to confirm the terms of the transaction and our accounting for the
transaction, including whether all criteria for the recognition of revenue had
been satisfied and whether we had properly estimated allowances for returns and
other customer credits. In addition, the Company reviewed in detail each of
the matters identified by the Special Committee and its independent counsel and
independent forensic accountants. The investigation of the Special Committee
is discussed in Item 7. Managements Discussion and Analysis of Financial
Condition and Results of Operations  Special Committee Investigation. In light of the foregoing, the Company has taken the following actions, in
addition to those described above, after the end of the fiscal year covered by
this report to address the deficiencies as described above:  
    
    reassigned all financial controllers from operating units
into the Finance Department reporting to the Companys Controller
and Chief Accounting Officer who reports directly to the Chief
Financial Officer,
    
    commenced a company-wide education effort regarding our Code
of Conduct and contract-approval policies,
    
    implemented a more vigorous contract-approval process,
    
    implemented formal revenue recognition protocols and training programs; and
    
    contracted with a third-party consulting group, FTI
Consulting, to provide transitional management services in the area
of operations and finance. In addition, since December 31, 2003, the Companys then Chief Executive
Officer, Chief Operating Officer and Chief Financial Officer have left the
Company. In March of 2004, Dr. Sancilio, the Companys Executive Chairman and
Chief Scientific Officer, was appointed Chief Executive Officer, and Gregory F.
Rayburn, a consultant with FTI Consulting, was appointed Interim Chief
Operating Officer. In April 2004, Timothy R. Wright was appointed President of
the Companys Pharmaceuticals Products Division. Gina Gutzeit, another
consultant with FTI Consulting, was appointed as interim Chief Financial
Officer in May 2004. The Company is fully committed to implementing controls identified by the
Companys independent auditors and the Special Committee. The Companys
efforts to strengthen its financial and internal controls continue, and the
Company expects to complete remediation of 136




---



##### 



the material weaknesses and reportable condition identified by its independent
auditors by the end of 2004. PART III Item 10. Directors and Executive Officers of the Registrant Directors The business and affairs of the Company are managed under the direction of its
Board of Directors, which is presently comprised of ten members. The Board of
Directors is classified, with the directors serving staggered three-year terms.
The following sets forth certain information with respect to our directors as
of May 18, 2004. James L. Waters(age 78) has served as a director of the Company since 1981 and
as a non-employee officer from 1982 until 1996. Mr. Waters is a private
investor in numerous companies, is president of Cetek Corporation, a drug
discovery company, Secretary of Trans-Tek, Inc., an instrument measurement
company, and is the founder of Waters Associates, Inc., now known as Waters
Corporation, a scientific instrumentation manufacturer. James G. Martin, Ph.D. (age 68) joined the Companys Board of Directors 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. Kurt M. Landgraf(age 57) joined the Companys Board of Directors in 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 director of IKON Office Solutions, Inc., and NDC Health
Corporation. John E. Avery(age 75) joined the Companys Board of Directors 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 1993 to 1996 as Chairman of each of the Americas Society and the
Council of the Americas, each a non-profit organization. 137




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##### 



Frederick D. Sancilio, Ph.D.(age 54) is Executive Chairman of the Board of
Directors and Chief Scientific Officer of the Company. With more than 25 years
experience in the pharmaceutical industry, Dr. Sancilio worked with
Burroughs-Wellcome Co., Schering-Plough Corporation, and Hoffmann-LaRoche, Inc.
before founding the Company in 1979. William H. Underwood(age 56) is Executive Vice President, Corporate
Development of the Company, and has served as Chief Operating Officer from 1995
to 1997, as Executive Vice President since 1992, as Vice President from 1986 to
1992, and as a director since 1996. He has held positions in the pharmaceutical
and cosmetic industries for more than 17 years, in positions 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 M. Ryan(age 59) has served as a director of the Company since 1996. Mr.
Ryan serves as managing partner of Ryan Partners, a business advisory and
venture capital firm he founded in July 1996 and 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. Joseph H. Gleberman(age 46) joined the Companys Board of Directors in 1995.
Mr. Gleberman has been employed by Goldman, Sachs & Co., an investment-banking
firm, since 1982 and has been a Partner of Goldman, Sachs & Co. since 1990 and
as Managing Director since 1996. Mr. Gleberman serves as a director of BackWeb
Technologies Ltd., Berry Plastics Corporation, IPC Acquisition Corp. and MCG
Capital Corporation. Pursuant to a stockholders agreement entered into in
connection with a 1995 investment in the Company, certain Goldman Sachs
investment partnerships have the right to designate one member of the Companys
Board of Directors for as long as the investment partnerships collectively own
at least 10% of the Companys outstanding Common Stock. Mr. Gleberman is their
nominee. Richard G. Morrison, Ph.D.(age 67) joined the Companys Board of Directors 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. Timothy R. Wrightjoined the Company in April 2004 as President of the
Pharmaceuticals Division and was elected a director in May 2004. Prior to joining the Company, Mr. Wright served as
the President, Global Commercial Operations for Elan Bio-pharmaceuticals from
February 2001 to December 2003, as well as a member of Elan Pharmaceuticals, Inc.
Prior to Elan, Mr. Wright served as a Senior Vice President of Healthcare
Product Services with Cardinal Health, Inc. from May 1999 to January 2001.
Mr. Wright also held senior management positions with DuPont Merck
Pharmaceutical Company from 1984 to 1999. Executive Officers The following table contains information concerning our executive officers as
of May 18, 2004: 138




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##### 



Name
    
    Age
    
    PositionFrederick D. Sancilio, Ph.D.
    
    
    54
    
    
    Chief Executive Officer and PresidentTimothy R. Wright
    
    
    46
    
    
    President, Pharmaceuticals DivisionVijay Aggarwal, Ph.D.
    
