##### 



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549
 FORM 10-Q x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2005 o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the transition period _______ to _______ Commission File Number 0-21185 AAIPHARMA INC.  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 office)                       (Zip code) (910) 254-7000
(Registrants telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed
by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or
for such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days.      Yes þ      No o Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act
Rule 12b-2)      Yes þ      No o The number of shares of the registrants common stock outstanding as of April 1, 2005 was
28,585,582 shares.




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##### 



The terms we, us or our in this Form 10-Q 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. 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. At March 31, 2005, we owned the following registered and unregistered trademarks referenced herein:
Darvocet®, Darvon®, Darvon-N®, Darvocet-N®, Darvocet A500, Brethine®, ProSorb-D, Lynxorb,
Oramorph® SR, Roxicodone®, AzaSan®, aaiPharma® and AAI®. 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, collectively. We also reference trademarks owned by other
companies. M.V.I.®, M.V.I.-12®, M.V.I. Pediatric®, M.V.I. Adult, Aquasol®, Aquasol A® and Aquasol
E® are registered and unregistered trademarks owned by Mayne Pharma (USA) Inc. Prilosec® is a
registered trademark owned by AstraZeneca. Unless the context otherwise requires, references to
M.V.I. are to M.V.I.-12®, M.V.I. Pediatric® and M.V.I. Adult, collectively, and references to
Aquasol are to Aquasol A® and Aquasol E®, collectively. Duraclon® is a registered trademark owned
by Fujisawa Healthcare, Inc. and licensed to us. 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. aaiPharma Inc.
Table of Contents Page No.PART I.
    
    FINANCIAL INFORMATIONItem 1.
    
    Financial Statements(unaudited)Consolidated Statements of Operations
    
    
    3Consolidated Balance Sheets
    
    
    5Consolidated Statements of Cash Flows
    
    
    6Consolidated Statements of Comprehensive Loss
    
    
    8Notes to Consolidated Financial Statements
    
    
    9Item 2.
    
    Managements Discussion and Analysis of Financial
Condition and Results of Operations
    
    
    33Item 3.
    
    Quantitative and Qualitative Disclosures About
Market Risk
    
    
    51Item 4.
    
    Controls and Procedures
    
    
    51PART II.
    
    OTHER INFORMATIONItem 1.
    
    Legal ProceedingsItem 2.
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    53Item 3.
    
    Defaults Upon Senior Securities
    
    
    54Item 6.
    
    Exhibits
    
    
    55SIGNATURESEXHIBIT INDEX
 2




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##### 



PART I. FINANCIAL INFORMATION
Item 1. Financial Statements. aaiPharma Inc.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited) Three Months EndedMarch 31,2005
    
    
    2004Net revenues:Product sales
    
    $
    16,166
    
    
    $
    24,433Product development (milestones and royalties)
    
    
    4,005
    
    
    
    4,915Development services
    
    
    20,068
    
    
    
    24,894Reimbursed out-of-pocket
    
    
    3,226
    
    
    
    4,24543,465
    
    
    
    58,487Operating costs and expenses:Direct costs (excluding depreciation and royalty expense):Product sales (includes product rights amortization of $2,619 and $3,972)
    
    
    8,039
    
    
    
    14,147Development services
    
    
    13,030
    
    
    
    14,748Reimbursable out-of-pocket
    
    
    3,226
    
    
    
    4,245Total direct costs
    
    
    24,295
    
    
    
    33,140Selling expenses
    
    
    1,804
    
    
    
    13,027General and administrative expenses
    
    
    10,285
    
    
    
    13,140Research and development
    
    
    1,687
    
    
    
    6,407Depreciation
    
    
    2,207
    
    
    
    2,012Professional fees  internal and government investigations
    
    
    299
    
    
    
    3,200Professional fees  debt restructuring
    
    
    1,553
    
    
    
    M.V.I. contingent payment
    
    
    
    
    
    
    31,001Royalty expenses
    
    
    101
    
    
    
    500Total operating costs and expenses
    
    
    42,231
    
    
    
    102,427Income (loss) from operations
    
    
    1,234
    
    
    
    (43,940
    )Other income (expense):Interest expense, net
    
    
    (11,379
    )
    
    
    (5,645
    )Other
    
    
    (398
    )
    
    
    19(11,777
    )
    
    
    (5,626
    )
 3




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##### 



Loss before income taxes
    
    
    (10,543
    )
    
    
    (49,566
    )Provision for income taxes
    
    
    46
    
    
    
    6Net loss
    
    $
    (10,589
    )
    
    $
    (49,572
    )Basic and diluted loss per share
    
    $
    (0.37
    )
    
    $
    (1.74
    )Weighted average shares outstanding
    
    
    28,586
    
    
    
    28,502
 The accompanying notes are an integral part of these financial statements. 4




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##### 



aaiPharma Inc.
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data) March 31, 2005
    
    
    December 31, 2004(Unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    12,367
    
    
    $
    7,130Accounts receivable, net
    
    
    13,954
    
    
    
    12,756Work-in-progress
    
    
    9,334
    
    
    
    10,172Inventories, net
    
    
    8,173
    
    
    
    10,722Income taxes recoverable
    
    
    
    
    
    
    11,110Prepaid and other current assets
    
    
    12,323
    
    
    
    13,810Total current assets
    
    
    56,151
    
    
    
    65,700Property and equipment, net
    
    
    50,741
    
    
    
    52,942Goodwill, net
    
    
    13,689
    
    
    
    14,350Intangible assets, net
    
    
    187,509
    
    
    
    190,099Other assets
    
    
    15,233
    
    
    
    15,979Total assets
    
    $
    323,323
    
    
    $
    339,070LIABILITIES AND STOCKHOLDERS EQUITY (DEFICIT)Current liabilities:Current maturities of long-term debt
    
    $
    351,591
    
    
    $
    351,645Accounts payable
    
    
    17,244
    
    
    
    22,031Customer advances
    
    
    12,758
    
    
    
    11,043Accrued wages and benefits
    
    
    5,422
    
    
    
    4,881Interest payable
    
    
    12,244
    
    
    
    5,738Deferred product revenue
    
    
    2,341
    
    
    
    4,127Other accrued liabilities
    
    
    45,093
    
    
    
    51,481Total current liabilities
    
    
    446,693
    
    
    
    450,946Other liabilities
    
    
    9
    
    
    
    14Stockholders equity (deficit):Common stock
    
    
    29
    
    
    
    29Paid-in capital
    
    
    91,425
    
    
    
    91,425Accumulated deficit
    
    
    (218,067
    )
    
    
    (207,478
    )Accumulated other comprehensive income
    
    
    3,372
    
    
    
    4,398Deferred compensation
    
    
    (138
    )
    
    
    (264
    )Total stockholders equity (deficit)
    
    
    (123,379
    )
    
    
    (111,890
    )Total liabilities and stockholders equity (deficit)
    
    $
    323,323
    
    
    $
    339,070
 The accompanying notes are an integral part of these financial statements. 5




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##### 



aaiPharma Inc.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited) Three Months EndedMarch 31,2005
    
    
    2004Cash flows from operating activities:Net loss
    
    $
    (10,589
    )
    
    $
    (49,572
    )Adjustments to reconcile net loss to
net cash provided by operating activities:Depreciation and amortization
    
    
    4,826
    
    
    
    5,984Noncash stock based compensation
    
    
    126
    
    
    
    23Loss on disposal of assets and other
    
    
    926
    
    
    
    78Changes in operating assets and liabilities:Accounts receivable, net
    
    
    (1,340
    )
    
    
    32,475Work-in-progress
    
    
    317
    
    
    
    (841
    )Inventories
    
    
    2,474
    
    
    
    (3,452
    )Income taxes recoverable
    
    
    11,110
    
    
    
    Prepaid and other assets
    
    
    2,215
    
    
    
    2,172Accounts payable
    
    
    (4,686
    )
    
    
    1,772Customer advances
    
    
    2,043
    
    
    
    (1,892
    )Accrued wages and benefits
    
    
    613
    
    
    
    2,051Interest payable
    
    
    6,506
    
    
    
    4,700Deferred product revenue
    
    
    (1,786
    )
    
    
    (7,803
    )Other accrued liabilities
    
    
    (6,231
    )
    
    
    26,083Net cash provided by operating activities
    
    
    6,524
    
    
    
    11,778Cash flows from investing activities:Purchases of property and equipment
    
    
    (1,109
    )
    
    
    (2,572
    )Other
    
    
    (75
    )
    
    
    (60
    )Net cash used in investing activities
    
    
    (1,184
    )
    
    
    (2,632
    )Cash flows from financing activities:Payments on long-term borrowings
    
    
    
    
    
    
    (10,170
    )Payments on interest rate swaps, net
    
    
    (90
    )
    
    
    (488
    )Proceeds from stock option exercises
    
    
    
    
    
    
    3,573Other
    
    
    (4
    )
    
    
    (308
    )Net cash used in financing activities
    
    
    (94
    )
    
    
    (7,393
    )Net increase in cash and cash equivalents
    
    
    5,246
    
    
    
    1,753Effect of exchange rate changes on cash
    
    
    (9
    )
    
    
    (12
    )Cash and cash equivalents, beginning of period
    
    
    7,130
    
    
    
    8,785Cash and cash equivalents, end of period
    
    $
    12,367
    
    
    $
    10,526
 6




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##### 



Supplemental information, cash paid for:Interest
    
    $
    3,449
    
    
    $
    1,687Income taxes (refunds)
    
    $
    (11,220
    )
    
    $
    10,145
 The accompanying notes are an integral part of these financial statements. 7




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##### 



aaiPharma Inc.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(In thousands)
(Unaudited) Three Months Ended March 31,2005
    
    
    2004Net loss
    
    $
    (10,589
    )
    
    $
    (49,572
    )Currency translation adjustments, net of tax
    
    
    (1,026
    )
    
    
    (820
    )Comprehensive loss
    
    $
    (11,615
    )
    
    $
    (50,392
    )
 The accompanying notes are an integral part of these financial statements. 8




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##### 



aaiPharma Inc.
Notes to Consolidated Financial Statements
(Unaudited) 1. Basis of presentation and other matters aaiPharma Inc. (aaiPharma or the Company) is a science-based company with corporate
headquarters in Wilmington, North Carolina with over 25 years experience in drug development. The
Company sells branded pharmaceutical products, including the Darvon and Darvocet product lines,
primarily in the area of pain management. The Company also offers comprehensive drug development
services to the pharmaceutical, biotechnology, generic and device industries through its
development services division. The accompanying unaudited consolidated financial statements have
been prepared in accordance with accounting principles generally accepted in the United States and
applicable Securities and Exchange Commission (the SEC) regulations for interim financial
information. These financial statements do not include all of the information and footnotes
required by accounting principles generally accepted in the United States for annual financial
statements. The consolidated financial information as of December 31, 2004 has been derived from
audited financial statements; certain amounts from the three months ended March 31, 2004 have been
reclassified for consistent presentation with current year financial statements. It is presumed
that users of this interim financial information have read or have access to the audited financial
statements for the preceding fiscal year, which were included in the
Companys Annual Report on Form 10-K for the year ended
December 31, 2004 (the 2004
Form 10-K). In the opinion of
management, all adjustments (consisting of normal recurring adjustments) considered necessary for
fair presentation have been included in these interim financial statements. Operating results for
the interim periods presented are not necessarily indicative of the results that may be expected
for the full year. 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.
Actual results could differ from such estimates and changes in such estimates may affect amounts
reported in future periods. The Company applies Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees (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. Under
APB 25, if the exercise price of the Companys stock options is not less than the estimated fair
market value of the underlying stock on the date of grant, no compensation expense is recognized.
If compensation cost for the Companys plans had been determined based on the fair value at the
grant dates for awards under those plans consistent with the fair value method of Statement of
Financial Accounting Standards No. 123 Accounting for Stock Based Compensation (SFAS 123"), the
Companys net income (loss) and income (loss) per share would have been changed to the pro forma
amounts indicated below: Three Months Ended March 31,2005
    
    
    2004(In thousands, except per share data)Net loss, as reported
    
    $
    (10,589
    )
    
    $
    (49,572
    )Add back deferred compensation expense, net of tax
    
    
    76
    
    
    
    14Less pro forma stock-based compensation cost, net of tax
    
    
    (1,081
    )
    
    
    (3,081
    )Pro forma net loss
    
    $
    (11,594
    )
    
    $
    (52,639
    )
 9




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##### 



Loss per share:As reported -Basic and diluted
    
    
    ($0.37
    )
    
    
    ($1.74
    )Pro forma -Basic and diluted
    
    
    ($0.41
    )
    
    
    ($1.85
    )
 Going Concern The Company incurred a substantial net loss and loss from operations for 2004 and a substantial net
loss for the quarter ended March 31, 2005. The Companys results of operations have continued to
deteriorate as customer concerns regarding its financial condition have affected sales of the
Companys pharmaceutical products as well as the Companys ability to obtain and maintain
development services engagements. As a result of the Companys substantial and recurring net losses, the Company believes that it
does not have adequate sources of liquidity to fund operations in the near term unless the Company
obtains additional sources of liquidity. Because the Company did not make the $10.5 million
scheduled interest payment due on April 1, 2005 on its senior subordinated notes within 30 days
after April 1, holders of 25% of the notes or the trustee under the indenture governing the notes
may accelerate the notes. The ability of the holders of the notes or the trustee to accelerate the
notes is an event of default under the Companys senior credit facilities, entitling the lenders to
accelerate the debt thereunder. In addition, the Company was in default of certain covenants under
the senior credit facilities on March 31, 2005. In light of its current financial condition, the Company believes that its operations can no longer
support its existing debt and that the Company must restructure its debt to levels that are more in
line with its operations. Thus, it is highly likely that the Company and its U.S. subsidiaries
will seek relief under chapter 11 of Title 11 of the U.S. Code (the Bankruptcy Code) which would
substantially dilute and may eliminate the interests of the holders of the Companys common stock.
On April 29, 2005, the Company accepted a commitment letter from Silver Point Finance, LLC to
provide debtor-in-possession financing if the Company and its U.S.
subsidiaries commence bankruptcy proceedings under the
Bankruptcy Code. This debtor-in-possession financing would be subject to a number of conditions,
including approval by the bankruptcy court. See Note 10 and Managements Discussion and Analysis
of Financial Condition and Results of Operations  Liquidity and Capital Resources. These conditions raise substantial doubt about the Companys ability to continue as a going
concern. The accompanying consolidated financial statements do not include any adjustments to
reflect the possible future effects on the recoverability and classification of assets or the
amounts and classifications of liabilities that may result from the outcome of this uncertainty. Because of the defaults under the Companys senior credit facilities and the senior subordinated
notes at March 31, 2005, all $350.5 million of debt under the Companys senior credit facilities
and the notes was classified as current liabilities on the Companys consolidated balance sheet at
March 31, 2005. Impact of Recently Issued Accounting Standards In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting
Standards No. 123 (revised 2004), Share-Based
Payment (SFAS 123(R)), which amends SFAS 123, and
supersedes APB 25, Accounting for Stock Issued
to Employees. SFAS 123(R) requires
compensation expense to be recognized for all share-based payments made to employees based on the
fair value of the award at the date of grant, eliminating the intrinsic value alternative allowed
by SFAS 123. SFAS 123(R) requires all share-based payments to employees, including grants of
employee stock options, to be recognized in 10




