##### 



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, 2004 [  ] 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 June 1,
2004 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, 2004, we owned the following registered and unregistered
trademarks referenced herein: Darvocet®, Darvon®, Darvon-N®, Darvocet-N®, Darvocet A500,
Brethine®, ProSorb-D, 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. 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 Aquaol E® are registered
and unregistered trademarks owned by Mayne Pharma (USA) Inc. 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 Aquaol 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 FinancialCondition and Results of Operations
    
    
    27Item 3.
    
    Quantitative and Qualitative Disclosures AboutMarket Risk
    
    
    38Item 4.
    
    Controls and Procedures
    
    
    38PART II.
    
    OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    
    40Item 2.
    
    Issuer Purchases of Equity Securities
    
    
    46
 1




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Page No.Item 3.
    
    Defaults Upon Senior Securities
    
    
    46Item 6.
    
    Exhibits and Reports on Form 8-K
    
    
    46SIGNATURES
    
    
    
    
    48EXHIBIT INDEX
    
    
    
    
    49
 2




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##### 



PART I. FINANCIAL INFORMATIONItem 1. Financial Statements. aaiPharma Inc.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited) Three Months EndedMarch 31,2004
    
    2003Net revenues:Product sales
    
    $
    24,886
    
    
    $
    24,965Product development (royalties and fees)
    
    
    4,915
    
    
    
    3,810Development services
    
    
    24,441
    
    
    
    20,21254,242
    
    
    
    48,987Operating costs and expenses:Direct costs (excluding depreciation and royalty expense):Product sales (includes product rights amortization of $3,972 and $2,968)
    
    
    14,405
    
    
    
    11,270Development services
    
    
    14,490
    
    
    
    12,004Total direct costs
    
    
    28,895
    
    
    
    23,274Selling expenses
    
    
    13,027
    
    
    
    7,734General and administrative expenses
    
    
    16,340
    
    
    
    10,030Research and development
    
    
    6,407
    
    
    
    4,486Depreciation
    
    
    2,012
    
    
    
    1,888M.V.I. contingent payment
    
    
    31,001
    
    
    
    Royalty expense
    
    
    500
    
    
    
    Total operating costs and expenses
    
    
    98,182
    
    
    
    47,412(Loss) income from operations
    
    
    (43,940
    )
    
    
    1,575Other expense:Interest, net
    
    
    (5,645
    )
    
    
    (5,550
    )Other income (expense), net
    
    
    19
    
    
    
    (83
    )(5,626
    )
    
    
    (5,633
    )Loss before income taxes
    
    
    (49,566
    )
    
    
    (4,058
    )Provision for (benefit from) income taxes
    
    
    6
    
    
    
    (1,590
    )
 3




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Three Months EndedMarch 31,2004
    
    2003Net loss
    
    $
    (49,572
    )
    
    $
    (2,468
    )Basic loss per share
    
    $
    (1.74
    )
    
    $
    (0.09
    )Weighted average shares outstanding
    
    
    28,502
    
    
    
    27,558Diluted loss per share
    
    $
    (1.74
    )
    
    $
    (0.09
    )Weighted average shares outstanding
    
    
    28,502
    
    
    
    27,558
 The accompanying notes are an integral part of these financial statements. 4




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##### 



aaiPharma Inc.
CONSOLIDATED BALANCE SHEETS
(In thousands) March 31,
    
    December 31,2004
    
    2003(Unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    10,526
    
    
    $
    8,785Accounts receivable, net
    
    
    
    
    
    
    32,614Work-in-progress
    
    
    13,109
    
    
    
    12,503Inventories
    
    
    18,110
    
    
    
    14,693Deferred tax assets
    
    
    19,184
    
    
    
    19,184Prepaid and other current assets
    
    
    9,200
    
    
    
    10,398Total current assets
    
    
    70,129
    
    
    
    98,177Property and equipment, net
    
    
    57,678
    
    
    
    57,236Goodwill, net
    
    
    13,016
    
    
    
    13,361Intangible assets, net
    
    
    347,312
    
    
    
    351,315Other assets
    
    
    13,524
    
    
    
    14,508Total assets
    
    $
    501,659
    
    
    $
    534,597LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Current maturities of long-term debt
    
    $
    7,889
    
    
    $
    4,000Accounts payable
    
    
    23,575
    
    
    
    21,879Customer advances
    
    
    15,593
    
    
    
    17,630Accrued wages and benefits
    
    
    7,334
    
    
    
    5,320Interest payable
    
    
    10,212
    
    
    
    5,511Deferred product revenue
    
    
    37,861
    
    
    
    45,664Other accrued liabilities
    
    
    37,119
    
    
    
    11,133Total current liabilities
    
    
    139,583
    
    
    
    111,137Long-term debt, less current portion
    
    
    329,761
    
    
    
    338,844Deferred tax liability
    
    
    2,246
    
    
    
    2,246Other liabilities
    
    
    2,141
    
    
    
    7,647Stockholders equity:Common stock
    
    
    29
    
    
    
    28Paid-in capital
    
    
    91,622
    
    
    
    88,049Accumulated deficit
    
    
    (65,879
    )
    
    
    (16,307
    )Accumulated other comprehensive income
    
    
    2,377
    
    
    
    3,197Deferred compensation
    
    
    (221
    )
    
    
    (244
    )Total stockholders equity
    
    
    27,928
    
    
    