    
    55
    
    
    President, Research & DevelopmentGregory F. Rayburn
    
    
    45
    
    
    Interim Chief Operating OfficerGina Gutzeit
    
    
    42
    
    
    Interim Chief Financial OfficerWilliam H. Underwood
    
    
    56
    
    
    Executive Vice President, Business DevelopmentGregory S. Bentley
    
    
    54
    
    
    Executive Vice President and General Counsel
 Frederick D. Sancilio, Ph.D.has been a Director since 1979, and is currently
Executive Chairman of the Board of Directors and Chief Executive 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 and resumed this role in March
2004. Timothy R. Wrightjoined the Company in April 2004 as President of the
Pharmaceuticals Division and was elected a director in May 2004. Prior to joining the Company, Mr. Wright served as
the President, Global Commercial Operations for Elan Bio-pharmaceuticals from
February 2001 to December 2003, as well as a member of Elan Pharmaceuticals, Inc.
Prior to Elan, Mr. Wright served as a Senior Vice President of Healthcare
Product Services with Cardinal Health, Inc. from May 1999 to January 2001.
Mr. Wright also held senior management positions with DuPont Merck
Pharmaceutical Company from 1984 to 1999. Vijay Aggarwal, Ph.D. has served as President of Research and Development for
aaiPharma since January 2004, having previously 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. Gregory F. Rayburnjoined the company as interim Chief Operating Officer in
March 2004. Mr. Rayburn is also a senior managing director and the Interim
Management practice leader with FTI Consulting, a leading provider of
turnaround, performance improvement, financial and operational restructuring
services. Mr. Rayburn provides services to us through a contract between the
Company and FTI Consulting. Mr. Rayburn joined FTI Consulting in 2003. Prior
to FTI Consulting, Mr. Rayburn served as a principal with AlixPartners from 2000
to 2003. While at AlixPartners, Mr. Rayburn served as the Chief Restructuring
Officer of WorldCom. Prior to AlixPartners, Mr. Rayburn served from 1998 to
2000 as the president of The 139




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##### 



Capstone Group LLC, a private investment partnership. Prior to Capstone Mr.
Rayburn was a partner in the Corporate Recovery Services Group of Arthur
Andersen LLP. Gina Gutzeitbecame our interim Chief Financial Officer in May 2004. Ms.
Gutzeit is a senior managing director in FTI Consultings Corporate
Finance/Restructuring practice. FTI Consulting is a leading provider of
turnaround, performance improvement, financial and operational restructuring
services. Ms. Gutzeit has been a senior managing director since September
2002. Prior to September 2002, Ms. Gutzeit was a partner with
PricewaterhouseCoopers LLP in the Business Recovery Services group. The
Business Recovery Services group was acquired by FTI Consulting on August 30,
2002. She joined PricewaterhouseCoopers in 1996. 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. 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. 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 SEC 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, 2003, all officers and directors
complied with all applicable Section 16(a) filing requirements,
except that Dr. Sancilio was late in reporting a purchase of
Common Stock that occurred on March 24, 2003. The report was
filed on March 31, 2003. Audit Committee The Board of Directors has determined that the members of the Audit Committee
are independent as defined in Rule 4200(a)(15) of the National Association of
Securities Dealers listing standards. The audit committee is composed of James
G. Martin, Ph.D., Richard G. Morrison, Ph.D., and Kurt M. Landgraf. The Board
of Directors has also determined that Mr. Landgraf is an audit committee
financial expert as defined in Item 401(h) of Regulation S-K. 140




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##### 



Code of Ethics In addition to a code of conduct that applies to all of our employees, our
Board of Directors has adopted a code of ethics that applies to our Chief
Executive Officer, Chief Financial Officer, Chief Accounting Officer and
Controller. We will provide copies of our code of ethics without charge upon
request. To obtain a copy of the code of ethics free of charge, please send
your written request to our General Counsel, aaiPharma Inc., 2320 Scientific
Park Drive, Wilmington, North Carolina 28405. Item 11. Executive Compensation Compensation of Directors All non-employee directors receive $3,000 per meeting for attending in person
meetings of the Board of Directors and meetings of Board committees not held in
connection with a regular Board meeting. Non-employee directors also receive
$1,000 per meeting lasting longer than one hour for participating in telephonic
meetings of the Board of Directors and $500 for Board committee telephonic
meetings. In addition, non-employee directors who serve on the Audit and the
Executive and Corporate Governance Committees receive an annual retainer of
$15,000 and $10,000, respectively. Each non-employee chair of the Audit, the
Executive and Corporate Governance and the Compensation Committees receives an
annual retainer of $30,000, $15,000 and $10,000, respectively. Directors are
also reimbursed for expenses incurred in connection with attending meetings. 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
2003 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, 2003 (collectively, the Named Executive Officers): 141




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##### 



Summary Compensation Table Annual CompensationAnnual Compensation
    
    
    
    
    
    SecuritiesName and
    
    
    
    
    
    
    
    
    
    
    
    
    
    Other Annual
    
    Restricted Stock
    
    Underlying
    
    All OtherPrincipal Position
    
    Year
    
    Salary ($) (1)
    
    Bonus ($) (2)
    
    Compensation
    
    Awards (#)
    
    Options/SARs (#)
    
    Compensation($)Frederick D.
Sancilio, Ph.D.
    
    
    2003
    
    
    
    438,193
    
    
    
    100,000
    
    
    
    73,125
    (3)
    
    
    0
    
    
    
    
    
    
    
    0Executive Chairman and
    
    
    2002
    
    
    
    407,115
    
    
    
    427,000
    
    
    
    58,499
    (4)
    
    
    0
    
    
    
    82,500
    
    
    
    0Chief Scientific Officer
    
    
    2001
    
    
    
    400,000
    
    
    
    0
    
    
    
    
    (5)
    
    
    0
    
    
    
    67,500
    
    
    
    0Philip S. Tabbiner, D.B.A. (6)
    
    
    2003
    
    
    
    527,500
    
    
    
    26,375
    
    
    
    
    
    
    
    0
    
    
    
    329,500
    
    
    
    3,000President &
    
    
    2002
    
    
    
    397,942
    
    
    
    360,500
    
    
    
    
    (5)
    