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##### 



the financial statements based on their fair values
(i.e., pro forma disclosure is no longer an alternative to financial statement recognition). SFAS
123(R) must be adopted in the first annual period beginning after June 15, 2005. The Company currently plans
to adopt SFAS 123(R) on January 1, 2006. This change in accounting is
not expected to materially impact the Companys financial position. However, because the Company
currently accounts for share-based payments to its employees under APB No. 25, the results of
operations have not included the recognition of compensation expense for the issuance of stock
option awards. Had the Company applied the fair-value criteria
established by SFAS 123(R) to
previous stock option grants, the impact to its results of operations would have approximated the
impact of applying SFAS 123, which was a reduction to net income of approximately $1.1 million and
$3.1 million in the three months ended March 31, 2005 and 2004, respectively. No other recently issued, but not yet effective, accounting standards are believed to have a
material impact on the Company. 2. M.V.I. and Aquasol Product Line Sale and Contingent Payment 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 certain 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 was held
in escrow to satisfy post-closing obligations under the agreement. The Company received
approximately $1.6 million from this escrow in September 2004 and does not anticipate receiving any
additional payments out of this escrow. The M.V.I. and Aquasol Sale resulted in a preliminary gain
of $37.5 million that the Company recorded in the second quarter of 2004. The gain on the sale was
based on the net cash received from the sale less the book value of the intangible assets,
inventories and other items related to the product lines sold. The Companys M.V.I. and Aquasol product line acquisition agreement with AstraZeneca AB, as
amended, 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. 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. The Company recorded this expense in the first quarter of 2004. As a result of an
amendment to the original acquisition agreement, the Company was precluded from recognizing this
obligation (the M.V.I. Contingent Payment) as additional purchase price for the M.V.I. and
Aquasol product lines; therefore, this adjustment was expensed in the first quarter of 2004. As
discussed above, the Company sold its M.V.I. and Aquasol product lines on April 26, 2004.
Concurrently with the closing of the M.V.I. and Aquasol Sale on April 26, 2004, the Company paid to AstraZeneca AB
the M.V.I. Contingent Payment, which was discounted to approximately $31.0 million as a result of
the early payment. 3. Income taxes The Company recorded no net federal income tax benefit or expense in the first quarter of 2005,
primarily as a result of current period net loss before taxes. Any tax benefit would be offset by
a valuation allowance for the entire amount because it is more likely than not that the deferred
tax asset resulting from this benefit will not be realized. 11




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##### 



4. Loss per share Basic loss per share is based on the weighted average number of common shares outstanding during
the year. Diluted loss 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. During the three months ended March 31, 2004, approximately 360,000 options were
exercised for aggregate proceeds to the Company of $3.6 million. No options were exercised in the
three months ended March 31, 2005. In the three months ended March 31, 2005 and 2004, 5.9 million
and 2.0 million options, respectively, which were all of the outstanding options, were excluded as
they were anti-dilutive. In each period presented, each of the net loss (the numerator) and the
weighted average number of common shares (the denominator) is the same for both basic and diluted
per share computations. 5. Financial information by business segment and geographic area In 2004 and the first quarter of 2005, the Company operated 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. 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. In late March 2005, the Company reorganized its operating structure to reflect the Companys
decision to curtail its research and development activities in light of its financial condition.
At that time, the Companys Research and Development Division was no longer actively engaged in any
shared-risk development projects. Personnel involved in the development of proprietary products
were assigned to the Companys Pharmaceuticals Division, while personnel who had focused on
independent research or shared-risk development projects were assigned to fee-for-service
development projects in the Companys AAI Development Services Division. As a result of this
reorganization of the operating structure, the Company began operating in only two business
segments in April 2005  proprietary pharmaceutical product development and sales through the
Pharmaceuticals Division and development services offered to third parties
through the AAI Development Services Division. The majority of the Companys non-U.S. operations
are located in Germany. 12




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##### 



Corporate income (loss) from operations includes general corporate overhead costs which are not
directly attributable to a business segment. Financial data by segment and geographic region are
as follows (in thousands): Three Months EndedMarch 31,2005
    
    
    2004(in thousands)Net revenues:Product sales
    
    $
    16,166
    
    
    $
    24,433Product development (milestones and royalties)
    
    
    4,005
    
    
    
    4,915Development services
    
    
    20,068
    
    
    
    24,894Reimbursed out-of-pocket
    
    
    3,226
    
    
    
    4,245$
    43,465
    
    
    $
    58,487United States
    
    $
    38,495
    
    
    $
    52,552Germany
    
    
    4,867
    
    
    
    6,118Other
    
    
    350
    
    
    
    554Less intercompany
    
    
    (247
    )
    
    
    (737
    )$
    43,465
    
    
    $
    58,487Income (loss) from operations:Product sales
    
    $
    5,329
    
    
    $
    (33,925
    )Product development (milestones and royalties)
    
    
    4,005
    
    
    
    4,915Development services
    
    
    563
    
    
    
    1019,897
    
    
    
    (28,909
    )Research and development expense
    
    
    (1,779
    )
    
    
    (6,509
    )Corporate
    
    
    (6,884
    )
    
    
    (8,522
    )$
    1,234
    
    
    $
    (43,940
    )United States
    
    $
    1,515
    
    
    $
    (44,578
    )Germany
    
    
    (225
    )
    
    
    552Other
    
    
    (56
    )
    
    
    86$
    1,234
    
    
    $
    (43,940
    )Depreciation and amortization:Product sales
    
    $
    3,076
    
    
    $
    4,191Development services
    
    
    1,196
    
    
    
    1,183Research and development expense
    
    
    93
    
    
    
    102Corporate
    
    
    461
    
    
    
    508$
    4,826
    
    
    $
    5,984
 13




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##### 



March 31, 2005
    
    
    December 31, 2004Total assets:Product sales
    
    $
    230,371
    
    
    $
    233,682Product development (milestones and royalties)
    
    
    4,838
    
    
    
    14,777Development services
    
    
    45,431
    
    
    
    51,939Corporate
    
    
    42,683
    
    
    
    38,672$
    323,323
    
    
    $
    339,070United States
    
    $
    294,197
    
    
    $
    308,018Germany
    
    
    28,286
    
    
    
    29,943Other
    
    
    840
    
    
    
    1,109$
    323,323
    
    
    $
    339,070Goodwill, net:Development services
    
    $
    13,689
    
    
    $
    14,350
 6. Accounts receivable, net The following table presents the components of accounts receivable (in thousands): March 31,
    
    
    December 31,2005
    
    
    2004Gross accounts receivable
    
    $
    34,609
    
    
    $
    39,885Allowance for uncollectible accounts
    
    
    (2,431
    )
    
    
    (2,564
    )Allowance for customer credits
    
    
    (18,224
    )
    
    
    (24,565
    )Total accounts receivable, net
    
    $
    13,954
    
    
    $
    12,756
 Accounts receivable are presented net of an allowance for uncollectible accounts and net of an
allowance for customer credits, including discounts, rebates, chargebacks, product returns and
other allowances. The decrease in the allowance for customer credits is due to decreases in
product returns reserves primarily related to decreases in wholesaler inventory levels due to
wholesaler shipments, product returns and related decreases in chargeback reserves. 7. Inventories, net The following table presents the components of inventories (in thousands): March 31,
    
    
    December 31,2005
    
    
    2004Finished goods
    
    $
    7,363
    
    
    $
    11,492Work-in-process
    
    
    908
    
    
    
    920
 14




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##### 



Raw materials and supplies
    
    
    4,473
    
    
    
    5,747Inventory reserves
    
    
    (4,571
    )
    
    
    (7,437
    )Total inventories, net
    
    $
    8,173
    
    
    $
    10,722
 8. Debt March 31,
    
    
    December 31,2005
    
    
    2004(In thousands)Current maturities of long-term debt
    
    $
    351,591
    
    
    $
    351,645
 The following table presents the components of long-term debt: March 31,
    
    
    December 31,2005
    
    
    2004(In thousands)Term loan
    
    $
    165,000
    
    
    $
    165,000Revolving credit facility
    
    
    10,500
    
    
    
    10,50011.5% senior subordinated notes due 2010, net of original
issue discount
    
    
    174,285
    
    
    
    174,249Interest rate swap monetization deferred income, net
    
    
    1,806
    
    
    
    1,896Less current maturities of long-term debt
    
    
    (351,591
    )
    
    
    (351,645
    )Total long-term debt due after one year
    
    $
    
    
    
    $
    
 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 is being charged to interest expense over the term of the notes. These
notes initially had 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. When issued, the notes were not secured. Prior to the third anniversary
of the date of issuance of the notes, up to 35% of the notes were 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%. Concurrently 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. In 2003, the Company sold the then outstanding
interest rate hedging agreement and replaced it with a similar interest rate hedging agreement. In
April 2004, the Company paid $9.4 million to terminate this second interest rate hedging agreement.
The amounts received, less the termination payment and 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. 15




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##### 



In April 2004, the Company, following the completion of a solicitation seeking the consent of
holders of its senior subordinated notes, entered into a supplemental indenture 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 current senior credit facilities but covers the
same collateral, and to increase the interest rate of the senior subordinated notes from 11% per
annum to 11.5% per annum effective April 1, 2004. On October 29, 2004, the Company, following the completion of a solicitation seeking the consent of
holders of its senior subordinated notes, entered into an additional supplemental indenture to,
among other things:  
    permit the Company to incur up to $30 million of additional indebtedness under credit
facilities;
    permit the Company to incur additional senior debt in order to maintain $40 million
(subject to an increase up to $50 million in order to allow the Company to make interest
payments on the senior subordinated notes) in senior debt under credit facilities in the event
the Company is required to pay down senior debt with the proceeds of asset sales;
    require proceeds of asset sales to be used to reduce senior debt under credit facilities to
$40 million;
    provide that the liens on assets that secure obligations under the senior subordinated
notes will continue if all senior debt is repaid, but will resume as junior liens if the
Company thereafter incurs any new senior debt; and
    temporarily increase the interest rate on the senior subordinated notes by 0.5% per annum
(to 12% per annum), commencing to accrue on October 1, 2004 and ending on March 31, 2005. In connection with the October 2004 consent solicitation, the Company paid a consent fee to the
holders of senior subordinated notes who had submitted valid and unrevoked consents by the
expiration date of the consent solicitation of $20 for each $1,000 in principal amount of senior
subordinated notes for which a consent was submitted. Following discussions with representatives
of an ad hoc committee of holders of the senior subordinated notes, the Company offered to pay the
same consent fee with respect to senior subordinated notes for which a valid and unrevoked consent
had not been properly submitted by the expiration of the consent solicitation, if the holder of
such senior subordinated notes completed a consent and release for payment by February 7, 2005 that
consented to the proposed amendments and waivers described above and waived all claims the holder
may have against the Company, the trustee under the indenture governing the senior subordinated
notes, Global Bondholder Services Corporation, and their respective directors, officers, employees,
agents, attorneys, affiliates and advisors with respect to matters related to the consent
solicitation. In 2004, the Company paid approximately $4.2 million in consent fees in connection with the consent
solicitations discussed above. On February 9, 2005, the Company paid approximately $1.0 million in
additional consent fees. At March 31, 2005, the Company was in default under the covenants under the senior subordinated
notes as a result of its failure to timely file its 2004 Form 10-K and to deliver to the trustee of
the indenture governing the senior subordinated notes certain certificates of its officers and its
registered independent public accountants. These events of default would entitle the trustee under
the indenture for the notes or the holders of 25% of the principal amount of the notes to
accelerate the notes if such events of default were not cured within 60 days of notice provided by
such person. The Company has since filed its 2004 Form 10-K. In addition, the Company failed to
pay the $10.5 million of scheduled interest due on April 1, 2005 within 30 days after April 1.
This event of default entitles the trustee under the indenture for the notes or the holders of 25%
of the principal amount of the notes to accelerate the notes immediately. Any event of default
entitling the trustee or the holders of the notes to accelerate the notes also constitutes an event
of default under our senior credit facilities entitling the Companys senior lenders to accelerate
the debt thereunder. 16




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##### 



On April 23, 2004, aaiPharma entered into $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. These senior credit facilities consisted 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 Companys 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. On August 9, 2004 and August 13, 2004, the Company entered into amendments to its senior secured
credit facilities to, among other things, increase the amount of the term loans by up to $10
million, extend the maturity date of the facilities by one year to April 21, 2007, increase the
interest rate on the loans by an additional 1.5% subject to potential incremental reduction based
on the Companys financial performance, adjust certain covenants under the facilities and waive
certain defaults and events of default. Under the amended credit facility, the Company borrowed an
additional $10 million in term loans on August 13, 2004. Effective as of October 8, 2004, the Company amended its senior secured credit facilities to, among
other things, adjust financial covenants. On October 22, 2004, the Company entered into another
amendment to its senior secured credit facilities that increased the existing term loan facility
under the senior secured credit facilities by $30 million (the Supplemental Term Loan), subject
to certain specified conditions which were
satisfied on October 29, 2004. The Supplemental Term Loan was made available in up to three draws
to be made on or prior to January 15, 2005, and the Company borrowed $20 million of such term loans
on October 29, 2004. The remaining $10 million of such term loans was borrowed in increments by
the Company on November 5, 2004, November 12, 2004, November 24, 2004 and December 9, 2004.
Following effectiveness of the amendment and these borrowings, the senior secured credit facilities
consisted of a term loan of $165 million and a revolving credit facility of up to $15 million. The amendment also modified the interest rate on the entire senior secured credit facility,
including the Supplemental Term Loan, to equal a defined LIBOR rate (with a floor of 2%) plus 8.25%
per annum or a defined reference rate (with a floor of 4%) plus 7.25% per annum. The amendment
also provided for a commitment fee equal to 0.75% per annum on any undrawn portion of the
Supplemental Term Loan, payable monthly in arrears. In addition, the amendment retained a covenant requiring certain levels of cash or revolver
availability and increased the level of cash or revolver availability required for the period from
March 31, 2005 through May 15, 2005 to $15.0 million. The amendment added a covenant requiring the
Company to retain Rothschild Inc. or another financial advisor to assist with its exploration of
the potential sale of some or all of the assets of the Companys Pharmaceuticals Division. The
amendment also added an event of default if the Company fails to pursue in good faith the
exploration of the potential sale of some or all of the assets comprising its Pharmaceuticals
Division or other non-core assets. As of March 31, 2005, events of default existed under the Companys senior credit facilities that
prohibited borrowings thereunder absent a waiver from its senior lenders. These events of default
included the violation of the cash/revolver availability covenant described above and the failure
to timely file the Companys 2004 Form 10-K, which was subsequently filed on April 27, 2005. On
March 31, 2005, the Company entered into a waiver agreement pursuant to which its senior lenders
agreed to forbear in exercising remedies with respect to the defaults and events of default
existing on that date until the earlier of April 30, 2005 or the occurrence of another default
under the waiver agreement or the Companys senior credit facilities. The forbearance period under
the waiver agreement terminated on April 30, 2005, and the Companys senior lenders accordingly
have the right to accelerate the debt outstanding under the Companys senior credit facilities. 17




---



##### 



The waiver agreement also permitted the Company to immediately use approximately $5.7 million of
its $11.3 million tax refund received in March 2005 to meet budgeted liquidity needs and required
the Company to temporarily pay down revolving loans under the senior credit facilities with the
remaining $5.6 million of the tax refund. Despite the existing events of default, the waiver
permitted the Company to reborrow this $5.6 million, in weekly draws, to meet budgeted liquidity
needs, and the Company has fully borrowed this amount. Pursuant to an additional waiver agreement
entered into by the Company and the lenders on April 29, 2005, the senior lenders permitted the
Company to borrow approximately $1.0 million, provided that $750,000 of the borrowing was applied
to pay commitment fees and expense deposits in connection with a specified debtor-in-possession
financing facility for which the Company accepted a commitment letter on April 29, 2005. The
Company has borrowed this additional amount and applied $750,000 of the proceeds of this borrowing
as required under the waiver. On May 3 and May 4, 2005, as permitted by the terms of the senior
credit facilities and as authorized by the Company, the lenders advanced approximately $1.8 million
in aggregate revolving loans under the senior credit facilities to pay interest then due under the
senior credit facilities. No other borrowings are permitted under the Companys senior credit
facilities absent a consent of the Companys senior lenders. Because of the defaults under the Companys senior credit facilities and the notes at March 31,
2005, all $350.5 million of debt under the Companys senior credit facilities and the senior
subordinated notes was classified as a current liability on the Companys consolidated balance
sheet at March 31, 2005. 9. Other Accrued Liabilities and Restructuring Charges The following table represents the components of other accrued liabilities: March 31,
    