    74,723Total liabilities and stockholders equity
    
    $
    501,659
    
    
    $
    534,597
 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 31,2004
    
    2003Cash flows from operating activities:Net loss
    
    $
    (49,572
    )
    
    $
    (2,468
    )Adjustments to reconcile net loss to
net cash provided by operating activities:Depreciation and amortization
    
    
    5,984
    
    
    
    4,856Other
    
    
    78
    
    
    
    52Changes in operating assets and liabilities:Accounts receivable, net
    
    
    32,475
    
    
    
    5,713Work-in-progress
    
    
    (841
    )
    
    
    (1,640
    )Inventories
    
    
    (3,452
    )
    
    
    (4,033
    )Prepaid and other assets
    
    
    2,172
    
    
    
    856Accounts payable
    
    
    1,772
    
    
    
    137Customer advances
    
    
    (1,892
    )
    
    
    (843
    )Interest payable
    
    
    4,700
    
    
    
    4,708Deferred product revenue
    
    
    (7,803
    )
    
    
    10,211Accrued wages and benefits and other accrued liabilities
    
    
    28,134
    
    
    
    (2,223
    )Net cash provided by operating activities
    
    
    11,755
    
    
    
    15,326Cash flows from investing activities:Purchases of property and equipment
    
    
    (2,572
    )
    
    
    (3,212
    )Acquisitions of product rights and other intangibles
    
    
    
    
    
    
    (500
    )Other
    
    
    (60
    )
    
    
    (232
    )Net cash used in investing activities
    
    
    (2,632
    )
    
    
    (3,944
    )Cash flows from financing activities:Payments on long-term borrowings
    
    
    (10,170
    )
    
    
    (8,500
    )(Payments on) proceeds from interest rate swaps, net
    
    
    (488
    )
    
    
    435Proceeds from stock option exercises
    
    
    3,596
    
    
    
    428Other
    
    
    (308
    )
    
    
    409Net cash used in financing activities
    
    
    (7,370
    )
    
    
    (7,228
    )Net increase in cash and cash equivalents
    
    
    1,753
    
    
    
    4,154Effect of exchange rate changes on cash
    
    
    (12
    )
    
    
    19Cash and cash equivalents, beginning of period
    
    
    8,785
    
    
    
    6,532Cash and cash equivalents, end of period
    
    $
    10,526
    
    
    $
    10,705
 6




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##### 



Three Months EndedMarch 31,2004
    
    2003Supplemental information, cash paid for:Interest
    
    $
    1,687
    
    
    $
    1,497Income taxes
    
    $
    10,145
    
    
    $
    2,202
 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 31,2004
    
    2003Net loss
    
    $
    (49,572
    )
    
    $
    (2,468
    )Currency translation adjustments
    
    
    (820
    )
    
    
    731Comprehensive loss
    
    $
    (50,392
    )
    
    $
    (1,737
    )
 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, specialty
pharmaceutical company focused on acquiring, improving and marketing
well-known, branded medicines in pain management and critical care. 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 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, 2003 has been derived from audited financial statements; certain
amounts from the three months ended March 31, 2003 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, 2003 (the 2003
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, the Companys net
loss and loss per share would have been changed to the pro forma amounts
indicated below: Three Months Ended March 31,2004
    
    2003(In thousands, except per share data)Net loss, as reported
    
    $
    (49,572
    )
    
    $
    (2,468
    )Less pro forma stock-based compensation
cost, net of tax
    
    
    3,067
    
    
    
    1,846Pro forma net loss
    
    $
    (52,639
    )
    
    $
    (4,314
    )
 9




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Three Months Ended March 31,2004
    
    2003(In thousands, except per share data)Loss per share:As reported
-Basic
    
    $
    (1.74
    )
    
    $
    (0.09
    )Diluted
    
    $
    (1.74
    )
    
    $
    (0.09
    )Pro forma
-Basic
    
    $
    (1.85
    )
    
    $
    (0.16
    )Diluted
    
    $
    (1.85
    )
    
    $
    (0.16
    )
 2. Recent developments Special Committee On February 27, 2004, the Companys Board of Directors appointed a committee
consisting of all of the non-employee members of the Board of Directors (the
Special Committee) to conduct an inquiry into unusual sales in the Brethine
and Darvocet product lines during the second half of 2003. King & Spalding
LLP, an independent law firm, and Deloitte & Touche USA LLP, as independent
forensic accountants, were engaged to assist the Special Committee in this
inquiry. In connection with the Special Committees inquiry, the Company determined that
certain matters identified by the Special Committee, along with certain other
adjustments identified by the Company, required material adjustments to the
2003 financial information included in the Companys February 5, 2004 press
release and the financial information for the periods ended March 31, June 30,
and September 30, 2003. The Company also restated financial information for
all periods of 2002. The Special Committees investigation, along with these
adjustments, are discussed in greater detail in the 2003 Form 10-K, in Item 7,
Managements Discussion and Analysis of Financial Condition and Results of
Operations, and in Note 1 of Notes to Consolidated Financial Statements. The
restated quarterly information can be found in the Companys Quarterly Reports
on Form 10-Q/A for the periods ended March 31, 2003, June 30, 2003 and
September 30, 2003. Potential
NASDAQ Delisting The Company received notice on March 30, 2004 from the NASDAQ Stock Market
that, due to the delay in filing of its 2003 Form 10-K, the Company is not in
compliance with certain NASDAQ marketplace rules and that its common stock
would be subject to delisting at the opening of business on April 8, 2004,
unless the Company requested a hearing pursuant to NASDAQ rules. The Company
requested and participated in a hearing before a NASDAQ listing qualifications
panel on April 29, 2004 in which it committed to filing the Companys 2003 Form
10-K on or before June 15, 2004 and to filing amended Quarterly Reports on Form
10-Q for each of the first three quarters of 2003 and its Quarterly Report on
Form 10-Q for the period ended March 31, 2004 on or before June 30, 2004. On May 18,
2004, the Company received notice from the NASDAQ Stock Market that the Company
was delinquent in the filing of this Quarterly Report on Form 10-Q for the
period ended March 31, 2004. The 2003 Form 10-K was filed on June 15, 2004. On June 21, 2004, NASDAQ
notified the Company that the listing qualifications panel has determined to
continue the listing of the Companys common stock if the Company meets certain
conditions, including providing NASDAQ with additional information, filing
the Quarterly Reports on Form 10-Q/A for each of the first three quarters
of 2003 and the Quarterly Report on Form 10-Q for the first quarter of 2004 by
the June 30, 2004 deadline, and filing on a timely basis all
periodic reports for reporting periods ending on or before
June 30, 2005. The amended Quarterly Reports on Form 10-Q for
2003 were filed on June 24, 2004. 10