    
    37,500
    
    
    
    168,000
    
    
    
    0Chief Executive Officer
    
    
    2001
    
    
    
    285,000
    
    
    
    0
    
    
    
    
    (5)
    
    
    0
    
    
    
    12,000
    
    
    
    65,160
    (7)David M. Hurley (8)
    
    
    2003
    
    
    
    374,063
    
    
    
    18,703
    
    
    
    
    (5)
    
    
    0
    
    
    
    142,750
    
    
    
    766Executive Vice President
    
    
    2002
    
    
    
    309,615
    
    
    
    161,000
    
    
    
    
    (5)
    
    
    0
    
    
    
    300,000
    
    
    
    02001
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    William L. Ginna, Jr. (9)
    
    
    2003
    
    
    
    274,301
    
    
    
    13,175
    
    
    
    
    (5)
    
    
    0
    
    
    
    157,750
    
    
    
    3,000Executive Vice President &
    
    
    2002
    
    
    
    260,000
    
    
    
    197,300
    
    
    
    30,000
    (10)
    
    
    0
    
    
    
    187,500
    
    
    
    3,000Chief Financial Officer
    
    
    2001
    
    
    
    209,750
    
    
    
    0
    
    
    
    
    (5)
    
    
    0
    
    
    
    0
    
    
    
    3,000Gregory S. Bentley
    
    
    2003
    
    
    
    237,375
    
    
    
    11,869
    
    
    
    
    (5)
    
    
    0
    
    
    
    27,500
    
    
    
    3,000Executive Vice President
    
    
    2002
    
    
    
    225,000
    
    
    
    219,250
    
    
    
    
    (5)
    
    
    0
    
    
    
    75,000
    
    
    
    3,000& General Counsel
    
    
    2001
    
    
    
    184,750
    
    
    
    30,000
    
    
    
    
    (5)
    
    
    0
    
    
    
    0
    
    
    
    3,000Vijay Aggarwal, Ph.D. (11)
    
    
    2003
    
    
    
    356,645
    
    
    
    17,832
    
    
    
    
    (5)
    
    
    
    
    
    
    142,750
    
    
    
    2,675Executive Vice President
    
    
    2002
    
    
    
    232,212
    
    
    
    59,875
    (12)
    
    
    0
    
    
    
    0
    
    
    
    0
    
    
    
    02001
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
  (1)
    
    Includes salary amounts deferred pursuant to the Companys
401(k) plan.(2)
    
    Includes discretionary bonuses granted in March 2002 that were paid
in 2003 and 2004; performance bonuses for 2002 that were paid in 2003;
bonuses paid in 2003 for regulatory approval of Company products; and
one bonus deferred in 2001 and paid in 2003. Discretionary bonuses were
granted in March 2002 and were payable 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 received an additional 100% of the bonus in
January 2004, unless the deferring executive voluntarily left our
employment prior to the payment date. The following listed executives
elected to defer the bonus payment and received the following amounts
in each of 2003 and 2004, and the aggregate of the bonuses received is
reflected in the executives 2002 bonus line: Dr. Sancilio, $140,000;
Dr. Tabbiner, $99,750; Mr. Ginna, $75,250 and Mr. Bentley, $66,500. In
addition, Mr. Bentley received a $30,000 bonus in 2002 and an equal
amount that was deferred until 2003. Both bonus payments are reflected
in Mr. Bentleys 2002 bonus. The named executives received bonuses for
2002 performance in the following amounts, which are included in the
2002 bonus line: Dr. Sancilio, $147,000; Dr. Tabbiner, $161,000; Mr.
Hurley, $161,000; Mr. Ginna, $46,800; Mr. Bentley, $56,250; and Dr.
Aggarwal, $25,875. The executives also received bonuses upon the
commercialization of certain products which received regulatory
approval in 2003, in the following amounts: Dr. Sancilio, $100,000;
Dr. Tabbiner, $26,375; Mr. Hurley, $18,703; Mr. Ginna, $13,715; Mr.
Bentley, $11,869; and Dr. Aggarwal, $17,832. No bonuses were paid to
executives as a result of their individual or collective performance
during 2003. 142




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##### 



(3)
    
    Such amounts include $62,230 for non-business use of the Companys
aircraft and $10,895 for reimbursement for accounting fees and club
memberships pursuant to Dr. Sancilios employment agreement with the
Company.(4)
    
    Such amounts include $24,414 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.(5)
    
    Amounts received do not exceed the lesser of $50,000 or 10% of
salary.(6)
    
    Dr. Tabbiner left the Company on March 29, 2004.(7)
    
    Relocation expense reimbursement.(8)
    
    Mr. Hurley commenced employment with us on February 4, 2002 and
left the Company on February 13, 2004.(9)
    
    Mr. Ginna left the Company on May 10, 2004.(10)
    
    Includes reimbursement of $24,000 for a country club membership.(11)
    
    Dr. Aggarwal commenced employment with the Company on April 22, 2002.(12)
    
    Includes signing bonus of $34,000. The following table sets forth certain information with respect to options
granted during 2003 to the executive officers named in the Summary Compensation
Table. Stock Option Grants in 2003 Individual GrantsNumber of
    
    
    
    
    
    
    
    
    
    
    
    
    
    Potential Realizable ValueSecurities
    
    Percent of Total
    
    
    
    
    
    
    
    
    
    at Assumed Annual RatesUnderlying
    
    Options/SARs
    
    
    
    
    
    
    
    
    
    of Stock PriceOptions
    
    Granted to
    
    Exercise
    
    
    
    
    
    Appreciation for OptionName and
    
    Granted
    
    Employees in
    
    Price
    
    Expiration
    
    Term
(1)Principal Position
    
    (#) (2)
    
    Fiscal Year
    
    ($/Sh)
    
    Date
    
    5%($)
    
    10%($)Frederick D. Sancilio, Ph.D.
    
    
    0
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Philip S. Tabbiner, D.B.A.
    