    
    December 31,2005
    
    
    2004(In thousands)Reserve for restructuring
    
    $
    12,822
    
    
    $
    14,953Consignment inventory returns reserve
    
    
    12,422
    
    
    
    12,412Guaranteed purchase commitments
    
    
    11,695
    
    
    
    11,695Advance royalty payments
    
    
    3,538
    
    
    
    7,209Other
    
    
    4,616
    
    
    
    5,212Total other accrued liabilities, net
    
    $
    45,093
    
    
    $
    51,481
 The following table represents the components of the restructuring reserve (in thousands): December 31,
    
    
    
    
    
    
    Less
    
    
    March 31,2004
    
    
    
    
    
    
    Payments/
    
    
    2005Balance
    
    
    Charges
    
    
    Write-downs
    
    
    BalanceLease costs, net of estimated sub-lease income
    
    $
    10,277
    
    
    $
    
    
    
    $
    (863
    )
    
    $
    9,414Severance costs
    
    
    4,082
    
    
    
    
    
    
    
    (1,268
    )
    
    
    2,814Other costs
    
    
    594
    
    
    
    
    
    
    
    
    
    
    
    594Total
    
    $
    14,953
    
    
    $
    
    
    
    $
    (2,131
    )
    
    $
    12,822
 18




---



##### 



10. Commitments and Contingencies The Company may have to make contingent payments of $4.7 million over three years in connection
with the purchase of its Charleston, South Carolina manufacturing facility, based on the level of
manufacturing revenues at this facility. At March 31, 2005, these contingent payment obligations
are not liabilities and have not been recorded on the Companys consolidated balance sheet. In April 2004, in connection with an investigation conducted by the United States Attorneys Office
for the Western District of North Carolina (the U.S. Attorneys 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
the Company, extensions of credit, if any, by aaiPharma to officers or directors, accounting for
sales and returns of the Companys foregoing products, its analysts conference calls on financial
results, internal and external investigations of pharmaceutical product sales activities, and
related matters. The SEC has also commenced an investigation and the Company has received a
subpoena from the SEC covering similar matters. In addition, both the U.S. Attorneys Office and
the SEC have made informal requests for documents and other information related to these matters.
Certain of the Companys current and former officers, directors and employees have received
subpoenas to appear before the federal grand jury or requests to provide information to the U.S.
Attorneys Office. A former officer of the Company, David M. Hurley, has been advised by the U.S.
Attorneys Office that he is a target of its investigation. The Company and a special committee of
its Board of Directors established in February 2004 (the Special Committee) have agreed to
cooperate fully with the government investigations, and the Special Committee has shared
information regarding its investigation with the SEC and the U.S. Attorneys Office. The U.S.
Attorneys Office, 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, aaiPharmas business and 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. The Company has agreed
to advance expenses reasonably incurred by certain of its current directors and current and former
officers in connection with these investigations. This advancement of expenses was conditioned
upon the execution by such persons of undertakings to assist and cooperate with the Company in
connection with the investigations and to repay to the Company any advanced funds in the event that
(i) aaiPharma determines that certain representations made by such directors and officers are
inaccurate, (ii) aaiPharma is prohibited from providing indemnification to such directors or
officers pursuant to Delaware law or its organizational documents, or (iii) such directors or
officers stop cooperating with aaiPharma on the investigations. The Company, certain of its current and former officers and directors, and its independent
registered public accountants have been named as defendants in purported stockholder class action
lawsuits alleging violations of federal securities laws and a stockholder derivative action
alleging violations of state law fiduciary responsibilities. The securities lawsuits were filed
beginning in February 2004 and are pending in the U.S. District Court for the Eastern District of
North Carolina. By order dated April 16, 2004, the district court consolidated the securities
lawsuits into one consolidated action, and on February 11, 2005 the plaintiffs filed a 19




---



##### 



consolidated
amended complaint. The amended securities complaint asserts claims arising under Sections 10(b) and
20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 there under on behalf of a class of
purchasers of the Companys common stock during the period from April 24, 2002 through and
including June 15, 2004. The securities 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
amended securities complaint seeks certification as a class action, unspecified compensatory
damages, attorneys fees and costs, and other relief. A stockholder derivative suit was filed in
the United States District Court for the Eastern District of North Carolina on August 26, 2004 by
two putative shareholders against current and former members of the Companys Board of Directors
and senior management. aaiPharma is named as a nominal defendant. The complaint alleges that
the individual director and officer defendants breached fiduciary and contractual obligations to
the Company by implementing an inadequate system of internal controls, and causing the Company to
issue false and misleading statements exposing it to securities fraud liability, and that certain
defendants engaged in insider trading. The complaint seeks unspecified compensatory damages,
attorneys fees and costs, and other relief. In addition, the Company and certain of its current and former directors, officers and employees
have been named in a purported class action brought by an aaiPharma pension 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 June 15, 2004. An amended complaint was filed on March 14, 2005 which
alleges generally that the defendants breached fiduciary duties owed under ERISA with respect to
the prudence and lack of diversification of investment of Plan assets in the Companys common
stock, by misleading participants and beneficiaries of the Plan regarding the Companys earnings,
prospects, and business condition, by failing to act in the sole interest of Plan participants, and
by failing to monitor the actions of other Plan fiduciaries. The complaint seeks certification as
a class action, unspecified compensatory damages, attorneys fees and costs, and other equitable
relief. This ERISA lawsuit is pending in U.S. District Court for the Eastern District of North
Carolina. The proceedings in this matter will be coordinated with the securities lawsuits
described above. These lawsuits are at an early stage. The Companys response to the amended securities complaint
is not due until May 26, 2005, and its response to the amended ERISA complaint is not due until
June 30, 2005 at the earliest. By agreement, no response to the derivative suit is due until 60
days after the court's decision on the Company's motion to dismiss
the  amended complaint, and no discovery has yet occurred in either
the securities or derivative litigation. Only limited discovery has occurred in the ERISA
litigation. By, and subject to, the terms of the Companys bylaws, the Company has certain obligations to
indemnify its current and former officers, directors and employees 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. The Company has given notice to its D&O insurance carriers of the securities and
derivative suits described above, and the insurers have responded by requesting additional
information and by reserving their rights under the policies, including the rights to deny coverage
under various policy exclusions or to rescind the policies. There is a risk, however, that the D&O
insurance carriers will rescind the policies or 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. The Companys fiduciary liability insurance carrier has denied coverage
of claims made in connection with the ERISA litigation complaint. 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 insurance policies for litigation
and indemnification costs and any damages ultimately 20




---



##### 



borne by us 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. The Company is a party to a number of legal actions with generic drug companies. The Company is
involved in two lawsuits centered on its omeprazole-related patents, including one lawsuit brought
by it against an alleged infringer of its patents and another lawsuit which was brought by a third
party against the Company and is currently essentially inactive. Omeprazole is the active
ingredient found in Prilosec, a drug sold by AstraZeneca PLC. An additional lawsuit brought against
the Company by Andrx Pharmaceuticals, Inc. involving omeprazole was dismissed without prejudice in
December 2004. An omeprazole-related case has been filed against the Company by Dr. Reddys Laboratories Ltd. and
Reddy-Cheminor Inc. in the U.S. District Court for the Southern District of New York in November
2001. The plaintiffs in this case have challenged the validity of five patents that aaiPharma 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 Company has denied the substantive allegations made in these cases. A
second lawsuit brought by the plaintiffs involving omeprazole was filed in July 2001 and was
dismissed without prejudice in March 2005. The case is in the early stages of litigation. However, while these plaintiffs have sought
approval from the FDA to market a generic form of Prilosec, to the best of the Companys knowledge
as of May 5, 2005, no such FDA approval has 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. The lawsuit is essentially inactive at
this time. Only limited discovery has occurred in this lawsuit and no additional discovery is
currently being sought. No date has been set for the trial. In the event that the lawsuit again
becomes active, the Company intends to vigorously defend the patents validity and to determine
whether or not the plaintiffs product infringes any of its relevant patents. The other lawsuit involving the Companys omeprazole patents was brought in December 2002 by it
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. The Company initially brought the lawsuit alleging infringement of the Companys U.S. Patent No.
6,268,385. Following the collection of additional information concerning KUDCOs commercially
marketed product, the Company sought leave of the court to file an amended complaint, adding
additional claims of infringement and contributory infringement under the Companys 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 aaiPharma leave to file the first amended complaint adding the
Companys second patent and the additional KUDCO affiliates to the lawsuit. Following initial
discovery, the Company sought leave of the court to file a second amended complaint, adding Kremers
Urban Inc., another KUDCO affiliate, to the lawsuit. On February 26, 2004, the judge granted the
Company leave to file the second amended complaint, adding Kremers Urban Inc. to the lawsuit. 21




---



##### 



KUDCO has filed its answer to aaiPharmas complaint, denying its claims, asserting various
affirmative defenses to its claims (including patent invalidity and product non-infringement), and
asserting counterclaims 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. The Company has denied the substantive
allegations made by KUDCO in its counterclaims, and the court has granted aaiPharmas motion to
stay antitrust discovery. 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. On
February 26, 2004, the judge assigned the discovery disputes to a federal magistrate for resolution. Discovery
is continuing at this time. No trial date has been set. 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 KUDCO taking a royalty-bearing license,
aaiPharma is 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 the
Company ultimately prevails in the litigation. The KUDCO defendants have publicly confirmed sales
of their generic omeprazole product during the first twenty-two months after launch of their
product of approximately $1.3 billion. In the absence of a license or settlement, the Company
intends to vigorously prosecute the case, defend its patent rights and defend against the foregoing
defenses and counterclaims asserted by KUDCO. It is possible that the omeprazole-related patents
subject to the foregoing four lawsuits will be found invalid, unenforceable or not infringed and,
while currently stayed by the court, it is possible that the defendants antitrust counterclaims in
the KUDCO litigation will ultimately be allowed to proceed and be litigated. If adverse findings
were to occur, they could have a material adverse effect on aaiPharmas consolidated financial
statements, results of operations and cash flow. In cases where the Company has initiated an action, it intends to prosecute its claims to the full
extent of its rights under the law. In cases where the Company is a named defendant, the Company
intends to vigorously pursue all defenses available. On April 15, 2004, the Company filed a lawsuit against Athlon Pharmaceuticals, Inc. in the U.S.
District Court for the Northern District of Georgia seeking a declaratory judgment that it was
entitled to terminate the Service Agreement (the Athlon Service Agreement) dated July 16, 2003,
as amended, between the Company 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 the
Companys Darvocet A500 product to physicians. The Company initially paid Athlon $3,350,000 to
build its sales force to promote the sale of the Companys 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 the
Companys 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 22




---



##### 



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. In May 2004, the Company ceased making payments under the Athlon Service Agreement, and on June 4,
2004, it sent a notice of termination of the agreement to Athlon. On July 7, 2004, the Company
amended the lawsuit to assert claims of fraud and breaches of contract and implied covenants,
seeking to recover compensatory and punitive damages and attorneys fees. Athlon has amended its
counterclaim to assert fraud claims and to seek punitive damages. On August 11, 2004, Athlon filed a lawsuit against the Company, also in the U.S. District Court for
the Northern District of Georgia, alleging that the Company breached the Asset Purchase Agreement
(the Purchase Agreement) dated July 16, 2003 pursuant to which the Company acquired Darvocet A500
from Athlon. Athlon is seeking royalties it alleges the Company failed properly to calculate and
pay under the Purchase Agreement, as well as attorneys fees. The Company has denied the
substantive allegations in this case and filed counterclaims seeking to recover an overpayment in
the royalties owed to Athlon. The two cases have been consolidated and are currently in discovery. No trial date has been set.
The Company intends to prosecute its claims and counterclaims, and defend against the claims and
counterclaims made by Athlon, in these lawsuits to the full extent permitted by law. CIMA Labs, Inc. (CIMA) commenced an action against the Company in the Fourth Judicial District,
State of Minnesota, Hennepin County, on August 11, 2004. In its complaint, CIMA alleges that the
Company is liable for fraudulent inducement, negligent fraudulent misrepresentation, fraudulent
concealment, breach of contract, and attorneys fees and interest, all arising out of an Agreement
and Plan of Merger dated as of August 5, 2003, between CIMA and aaiPharma (Merger Agreement).
CIMA alleges that in the negotiations leading up to the Merger Agreement, the Company engaged in
misrepresentations and concealments relating to its financial condition, and that in the Merger
Agreement, the Company made false representations and warranties concerning its financial
statements, regulatory filings, and absence of material adverse effects, among other things. Much
of CIMAs claims are based on disclosures made by the Company in its Amended Form 10-Q, filed with
the SEC on June 24, 2004, for the period ended June 30, 2003. CIMA seeks to recover the amount of
$11.5 million, which it paid to aaiPharma as a termination fee under the Merger Agreement, plus
additional sums it spent for professional fees and due diligence activities (which it claims are in
excess of $5 million), attorneys fees, litigation expenses, and interest. The Company answered
CIMAs complaint on September 17, 2004, denying all liability and raising a number of affirmative
defenses. Among other things, the Company asserted that CIMAs termination of the Merger Agreement
barred any claims except those based on the Companys willful breach of its representations,
warranties, covenants, or other agreements as set forth in that Agreement. In addition, the
Company affirmatively alleged that CIMA terminated the Merger Agreement and paid the termination
fee not as the result of any alleged breach by aaiPharma, but rather as part of CIMAs plan to
secure and act on a Superior Proposal from another bidder, which allowed it to consummate a
transaction with that other bidder on terms that it believed were more favorable to it than those
set forth in the Merger Agreement. The case is scheduled for trial in the fall of 2005, and the
parties are currently involved in document productions and written discovery. On January 14, 2005,
the Minnesota court rejected a relevance objection made by the Company in response to CIMAs
discovery requests and ordered the Company to 23




---



##### 



produce voluminous documents to CIMA. On March 21,
2005, the Minnesota court approved a motion to compel made by CIMA against the Company to produce
documents by April 5, 2005 and an extensive privilege log by April 20, 2005 with respect to
documents generated by the Companys legal counsel in the internal investigation. The Company has
produced the documents and has moved to delay the production of the privilege log due to its
liquidity situation. The Court may deny the Companys motion for additional time to produce the
privilege log and may sanction the Company, including holding the Company in contempt or entering a
default judgment against the Company. The Company intends to contest the action as vigorously as
its limited resources permit. 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. On April 29, 2005, the Company accepted a commitment letter from Silver Point Finance, LLC to
provide debtor-in-possession financing in the event the Company and
its U.S. subsidiaries commence bankruptcy
proceedings under chapter 11 of Title 11 of the United States Code (the Bankruptcy Code). The
debtor-in-possession financing, which would be available only if the Company commenced bankruptcy
proceedings under chapter 11 of the Bankruptcy Code and the financing was approved by the
bankruptcy court, would consist of a revolving credit facility in aggregate principal amount not to
exceed $30 million and a term loan facility in the aggregate principal amount of $180 million. The
proceeds of the debtor-in-possession financing would be used to refinance the Companys obligations
under its existing senior credit facilities, pay fees and expenses in connection with the financing
and to fund working capital and general corporate requirements while the bankruptcy proceedings
were pending. 11. Financial information for subsidiary guarantors and non-guarantors The Companys senior subordinated notes, due April 1, 2010, 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 inter-company
balances and transactions. The following information presents consolidating statements of operations, balance sheets and cash
flows for the periods and as of the dates indicated: 24