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Credit Ratings Downgrade On March 31, 2004, each of Moodys Investors Service and Standard & Poors
Ratings Services announced that it had lowered the Companys corporate credit
rating: Moodys to Caa2 from B2 and Standard & Poors to CCC from B+. At the
same time, Moodys lowered its rating of aaiPharmas senior subordinated notes
to Ca from Caa1 and aaiPharmas senior unsecured issuer rating to Caa3 from B3.
Standard & Poors lowered its senior secured debt rating to CCC+ from BB-, and
its subordinated debt rating to CC from B-. Senior Credit Agreement and Indenture Defaults aaiPharma did not file its 2003 Form 10-K in the time required by the federal
securities laws. This failure to file the 2003 Form 10-K constituted an event
of default under its former senior credit agreement, dated as of March 28, 2002,
with Bank of America, N.A. as
administrative agent (in such capacity, the Administrative Agent). Due to
this and other events of default under that senior credit agreement, the Company was
advised by the Administrative Agent that the Company was not permitted to make
any borrowings under the $100 million revolving credit facility portion of the
credit agreement. On
April 23, 2004, aaiPharma refinanced that senior credit agreement with $140 million
of senior credit facilities with a syndicate of lenders, Silver Point Finance
LLC as collateral agent, and Bank of America, N.A., as administrative agent.
These new senior credit facilities consist of a
two-year, $125 million senior secured term loan facility (which was fully drawn
at closing) and a two-year, $15 million senior secured revolving credit
facility. Under
the terms of the indenture for its senior subordinated notes due 2010
(described in Note 10 below), the Company was required to
comply with various covenants, including, but not limited to, a covenant
relating to incurrence of additional indebtedness. The Company was not in
compliance with certain of these indenture covenants at March 31, 2004; however, defaults
under these covenants have been subsequently waived. M.V.I. and Aquasol Sale On April 26, 2004, the Company sold its M.V.I. and Aquasol product lines to
Mayne Pharma (USA) Inc. for $105 million, subject to adjustments based on
inventory levels at closing and other post-closing obligations (the M.V.I. and
Aquasol Sale). A portion of the closing payment is held in escrow to satisfy
post-closing obligations under the agreement. The M.V.I. and Aquasol Sale
resulted in a gain of approximately $37 million that the Company will record
in the second quarter of 2004. Royalties Receivable The Company entered into a definitive agreement to receive a prepayment of
certain royalties receivable (the Accelerated Royalties), that would
otherwise have been paid to it quarterly through the second quarter of 2005
pursuant to the significant development agreement discussed in the 2003 Form
10-K. These royalties would have aggregated $15.4 million. The agreement to
receive a prepayment of these royalties discounted the Accelerated Royalties by
5% per annum from the date originally due to the advance payment date. The
Company received approximately $15.0 million in gross proceeds from the
Accelerated Royalties in April 2004. Termination of Interest Rate Hedging Obligation At March 31, 2004, aaiPharma was a party to an interest rate hedging agreement
to effect a swap of its fixed interest rate on a notional amount of the
Companys 11% senior subordinated notes (see Note 10) to a floating interest
rate. The Company terminated the interest rate hedging agreement. The
Companys 11




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##### 



termination obligations under this interest rate hedging agreement were
approximately $9.4 million, which were paid in full on April 26, 2004 and will
be expensed as additional interest over the life of the senior subordinated
notes. Governmental Investigations and Litigation In April 2004, the Company received subpoenas for document production and
potential testimony issued by a grand jury of the U.S. District Court for the
Western District of North Carolina related primarily to 2002 and 2003 financial
information, certain loans obtained by it, extensions of credit, and other
information. The Company has also been advised by the Office of the United
States Attorney for the Western District of North Carolina that it may receive
a subpoena from the Securities and Exchange Commission (SEC). On April 15, 2004, the Company filed a lawsuit against Athlon Pharmaceuticals,
Inc. 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 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. Athlon has asserted
several counterclaims, including breach of an implied covenant of good faith in
fair dealing and anticipatory breach of the contract. The Company has filed a
reply denying these allegations. On June 4, 2004, the Company sent a notice of termination of the Athlon Service
Agreement to Athlon. The Company also informed Athlon of its intent to amend
the lawsuit to assert the defense of fraud in the inducement in the formation
of the agreement on the part of Athlon and other claims. In addition, the Company and certain of its current and former officers and
employees have been named as defendants in multiple purported class action
lawsuits commenced by stockholders and retirement plan participants beginning
in February 2004 alleging violations of federal securities laws and ERISA. Generic Competition In 2004, the Food and Drug Administration approved generic versions of the
Companys Roxicodone and Brethine injectable products. In the
first quarter, a generic version of Roxicodone was introduced, and in May 2004, a generic
version of injectable Brethine was introduced. 3. M.V.I. Contingent Payment 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 the obligation for
this payment (the M.V.I. Contingent Payment) as additional 12