    
    304,500
    
    
    
    16.2
    %
    
    
    14.65
    
    
    
    5/30/13
    
    
    
    2,805,452
    
    
    
    7,109,56625,000
    
    
    
    1.3
    %
    
    
    17.98
    
    
    
    11/20/13
    
    
    
    282,609
    
    
    
    716,188David M. Hurley
    
    
    117,750
    
    
    
    6.2
    %
    
    
    14.65
    
    
    
    5/30/12
    
    
    
    1,084,667
    
    
    
    2,749,26625,000
    
    
    
    1.3
    %
    
    
    17.98
    
    
    
    11/20/13
    
    
    
    282,609
    
    
    
    716,188William L. Ginna, Jr.
    
    
    132,750
    
    
    
    7.0
    %
    
    
    14.65
    
    
    
    5/30/13
    
    
    
    1,223,066
    
    
    
    3,099,49025,000
    
    
    
    1.3
    %
    
    
    17.98
    
    
    
    11/20/13
    
    
    
    282,609
    
    
    
    716,188Gregory S. Bentley
    
    
    7,500
    
    
    
    0.4
    %
    
    
    12.65
    
    
    
    2/19/13
    
    
    
    59,681
    
    
    
    151,24210,000
    
    
    
    0.5
    %
    
    
    14.59
    
    
    
    6/3/13
    
    
    
    91,724
    
    
    
    232,44710,000
    
    
    
    0.5
    %
    
    
    17.98
    
    
    
    11/20/13
    
    
    
    113,044
    
    
    
    286,475Vijay Aggarwal, Ph.D.
    
    
    117,750
    
    
    
    6.2
    %
    
    
    14.65
    
    
    
    5/30/13
    
    
    
    1,084,667
    
    
    
    2,749,26625,000
    
    
    
    1.3
    %
    
    
    17.98
    
    
    
    11/20/13
    
    
    
    282,609
    
    
    
    716,188
  (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 SEC 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 granted on May 30, 2003 vest 143




---



##### 



on the seventh anniversary of the grant date, but may vest sooner in
the following proportions if the closing price equals or exceeds the
following targets for a period of seven consecutive days: 25%, $22.67;
50%, $34.00; 75%, $45.33; and 100%, $55.67. The following table sets forth certain information with respect to the number
of shares underlying unexercised options and the value of unexercised options
held at fiscal year end by the Named Executive Officers: Aggregated 2003 Year-End Option Values Value of UnexercisedNumber of Securities Underlying
    
    In-the-Money OptionsName and
    
    Unexercised Options at Fiscal Year-
    
    At Fiscal Year-End($)(1)Principal Position
    
    End(#) Exercisable/Unexercisable
    
    Exercisable/UnexercisableFrederick D. Sancilio, Ph.D.
    
    
    140,000/77,500
    
    
    
    2,434,925/930, 753Philip S. Tabbiner, D.B.A.
    
    
    231,876/374,624
    
    
    
    3,466,912/4,126,925David M. Hurley
    
    
    117,564/325,187
    
    
    
    1,507,699/4,026,809William L. Ginna, Jr.
    
    
    197,546/260,206
    
    
    
    3,226,470/3,048,223Gregory S. Bentley
    
    
    129,977/77,523
    
    
    
    2,362,541/857,501Vijay Aggarwal, Ph.D.
    
    
    117,523/325,228
    
    
    
    828,621/2,485,862
  (1)
    
    Market value of underlying securities at fiscal year end minus the
exercise price of in-the-money options. Employment and Compensation Agreements On November 17, 1995, the Company entered into an employment agreement with Dr.
Frederick D. Sancilio. The employment agreement was amended in 2003. The
employment agreement renews automatically for successive two-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 Executive Officer. From July 2002 to March 29,
2004, he served as 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. In July 2002, Dr. Sancilios salary was adjusted downward to $400,000 to
reflect his new role as Executive Chairman and Chief Scientific Officer. The
Board of Directors increased Dr. Sancilios annual salary from $400,000 to
$422,000 effective January 1, 2003. Dr. Sancilio resumed his previous role
as Chief Executive Officer on March 29, 2004. His salary has not yet been
adjusted to reflect his increased responsibilities. Pursuant to the employment
agreement, Dr. Sancilio receives a bonus when aaiPharma receives certain
regulatory approvals. This bonus will be in the amount of $250,000 for each
new drug application and $50,000 for each supplemental new drug application or
abbreviated new drug application. Dr. Sancilio was awarded a bonus of $100,000
in March 2003 upon regulatory approval and commercialization of two products. 144




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##### 



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 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. Other than Dr. Sancilios
agreement described above, no executive officer of the Company has an
employment contract with aaiPharma. On March 29, 2004, we announced that Dr. Tabbiner resigned to take a consulting
position with us. Dr. Tabbiner entered into a consulting agreement with us for
a period of fifteen months. Dr. Tabbiner agreed to provide such services as
may be reasonably requested by the Company. Dr. Tabbiner is to receive $10,615
per week during the term of the agreement. The consulting agreement ends in
June 2005 or earlier if it is determined that Dr. Tabbiner committed an act of
willful misconduct while serving as an employee of the Company. On May 11, 2004, our Chief Financial Officer, William L. Ginna, Jr., left the
Company. Mr. Ginna also agreed to enter into a consulting agreement, for a
twelve-month period. Mr. Ginna is to receive $6,173 per week during the term of
the agreement The consulting agreement ends in May 2005 or earlier if it is
determined that Mr. Ginna committed an act of willful misconduct or gross
negligence in the performance of his duties as an employee of the Company. Item 12. Security Ownership of Certain Beneficial Owners and Management Security Ownership The following table sets forth certain information known to aaiPharma with
respect to beneficial ownership of aaiPharmas common stock as of May 15, 2004
by (i) each stockholder known by aaiPharma to be the beneficial owner of more
than 5% of aaiPharma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. 145




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##### 



Number of Shares
    
    Percent ofName of Beneficial Owner
    
    Beneficially Owned (1)
    
    Shares (2)Frederick D. Sancilio, Ph.D. (3)(4)
    
    
    6,313,167
    
    
    
    21.9
    %Brown Capital Management, Inc. (5)
    
    
    4,495,150
    
    
    
    15.7
    %The Goldman Sachs Group, Inc. (6)
    
    
    3,415,249
    
    
    
    11.9
    %James Waters (7)
    
    
    3,326,254
    
    
    
    11.6
    %Royce Associates, LLC (8)
    
    
    1,440,600
    
    
    
    5.0
    %Arnold H. Snider (9)
    
    
    1,780,000
    
    
    
    6.2
    %John E. Avery
    
    
    154,995
    
    
    
    *Joseph H. Gleberman (10)
    
    
    4,995
    
    
    
    *Kurt M. Landgraf
    
    
    76,295
    
    
    
    *James G. Martin, Ph.D.
    