---



##### 



aaiPharma Inc.
Consolidating Statement of Operations
(In thousands)
(Unaudited) Three Months Ended March 31, 2005Guarantor
    
    
    Non-GuarantorIssuer
    
    
    Subsidiaries
    
    
    Subsidiaries
    
    
    Eliminations
    
    
    ConsolidatedNet revenues
    
    $
    11,033
    
    
    $
    27,462
    
    
    $
    5,217
    
    
    $
    (247
    )
    
    $
    43,465Equity earnings from
subsidiaries
    
    
    (1,854
    )
    
    
    
    
    
    
    
    
    
    
    1,854
    
    
    
    Total revenues
    
    
    9,179
    
    
    
    27,462
    
    
    
    5,217
    
    
    
    1,607
    
    
    
    43,465Operating costs and expenses:Direct costs (excluding
depreciation and royalty
expense)
    
    
    7,724
    
    
    
    12,878
    
    
    
    3,858
    
    
    
    (165
    )
    
    
    24,295Selling expenses
    
    
    555
    
    
    
    766
    
    
    
    483
    
    
    
    
    
    
    
    1,804General and administrative
expenses
    
    
    9,276
    
    
    
    118
    
    
    
    891
    
    
    
    
    
    
    
    10,285Research and development
    
    
    
    
    
    
    1,687
    
    
    
    
    
    
    
    
    
    
    
    1,687Depreciation
    
    
    1,270
    
    
    
    671
    
    
    
    266
    
    
    
    
    
    
    
    2,207Professional fees  internal and
government investigations
    
    
    
    
    
    
    299
    
    
    
    
    
    
    
    
    
    
    
    299Professional fees  debt
restructuring
    
    
    
    
    
    
    1,553
    
    
    
    
    
    
    
    
    
    
    
    1,553Royalty expenses
    
    
    
    
    
    
    101
    
    
    
    
    
    
    
    
    
    
    
    10118,825
    
    
    
    18,073
    
    
    
    5,498
    
    
    
    (165
    )
    
    
    42,231(Loss) income from operations
    
    
    (9,646
    )
    
    
    9,389
    
    
    
    (281
    )
    
    
    1,772
    
    
    
    1,234Other income (expense):Interest, net
    
    
    (267
    )
    
    
    (11,192
    )
    
    
    80
    
    
    
    
    
    
    
    (11,379
    )Net intercompany interest
    
    
    (633
    )
    
    
    716
    
    
    
    (83
    )
    
    
    
    
    
    
    Other expense, net
    
    
    (43
    )
    
    
    (98
    )
    
    
    (257
    )
    
    
    
    
    
    
    (398
    )(943
    )
    
    
    (10,574
    )
    
    
    (260
    )
    
    
    
    
    
    
    (11,777
    )(Loss) income before income
taxes
    
    
    (10,589
    )
    
    
    (1,185
    )
    
    
    (541
    )
    
    
    1,772
    
    
    
    (10,543
    )Provision for (benefit from)
income taxes
    
    
    
    
    
    
    82
    
    
    
    (36
    )
    
    
    
    
    
    
    46Net (loss) income
    
    $
    10,589
    )
    
    $
    (1,267
    )
    
    $
    (505
    )
    
    $
    1,772
    
    
    $
    (10,589
    )
 25




---



##### 



aaiPharma Inc.
Consolidating Statement of Operations
(In thousands)
(Unaudited) Three Months Ended March 31, 2004Guarantor
    
    
    Non-GuarantorIssuer
    
    
    Subsidiaries
    
    
    Subsidiaries
    
    
    Eliminations
    
    
    ConsolidatedNet revenues
    
    $
    14,457
    
    
    $
    38,095
    
    
    $
    6,672
    
    
    $
    (737
    )
    
    $
    58,487Equity earnings from
subsidiaries
    
    
    (38,582
    )
    
    
    
    
    
    
    
    
    
    
    38,582
    
    
    
    Total revenues
    
    
    (24,125
    )
    
    
    38,095
    
    
    
    6,672
    
    
    
    37,845
    
    
    
    58,487Operating costs and expenses:Direct costs (excluding
depreciation and royalty
expense)
    
    
    9,883
    
    
    
    19,722
    
    
    
    4,068
    
    
    
    (533
    )
    
    
    33,140Selling expenses
    
    
    1,728
    
    
    
    10,676
    
    
    
    623
    
    
    
    
    
    
    
    13,027General and administrative
expenses
    
    
    12,111
    
    
    
    (42
    )
    
    
    1,071
    
    
    
    
    
    
    
    13,140Research and development
    
    
    8
    
    
    
    6,399
    
    
    
    
    
    
    
    
    
    
    
    6,407Depreciation
    
    
    1,323
    
    
    
    417
    
    
    
    272
    
    
    
    
    
    
    
    2,012Professional fees  internal
inquiry
    
    
    
    
    
    
    3,200
    
    
    
    
    
    
    
    
    
    
    
    3,200M.V.I. Contingent
payment
    
    
    
    
    
    
    31,001
    
    
    
    
    
    
    
    
    
    
    
    31,001Royalty expenses
    
    
    
    
    
    
    500
    
    
    
    
    
    
    
    
    
    
    
    50025,053
    
    
    
    71,873
    
    
    
    6,034
    
    
    
    (533
    )
    
    
    102,427(Loss) income from
operations
    
    
    (49,178
    )
    
    
    (33,778
    )
    
    
    638
    
    
    
    38,378
    
    
    
    (43,940
    )Other expense:Interest, net
    
    
    (17
    )
    
    
    (5,666
    )
    
    
    38
    
    
    
    
    
    
    
    (5,645
    )Net intercompany interest
    
    
    (493
    )
    
    
    532
    
    
    
    (39
    )
    
    
    
    
    
    
    Other (expense) income, net
    
    
    122
    
    
    
    7
    
    
    
    (110
    )
    
    
    
    
    
    
    19(388
    )
    
    
    (5,127
    )
    
    
    (111
    )
    
    
    
    
    
    
    (5,626
    )(Loss) income before income
taxes
    
    
    (49,566
    )
    
    
    (38,905
    )
    
    
    527
    
    
    
    38,378
    
    
    
    (49,566
    )Provision for income taxes
    
    
    6
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6Net (loss) income
    
    $
    (49,572
    )
    
    $
    (38,905
    )
    
    $
    527
    
    
    $
    38,378
    
    
    $
    (49,572
    )
 26




---



##### 



aaiPharma Inc.
Consolidating Balance Sheet
(In thousands)
(Unaudited) March 31, 2005Guarantor
    
    
    Non-GuarantorIssuer
    
    
    Subsidiaries
    
    
    Subsidiaries
    
    
    Eliminations
    
    
    ConsolidatedASSETSCurrent assets:Cash and cash equivalents
    
    $
    11,822
    
    
    $
    264
    
    
    $
    281
    
    
    $
    
    
    
    $
    12,367Accounts receivable, net
    
    
    10,289
    
    
    
    364
    
    
    
    3,301
    
    
    
    
    
    
    
    13,954Work-in-progress
    
    
    2,360
    
    
    
    4,317
    
    
    
    8,154
    
    
    
    (5,497
    )
    
    
    9,334Inventories, net
    
    
    1,965
    
    
    
    4,875
    
    
    
    1,333
    
    
    
    
    
    
    
    8,173Prepaid and other current assets
    
    
    3,691
    
    
    
    8,268
    
    
    
    364
    
    
    
    
    
    
    
    12,323Total current assets
    
    
    30,127
    
    
    
    18,088
    
    
    
    13,433
    
    
    
    (5,497
    )
    
    
    56,151Investments in and advances to
subsidiaries
    
    
    66,099
    
    
    
    (46,240
    )
    
    
    
    
    
    
    (19,859
    )
    
    
    Property and equipment, net
    
    
    35,081
    
    
    
    11,820
    
    
    
    3,840
    
    
    
    
    
    
    
    50,741Goodwill, net
    
    
    726
    
    
    
    1,229
    
    
    
    11,734
    
    
    
    
    
    
    
    13,689Intangible assets, net
    
    
    1,193
    
    
    
    186,316
    
    
    
    
    
    
    
    
    
    
    
    187,509Other assets
    
    
    152
    
    
    
    14,962
    
    
    
    119
    
    
    
    
    
    
    
    15,233Total assets
    
    $
    133,378
    
    
    $
    186,175
    
    
    $
    29,126
    
    
    $
    (25,356
    )
    
    $
    323,323LIABILITIES AND
STOCKHOLDERS EQUITY
(DEFICIT)Current liabilities:Current maturities of long-term
debt
    
    $
    10,500
    
    
    $
    341,091
    
    
    $
    
    
    
    $
    
    
    
    $
    351,591Accounts payable
    
    
    6,362
    
    
    
    10,187
    
    
    
    695
    
    
    
    
    
    
    
    17,244Customer advances
    
    
    5,923
    
    
    
    4,307
    
    
    
    6,563
    
    
    
    (4,035
    )
    
    
    12,758Accrued wages and benefits
    
    
    2,602
    
    
    
    803
    
    
    
    2,017
    
    
    
    
    
    
    
    5,422Interest payable
    
    
    232
    
    
    
    12,012
    
    
    
    
    
    
    
    
    
    
    
    12,244Deferred product revenue
    
    
    
    
    
    
    2,341
    
    
    
    
    
    
    
    
    
    
    
    2,341Other accrued liabilities
    
    
    17,773
    
    
    
    28,466
    
    
    
    (445
    )
    
    
    (701
    )
    
    
    45,093Total current liabilities
    
    
    43,392
    
    
    
    399,207
    
    
    
    8,830
    
    
    
    (4,736
    )
    
    
    446,693Other liabilities
    
    
    9
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    9Investments in and advances to
subsidiaries
    
    
    164,407
    
    
    
    (168,333
    )
    
    
    3,155
    
    
    
    771
    
    
    
    Total stockholders equity
(deficit)
    
    
    (74,430
    )
    
    
    (44,699
    )
    
    
    17,141
    
    
    
    (21,391
    )
    
    
    (123,379
    )Total liabilities and
stockholders equity
(deficit)
    
    $
    133,378
    
    
    $
    186,175
    
    
    $
    29,126
    
    
    $
    (25,356
    )
    
    $
    323,323
 27




---



##### 



aaiPharma Inc.
Consolidating Balance Sheet
(In thousands) December 31, 2004Guarantor
    
    
    Non-GuarantorIssuer
    
    
    Subsidiaries
    
    
    Subsidiaries
    
    
    Eliminations
    
    
    ConsolidatedASSETSCurrent assets:Cash and cash equivalents
    
    $
    6,696
    
    
    $
    276
    
    
    $
    158
    
    
    $
    
    
    
    $
    7,130Accounts receivable, net
    
    
    10,831
    
    
    
    (756
    )
    
    
    2,681
    
    
    
    
    
    
    
    12,756Work-in-progress
    
    
    2,079
    
    
    
    4,830
    
    
    
    9,745
    
    
    
    (6,482
    )
    
    
    10,172Inventories, net
    
    
    1,871
    
    
    
    7,449
    
    
    
    1,402
    
    
    
    
    
    
    
    10,722Income taxes recoverable
    
    
    11,110
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    11,110Prepaid and other current assets
    
    
    4,600
    
    
    
    8,999
    
    
    
    211
    
    
    
    
    
    
    
    13,810Total current assets
    
    
    37,187
    
    
    
    20,798
    
    
    
    14,197
    
    
    
    (6,482
    )
    
    
    65,700Investments in and advances to
subsidiaries
    
    
    66,099
    
    
    
    (46,240
    )
    
    
    
    
    
    
    (19,859
    )
    
    
    Property and equipment, net
    
    
    36,108
    
    
    
    12,501
    
    
    
    4,333
    
    
    
    
    
    
    
    52,942Goodwill, net
    
    
    725
    
    
    
    1,229
    
    
    
    12,396
    
    
    
    
    
    
    
    14,350Intangible assets, net
    
    
    1,159
    
    
    
    188,940
    
    
    
    
    
    
    
    
    
    
    
    190,099Other assets
    
    
    155
    
    
    
    15,698
    
    
    
    126
    
    
    
    
    
    
    
    15,979Total assets
    
    $
    141,433
    
    
    $
    192,926
    
    
    $
    31,052
    
    
    $
    (26,341
    )
    
    $
    339,070LIABILITIES AND
STOCKHOLDERS EQUITY
(DEFICIT)Current liabilities:Current maturities of long-term
debt
    
    $
    10,500
    
    
    $
    341,145
    
    
    $
    
    
    
    $
    
    
    
    $
    351,645Accounts payable
    
    
    7,057
    
    
    
    13,093
    
    
    
    1,881
    
    
    
    
    
    
    
    22,031Customer advances
    
    
    5,208
    
    
    
    4,327
    
    
    
    6,154
    
    
    
    (4,646
    )
    
    
    11,043Accrued wages and benefits
    
    
    2,553
    
    
    
    993
    
    
    
    1,335
    
    
    
    
    
    
    
    4,881Interest payable
    
    
    160
    
    
    
    5,578
    
    
    
    
    
    
    
    
    
    
    
    5,738Deferred product revenue
    
    
    
    
    
    
    4,127
    
    
    
    
    
    
    
    
    
    
    
    4,127Other accrued liabilities
    
    
    18,939
    
    
    
    33,699
    
    
    
    (408
    )
    
    
    (749
    )
    
    
    51,481Total current liabilities
    
    
    44,417
    
    
    
    402,962
    
    
    
    8,962
    
    
    
    (5,395
    )
    
    
    450,946Other liabilities
    
    
    14
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    14Investments in and advances to
subsidiaries
    
    
    162,822
    
    
    
    (166,642
    )
    
    
    3,457
    
    
    
    363
    
    
    
    Total stockholders equity (deficit)
    
    
    (65,820
    )
    
    
    (43,394
    )
    
    
    18,633
    
    
    
    (21,309
    )
    
    
    (111,890
    )Total liabilities and
stockholders equity (deficit)
    
    $
    141,433
    
    
    $
    192,926
    
    
    $
    31,052
    
    
    $
    (26,341
    )
    
    $
    339,070
 28




---



##### 



aaiPharma Inc.
Consolidating Statement of Cash Flows
(In thousands)
(Unaudited) Three Months Ended March 31, 2005Non-Guarantor
    
    
    GuarantorIssuer
    
    
    Subsidiaries
    
    
    Subsidiaries
    
    
    Eliminations
    
    
    ConsolidatedCash flows from operating activities:Net loss
    
    $
    (10,589
    )
    
    $
    (1,267
    )
    
    $
    (505
    )
    
    $
    1,772
    
    
    $
    (10,589
    )Adjustments to reconcile net loss to
net cash provided by operating
activities:Depreciation and amortization
    
    
    1,178
    
    
    
    3,382
    
    
    
    266
    
    
    
    
    
    
    
    4,826Noncash stock based compensation
    
    
    126
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    126Loss on disposal of assets and
other
    
    
    2
    
    
    
    875
    
    
    
    49
    
    
    
    
    
    
    
    926Changes in operating assets and
liabilities:Accounts receivable, net
    
    
    542
    
    
    
    (1,119
    )
    
    
    (763
    )
    
    
    
    
    
    
    (1,340
    )Work-in-progress
    
    
    (281
    )
    
    
    512
    
    
    
    1,072
    
    
    
    (986
    )
    
    
    317Inventories
    
    
    (95
    )
    
    
    2,575
    
    
    
    (6
    )
    
    
    
    
    
    
    2,474Income taxes recoverable
    
    
    11,110
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    11,110Prepaid and other assets
    
    
    913
    
    
    
    1,466
    
    
    
    (164
    )
    
    
    
    
    
    
    2,215Accounts payable
    
    
    (695
    )
    
    
    (2,905
    )
    