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##### 



purchase price for the M.V.I.
and Aquasol product line under Statement of Financial Accounting Standards No. 142, Goodwill and Other
Intangible Assets, and No. 141, Business Combinations; therefore, this
adjustment was expensed in the
first quarter of 2004. As discussed in Note 2 above, the Company sold its
M.V.I. and Aquasol product lines on April 26, 2004. Because the $31.5 million
contingent payment was not included in the basis of the assets sold, the gain
from the sales transaction in the second quarter of 2004 will offset the
expense discussed in this Note. 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. 4. Income taxes The
Company recorded a tax benefit of approximately $19 million in the first quarter of
2004 as a result of current period operating losses, offset by a valuation
allowance for the entire amount because it is more likely than not that the
deferred tax asset resulting from that benefit will not be realized. The
Companys effective tax rate for the first quarter of 2004 was less than 1%.
Its effective tax for the first quarter of 2003 was 39%. 5. 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 weighted average number of common shares was increased by the conversion of
stock options issued to employees and members of the Companys Board of
Directors. The diluted per share amounts reflect a change in the number of
shares outstanding (the denominator) to include the options as if they were
converted to shares and issued, unless their inclusion would be anti-dilutive.
During the three months ended March 31, 2004, approximately 360,000 options were
exercised for aggregate proceeds to the Company of $3.6 million. In the three months ended March 31, 2003, 2.5 million
options were excluded as they were anti-dilutive. In each period presented,
the net loss (the numerator) is the same for both basic and diluted per share
computations. 6. Financial information by business segment and geographic area The Company operates in three business segments consisting of a product sales
business, primarily comprised of the pharmaceuticals division, a product
development business, primarily the research and development business unit, and
a development services business, primarily the AAI Development Services
business unit. The product sales business provides for the sales of the
Companys pharmaceutical product lines and for the commercial manufacturing of
small quantity products outsourced by other pharmaceutical companies. In the
product development segment, the Company internally develops drugs and
technologies for future sales by the product sales business or with the
objective of licensing marketing rights to third parties in exchange for
license fees and royalties. The core services provided by the development
services business on a fee-for-service basis to pharmaceutical and
biotechnology industries worldwide include comprehensive formulation, testing
and manufacturing expertise, in addition to the ability to take investigational
products into and through human clinical trials. The majority of the Companys
non-U.S. operations are located in Germany. Corporate income (loss) from operations includes general corporate overhead
costs which are not directly attributable to a business segment. Financial
data by segment and geographic region are as follows (in thousands): Three Months Ended March 31,2004
    
    2003(In thousands)Net revenues:Product sales
    
    $
    24,886
    
    
    $
    24,965Product development
    
    
    4,915
    
    
    
    3,810
 13




---



##### 



Three Months Ended March 31,2004
    
    2003(In thousands)Development services
    
    
    24,441
    
    
    
    20,212$
    54,242
    
    
    $
    48,987United States
    
    $
    48,310
    
    
    $
    44,319Germany
    
    
    6,115
    
    
    
    5,311Other
    
    
    554
    
    
    
    325Less intercompany
    
    
    (737
    )
    
    
    (968
    )$
    54,242
    
    
    $
    48,987(Loss) income from operations:Product sales
    
    $
    (33,971
    )
    
    $
    7,319Product development
    
    
    4,915
    
    
    
    3,810Development services
    
    
    147
    
    
    
    331(28,909
    )
    
    
    11,460Research and development
    
    
    (6,509
    )
    
    
    (4,586
    )Corporate
    
    
    (8,522
    )
    
    
    (5,299
    )$
    (43,940
    )
    
    $
    1,575United States
    
    $
    (44,580
    )
    
    $
    867Germany
    
    
    554
    
    
    
    729Other
    
    
    86
    
    
    
    (21
    )$
    (43,940
    )
    
    $
    1,575Depreciation and amortization:Product sales
    
    $
    4,329
    
    
    $
    3,191Product development
    
    
    102
    
    
    
    100Development services
    
    
    1,045
    
    
    
    1,027Corporate
    
    
    508
    
    
    
    538$
    5,984
    
    
    $
    4,856
 March 31,
    
    December 31,2004
    
    2003Total assets:Product sales
    
    $
    379,890
    
    
    $
    424,452Product development
    
    
    14,153
    
    
    
    13,062Development services
    
    
    60,009
    
    
    
    55,791Corporate
    
    
    47,607
    
    
    
    41,292$
    501,659
    
    
    $
    534,597United States
    
    $
    472,461
    
    
    $
    504,575Germany
    
    
    27,422
    
    
    