    
    115,744
    
    
    
    *Richard Morrison, Ph.D.
    
    
    107,494
    
    
    
    *John M. Ryan
    
    
    125,495
    
    
    
    *William H. Underwood (11)
    
    
    301,929
    
    
    
    1.0
    %Timothy R.
Wright
    
    
    0
    
    
    
    *Phillip S. Tabbiner, D.B.A.
    
    
    286,629
    
    
    
    1.0
    %Gregory S. Bentley
    
    
    175,287
    
    
    
    *William L. Ginna, Jr.
    
    
    217,526
    
    
    
    *David M. Hurley
    
    
    0
    
    
    
    *All executive officers and directors as a group (18 persons)
    
    
    10,964,808
    
    
    
    37.6
    %
   *
    
    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
aaiPharmas 1995 Stock Option Plan, 1996 Stock Option Plan, 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, 124,995 shares;
Mr. Underwood, 174,833 shares; Dr. Martin, 115,744 shares; Dr.
Morrison, 107,494 shares; Mr. Gleberman, 4,995 shares; Mr. Bentley,
155,787 shares; Dr. Sancilio, 190,000 shares; Mr. Waters, 4,995 shares;
Mr. Avery, 124,995 shares; Mr. Landgraf, 74,295 shares; Mr. Ginna,
217,526 shares; Mr. Hurley,0 shares; Dr. Tabbiner, 245,376 shares; and
all executive officers and directors as a group, 1,753,086 shares.(2)
    
    These calculations are based on an aggregate of 28,585,582 shares
issued and outstanding as of May 15, 2004. Options to purchase shares
held by a person that are exercisable or become exercisable within the
60-day period after May 15, 2004 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. 146




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##### 



(5)
    
    Based on the Schedule 13G/A filed by Brown Capital Management, Inc.
with the SEC on February 11, 2004. The address of Brown Capital
Management, Inc. is 1201 N. Calvert Street, Baltimore, Maryland 21202.
This Schedule 13G/A indicates that Brown Capital Management, Inc. has
sole dispositive power for 4,495,150 shares and sole voting power for
2,516,145 shares.(6)
    
    Goldman, Sachs & Co. is a wholly-owned, direct and indirect,
subsidiary of The Goldman Sachs Group, Inc. Goldman, Sachs, an 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. The Goldman Sachs Group and
Goldman, Sachs may be deemed to own beneficially and indirectly in the
aggregate 3,415,249 shares of aaiPharmas common stock through certain
investment partnerships of which affiliates of Goldman, Sachs and The
Goldman Sachs Group are the general partner, managing general partner
or managing partner. Each investment partnership shares voting and
dispositive power with respect to its shares with The Goldman Sachs
Group, Goldman, Sachs and certain of their affiliates. Goldman, Sachs
is the investment manager of one or more of the investment
partnerships. The address of Goldman, Sachs is 85 Broad Street, New
York, New York 10004.(7)
    
    Includes 659,207 shares of common stock beneficially owned by Mr.
Waters spouse and 46,275 shares owned by the Waters Foundation.
Mr. Waters and his spouse are the only trustees of the Waters
Foundation. Mr. Waters address is 47 New York Avenue, Framingham,
Massachusetts 01701.(8)
    
    Based on Schedule 13G filed by Royce & Associates, LLC with the
SEC 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.(9)
    
    Based on the Schedule 13G filed with the SEC on February 20, 2004
by Arnold H. Snider, Deerfield Capital, L.P., Deerfield Partners LP,
Deerfield Management Company and Deerfield International Limited. Mr.
Sniders address is 780 Third Avenue, 37th Floor, New York, NY 10017.
This Schedule 13G indicates that Mr. Snider has shared dispositive
power for 1,780,000 shares and shared voting power for 1,780,000 shares.(10)
    
    Mr. Gleberman, a managing director of Goldman, Sachs, disclaims
beneficial ownership of the 3,415,249 shares that may be deemed
beneficially owned by The Goldman Sachs Group as described in note (6)
above. Mr. Gleberman, a managing director of Goldman, Sachs, disclaims beneficial
ownership of the securities reported herein except to the extent of his
pecuniary interest therein, if any.(11)
    
    Includes 1,387 shares owned by Mr. Underwoods children. 147




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##### 



Equity Compensation Plan Information The following table sets forth the aggregate number of options issued and
available for issuance as of December 31, 2003 and the weighted average
exercise price of the outstanding options in each case. Number of securities to be
    
    Weighted averageissued upon exercise of
    
    exercise price of
    
    Number of securitiesoutstanding options,
    
    outstanding options,
    
    remaining available forPlan Category
    
    warrants and rights
    
    warrants and rights
    
    future issuanceEquity compensation
plans approved by
security holders
    
    
    6,426,854
    
    
    $
    12.27
    
    
    
    1,031,587Equity compensation
plans not approved
by security holders
    
    
    0
    
    
    
    0
    
    
    
    0TOTAL
    
    
    6,426,854
    
    
    $
    12.27
    
    
    
    1,031,587
 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 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 148