    
    (1,086
    )
    
    
    
    
    
    
    (4,686
    )Customer advances
    
    
    714
    
    
    
    (20
    )
    
    
    738
    
    
    
    611
    
    
    
    2,043Accrued wages and benefits
    
    
    49
    
    
    
    (189
    )
    
    
    753
    
    
    
    
    
    
    
    613Interest payable
    
    
    71
    
    
    
    6,435
    
    
    
    
    
    
    
    
    
    
    
    6,506Deferred product revenue
    
    
    
    
    
    
    (1,786
    )
    
    
    
    
    
    
    
    
    
    
    (1,786
    )Other accrued liabilities
    
    
    (1,173
    )
    
    
    (5,232
    )
    
    
    126
    
    
    
    48
    
    
    
    (6,231
    )Intercompany receivables and
payables
    
    
    3,439
    
    
    
    (1,691
    )
    
    
    (303
    )
    
    
    (1,445
    )
    
    
    Net cash provided by operating
activities
    
    
    5,311
    
    
    
    1,036
    
    
    
    177
    
    
    
    
    
    
    
    6,524Cash flows from investing activities:Purchases of property and
equipment
    
    
    (110
    )
    
    
    (954
    )
    
    
    (45
    )
    
    
    
    
    
    
    (1,109
    )Other
    
    
    (75
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (75
    )Net cash used in investing activities
    
    
    (185
    )
    
    
    (954
    )
    
    
    (45
    )
    
    
    
    
    
    
    (1,184
    )Cash flows from financing activities:Payments on interest rate swaps,
net
    
    
    
    
    
    
    (90
    )
    
    
    
    
    
    
    
    
    
    
    (90
    )Other
    
    
    
    
    
    
    (4
    )
    
    
    
    
    
    
    
    
    
    
    (4
    )Net cash used in financing activities
    
    
    
    
    
    
    (94
    )
    
    
    
    
    
    
    
    
    
    
    (94
    )
 29




---



##### 



Net increase (decrease) in cash and
cash equivalents
    
    
    5,126
    
    
    
    (12
    )
    
    
    132
    
    
    
    
    
    
    
    5,246Effect of exchange rate changes on
cash
    
    
    
    
    
    
    
    
    
    
    (9
    )
    
    
    
    
    
    
    (9
    )Cash and cash equivalents, beginning
of period
    
    
    6,696
    
    
    
    276
    
    
    
    158
    
    
    
    
    
    
    
    7,130Cash and cash equivalents, end of
period
    
    $
    11,822
    
    
    $
    264
    
    
    $
    281
    
    
    $
    
    
    
    $
    12,367
 30




---



##### 



aaiPharma Inc.
Consolidated Statement of Cash Flows
(In thousands)
(Unaudited) Three Months Ended March 31, 2004Non-Guarantor
    
    
    GuarantorIssuer
    
    
    Subsidiaries
    
    
    Subsidiaries
    
    
    Eliminations
    
    
    ConsolidatedCash flows from operating
activities:Net (loss) income
    
    $
    (49,572
    )
    
    $
    (38,905
    )
    
    $
    527
    
    
    $
    38,378
    
    
    $
    (49,572
    )Adjustments to reconcile net
(loss) income to net cash
provided by
operating activities:Depreciation and amortization
    
    
    1,247
    
    
    
    4,465
    
    
    
    272
    
    
    
    
    
    
    
    5,984Noncash stock based
compensation
    
    
    23
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    23Other
    
    
    1
    
    
    
    
    
    
    
    77
    
    
    
    
    
    
    
    78Changes in operating assets and
liabilities:Accounts receivable, net
    
    
    2,783
    
    
    
    34,327
    
    
    
    167
    
    
    
    (4,802
    )
    
    
    32,475Work-in-progress
    
    
    (72
    )
    
    
    (868
    )
    
    
    (379
    )
    
    
    478
    
    
    
    (841
    )Inventories
    
    
    (280
    )
    
    
    (3,162
    )
    
    
    (10
    )
    
    
    
    
    
    
    (3,452
    )Prepaid and other assets
    
    
    (1,294
    )
    
    
    3,539
    
    
    
    (73
    )
    
    
    
    
    
    
    2,172Accounts payable
    
    
    3,322
    
    
    
    (802
    )
    
    
    (748
    )
    
    
    
    
    
    
    1,772Customer advances
    
    
    (810
    )
    
    
    (949
    )
    
    
    304
    
    
    
    (437
    )
    
    
    (1,892
    )Accrued wages and benefits
    
    
    1,289
    
    
    
    443
    
    
    
    319
    
    
    
    
    
    
    
    2,051Interest payable
    
    
    (8
    )
    
    
    4,708
    
    
    
    
    
    
    
    
    
    
    
    4,700Deferred product revenue
    
    
    
    
    
    
    (7,803
    )
    
    
    
    
    
    
    
    
    
    
    (7,803
    )Other accrued liabilities
    
    
    (9,282
    )
    
    
    30,823
    
    
    
    289
    
    
    
    4,253
    
    
    
    26,083Intercompany receivables and
payables
    
    
    60,319
    
    
    
    (21,842
    )
    
    
    (607
    )
    
    
    (37,870
    )
    
    
    Net cash provided by operating
activities
    
    
    7,666
    
    
    
    3,974
    
    
    
    138
    
    
    
    
    
    
    
    11,778Cash flows from investing
activities:Purchases of property and
equipment
    
    
    (1,260
    )
    
    
    (950
    )
    
    
    (362
    )
    
    
    
    
    
    
    (2,572
    )Other
    
    
    (60
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (60
    )Net cash used in investing
activities
    
    
    (1,320
    )
    
    
    (950
    )
    
    
    (362
    )
    
    
    
    
    
    
    (2,632
    )Cash flows from financing
activities:Payments on long-term
borrowings
    
    
    (8,000
    )
    
    
    (2,170
    )
    
    
    
    
    
    
    
    
    
    
    (10,170
    )
 31




---



##### 



Payments on interest rate swaps,
net
    
    
    
    
    
    
    (488
    )
    
    
    
    
    
    
    
    
    
    
    (488
    )Proceeds from stock option
exercises
    
    
    3,573
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,573Other
    
    
    
    
    
    
    (308
    )
    
    
    
    
    
    
    
    
    
    
    (308
    )Net cash used in financing
activities
    
    
    (4,427
    )
    
    
    (2,966
    )
    
    
    
    
    
    
    
    
    
    
    (7,393
    )Net increase (decrease) in cash
and cash equivalents
    
    
    1,919
    
    
    
    58
    
    
    
    (224
    )
    
    
    
    
    
    
    1,753Effect of exchange rate changes on
cash
    
    
    
    
    
    
    1
    
    
    
    (13
    )
    
    
    
    
    
    
    (12
    )Cash and cash equivalents,
beginning of period
    
    
    8,161
    
    
    
    192
    
    
    
    432
    
    
    
    
    
    
    
    8,785Cash and cash equivalents, end of
period
    
    $
    10,080
    
    
    $
    251
    
    
    $
    195
    
    
    $
    
    
    
    $
    10,526
 32




---



##### 



Item 2. Managements Discussion and Analysis of Financial Condition and Results of
Operations. Our quarterly results have been, and we expect them to continue to be, subject to fluctuations.
Quarterly results can fluctuate as a result of a number of factors, including without limitation,
demand for our pharmaceutical product lines and product development services, the amount and timing
of product returns, ability of contract manufacturers to supply conforming products on a timely
basis, costs and results of ongoing and future litigation by and against us, contractual disputes
with customers, progress of ongoing contracts, amounts recognized for licensing and royalty
revenues, the commencement, completion or cancellation of large contracts, timing and amounts of
start-up expenses for new facilities, timing and level of research and development expenditures,
changes in the mix of products and services, restructuring charges, intangible asset impairments
and debt refinancing costs. Because a large percentage of our development services operating costs
are relatively fixed, variations in the timing and progress of large contracts, changes in the
demand for our services and products, or the recognition of licensing and royalty revenues (on
projects for which associated expenses may have been recognized in prior periods) can materially
affect our quarterly results. Accordingly, we believe that comparisons of our quarterly financial
results may not be meaningful. There have been no significant changes in our critical accounting
policies previously disclosed in our Annual Report on Form 10-K for the year ended December 31,
2004 (the 2004 Form 10-K). Summary Liquidity continued to be a significant focus of management attention during the first quarter of
2005. Our results of operations deteriorated as customer concerns regarding our financial
condition have affected sales of our pharmaceutical products and our ability to obtain development services engagements. As a result of our substantial and recurring net losses, we
believe that we do not have adequate sources of liquidity to fund our operations in the near term
unless we obtain additional sources of liquidity. Because we did not make the $10.5 million
scheduled interest payment due April 1, 2005 on our senior subordinated notes within 30 days after
April 1, holders of 25% of the notes and the trustee under the indenture governing the notes are
each entitled to accelerate the notes. Our senior lenders are also entitled to accelerate the
obligations outstanding under our senior credit facilities. We have also discontinued payments
under leases for assets not used in operations. In light of our current financial condition, we believe that our operations can no longer support
our existing debt and that we must restructure our debt to levels that are more in line with our
operations. Thus, it is highly likely that we and our U.S. subsidiaries will seek relief under
chapter 11 of Title 11 of the U.S. Code (the Bankruptcy Code) which would substantially dilute
and may eliminate the interests of the holders of our common stock. We have accepted a commitment
letter from Silver Point Finance, LLC to provide us debtor-in-possession financing should we
and our U.S. subsidiaries commence bankruptcy proceedings under chapter 11 of the Bankruptcy Code. This financing would be
available only if we and our U.S. subsidiaries commence bankruptcy proceedings under chapter 11 of the Bankruptcy Code and is
subject to the satisfaction of a number of conditions, including approval by the bankruptcy court.
See Managements Discussion and Analysis of Financial Condition and Results of Operations 
Liquidity and Capital Resources. The wholesalers that we deal with have recently limited, and may continue to limit, their purchases
of pharmaceutical products from us. We believe these wholesalers have reduced their purchases in
order to minimize any exposure that could result from our liquidity position. In addition, there
has been a trend of weakness in our development services business that we believe is a result of
customers being less willing to engage us for long-term development services projects due to our
liquidity issues. This 33




---



##### 



weakness in our long-term development services business has been partially
offset by continued strength in some of our short-term analytical development services. In
addition, the manufacturing capacity for our Charleston facility was planned to cover the
manufacturing needs of our Brethine injectable product. The introduction of a generic competitor
in the second quarter of 2004 eliminated the near-term need for manufacturing additional Brethine
injectable products and created for us an excess in sterile manufacturing capacity which we were
not able to fully sell to third parties. We have been exploring a potential sale of some or all of the assets of our Pharmaceuticals
Division, as well as other operating assets. On March 31, 2005, we entered into a limited
exclusivity agreement with a potential purchaser of certain of the assets of our Pharmaceuticals
Division to facilitate continued due diligence and negotiation over a potential sale. Although
this written exclusivity agreement expired by its terms on April 22, 2005, we are continuing to
negotiate with this potential purchaser on an exclusive basis. In 2004 and the first quarter of 2005, we operated three business units  a pharmaceutical product
sales business operated through our Pharmaceuticals Division, a development services business
operated through our AAI Development Services Division and a product development business operated
through our Research and Development Division. In late March 2005, we reorganized our operating
structure to reflect our decision to curtail our research and development activities in light of
our financial condition. At that time, our Research and Development Division was no longer
actively engaged in any shared-risk development projects. Personnel involved in the development of
proprietary products were assigned to our Pharmaceuticals Division, while personnel who had focused
on independent research or shared-risk development projects were assigned to fee-for-service
development projects in our AAI Development Services Division. As a result of this reorganization
of our operating structure, we began operating in only two business segments in April 2005 
proprietary pharmaceutical product development and sales through our Pharmaceuticals Division and
development services offered to third parties through our AAI Development Services Division. Results of Operations The following table presents the net revenues for each of our business units and our consolidated
expenses and net loss income for the three months ended March 31, 2005 and 2004, with each item
expressed as a percentage of consolidated net revenues: Three Months Ended March 31,2005
    
    
    2004(dollars in thousands)Net revenues:Product sales
    
    $
    16,166
    
    
    
    37
    %
    
    $
    24,433
    
    
    
    42
    %Product development (milestones and royalties)
    
    
    4,005
    
    
    
    9
    
    
    
    4,915
    
    
    
    8Development services
    
    
    20,068
    
    
    
    47
    
    
    
    24,894
    
    
    
    43Reimbursed out-of-pocket
    
    
    3,226
    
    
    
    7
    
    
    
    4,245
    
    
    
    7$
    43,465
    
    
    
    100
    %
    
    $
    58,487
    
    
    
    100
    %
 34




---



##### 



Direct costs (excluding depreciation and royalty
expense)
    
    $
    24,295
    
    
    
    56
    %
    
    $
    33,140
    
    
    
    57
    %Selling expenses
    
    
    1,804
    
    
    
    4
    
    
    
    13,027
    
    
    
    22General and administrative expenses
    
    
    10,285
    
    
    
    24
    
    
    
    13,140
    
    
    
    22Research and development
    
    
    1,687
    
    
    
    4
    
    
    
    6,407
    
    
    
    11Depreciation
    
    
    2,207
    
    
    
    5
    
    
    
    2,012
    
    
    
    3Professional
fees  internal and government
investigations
    
    
    299
    
    
    
    1
    
    
    
    3,200
    
    
    
    5Professional fees  debt restructuring
    
    
    1,553
    
    
    
    4
    
    
    
    
    
    
    
    M.V.I. contingent payment
    
    
    
    
    
    
    
    
    
    
    31,001
    
    
    
    53Royalty expenses
    
    
    101
    
    
    
    
    
    
    
    500
    
    
    
    1Income (loss) from operations
    
    
    1,234
    
    
    
    4
    
    
    
    (43,940
    )
    
    
    (75
    )Interest expense, net
    
    
    11,379
    
    
    
    26
    
    
    
    5,645
    
    
    
    10Other (expense) income, net
    
    
    (398
    )
    
    
    (1
    )
    
    
    19
    
    
    
    Provision for income taxes
    
    
    46
    
    
    
    
    
    
    
    6
    
    
    
    Net loss
    
    
    (10,589
    )
    
    
    (24
    )
    
    
    (49,572
    )
    
    
    (85
    )
 As is customary in the pharmaceutical industry, we accept returns of products we have sold as the
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. 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. Three Months EndedMarch 31,2005
    
    
    2004(dollars in thousands)Gross revenues
    
    $
    53,919
    
    
    $
    76,233Less allowances for customer credits
    
    
    10,454
    
    
    
    17,746Net revenues
    
    $
    43,465
    
    
    $
    58,487
 Allowances for customer credits as a percentage of consolidated gross revenues were 19.4% for the
first quarter of 2005 as compared to 23.3% for the first quarter of 2004. This change is primarily
related to lower pharmaceutical returns and chargeback reserve needs based on changes in sales mix,
primarily due to lower Brethine sales and the sale of our M.V.I. and Aquasol product lines. Three Months Ended March 31, 2005 Compared to Three Months Ended March 31, 2004 Our consolidated net revenues for the three months ended March 31, 2005 decreased 26% to $43.5
million, from $58.5 million in the same period in 2004. Net revenues from product sales decreased
34% in 2005 to $16.2 million, from $24.4 million in 2004. The decrease resulted from decreased
sales volumes in our Roxicodone, Oramorph and Brethine product lines, as well as the divestiture of
our 35