    28,242Other
    
    
    1,776
    
    
    
    1,780$
    501,659
    
    
    $
    534,597
 14




---



##### 



March 31,
    
    December 31,2004
    
    2003Goodwill, net:Development services
    
    $
    13,016
    
    
    $
    13,361
 7. Transactions with related parties The Company has revenue, accounts receivable and work-in-progress with Aesgen,
Inc. (Aesgen) and Endeavor Pharmaceuticals, Inc. (Endeavor). Both Endeavor
and Aesgen were organized by aaiPharma Inc., its principal
shareholders and others.
Aesgen was a related party as of March 31, 2004, and continues to be a related
party. Endeavor was a related party until the fourth quarter of 2003, when
Endeavor filed articles of dissolution and made a liquidating distribution to
the Company. No revenues were recognized from Aesgen for the three months
ended March 31, 2004 and 2003, respectively. Services performed by the Company
for Aesgen are covered by a Subscription Agreement, whereby the Company has
agreed to receive Aesgen preferred stock in lieu of cash for the services
performed.In February 2002, the Company acquired a calcitriol product from
Aesgen, under an agreement which included potential royalty payments. The
Company launched its calcitriol product in March 2003; however, no revenues or
royalty expenses were recorded for this product during the first quarter of
2003. Calcitriol is shipped to wholesalers and revenues are recorded under the
consignment model; therefore no revenue or expenses were recognized until the
product was shipped by those wholesalers. The Company expensed royalties of
$0.1 million under that agreement in the three months ended March 31, 2004.
Revenues recognized from Endeavor totaled $0.3 million for the three months
ended March 31, 2003. Certain services performed by the Company for Endeavor
were covered by a Securities Payment Agreement between the Company and
Endeavor, whereby the Company may receive Endeavor preferred stock in lieu of
cash for services performed. At March 31, 2004, the Company had no accounts
receivable or work-in-progress related to Aesgen. 8. Accounts receivable, net The following table presents the components of accounts receivable: March 31,
    
    December 31,2004
    
    2003(In thousands)Gross accounts receivable
    
    $
    45,247
    
    
    $
    85,726Allowance for uncollectible accounts
    
    
    (1,500
    )
    
    
    (1,130
    )Allowance for customer credits
    
    
    (48,549
    )
    
    
    (51,982
    )Subtotal
    
    
    (4,802
    )
    
    
    32,614Net customer credits reclassed to other current liabilities
    
    
    4,802
    
    
    
    Total accounts receivable, net
    
    $
    
    
    
    $
    32,614
 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 net accounts
receivable balance at March 31, 2004 has been reclassed to other current
liabilities. 9. Inventories, net The following table presents the components of inventories: 15




---



##### 



March 31,
    
    December 31,2004
    
    2003(In thousands)Finished goods (including consigned inventory of $4,376
in 2004 and $4,792 in 2003)
    
    $
    21,204
    
    
    $
    18,579Work-in-process
    
    
    2,667
    
    
    
    1,865Raw materials and supplies
    
    
    4,459
    
    
    
    5,007Inventory reserves
    
    
    (10,220
    )
    
    
    (10,758
    )Total inventories, net
    
    $
    18,110
    
    
    $
    14,693
 10. Debt The following table presents the components of current maturities of long-term debt: March 31,
    
    December 31,2004
    
    2003(In thousands)Current maturities of long-term debt
    
    $
    7,889
    
    
    $
    4,000
 The following table presents the components of long-term debt: March 31,
    
    December 31,2004
    
    2003(In thousands)U.S. bank term loan
    
    $
    153,830
    
    
    $
    156,000U.S. revolving credit facility
    
    
    
    
    
    
    8,00011% senior subordinated notes due 2010, net of original issue
discount
    
    
    174,142
    
    
    
    174,106Interest rate swap monetization deferred income
    
    
    11,702
    
    
    
    12,189Fair value of interest rate swap
    
    
    (2,024
    )
    
    
    (7,451
    )Less current maturities of long-term debt
    
    
    (7,889
    )
    
    
    (4,000
    )Total long-term debt due after one year
    
    $
    329,761
    
    
    $
    338,844
 In March 2002, the Company entered into a $175 million senior secured credit
facility consisting of a $75 million five-year revolving credit facility and
a $100 million five-year term loan facility. The term loan facility was
scheduled to be amortized over the full five-year term. The senior facility
was subsequently reduced due to early repayments made under the term loan
facility. In December 2003, the remaining term loan facility of $40 million
was repaid and a new term loan facility was entered into. As part of this
transaction, the Company recorded a $1.5 million loss for the early
extinguishment of debt related to the write-off of financing fees associated
with the original term loan. The December 2003 term loan was a $160 million
facility which amortized over a six-year term. The net proceeds from this
facility were used to fund the acquisition of certain pain management products
in December 2003. In December 2003, the revolving credit facility was amended
and increased to $85 million, which was 16