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##### 



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 continued through April 2004. In the fourth
quarter of 2003, Endeavor sold
substantially all of its assets to Barr Laboratories, Inc. As part of this
transaction, we recorded a pretax gain of $1.8 million for the sale of our
investment in Endeavor. Also in December 2003, Endeavor filed articles of
dissolution with the Delaware Secretary of State. Pursuant to our product development and supply agreements with Endeavor, we had
net sales to Endeavor of approximately $0.6 million in 2003, $1.1 million in
2002 and $0.2 million in 2001. These amounts were charged at our commercial
rates similar to those charged to other clients. At December 31, 2003, we had
no related accounts receivable and at December 31, 2002, we had $0.3 million in
related accounts receivable. 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, 2003: Dr. Sancilio, 3.7%, Mr. Waters,
9.4% (including shares owned by his spouse and the Waters Foundation) and Mr. Underwood,
0.3%. In addition, the Goldman Sachs investment partnerships own 1.8% of the
fully diluted common equity of Aesgen as of December 31, 2003. In January 2001,
the terms of the nonconvertible, 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 Development
Services, in exchange for up to $1.1 million of Aesgen convertible preferred
stock. Through December 31, 149




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##### 



2003, the Company had performed $580,000 of
services under the agreement. As of December 31, 2003, we owned 10.0% of the
common equity of Aesgen on a fully diluted basis. We do not anticipate
performing any additional services for Aesgen under this agreement. 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. In 2003, 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
market this product as an extension of the Aquasol product line. Under this
agreement, we are obligated to pay royalty payments for the eight-year period
following the first commercial sale of this product. In 2003, we expensed
royalties related to this agreement of $0.6 million. Of this amount, none was
payable at December 31, 2003. We recognized net revenues of zero, $494,000 and $86,000 from Aesgen in 2003,
2002, and 2001, respectively and we had no accounts receivable or work in
progress at December 31, 2003 or 2002. 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, 2003, no
options were outstanding to acquire shares of our common stock under our 1995
Stock Option Plan. We acquired 4,202 shares in 2003 for $23,388 from Mr.
Waters,
no shares in 2002 and 39,198 shares in 2001 for $218,202, and we acquired 5,715
shares in 2003 for $28,590 from Dr. Sancilio, no shares in 2002 and 47,910
shares in 2001 for $266,699. 150




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##### 



Item 14. Principal Accountant Fees and Services Fees Paid to Independent Auditors Audit Fees The
Company has incurred fees of $884,921 and $1,905,870 in 2002 and 2003,
respectively, for services rendered for the audits of the
Companys consolidated financial statements including restatement of
previously issued financial statements, timely reviews of Forms 10-Q,
consents, issuance of comfort letters,
assistance with review of documents filed with the SEC and statutory audits of
various international
subsidiaries. Audit-Related Fees The
Company has been billed $330,921 and $451,873 for services rendered in 2002 and 2003,
respectively, for accounting consultations and due diligence related to
acquisitions, assistance with internal control reporting requirements, audit services
concerning the Companys 401k plan, and various audit related
consultations concerning financial accounting and reporting standards. Tax Fees Aggregate fees billed for all tax compliance, tax advice and tax planning
services rendered in 2002 and 2003 are $378,657 and
$722,795. These fees are primarily for services rendered in the areas of international
tax planning, transfer pricing consultation, research and
development tax credits, state and local tax preparation
assistance, tax compliance and general tax consulting. All Other Fees No
other fees were paid to our independent auditors in 2002 and 2003. Pre-approval Policy On January 29, 2003, the Audit Committee of our Board of Directors adopted the
policy described below regarding the pre-approval of all audit and permissible
non-audit services provided by the independent auditor after such date. Prior
to engagement of the independent auditor for the next years audit, management
is required to submit an aggregate of services expected to be rendered during that
year for each of the four categories of services listed below to the audit
committee for approval.  
    
    Audit services, which include audit work performed in the
preparation of financial statements, as well as work that generally
only the independent auditor can reasonably be expected to provide,
including comfort letters, statutory audits, and attest services and
consultation regarding financial accounting and/or reporting standards.  
    
    Audit-related services for assurance and related services that are
traditionally performed by the independent auditor, such as due
diligence related to mergers and acquisitions, employee benefit plan
audits, and special procedures required to meet certain regulatory
requirements.
    
    Tax services, which include services performed by the independent
auditors tax personnel other than services specifically related to the
audit of the financial statements, such as tax compliance, tax
planning, and tax advice. 151




---



##### 




    
    Other services, which include services not captured in the other
categories. Prior to engagement, the Audit Committee pre-approves these services by
category of service. The fees are budgeted and the Audit Committee requires the
independent auditor and management to report actual fees versus the budget
periodically throughout the year by category of service. During the year,
circumstances may arise that make it necessary to engage the independent
auditor for additional services not contemplated in the original pre-approval.
In those instances, the Audit Committee requires specific pre-approval of the
services before engaging the independent auditor. The audit committee may delegate pre-approval authority to one or more of its
members. The member to whom such authority is delegated must report, for
informational purposes only, any pre-approval decisions to the Audit Committee
at its next scheduled meeting. 152




---



##### 



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 2003, we furnished the following current
reports on Form 8-K:  
    
    dated October 3, 2003, to furnish a press release announcing financial
results for the period ended September 30, 2003 and the execution of
agreements to acquire a portfolio of pain management products from
Elan Corporation, plc.  
    
    dated December 15, 2003, to furnish a press release announcing the
completion of the previously announced acquisition from Elan
Pharmaceuticals, Inc. and Elan Pharma Limited of the U.S. and U.S.
territorial rights and related intangibles associated with the
Roxicodone, Oramorph SR, Roxanol and Duraclon. (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. 153




---



##### 



SCHEDULE II aaiPharma Inc. VALUATION AND QUALIFYING ACCOUNTS (In thousands) Balance at
    
    Charged to
    
    Charged to
    
    
    
    
    
    
    
    
    
    
    
    
    
    Balance atBeginning
    
    Costs and
    
    Other
    
    
    
    
    
    
    
    
    
    
    
    End ofDescription
    
    of Period
    
    Expenses
    
    Accounts
    
    
    