---



##### 



M.V.I. and Aquasol product lines in the second quarter of 2004 and calcitriol product line in
December 2004, which was partially offset by increases in sales volumes of our Darvon/Darvocet
product lines. Sales volumes of Roxicodone and Brethine decreased in part due to the introduction
of generic versions of these products in the first and second quarters of 2004, respectively. In
addition, we decreased the price of our Brethine product significantly in the second half of 2004
due to the introduction of generic competition. Our net revenues for the three months ended March
31, 2005 and 2004 included $0.6 million and $4.3 million, respectively, recognized under the
consignment sales method. The following table presents the net revenues for each of our major pharmaceutical product lines: Three Months Ended March 31,2005
    
    
    2004Darvon/Darvocet
    
    $
    7,816
    
    
    $
    3,157Brethine
    
    
    (576
    )
    
    
    2,077MVI/Aquasol
    
    
    
    
    
    
    5,487Roxicodone, Oramorph SR, Roxanol and
Duraclon
    
    
    7,353
    
    
    
    10,667All Other
    
    
    1,573
    
    
    
    3,045Total net revenues
    
    $
    16,166
    
    
    $
    24,433
 Brethine net revenues were negative due to higher than anticipated actual returns received in the
first quarter of 2005 and additional returns reserves recorded based on the level of Brethine
ampoule product reported in wholesaler inventories at March 31, 2005. Net revenues from product development decreased 19% in the three months ended March 31, 2005 to
$4.0 million, or 9% of net revenues, from $4.9 million, or 8% of net revenues, in the 2004 period,
primarily due to lower product development revenues under our significant development agreement.
We expect to record net revenues of $7.2 million under our significant development agreement in the
first half of 2005, of which $3.7 million was recorded in the three months ended March 31, 2005,
although we received the cash associated with this revenue in April 2004. We do not expect any
further cash receipts or revenues under this agreement. Net revenues from our development services business decreased 19% in the three months ended March
31, 2005 to $20.1 million, from $24.9 million in the 2004 period. The decrease was principally
attributable to lower revenues from our clinical, analytical and sterile manufacturing services.
Customer concerns with respect to our uncertain financial condition have adversely affected our
ability to obtain new development service projects, particularly long-term projects. This trend,
if it continues, could adversely affect future period net revenues of our Development Services
Division. Reimbursed out-of-pocket revenues represent out-of-pocket expenses we incur that are reimbursed to
us by our clients. Reimbursed out-of-pocket revenues decreased to $3.2 million in the three months
ended March 31, 2005, from $4.2 million in the 2004 period. This decrease is primarily related to
projects in our clinical trials operations and is expected to fluctuate from one period to another
as a result of changes in the clinical trials conducted during any period of time. 36




---



##### 



Direct costs (excluding depreciation and royalty expense) decreased $8.8 million, or 27%, to $24.3
million in the three months ended March 31, 2005, from $33.1 million in the same period in 2004.
This decrease in direct costs resulted primarily from lower unit sales of our pharmaceutical
products and a decrease in reimbursable out-of-pocket expenses. Direct costs as a percentage of
net revenues were 56% in the three months ended March 31, 2005 as compared to 57% in the 2004
period. Selling expenses decreased 86% in the three months ended March 31, 2005 to $1.8 million, or 4% of
net revenues, from $13.0 million, or 22% of net revenues, in the 2004 period. This decrease is
primarily due to reduced personnel and marketing and promotional costs related to our product sales
business and a decrease of $3.6 million associated with sales force related expenses under an
agreement with Athlon Pharmaceuticals. We terminated the agreement with Athlon for our contract
sales force in the second quarter of 2004 and we terminated our entire internal sales force in the
fourth quarter of 2004. General and administrative costs decreased $2.8 million in the three months ended March 31, 2005 to
$10.3 million, or 24% of net revenues, from $13.1 million, or 22% of net revenues, in the 2004
period. This decrease was primarily due to lower employee-related expenses resulting from staff
reductions made in 2004, offset by increased legal fees and expenses related to our ongoing
litigation. We anticipate that we will continue to incur legal fees and expenses in connection
with this litigation in 2005, as well as other litigation and investigations and bankruptcy
proceedings. See Legal Proceedings in the 2004 Form 10-K for additional information regarding
this litigation and other pending litigation that may significantly increase our legal expenses in
2005. Research and development expenses were $1.7 million, or 4% of net revenues, in the three months
ended March 31, 2005, compared to $6.4 million, or 11% of net revenues, in the 2004 period. The
decrease in research and development expenses was primarily attributable to decisions to reduce our
active research and development projects due to the liquidity issues we face in 2005. Significant
project spending in 2005 was related to our Lynxorb pain management product and Darvocet line
extension program. Due to liquidity constraints, we have curtailed our research and development
activities, and as of the date of this report the only product under active development is the
Darvocet line extension. In the three months ended March 31, 2005, we recorded $1.6 million of legal, financial and
consulting professional fees associated with debt restructuring activities, including costs related
to a potential filing under chapter 11 of the Bankruptcy Code, and we expect that these expenses
will substantially increase. In the first quarter of 2004, we recorded a $31.0 million expense for a contingent payment to
AstraZeneca AB based on the status of the reformulation of our M.V.I.-12 product (the M.V.I.
Contingent Payment). The FDAs approval in the first quarter of 2004 of the reformulation of this
product created an obligation under our product line acquisition agreement for us to make this
contingent payment (the 2004 M.V.I. Contingent Payment). Royalty expenses for the three months ended March 31, 2005 were $0.1 million. We accrued royalties
based on revenues generated by certain acquired products. We will continue to incur royalty
expenses on these products in 2005. Royalty expenses were $0.5 million for the 2004 period. Our consolidated income from operations was $1.2 million in the three months ended March 31, 2005,
as compared to a loss from operations of $43.9 million in the 2004 period. This increase is
primarily attributable to the 2004 M.V.I. Contingent Payment and the other items discussed above,
including the 37




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lower selling, research and development, general and administrative and professional
fees, partially offset by the decrease in product sales. Income from operations for our product sales business was $5.3 million in the three months ended
March 31, 2005, compared to a loss from operations of $33.9 million in the 2004 period. This
increase is attributable to the 2004 M.V.I. Contingent Payment, partially offset by a decrease in
revenue due to the divestiture of our M.V.I. and Aquasol product lines, the reduction in sales
volumes of our Brethine products and the introduction of generic competition for our Brethine and
Roxicodone products. Income from operations for our product development business was $4.0 million in the three months
ended March 31, 2005, compared to income from operations of $4.9 million in the 2004 period. This
change resulted from the decreased revenues from our significant development agreement, as
discussed above. Income from operations for our development services business was $0.6 million in the three months
ended March 31, 2005, compared to $0.1 million in the 2004 period. This change is primarily due to
reduced overhead costs, resulting from selling, general and administrative expense
restructuring actions taken in 2004, partially offset by the lower revenues, as discussed above,
and resulting decrease in gross margin dollars. Unallocated corporate expenses decreased in the three months ended March 31, 2005 to $6.9 million,
from $8.5 million in the 2004 period. This decrease is primarily related to the lower
employee-related expenses attributable to reductions in force completed in 2004, as discussed
above. Net interest expense increased to $11.4 million in the three months ended March 31, 2005 from $5.6
million in the 2004 period due to increased borrowings and interest rates under our senior credit
facilities (see Liquidity and Capital Resources for additional information on changes to our
debt). We recorded no federal income tax benefit or expense in the three months ended March 31, 2005. We
currently believe that it is more likely than not that any deferred tax assets generated during
2005 will not be utilized; therefore, no tax benefit was recorded. Our effective tax rate for the
three months ended March 31, 2005 and 2004 was zero. Liquidity and Capital Resources Because of the defaults under our senior credit facilities and senior subordinated notes as of
March 31, 2005 and our failure to pay the interest on our notes due April 1, 2005, all $350.5
million of debt outstanding at March 31, 2005 under our senior credit facilities and notes is
classified as current liabilities on our consolidated balance sheet at March 31, 2005. Due in part
to this classification, our current liabilities at March 31, 2005 exceed our current assets by
$390.5 million. In light of our current financial condition, we believe that our operations cannot support our
existing debt and that we must restructure our debt to levels that are more in line with our
operations. Thus, it is highly likely that we and our U.S.
subsidiaries will seek relief in bankruptcy under chapter 11 of
the Bankruptcy Code. See Analysis of Liquidity below. Historically, we have funded our businesses with cash flows provided by operations and proceeds
from borrowings. Cash flow provided by operations in the first three months of 2005 was $6.5
million, 38




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compared to cash flow provided by operations of $11.8 million in the first three months of
2004. This decrease was primarily due to a significant decrease in cash receipts from the sale of
our pharmaceutical products and payments for the development services we performed for third
parties, partially offset by an $11.3 million income tax refund we received in March 2005. Cash used in investing activities was $1.2 million and $2.6 million in the first three months of
2005 and 2004, respectively, primarily related to capital spending. Net cash used in financing activities during the first three months of 2005 was $0.1 million,
compared to $7.4 million in the first three months of 2004, which resulted from the $10.2 million
of payments on our debt, partially offset by $3.6 million received from the exercise of stock
options. One of our major pharmaceutical products customers continues to set off cash payments due to us for
the pharmaceutical products that it purchases from us against amounts due from us for services
under separate agreements with affiliates of such customer. This customer also has set off cash
payments due to us against amounts that we may owe it for product returns and chargebacks related
to certain pharmaceutical products that it has already purchased from us. Other Commitments and Contingencies We may have to make contingent payments of $4.7 million over three years in connection with the
purchase of our Charleston, South Carolina manufacturing facility, based on the level of future
manufacturing revenues at this facility. At March 31, 2005, these contingent payment obligations
are not liabilities and have not been recorded on our consolidated balance sheet. For additional information about other contingencies to which we are subject, including litigation
and governmental investigations, see Legal Proceedings and Managements Discussion and Analysis
of Financial Condition and Results of Operations-Liquidity and Capital Resources-Commitments and
Contingencies in our 2004 Form 10-K. Analysis of Liquidity We incurred a substantial net loss and loss from operations for 2004 and a substantial net loss in
the quarter ended March 31, 2005. As a result of our recurring substantial net losses, we did not
have available sufficient cash on hand, or the ability to borrow under our senior credit
facilities, to pay the approximately $10.5 million of scheduled interest due on April 1, 2005 on
our $175 million of senior subordinated notes due 2010. In March 2005, we received a tax refund of approximately $11.3 million, all or substantially all of
which was required to be paid down under our senior credit facilities. Events of default had also
occurred under our senior credit facilities that would prohibit borrowings thereunder absent a
waiver from our senior lenders. On March 31, 2005, we entered into a waiver agreement pursuant to
which our senior lenders agreed to forbear in exercising remedies with respect to these existing
events of default until the earlier of April 30, 2005 or the occurrence of another default under
the waiver agreement or our senior credit facilities. This forbearance period terminated on April
30, 2005, and our senior lenders are entitled to accelerate the debt outstanding under our senior
credit facilities. This waiver agreement also permitted us to immediately use approximately $5.7
million of the tax refund to meet budgeted liquidity 39




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needs and required us to temporarily pay down
revolving loans under the senior credit facilities with the remaining $5.6 million of the tax
refund. Despite the existing events of default, the waiver permitted us to reborrow this $5.6
million, in weekly draws, to meet budgeted liquidity needs. We have subsequently borrowed the
entire $5.6 million. Pursuant to an additional waiver agreement we entered into with our senior
lenders on April 29, 2005, such lenders permitted us to borrow approximately $1.0 million, provided
that $750,000 of the borrowing is applied to pay commitment fees and expense deposits in connection
with a specified debtor-in-possession financing facility for which we accepted a commitment letter
on April 29, 2005. We have borrowed this additional amount and applied $750,000 of the proceeds of
this borrowing as required under the waiver. On May 3 and May 4, 2005, as permitted by the terms
of the senior credit facilities and as authorized by us, the lenders advanced approximately $1.8
million in aggregate revolving loans under the senior credit facilities to pay interest then due
under the senior credit facilities. No other borrowings are permitted under our senior credit
facilities absent a consent of our senior lenders. Because we did not make the $10.5 million scheduled interest payment due April 1, 2005 on our
senior subordinated notes within 30 days after April 1, holders of 25% of the notes and the trustee
under the indenture governing the notes are each entitled to accelerate the notes. Our senior
lenders are also entitled to accelerate the obligations outstanding under our senior credit
facilities. We have been exploring a potential sale of some or all of the assets of our Pharmaceuticals
Division, as well as other operating assets. In October 2004, we engaged Rothschild Inc. to assist
us, and in November 2004 Rothschild began a process to gauge the interest in any asset sale
transaction by contacting potential strategic and financial purchasers. Potential purchasers
expressing an interest were provided an opportunity to examine detailed information regarding our
Pharmaceuticals Division, its business, products and products in development. On March 31, 2005,
we entered into a limited exclusivity agreement with a potential purchaser of certain of the assets
of our Pharmaceuticals Division to facilitate continued due diligence and negotiation over a
potential sale. This written exclusivity agreement expired by its terms on April 22, 2005, though
we are continuing to negotiate with this potential purchaser on an exclusive basis. We have not
reached a definitive agreement with this potential purchaser regarding a sale and we cannot provide
any assurance that any material asset sale will be agreed upon or completed. In addition, we have
not determined to sell any material assets, and we plan to continue to operate our Pharmaceuticals
Division if we do not complete such a sale of its assets. Pursuant to the terms of our senior credit facilities, the net proceeds of any material asset sale
are required to be applied to permanently reduce our outstanding indebtedness under our senior
credit facilities. Similarly, the indenture governing our notes requires that the net proceeds of
material asset sales be applied to permanently reduce indebtedness under the senior credit
facilities to $40 million, at which point we would be permitted under the indenture to incur an
additional $10 million of indebtedness solely to fund payments of interest on the notes.
Accordingly, such a sale would not provide liquidity unless the amount of the net proceeds was in
excess of the amount needed to discharge our indebtedness under the senior credit facilities or our
senior lenders and holders of our notes consented to permit a portion of the net proceeds to be
used for a purpose other than repayment of our senior debt. Based on our exploration of a possible
sale of some or all of the assets of our Pharmaceuticals Division, we believe that the sale of all
of the assets of our Pharmaceuticals Division at this time, given our financial condition and other
circumstances, would yield net proceeds in an amount substantially less than the amount needed to
discharge the indebtedness under our senior credit facilities. 40




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A sale of some or all of the assets
of the Pharmaceuticals Division would require the consent of the lenders under our senior credit
facilities, and such a sale may require the consent of the holders of our notes and our
stockholders. In light of our current financial condition, we believe that our operations can no longer support
our existing debt and that we must restructure our debt to levels that are more in line with our
operations. Thus, it is highly likely that we and our U.S. subsidiaries will seek relief under
chapter 11 of the U.S. Bankruptcy Code which would substantially dilute and may eliminate the
interests of the holders of our common stock. We have continued our engagement of FTI Consulting, Inc. (FTI) as our financial advisor to assist
us in exploring our alternatives. With FTI, we have held discussions with lenders under our senior
credit facilities and advisors to an ad hoc committee of holders of our notes in an effort to
negotiate a consensual restructuring of our debt. In addition, we have engaged in discussions and
negotiations with prospective lenders to obtain financing sufficient to refinance indebtedness
outstanding under the senior credit facilities and/or to provide additional credit facilities in
order to fund our operations
while in a chapter 11 proceeding under the Bankruptcy Code if we were to commence such a
proceeding. On April 29, 2005, we accepted a commitment letter from Silver Point Finance, LLC to
provide debtor-in-possession financing if we and our U.S. subsidiaries commence bankruptcy
proceedings under chapter 11 of the Bankruptcy Code. This debtor-in-possession financing would be
subject to a number of conditions, including approval by the bankruptcy court. See Managements
Discussion and Analysis of Financial Condition and Results of Operations  Liquidity and Capital
Resources  Debtor-in-Possession Financing. Senior Credit Facilities On April 23, 2004, we entered into $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. We entered into amendments to these credit facilities on August 9, 2004
and August 13, 2004 to, among other things, increase the amount of the term loan by up to $10
million, extend the maturity date of the facilities by one year, increase the interest rate on the
loans by an additional 1.5% subject to potential incremental reduction, adjust certain covenants
under the facilities and waive certain defaults and events of default. As amended, our new senior
credit facilities consisted of a $135 million senior secured term loan facility (of which $125
million was fully drawn at the initial closing in April and the remaining $10 million was drawn on
August 13, 2004) and a $15 million senior secured revolving credit facility. Our senior credit
facilities included a covenant requiring us to maintain combined availability under the revolving
credit facility and cash and cash equivalents in the aggregate amount of $5.0 million plus certain
other amounts related to payables, bank overdrafts and interest payments on the loans paid in the
form of additional notes. The outstanding loans under our new senior credit facilities are payable
in full on April 21, 2007. The August amendments also required us to retain FTI during the term of
the senior credit facilities unless certain available cash and annualized cost reduction thresholds
were satisfied by a specific date, at which time our retention of FTI could be terminated. These
thresholds were not met. Our 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. As part of the initial borrowing under these senior credit facilities, we recorded a
$6.2 million loss for the early 41