---



##### 



subsequently increased to $100 million in January 2004. The availability of
borrowings under the revolving credit facility was not limited by a borrowing
base. Both the term loans and the revolving credit facility provided for variable
interest rates based on LIBOR or an alternate base rate, at the Companys
option. At March 31, 2004, the Companys applicable interest rate on its term
loan borrowings, including default interest, was 7.47%. The revolving
credit facility had no outstanding balance at March 31, 2004. The senior
secured credit facility was guaranteed by all domestic subsidiaries and
secured by a security interest on substantially all domestic assets, all of the
stock of domestic subsidiaries and 65% of the stock of material foreign
subsidiaries. The facility required the payment of certain
commitment fees based on the unused portion of the revolving credit facility
and could be prepaid at any time without a premium. Also in March 2002, the Company issued $175 million of senior subordinated
notes due April 1, 2010. The proceeds from the issuance of these notes were
$173.9 million, which was net of the original issue discount. This discount
will be charged to interest expense over the term of the notes. These notes
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. The notes were not
secured. Prior to the third anniversary of the date of issuance of the notes,
up to 35% of the notes are redeemable with the proceeds of qualified sales of
equity at 111% of par value. On or after the fourth anniversary of the date of
issuance of the notes, all or any portion of the notes are redeemable at
declining premiums to par value, beginning at 105.5%. Concurrent with the issuance of the senior subordinated notes, the Company
entered into an interest rate hedging agreement to effectively convert
interest expense on a portion of the senior subordinated notes for the term of
the notes from an 11% fixed annual rate to a floating annual rate equal to
6-month LIBOR plus a base rate. In 2003, the Company sold the then outstanding
interest rate hedging agreement and replaced it with a similar interest rate
hedging agreement. The amounts received, less the interest benefits earned
through the dates of sale, have been recorded as premiums to the carrying
amount of the notes and are being amortized into interest income over their
remaining life. At March 31, 2004, the Company had an interest rate hedging
agreement in place covering $150 million of the notes, at a rate of 6-month
LIBOR plus 7.41%. On March 31, 2004, 6-month LIBOR was 1.16%, giving the
Company an estimated all-in rate of 8.57%. The terms of the interest rate
hedging agreements, other than the base rate, were identical and were perfectly
matched with the terms of the related hedged instrument. As of March 31, 2004, scheduled maturities of long-term debt for the years
ending December 31, 2004 through 2010 were as follows (rounded in thousands): 2004
    
    $
    4,0002005
    
    
    16,0002006
    
    
    24,0002007(including the revolving credit facility)
    
    
    40,0002008
    
    
    40,0002009
    
    
    40,0002010
    
    
    175,000Total
    
    $
    339,000
 17




---



##### 



As a result of aaiPharmas failure to timely file the 2003 Form 10-K, among
other matters, aaiPharma was in default of its senior secured credit facility.
On April 23, 2004, aaiPharma refinanced this facility with a portion of the
proceeds from the M.V.I. sale and with $140 million of senior credit facilities
with a syndicate of lenders, Silver Point Finance LLC (Silver Point) as
collateral agent, and Bank of America, N.A., as administrative agent. The
Companys new senior credit facilities consist of a two-year, $125 million
senior secured term loan facility (which was fully drawn at closing) and a
two-year, $15 million senior secured revolving credit facility, of which the
entire amount was available for borrowing at closing. The outstanding loans
under the Companys new senior credit facilities are payable in full on the
two-year anniversary date of the closing of the facilities. The Companys new
senior credit facilities are secured by a security interest on substantially
all domestic assets, all of the stock of domestic subsidiaries and 65% of the
stock of material foreign subsidiaries. Subject to exceptions set forth in the
definitive documentation, loans under the Companys new senior credit
facilities are also required to be prepaid with a negotiated percentage of:  
    
    excess cash flow, as defined;
    
    non-ordinary course assets sales;
    
    net proceeds from the sale of subordinated indebtedness;
    
    net proceeds from the issuance of equity issuances; and
    
    extraordinary receipts, as defined. Optional reductions in revolving credit commitments and optional prepayments of
term loans are subject to a prepayment fee equal to 3% for the first 9 months
of the term of the facilities, 1.5% for the subsequent 9 months of such term,
and 0.75% for the next 3 months of such term (with no prepayment penalty
payable for the last 3 months of the term). Outstanding loans under the
facilities bear interest at a rate per annum equal to a defined LIBOR rate
(with a floor of 2%), plus 6.25%, or a defined reference rate (with a floor of
4%), plus 5.25%, in each case payable monthly in arrears. An additional 1% per
annum unused line fee is payable on unused revolving credit commitments,
payable quarterly in arrears. The proceeds of the loans were used, together with the net cash proceeds from
the sale of the M.V.I. and Aquasol product lines, to (i) fund payment of
termination obligations with respect to the Companys interest rate hedging
agreement (discussed below), (ii) refinance the Companys then-existing senior
credit facility, (iii) fund the April 2004 interest payment due on the
Companys senior subordinated notes due 2010, (iv) provide for ongoing
working capital and general corporate needs, and (v) pay for fees, costs and
expenses in connection with the new senior credit facilities and other
corporate transactions. The Companys new senior credit facilities include customary representations
and warranties and customary affirmative and negative covenants, including
limitations on liens, indebtedness, fundamental transactions, dispositions of
assets, changes in the nature of the Companys business, investments,
acquisitions, capital and operating leases, capital expenditures, dividends,
redemptions or other acquisitions of capital stock, redemptions or prepayments
of other debt, transactions with affiliates, issuances of capital stock,
modifications of indebtedness, organizational documents and other agreements,
and retention of excess cash. The facilities also provide for financial
covenants, including a minimum fixed charge ratio, a maximum total debt to
trailing twelve-month EBITDA ratio, and a covenant requiring a certain level of
cash or revolver availability. The Companys new senior credit 18