    
    
    Deductions
    
    
    
    
    
    PeriodAllowance for doubtful
accounts2001
    
    $
    829
    
    
    $
    970
    
    
    $
    268
    (2
    )
    
    
    
    
    $
    (1,023
    )
    (1
    )
    
    
    
    $
    1,0442002
    
    
    1,044
    
    
    
    1,294
    
    
    
    
    
    
    
    
    
    
    
    (670
    )
    (1
    )
    
    
    
    
    1,6682003
    
    
    1,668
    
    
    
    1,181
    
    
    
    
    
    
    
    
    
    
    
    (1,871
    )
    (1
    )
    
    
    
    
    978Product inventory
obsolescence reserves2001
    
    
    
    
    
    
    281
    
    
    
    
    
    
    
    
    
    
    
    (81
    )
    (3
    )
    
    
    
    
    2002002
    
    
    200
    
    
    
    526
    
    
    
    
    
    
    
    
    
    
    
    (5
    )
    (3
    )
    
    
    
    
    7212003
    
    
    721
    
    
    
    11,688
    
    
    
    
    
    
    
    
    
    
    
    (1,650
    )
    (3
    )
    
    
    
    
    10,759Tax asset valuation
allowances2001
    
    
    2,520
    
    
    
    129
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,6492002 (as
restated)
    
    
    2,649
    
    
    
    362
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,0112003
    
    
    3,011
    
    
    
    11,185
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    14,196
    (1)
    
    Represents amounts written off as uncollectible accounts receivable(2)
    
    Represents allowance on accounts assumed in acquisition(3)
    
    Represents amounts disposed 154




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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 and
Chief Executive Officer
    
    June 15, 2004
 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.
    
    Executive Chairman of the Board,
    
    June 15, 2004Chief Executive Officer and DirectorFrederick D. Sancilio, Ph.D./s/ Gina Gutzeit
    
    Interim Chief
    
    June 15, 2004Financial OfficerGina Gutzeit/s/ John D. Hogan
    
    Vice President and Controller
    
    June 15, 2004(Principal Accounting Officer)John D. Hogan/s/ William H. Underwood
    
    Executive Vice President and Director
    
    June 15, 2004William
H. Underwood/s/
Timothy R. Wright
    
    Executive Vice President and Director
    
    June 15, 2004Timothy
R. Wright/s/ John E. Avery
    
    Director
    
    June 15, 2004John E. Avery/s/ Joseph H. Gleberman
    
    Director
    
    June 15, 2004Joseph H. Gleberman/s/ Kurt M. Landgraf
    
    Director
    
    June 15, 2004Kurt M. Landgraf/s/ James G. Martin
    
    Director
    
    June 15, 2004James G. Martin, Ph.D./s/ Richard G. Morrison
    
    Director
    
    June 15, 2004Richard G. Morrison, Ph.D./s/ John M. Ryan
    
    Director
    
    June 15, 2004John M. Ryan/s/ James L. Waters
    
    Director
    
    June 15, 2004James L. Waters
 155




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##### 



aaiPharma Inc.
Exhibit Index ExhibitNumber
    

Description
 3.1
    
    Amended and Restated Certificate of Incorporation of the Company, and
amendments thereto (incorporated by reference to Exhibit 3.1 to the
Companys Quarterly Report on Form 10-Q for the quarter ended June 30,
2003)3.2
    
    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))4.4
    
    Indenture (which includes the form of 11% senior subordinate note due
2010) dated as of March 28, 2002 between the Company, certain of its
subsidiaries as guarantors and Wachovia Bank, National Association
(formerly, 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) filed with the SEC on April 5, 2002)4.5
    
    First Supplemental Indenture, dated as of April 20, 2004, among the
Company, certain of its subsidiaries as guarantor parties thereto and
Wachovia Bank, National Association (formerly, First Union National Bank),
as Trustee (incorporated by reference to Exhibit 99.4 to the Companys
Current Report on Form 8-K filed with the SEC on April 27, 2004)4.6
    
    Security Agreement, dated as of April 23, 2004, made by the Company and
certain subsidiaries of the Company as grantors in favor of Wachovia Bank,
National Association, in its capacity as collateral agent for the holders
of the Companys 11% Senior Subordinated Notes due 2010 (incorporated by
reference to Exhibit 99.5 to the Companys Current Report on Form 8-K
filed with the SEC on April 27, 2004)4.7
    
    Pledge and Security Agreement, dated as of April 23, 2004, made by the
Company and certain subsidiaries of the Company as pledgors in favor of
Wachovia Bank, National Association, in its capacity as collateral agent
for the holders of the 156




---



##### 



Companys 11% Senior Subordinated Notes due 2010 (incorporated by
reference to Exhibit 99.6 to the Companys Current Report on Form 8-K
filed with the SEC on April 27, 2004)10.1
    
    Amended and Restated Employment Agreement dated January 1, 2003 between
the Company and Frederick D. Sancilio (incorporated by reference to
Exhibit 10.1 to the Companys Quarterly Report on Form 10-Q for the period
ended June 30, 2003)*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. 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)*10.4
    
    Applied Analytical Industries, Inc. 1997 Stock Option Plan, as amended,
(incorporated by reference to Exhibit 10.2 to the Companys Quarterly
Report on Form 10-Q for the period ended June 30, 2003)*10.5
    
    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))10.6
    
    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))10.7
    
    Registration Rights 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
10.16 to the Companys Registration Statement on Form S-1 (Registration
No. 333-5535))10.8
    
    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 157




---



##### 



reference to Exhibit 10.17 to the Companys Quarterly Report on Form
10-Q for the quarter ended September 30, 1996)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)10.10
    
    First Amendment to Asset Purchase Agreement dated as of July 22, 2003
between aaiPharma LLC (formerly, NeoSan Pharmaceuticals Inc.) and
AstraZeneca AB (incorporated by reference to Exhibit 10.2 to the Companys
Quarterly Report on Form 10-Q for the period ended September 30, 2003)10.11
    