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extinguishment of debt related to the write-off of financing fees
related to our previous senior credit facilities. 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 equity issuances; and
    extraordinary receipts, as defined. Optional reductions in revolving credit commitments and optional prepayments of term loans, as well
as mandatory reductions in revolving credit commitments and mandatory prepayments of term loans
from the net proceeds of asset sales, subject to defined exceptions, are subject to a prepayment
fee equal to 3.5% until August 9, 2005, 2.5% for the subsequent 12 months, and 1.5% for the next 6
months (with no prepayment penalty payable for the remainder of the term). Prior to the August 9,
2004 amendment, outstanding loans under the facilities bore 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. As a result of, and effective with, the
August amendments to these credit facilities, the applicable interest rate on outstanding loans was
increased by an incremental amount, which was initially 1.5%, subject to incremental reductions
based on our financial performance. An additional 1% per annum unused line fee is payable on unused
revolving credit commitments, payable quarterly in arrears. The proceeds of the initial borrowings under these facilities were used, together with the net cash
proceeds from the sale of our M.V.I. and Aquasol product lines, to (i) fund payment of termination
obligations with respect to 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
senior subordinated notes due 2010, (iv) provide for ongoing working capital and general corporate
needs, and (v) pay fees, costs and expenses in connection with the new senior credit facilities and
other corporate transactions. Effective as of October 8, 2004, we amended our senior secured credit facilities to, among other
things, adjust financial covenants. The senior secured lenders also waived compliance with certain
financial covenants in the senior secured credit facilities for the quarter ended September 30,
2004 and the quarter ended December 31, 2004 provided that we met minimum consolidated EBITDA
thresholds (as defined in the senior secured credit facilities). The amendment also added a
minimum gross revenue requirement of $40 million for the quarter ended December 31, 2004 and
consented to certain asset disposition transactions and receipt of a deferred purchase price
payment pursuant to which we received approximately $4.2 million in the aggregate. These
transactions related to the sale of our investment in Aesgen Inc. and our M.V.I. and Aquasol
product lines. The amendment also waived any requirement to prepay the senior secured loans with
the net proceeds of these transactions. As a result of changes to certain financial covenants
affected by this amendment, we were in compliance with the adjusted covenants under our senior
credit facilities at and for the applicable periods ended December 31, 2004. On October 22, 2004, we entered into another amendment to our senior secured credit facilities that
increased the existing term loan facility under our senior secured credit facilities by $30 million
(the Supplemental Term Loan), subject to certain specified conditions which were satisfied on
October 29, 42




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2004. The Supplemental Term Loan was made available in up to three draws to be made on
or prior to January 15, 2005. We borrowed $20 million of such term loans on October 29, 2004 and
the remaining $10 million of such loans in increments on November 5, 2004, November 12, 2004,
November 24, 2004 and December 9, 2004. Following effectiveness of the amendment and these
borrowings, our senior secured credit facilities consisted of a term loan of $165 million and a
revolving credit facility of up to $15 million. The amendment also modified the interest rate on the entire senior secured credit facilities,
including the Supplemental Term Loan, to equal a defined LIBOR rate (with a floor of 2%) plus 8.25%
per annum or a defined reference rate (with a floor of 4%) plus 7.25% per annum. The amendment
also provided for a commitment fee equal to 0.75% per annum on any undrawn portion of the Supplemental
Term Loan, payable monthly in arrears. At March 31, 2005, 30-day LIBOR was 2.9%. The amendment retained the April 21, 2007 maturity date of the senior secured credit facilities and
the optional and mandatory prepayment requirements and premiums described above. The proceeds of the loans under the Supplemental Term Loan were used (i) to fund payment of the
October 1, 2004 interest payment due on our senior subordinated notes, (ii) to pay fees, costs and
expenses in connection with the amendment and the October 2004 consent solicitation for our senior
subordinated notes, and (iii) for working capital and other general corporate purposes. The amendment retained substantially the same representations, warranties and affirmative and
negative covenants as are provided in the existing senior secured credit facilities, 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
amendment also added a covenant requiring us to retain Rothschild Inc. or another financial advisor
to assist with our exploration of the potential sale of some or all of the assets comprising our
Pharmaceuticals Division. The amendment also maintained the existing financial covenants under the senior secured credit
facilities, including a minimum fixed charge coverage ratio, and a maximum total debt to trailing
twelve-month EBITDA leverage ratio, but eliminated a minimum gross revenue covenant for the quarter
ended December 31, 2004. Compliance with the fixed charge coverage ratio and the leverage ratio
was also waived through the first quarter of 2005 so long as defined minimum EBITDA thresholds were
satisfied. In addition, the amendment retained a covenant requiring certain levels of cash or
revolver availability and increased the level of cash or revolver availability required for the
period from March 31, 2005 through May 15, 2005 to $15.0 million. The amendment also substantially retained the existing events of default under the senior secured
credit facilities, including, among others, nonpayment of principal, interest or fees, violations
of covenants, inaccuracy of representations and warranties, a cross-default to our senior
subordinated notes and other material indebtedness, bankruptcy events, and a change in control and
added an event of default if we fail to pursue in good faith the exploration of the potential sale
of some or all of the assets comprising our Pharmaceuticals Division or other non-core assets. 43




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As of March 31, 2005, events of default existed under our senior credit facilities that prohibited
borrowings thereunder absent a waiver from our senior lenders. These events of default included
the violation of the cash/revolver availability covenant described above and the failure to timely
file our Form 10-K for the fiscal year ended December 31, 2004, which was subsequently filed on
April 27, 2005. On March 31, 2005, we entered into a waiver agreement pursuant to which our senior
lenders agreed to forbear in exercising remedies with respect to the defaults and events of default
existing on that date until the earlier of April 30, 2005 or the occurrence of another default
under the waiver agreement or our senior credit facilities. The forbearance under the waiver
agreement terminated on
April 30, 2005, and our senior lenders accordingly have the right to accelerate the debt
outstanding under our senior credit facilities. The waiver agreement also permitted us to immediately use approximately $5.7 million of our $11.3
million tax refund received in March 2005 to meet budgeted liquidity needs and required us to
temporarily pay down revolving loans under the senior credit facilities with the remaining $5.6
million of the tax refund. Despite the existing events of default, the waiver permitted us to
reborrow this $5.6 million, in weekly draws, to meet budgeted liquidity needs, and we have fully
borrowed this amount. Pursuant to an additional waiver agreement entered into by us and our senior
lenders on April 29, 2005, such lenders permitted us to borrow approximately $1.0 million, provided
that $750,000 of the borrowing was applied to pay commitment fees and expense deposits in
connection with a specified debtor-in-possession financing facility for which we accepted a
commitment letter on April 29, 2005. We have borrowed this additional amount and applied $750,000
of the proceeds of this borrowing as required under the waiver. On May 3 and May 4, 2005, as
permitted by the terms of the senior credit facilities and as authorized by us, the lenders
advanced approximately $1.8 million in aggregate revolving loans under the senior credit facilities
to pay interest then due under the senior credit facilities. No other borrowings are permitted
under our senior credit facilities absent a consent of our senior lenders. 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 is being charged to interest expense over the term of the notes. These
notes originally had 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
were 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 those facilities
before we may 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. On March 31, 2004, the lenders under our then-existing credit agreement, which was then in default,
exercised their right to block us from making the interest payment due on April 1, 2004 to holders
of our senior subordinated notes. Accordingly, we did not make that interest payment on April 1,
2004. In addition, our failure to timely file our 2003 Form 10-K constituted a default under the
indenture governing the senior subordinated notes. 44




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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 credit facilities
with our current 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 2003 Form 10-K was 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 2003 Form 10-K
was 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 2003 10-K was 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
effect these amendments and waivers and made the interest payment that had been due on April 1,
2004, together with default interest. On October 1, 2004, we failed to make the interest payment then due on our senior subordinated
notes. The failure to make the October 1, 2004 interest payment constituted a default under our
notes, subject to a 30-day cure period. On October 29, 2004, we made the interest payment, curing
the default under the notes. On October 29, 2004, we also completed a solicitation seeking the consent from the holders of our
senior subordinated notes to certain amendments to, and waivers under, the indenture governing our
senior subordinated notes to, among other things:  
    permit us to incur up to $30 million of additional indebtedness under credit facilities;
    permit us to incur additional senior debt in order to maintain $40 million (subject to an
increase up to $50 million in order to allow us to make interest payments on the senior
subordinated notes) in senior debt under credit facilities in the event we are required to
pay down senior debt with the proceeds of asset sales;
    require that debt permitted to be incurred under a fixed charge coverage ratio test set
forth in the indenture must rank on parity with or be subordinated in right of payment to
the senior subordinated notes and any liens granted to secure any such parity debt shall
rank pari passu with the liens securing our senior subordinated notes;
    require proceeds of asset sales to be used to reduce senior debt under credit facilities
to $40 million; 45




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
    provide that the liens on assets that secure obligations under our senior subordinated
notes will continue if all senior debt is repaid, but will resume as junior liens if we
thereafter incur any new senior debt;
    prohibit the payment in cash in excess of an aggregate of $5 million to settle pending
litigation, excluding payments funded or reimbursed under insurance policies, until we make
the interest payments due on our senior subordinated notes on April 1, 2005 and October 1,
2005;
    prohibit the payment of dividends on our common stock and other restricted payments (as
defined in the indenture) until the interest payments due on our senior subordinated notes
on April 1, 2005 and October 1, 2005 are paid; and
    temporarily increase the interest rate on our senior subordinated notes by 0.5% per annum
(to 12% per annum), beginning on October 1, 2004 and ending on March 31, 2005. The completion of the consent solicitation satisfied a condition of an amendment to our senior
credit facilities (described above) that, among other matters, made available a supplemental term
loan under the senior credit facilities that was used in part to make the October 1, 2004 interest
payment on our senior subordinated notes, together with default interest thereon, on October 29,
2004 and to pay the consent fee described below. In connection with the October 2004 consent solicitation, we paid a consent fee to the holders of
senior subordinated notes who had submitted valid and unrevoked consents by the expiration date of
the consent solicitation of $20 for each $1,000 in principal amount of senior subordinated notes
for which a consent was submitted. Following discussions with representatives of an ad hoc
committee of holders of the senior subordinated notes, we offered to pay the same consent fee with
respect to senior subordinated notes for which a valid and unrevoked consent had not been properly
submitted by the expiration of the consent solicitation, if the holder of such senior subordinated
notes completed a consent and release for payment by February 7, 2005 that consented to the
proposed amendments and waivers described above and waived all claims the holder may have against
us, the trustee under the indenture governing the senior subordinated notes, the payment agent in
the consent solicitation, and our and their respective directors, officers, employees, agents,
attorneys, affiliates and advisors with respect to matters related to the consent solicitation. On
February 9, 2005, we paid approximately $1.0 million in additional consent fees pursuant to
properly submitted consents and releases for payment. At March 31, 2005, we were in default under the covenants under the senior subordinated notes as a
result of our failure to timely file our Annual Report on Form 10-K for the year ended December 31,
2004 and to deliver to the trustee of the indenture governing the senior subordinated notes certain
certificates of our officers and our registered independent public accountants. These events of
default would entitle the trustee under the indenture for the notes or the holders of 25% of the
principal amount of the notes to accelerate the notes if such events of default were not cured
within 60 days of notice by such person. We have since filed our 2004 Annual Report on Form 10-K.
In addition, we failed to pay the $10.5 million of scheduled interest due on April 1, 2005 within
30 days after April 1. This event of default entitles the trustee under the indenture for the
notes or the holders of 25% of the principal amount of the notes to accelerate the notes. Any
event of default entitling the trustee or the holders of the notes to accelerate the notes also
constitutes an event of default under our senior credit facilities entitling our senior lenders to
accelerate the debt thereunder. Because of the defaults under our notes, all $175.0 million of debt outstanding at March 31, 2005
under our notes is classified as a current liability on our consolidated balance sheet at March 31,
2005. 46




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Debtor-in-Possession Financing On April 29, 2005, we accepted a commitment letter from Silver Point Finance, LLC to provide
debtor-in-possession financing (the DIP Facilities). The DIP Facilities would be available only
if we commenced bankruptcy proceedings under the Bankruptcy Code and are subject to a number of
conditions described below. In the event that we commenced such proceedings, subject to initial
approval of the bankruptcy court and the satisfaction of other conditions, the DIP Facilities would
provide a $15 million interim, 30-day revolving credit facility to meet our immediate liquidity
needs prior to final approval of such facilities by the bankruptcy court. Upon final approval of
the DIP Facilities by the bankruptcy court and the satisfaction of other conditions, the DIP
Facilities would consist of a revolving credit facility in an aggregate principal amount not to
exceed $30 million and a term loan facility in the aggregate principal amount of $180 million.
Silver Point Finance, LLC currently serves as a lender and the collateral agent under our existing
senior credit facilities. The description of the DIP Facilities set forth below is based upon a
term sheet attached to the commitment letter and such terms may change during the negotiation of
definitive documentation. We can provide no assurance that we will be able to complete the
definitive documentation for the DIP Facilities or meet the conditions to the closing of such
facilities. The proceeds of the DIP Facilities would be used initially for working capital purposes and upon
final approval by the bankruptcy court to refinance our obligations under the existing senior
credit facilities, pay fees and expenses in connection with the DIP Facilities and fund our working
capital and general corporate requirements while the bankruptcy proceedings were pending. The DIP
Facilities (other than the interim facility, which would mature in 30 days) would mature twelve
months after closing; however, we would be obligated to repay the DIP Facilities earlier upon
completion of a plan of reorganization that had been confirmed by an order of the bankruptcy court.
The DIP Facilities would also require mandatory prepayment with the net cash proceeds from the
issuance of additional debt, non-ordinary course asset sales, tax refunds, casualty and similar
events (with negotiated exceptions). The covenants under the DIP Facilities would be similar to those under our existing senior credit
facilities with changes to reflect the debtor-in-possession nature of the financing, and would
include provision of budgets and financial statements, notices of litigation and defaults and
provision of other information, compliance with laws, inspection of properties, books and records,
maintenance of insurance, retention of certain advisors and limitations on liens, dividends,
retirement of capital stock, guarantees, sale and leaseback transactions, consolidations and
mergers, investments, capital expenditures, loans and advances, indebtedness, operating leases,
transactions with affiliates, payment of pre-petition indebtedness, prepayment of indebtedness and
amendments to material agreements. Events of default would include matters similar to those under our existing senior credit
facilities and those customary for debtor-in-possession financings and, in addition, an event of
default related to the failure to meet certain sale process deadlines related to a potential sale of
the Pharmaceuticals Division. The obligations under the final DIP Facilities would be entitled to
super-priority administrative expense claim status under the Bankruptcy Code, subject to a basket
for professional fees in the case of an event of default. During the term of the interim facility,
the interim facility would receive super-priority administrative claim status, and the existing
senior credit facilities would retain their first priority position and also receive priority
administrative expense status solely to the extent of any diminution in
value of the existing senior credit facility claim in the bankruptcy proceedings caused by the
priming liens granted in favor of the interim facility. 47