---



##### 



facilities include a covenant requiring the Company to file with the Securities
and Exchange Commission by September 30, 2004 the Companys 2003 Form 10-K and
other periodic reports then required to be filed under the Securities Exchange
Act of 1934. Events of default under the facilities include, among others,
nonpayment of principal, interest or fees, violations of covenants, inaccuracy
of representations and warranties, a cross-default to the Companys senior
subordinated notes due 2010 and other material indebtedness, bankruptcy events,
and a change in control. On March 31, 2004, the lenders under the Companys then-existing credit
agreement, which was then in default as described above, exercised their right
to block the Company from making the interest payment due on April 1, 2004 to
holders of the Companys senior subordinated notes. Accordingly, aaiPharma did
not make that interest payment on April 1, 2004. In addition, the Companys
failure to timely file the 2003 Form 10-K constituted a default under the
indenture governing the senior subordinated notes. On April 20, 2004, aaiPharma completed a solicitation seeking the consent from
holders of the Companys senior subordinated notes to approve a refinancing or
replacement of the Companys then-existing credit facilities with the Companys
new senior credit facilities and certain amendments to, and waivers under, the
indenture governing the senior subordinated notes to, among other things:  
    
    grant a lien to secure the Companys obligations under the senior
subordinated notes, which lien is junior to the liens securing the
Companys new senior credit facilities but covers the same collateral;
    
    increase the interest rate of the senior subordinated from 11% per
annum to 11.5% per annum effective April 1, 2004;
    
    suspend the Companys obligation under the indenture to file periodic
reports with the SEC until the earlier of the date that the Companys
2003 Form 10-K is filed with the SEC or September 30, 2004 and suspend
the Companys obligation to furnish annual written statements of the
Companys accountants until the fifth day after the earlier of the
date that the Companys 2003 Form 10-K is filed with the SEC and
September 30, 2004;
    
    further limit the Companys ability to grant liens to secure certain
obligations unless the liens are subordinate to the liens securing the
senior subordinated notes or are otherwise permitted under the
indenture; and
    
    limit the Companys ability to incur up to $10 million of
indebtedness, and to grant liens to secure that amount of
indebtedness, not otherwise specifically permitted by the indenture,
until the Companys 2003 Form 10-K is filed with the SEC or unless the
indebtedness is incurred to fund an interest payment with respect to
the senior subordinated notes. Following the completion of a consent solicitation, aaiPharma entered into a
supplemental indenture to affect these amendments and waivers and made the
interest payments that had been due on April 1, 2004, together with default
interest. The Company made an interest payment on the senior subordinated notes of $9.7
million in April 2004. The April 2004 interest payment was offset by
approximately $1.7 million received under the Companys interest rate hedging
agreement, described above. As a condition to establishing the Companys new senior credit facilities,
aaiPharma terminated the interest rate hedging agreement in April 2004. The
Companys termination obligations under the interest 19




---



##### 



rate hedging agreement were approximately $9.4 million, which amount was paid
upon termination of that agreement and will be expensed as additional interest
over the life of the senior subordinated notes. 11. Commitments and Contingencies 
 The Company may have to make
contingent payments of $4.7 million over four years in connection with the
purchase of our Charleston, South Carolina manufacturing facility, based on the
level of manufacturing revenues at this facility. At March 31, 2004 these
contingent payment obligations had not yet been recorded as a liability on the
Companys consolidated balance sheet. At March 31, 2004,
the Company had $7.9 million of principal repayments due in the next twelve months under
its then-existing senior credit facility. The Company made interest payments on the senior
subordinated notes of $9.6 million in October 2003 and $9.7 million in April
2004, and a payment of $10.1 million will be due in October 2004. 
 For additional information about other contingencies to which the Company is
subject, including litigation and governmental investigations, see Part II,
Item 1, Legal Proceedings, below, and Managements Discussion and Analysis
of Financial Condition and Results of OperationsLiquidity and Capital
ResourcesCommitments and Contingencies in the Companys 2003 Form 10-K. 12. Financial information for subsidiary guarantors and non-guarantors In the first quarter of 2002, the Company issued senior subordinated notes
which are guaranteed by certain of the Companys subsidiaries. The following presents condensed consolidating financial information for the
Company, segregating: (1) aaiPharma Inc., which issued the notes (the
Issuer); (2) the domestic subsidiaries, which guarantee the notes (the
Guarantor Subsidiaries); and (3) all other subsidiaries (the Non-Guarantor
Subsidiaries). The Guarantor Subsidiaries are wholly-owned direct
subsidiaries of the Company and their guarantees are full, unconditional and
joint and several. Wholly-owned subsidiaries are presented on the equity basis
of accounting. Certain reclassifications have been made to conform all of the
financial information to the financial presentation on a consolidated basis.
The principal adjusting entries eliminate investments in subsidiaries and
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: 20




---



##### 



aaiPharma Inc.
CONSOLIDATING STATEMENT OF OPERATIONS
(In thousands) Three Months Ended March 31, 2004Guarantor
    
    Non-GuarantorIssuer
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedNet revenues
    
    $
    12,286
    
    
    $
    36,026
    
    
    $
    6,667
    
    
    $
    (737
    )
    
    $
    54,242Equity earnings from subsidiaries
    
    
    (38,582
    )
    
    
    
    
    
    
    
    
    
    
    38,582
    
    
    
    Total revenues
    
    
    (26,296
    )
    