    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 January 22,
2002)10.12
    
    First Amendment to Interim Supply Agreement dated as of July 22, 2003
between aaiPharma LLC (formerly, NeoSan Pharmaceuticals Inc.) and
AstraZeneca L.P. (incorporated by reference to Exhibit 10.1 to the
Companys Quarterly Report on Form 10-Q for the period ended September 30,
2003)10.13
    
    Asset Purchase Agreement dated as of December 13, 2001 between NeoSan
Pharmaceuticals Inc., Novartis Pharmaceuticals Corporation and Novartis
Corporation (incorporated by reference to Exhibit 2.3 to the Companys
Current Report on Form 8-K dated January 22, 2002)10.14
    
    Interim Supply Agreement dated as of December 13, 2001 between NeoSan
Pharmaceuticals Inc. and Novartis Pharmaceuticals Corporation
(incorporated by reference to Exhibit 2.3 to the Companys Current Report
on Form 8-K dated January 22, 2002)10.15
    
    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)10.16
    
    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)10.17
    
    Asset Purchase Agreement dated as of October 22, 2003 by and among
aaiPharma Inc., Elan Pharma International Limited and Elan
Pharmaceuticals, Inc. (incorporated by reference to Exhibit 2.1 to the Companys Current
Report on Form 8-K dated December 12, 2003) 158




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10.18
    
    Roxanne Assignment and Assumption Agreement dated as of October 22, 2003
by and among aaiPharma Inc., Elan Pharma International Limited, Elan
Pharmaceuticals, Inc., Elan Corporation, plc, Roxane Laboratories, Inc.
and Boehringer Ingelheim Corporation (incorporated by reference to Exhibit
2.2 to the Companys Current Report on Form 8-K dated December 12, 2003)10.19
    
    First Amendment to Manufacturing Agreement dated as of December 2, 2003
by and between Elan Pharma International Limited and Roxane Laboratories,
Inc. (incorporated by reference to Exhibit 2.3 to the Companys Current
Report on Form 8-K dated December 12, 2003)10.20
    
    Asset Purchase Agreement dated as of July 16, 2003 by and among
aaiPharma Inc. and Athlon Pharmaceuticals, Inc.10.21
    
    Service Agreement dated as of July 16, 2003 by and among aaiPharma Inc.
and Athlon Pharmaceuticals, Inc.10.22
    
    Manufacturing and Supply Agreement dated as of July 16, 2003 by and
between aaiPharma Inc. and Mikart, Inc.10.23
    
    First Amendment to Manufacturing and Supply Agreement dated as of May
13, 2004 between aaiPharma Inc. and Mikart, Inc.10.24
    
    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)10.25
    
    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)10.26
    
    Asset Purchase Agreement dated as of February 27, 2004, among aaiPharma
Inc., a Delaware corporation, aaiPharma LLC, a Delaware limited liability
company, AAI Properties, Inc., a North Carolina corporation and Mayne
Pharma (USA) Inc., a Delaware corporation (incorporated by reference to
Exhibit 2.1 to the Companys Current Report on Form 8-K dated May 7, 2004)10.27
    
    Amendment No. 1 to Asset Purchase Agreement dated as of April 22, 2004,
among aaiPharma Inc., a Delaware corporation, aaiPharma LLC, a Delaware
limited liability company, AAI Properties, Inc., a North Carolina
corporation and Mayne Pharma (USA) Inc., a Delaware corporation
(incorporated by reference to Exhibit 2.2 to the Companys Current Report
on Form 8-K dated May 7, 2004) 159




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10.28
    
    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))10.29
    
    First Amendment to Credit Agreement dated as of December 1, 2003 between
aaiPharma Inc., certain subsidiaries of aaiPharma Inc., the lenders party
thereto, and Bank of America, N.A., as administrative agent (incorporated
by reference to Exhibit 10.1 to the Companys Current Report on Form 8-K
dated December 12, 2003)10.30
    
    Financing Agreement (the Financing Agreement), dated as of April 23,
2004, by and among the Company and certain subsidiaries of the Company as
borrowers, the financial institutions from time to time party thereto as
lenders, Silver Point Finance, LLC, as collateral agent, and Bank of
America, N.A., as administrative agent (incorporated by reference to
Exhibit 99.1 to the Companys Current Report on Form 8-K dated April 27,
2004)10.31
    
    Security Agreement, dated April 23, 2004, made by the Company and
certain subsidiaries of the Company as grantors in favor of Silver Point
Finance, LLC, as collateral agent, and the lenders party to the Financing
Agreement (incorporated by reference to Exhibit 99.2 to the Companys
Current Report on Form 8-K dated April 27, 2004)10.32
    
    Pledge and Security Agreement, dated April 23, 2004, made by the Company
and certain subsidiaries of the Company as pledgors in favor of Silver
Point Finance, LLC, as collateral agent, and the lenders party to the
Financing Agreement (incorporated by reference to Exhibit 99.3 to the
Companys Current Report on Form 8-K dated April 27, 2004)10.33
    
    Intercreditor Agreement, dated as of April 23, 2004, among Silver Point
Finance, LLC, as senior collateral agent, Wachovia Bank, National
Association, as noteholder collateral agent, and the Company (incorporated
by reference to Exhibit 99.7 to the Companys Current Report on Form 8-K
dated April 27, 2004)18
    
    Letter regarding change in accounting policy21
    
    Subsidiaries of aaiPharma Inc. (incorporated by reference to Exhibit 21
to the Companys Annual Report on Form 10-K for the year ended December
31, 2002)23
    
    Consent of Ernst & Young LLP31.1
    
    Certification pursuant to Exchange Act Rule 13a  14(a) of Frederick D. Sancilio31.2
    
    Certification pursuant to Exchange Act Rule 13a  14(a) of Gina Gutzeit 160




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32
    
    Certification Pursuant to 18 U.S.C. Section 1350   * Management contract or compensatory plan required to be filed under Item
15(c) of this report and Item 601 of Regulation S-K of the SEC. 161