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Conditions to the initial funding under the interim facility would include, among other matters,
approval of the interim facility by the bankruptcy court and the lenders satisfaction with (i) the
terms of a proposed asset purchase agreement for the proposed sale of the assets of the
Pharmaceuticals Division, (ii) our projected budget, (iii) the proposed sale schedule for the
proposed sale of the Pharmaceuticals Division and (iv) certain lien matters. Conditions to the final facility would include, among other matters, (i) approval by the bankruptcy
court of the final facility no later than 30 days after the approval of the interim facility, (ii)
payoff of the existing senior credit facilities in full and (iii) the lenders satisfaction with
certain lien matters. New Accounting Standards In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting
Standards No. 123 (revised 2004), Share-Based
Payment (SFAS 123(R)), which amends Statement of
Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (SFAS 123), and
supersedes APB Opinion No. 25, Accounting for Stock Issued
to Employees. SFAS 123(R) requires
compensation expense to be recognized for all share-based payments made to employees based on the
fair value of the award at the date of grant, eliminating the intrinsic value alternative allowed
by SFAS 123. SFAS 123(R) requires all share-based payments to employees, including grants of
employee stock options, to be recognized in the financial statements based on their fair values
(i.e., pro forma disclosure is no longer an alternative to financial statement recognition). SFAS
123(R) must be adopted in the first annual period beginning after June 15, 2005. We currently plan to adopt
SFAS 123(R) on January 1, 2006. This change in accounting is not
expected to materially impact our financial position. However, because we currently account for
share-based payments to our employees under APB 25, our results of operations have not included the
recognition of compensation expense for the issuance of stock option awards. Had we applied the
fair-value criteria established by SFAS 123(R) to previous stock option grants, the impact to our
results of operations would have approximated the impact of applying SFAS 123, which was a
reduction to net income of approximately $1.1 million and $3.1 million in the three months ended
March 31, 2005 and 2004, respectively. We do not believe that any other recently issued, but not yet effective, accounting standards will
have a material impact on the company. Risk Factors and Forward Looking Statements Forward-Looking Statements and Safe Harbor Language This report 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 report 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 and businesses, and markets for our common stock. Forward-looking statements also include
statements about potential events of default, or acceleration of the debt, under our senior credit
facilities and outstanding notes, proposed financial restructuring transactions, the need to seek
protection under the Bankruptcy Code, 48




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potential asset sales, our internal control over financial
reporting, and plans and objectives of our management. 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 outcomes to differ
materially from those described in the forward-looking statements. These statements are not
guarantees of future outcomes, 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 may differ materially from what is expressed in the
forward-looking statement. 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:  
    our ability to obtain an agreement with our senior lenders and an ad hoc
committee of holders of our notes to a plan to restructure our debt and to effect such
an agreement,
    our ability to comply with, or receive further or continued waivers, consents
or forbearances of our lenders with respect to, financial covenants under our senior
credit agreement or other indebtedness or receive waivers of any defaults under such
agreements,
    our ability to generate sufficient cash from operations, asset sales and other
transactions to fund our cash needs, and our inability to do so has resulted in the
high likelihood that we will file a voluntary petition for bankruptcy,
    our ability to continue to operate in the ordinary course and to manage our
relationships with our lenders, bondholders, customers, vendors and suppliers and
employees,
    our ability to attract, retain and complete product development projects and
other customer relationships,
    our ability to obtain critical supplies,
    our ability to effect the sale of some or all of the assets comprising our
Pharmaceuticals Division and other assets, if we choose to do so, on attractive terms
or at all and to obtain necessary consents and waivers from our senior lenders and the
holders of our senior subordinated notes to permit such sales and the application of
the net proceeds of such sales for working capital purposes,
    our ability to obtain approval of debtor-in-possession credit facilities in
order to fund our operations while in any chapter 11 proceeding under the U.S.
Bankruptcy Code, including our ability to satisfy the conditions to the closing of the
DIP Facilities,
    the impact of material weaknesses in internal control over financial reporting
on our ability to timely prepare accurate financial statements and to avoid material
adverse effects on our financial and operational results,
    our ability to timely remediate identified material weaknesses in internal
control over financial reporting, 49




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
    the investigations by the U.S. Attorneys office and the SEC into our financial
reporting and related activity,
    the outcome of pending litigation filed against us,
    the outcome of pending litigation we have filed against others,
    significant changes in our management team and the loss of critical personnel,
    our ability to attract critical personnel,
    demand for our products and services and the products we produce for others,
    the prices that we or our customers can obtain for our products and services,
    the level of competition we face,
    distributors and wholesalers inventory levels and ordering and payment patterns,
    the amounts and timing of product returns and chargebacks,
    timely success in product development and regulatory approvals for new products
and line extensions, both for our proprietary products and products we develop for our
customers,
    market acceptance of new products and line extensions at levels that justify
our cost of developing or acquiring these products,
    actions by the United States Food and Drug Administration (FDA) in connection
with submissions related to our products or those of our competitors or customers,
    other governmental regulations and actions affecting our products and services
or those of our competitors,
    third-party payer decisions and actions affecting our products or those of our
competitors or customers,
    our ability to participate in federal health care programs, including the
Medicare and Medicaid programs,
    developments in patent or other proprietary rights owned by us or others, and
    general conditions in the economy and capital markets. Some of these factors and additional factors that may cause our actual results to differ materially
are discussed in our 2004 Form 10-K under the heading Managements Discussion and Analysis of
Financial Condition and Results of Operations  Risk Factors and Forward Looking Statements  Risk
Factors. Whenever you read or hear any subsequent written or oral forward-looking statements 50




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attributable to us or any person acting on our behalf, you should keep in mind the cautionary
statements contained or referred to in this report. We do not undertake, and expressly disclaim, any obligation to update or alter our forward-looking
statements, whether as a result of new information, future events or otherwise, except as required
under the securities laws. Item 3. 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, principally exchange rates between the U.S. dollar and the euro. As
foreign exchange rates change, the U. S. dollar equivalent of revenues and expenses denominated in
foreign currencies changes. If foreign exchange rates were to increase by 10%, our net loss would
have been higher by $0.5 million in the three months ended March 31, 2005 due to the reduction in
reported results from European operations. We are also exposed to fluctuations in interest rates on borrowings under our senior credit
facilities. The interest rates payable on these borrowings are based on LIBOR. If LIBOR rates
were to increase by 1%, annual interest expense on our variable rate debt would increase by
approximately $1.8 million. Item 4. Controls and Procedures. Evaluation of Disclosure Controls and Procedures We have carried out an evaluation, under the supervision and with the participation of our Chief
Executive Officer and 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
our disclosure controls and procedures as of March 31, 2005, the end of the period covered by this
Quarterly Report on Form 10-Q. Disclosure controls and procedures are to be designed to reasonably
assure that material information we must disclose in our reports filed or submitted under the
Securities Exchange Act of 1934, such as this Quarterly Report on Form 10-Q, is (i) recorded,
processed, summarized and reported on a timely basis and (ii) accumulated and communicated to our
management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to
allow timely decisions regarding disclosure. As a result of that evaluation, our Chief Executive
Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were
not effective as of March 31, 2005 due to the material weaknesses described in our managements
report on internal control over financial reporting included in Item 8 of our 2004 Form 10-K and
outlined below. As of March 31, 2005, none of the material weaknesses identified in the 2004 Form
10-K have been fully remediated. 1. The Companys controls over revenue recognition from Development Services activities do not
ensure that the revenue is not recorded in amounts in excess of the amount stated in the purchase
order or contract. 2. The Companys controls over the accounting for inventory of certain supplies used in the
non-clinical portion of the Development Services business lack adequate control processes to ensure
that timely adjustments are made to the recorded amount of inventory as the asset is consumed. 51




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3. The Company lacks effective controls over the period-end financial closing process due to
ineffective controls existing in the review processes, a lack of timely closing of the Companys
financial books and records and reporting of those results, and segregation of duties conflicts
within the accounting functions involved in the closing process. 4. The Company lacks effective controls over the processes and procedures involved in the
accounting for income taxes in connection with the preparation of consolidated financial
statements. 5. The Company lacks effective controls over the process for reviewing its intangible assets for
impairment in connection with the preparation of the Companys consolidated financial statements. 6. The Company lacks effective controls over the process for determining appropriate product
returns reserves for product sales. Changes in Internal Controls We made the following changes in our internal control over financial reporting during the first
quarter of 2005 that materially affected or are reasonably likely to materially affect our internal
control over financial reporting:  
    During the first quarter of 2005, we completed an initial review of all finance
employees security authorizations for the financial reporting system and, where
appropriate, eliminated security authorizations in order to prevent segregation of duties
conflicts.
    Quarterly reviews of divisional financial statements, performed by the corporate
Controller in conjunction with the divisional financial managers, began for the first
quarter of 2005. Significant variances between actual results and budgeted (forecast)
amounts and variances from prior years identified during these reviews were discussed with
each division. This new procedure provides additional controls over the period-end
closing process. We do not believe that these changes or the changes to internal control over financial reporting
that we implemented during 2004 to address the material weaknesses described in managements report
of its assessment of internal control over financial reporting (for information about these 2004
enhancements, please see managements report, which is included with the financial statements set
forth in Item 8 of our 2004 Form 10-K), fully remediate the material weaknesses. Accordingly, we
are in the process of implementing the following specific enhancements to our internal control over
financial reporting related to the material weaknesses described in our 2004 Form 10-K:  
    Management is currently reviewing the invoicing processes for our Development Services
Division and determining areas where more control and review processes should be added. We
are currently in the process of developing these new procedures; however, we do not expect
these to be in place until the fourth quarter of 2005. In order to provide assurance on the
financials as they relate to the invoicing function, management is performing quarterly
internal audits of the Development Services invoicing function.
    A review of the process used for accounting for the issuance of supplies inventory used
in the non-clinical portion of our Development Services business is currently being
performed by a task force identified to address this issue and determine the appropriate
control procedures to 52




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implement in this process. We expect that these new processes will
be implemented during the second quarter of 2005. In order to gain assurance as to the
reported non-clinical supplies inventory amounts for the first quarter of 2005, management
performed a physical inventory count of such inventory at the end of the first quarter of
2005. These procedures provide additional control over the accounting for inventory of
certain supplies used in the non-clinical portion of the Development Services business. Management is still considering additional control implementations that will be needed to
adequately address the identified material weaknesses and is also monitoring the implemented
control procedures to ensure they are performed properly. In order to remediate the numerous
material weaknesses in our internal control over financial reporting, we will be required to devote
significant financial resources and management attention to our remediation efforts. Due to our
liquidity and human resources constraints, we may not be able to devote sufficient financial
resources to successfully remediate the material weaknesses in our internal controls that we have
identified. In addition, our management is currently focused on dealing with our liquidity issues
while continuing to operate our business, and thus may not be able to devote sufficient time and
attention to our remediation efforts. PART II. OTHER INFORMATION Item 1. Legal Proceedings. There have been no material developments in the legal proceedings described in Legal Proceedings
in our 2004 Form 10-K, which was filed with the SEC on April 27, 2005. 53




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Item 2. Unregistered Sales of Equity Securities and Use of Proceeds (d) Maximum Number (or(c) Total Number of
    
    
    Approximate Dollar Value)(a)
    
    
    (b)
    
    
    Shares (or units)
    
    
    of Shares (or units) thatTotal Number
    
    
    Average Price
    
    
    Purchased as part of
    
    
    May Yet Be PurchasedShares (or units)
    
    
    Paid Per Share
    
    
    Publicly Announced
    
    
    Under the Plans orPeriod
    
    Purchased *
    
    
    (or unit)
    
    
    Plans or Programs
    
    
    ProgramsJanuary
    
    
    20,860
    
    
    $
    3.23
    
    
    
    
    
    
    
    February
    
    
    33,747
    
    
    
    2.67
    
    
    
    
    
    
    
    March
    
    
    17,253
    
    
    
    2.45
    
    
    
    
    
    
    
    Total
    
    
    71,860
    
    
    $
    2.78
    
    
    
    
    
    
    
    
 * All of these shares were purchased on the open market by the trustee of the Companys Retirement
Savings Plan with cash provided by the Company as an employer match. These shares are held as assets of the plan.
The Company does not consider these purchases to be part of a publicly announced plan or program.
The purchase of Company common stock as the employer match under the Retirement and Savings Plan
was discontinued in the first quarter of 2005. Item 3. Defaults Upon Senior Securities We have not paid the $10.5 million of scheduled interest due on April 1, 2005 on our $175 million
of senior subordinated unsecured notes due 2010. An event of default occurred under the indenture
governing the notes because this interest payment was not made within 30 days after April 1. This
event of default entitles the trustee under the indenture for the notes or the holders of 25% of
the principal amount of the notes to accelerate the notes. Events of default also exist under our $180 million 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. On March 31, 2005, we were not in compliance with a covenant requiring
cash or revolver availability to be $15,000,000 and certain additional covenants resulting in
defaults and events of default under the senior credit facilities. As of the date of this report,
we continue to be in breach of the cash and revolver availability covenant described above. On
March 31, 2005, we entered into a waiver agreement pursuant to which our senior lenders agreed to
forbear in exercising remedies with respect to the defaults and events of default existing on that
date until the earlier of April 30, 2005 or the occurrence of another default under the waiver
agreement or our senior credit facilities. This forbearance period has expired, and accordingly
our senior lenders are entitled to accelerate the debt outstanding under our senior credit
facilities. In addition, our failure to pay the April 1 interest payment on the notes (which
entitles the trustee or the holders of the notes to accelerate the notes) constitutes an event of
default under our senior credit facilities entitling our senior lenders to accelerate the debt
thereunder. Our senior credit facilities and the notes 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. 54




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Item 6. Exhibits A list of the exhibits required to be filed as part of this Quarterly Report on Form 10-Q is set
forth in the Exhibit Index, which immediately precedes such exhibits, and is incorporated herein
by reference. 55




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused
this report to be signed on its behalf by the undersigned thereunto duly authorized. aaiPharma Inc.Date:      May 5, 2005
    
    By:
    
    /s/Ludo J. ReyndersLudo J. Reynders
Chief Executive OfficerDate:      May 5, 2005
    
    By:
    
    /s/ Matthew CzajkowskiMatthew Czajkowski
Chief Financial Officer
 56




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aaiPharma Inc.
Exhibit Index ExhibitNo.
    
    Description10.1
    
    Letter agreement between aaiPharma Inc. and Timothy Wright*, **10.2
    
    Waiver and Consent effective as of March 28, 2005 with respect to 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 10.1 to the Companys Current Report on Form 8-K filed
with the SEC on April 4, 2005)10.3
    
    Waiver Consent and Agreement dated as of March 31, 2005 with respect to 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 10.2 to the Companys Current
Report on Form 8-K filed with the SEC on April 4, 2005)31.1
    
    Certification pursuant to Exchange Act Rule 13a  14(a) of Dr. Ludo J. Reynders**31.2
    
    Certification pursuant to Exchange Act Rule 13a  14(a) of Matthew E. Czajkowski**32.1
    
    Certification Pursuant to 18 U.S.C. Section 1350**
 *
    
    A request for confidential treatment with respect to this exhibit has been submitted to the
SEC, and the information for which confidential treatment has been requested has been redacted
from this exhibit. A complete copy of this document, including the information that has been
redacted from the exhibit, is being separately filed with the SEC.**
    
    Filed herewith.
 57