    
    36,026
    
    
    
    6,667
    
    
    
    37,845
    
    
    
    54,242Operating costs and expenses:Direct costs (excluding depreciation)
    
    
    7,712
    
    
    
    17,653
    
    
    
    4,063
    
    
    
    (533
    )
    
    
    28,895Selling
    
    
    1,728
    
    
    
    10,676
    
    
    
    623
    
    
    
    
    
    
    
    13,027General and administrative
    
    
    12,111
    
    
    
    3,158
    
    
    
    1,071
    
    
    
    
    
    
    
    16,340Research and development
    
    
    8
    
    
    
    6,399
    
    
    
    
    
    
    
    
    
    
    
    6,407Depreciation
    
    
    1,323
    
    
    
    417
    
    
    
    272
    
    
    
    
    
    
    
    2,012M.V.I. contingent payment
    
    
    
    
    
    
    31,001
    
    
    
    
    
    
    
    
    
    
    
    31,001Royalty expense
    
    
    
    
    
    
    500
    
    
    
    
    
    
    
    
    
    
    
    500

22,882
    
    
    
    69,804
    
    
    
    6,029
    
    
    
    (533
    )
    
    
    98,182(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 income (expense), 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
    )
 21




---



##### 



aaiPharma Inc.
CONSOLIDATING STATEMENT OF OPERATIONS
(In thousands) Three Months Ended March 31, 2003Guarantor
    
    Non-GuarantorIssuer
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedNet revenues
    
    $
    10,630
    
    
    $
    33,689
    
    
    $
    5,636
    
    
    $
    (968
    )
    
    $
    48,987Equity earnings from subsidiaries
    
    
    3,543
    
    
    
    
    
    
    
    
    
    
    
    (3,543
    )
    
    
    Total revenues
    
    
    14,173
    
    
    
    33,689
    
    
    
    5,636
    
    
    
    (4,511
    )
    
    
    48,987Operating costs and expenses:Direct costs (excluding depreciation)
    
    
    6,521
    
    
    
    14,324
    
    
    
    3,172
    
    
    
    (743
    )
    
    
    23,274Selling
    
    
    1,309
    
    
    
    5,913
    
    
    
    512
    
    
    
    
    
    
    
    7,734General and administrative
    
    
    7,777
    
    
    
    1,260
    
    
    
    993
    
    
    
    
    
    
    
    10,030Research and development
    
    
    
    
    
    
    4,486
    
    
    
    
    
    
    
    
    
    
    
    4,486Depreciation
    
    
    1,356
    
    
    
    279
    
    
    
    253
    
    
    
    
    
    
    
    1,88816,963
    
    
    
    26,262
    
    
    
    4,930
    
    
    
    (743
    )
    
    
    47,412Loss (income) from operations
    
    
    (2,790
    )
    
    
    7,427
    
    
    
    706
    
    
    
    (3,768
    )
    
    
    1,575Other (expense):Interest, net
    
    
    (692
    )
    
    
    (4,859
    )
    
    
    1
    
    
    
    
    
    
    
    (5,550
    )Net intercompany interest
    
    
    (516
    )
    
    
    559
    
    
    
    (43
    )
    
    
    
    
    
    
    Other income (expense), net
    
    
    (60
    )
    
    
    2
    
    
    
    (25
    )
    
    
    
    
    
    
    (83
    )(1,268
    )
    
    
    (4,298
    )
    
    
    (67
    )
    
    
    
    
    
    
    (5,633
    )(Loss) income before income taxes
    
    
    (4,058
    )
    
    
    3,129
    
    
    
    639
    
    
    
    (3,768
    )
    
    
    (4,058
    )Benefit from income taxes
    
    
    (1,590
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,590
    )Net (loss) income
    
    $
    (2,468
    )
    
    $
    3,129
    
    
    $
    639
    
    
    $
    (3,768
    )
    
    $
    (2,468
    )
 22




---



##### 



aaiPharma Inc.
CONSOLIDATING BALANCE SHEET
(In thousands) March 31, 2004Guarantor
    
    Non-GuarantorIssuer
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedASSETSCurrent assets:Cash and cash equivalents
    
    $
    10,080
    
    
    $
    251
    
    
    $
    195
    
    
    $
    
    
    
    $
    10,526Accounts receivable, net
    
    
    8,460
    
    
    
    (17,543
    )
    
    
    4,281
    
    
    
    4,802
    
    
    
    Work-in-progress
    
    
    3,760
    
    
    
    6,205
    
    
    
    7,937
    
    
    
    (4,793
    )
    
    
    13,109Inventories
    
    
    4,869
    
    
    
    12,070
    
    
    
    1,171
    
    
    
    
    
    
    
    18,110Deferred tax assets
    
    
    19,184
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    19,184Prepaid and other current assets
    
    
    3,174
    
    
    
    5,738
    
    
    
    288
    
    
    
    
    
    
    
    9,200Total current assets
    
    
    49,527
    
    
    
    6,721
    
    
    
    13,872
    
    
    
    9
    
    
    
    70,129Investments in and advances to subsidiaries
    
    
    66,061
    
    
    
    (46,202
    )
    
    
    
    
    
    
    (19,859
    )
    
    
    Property and equipment, net
    
    
    39,056
    
    
    
    14,469
    
    
    
    4,153
    
    
    
    
    
    
    
    57,678Goodwill, net
    
    
    725
    
    
    
    1,229
    
    
    
    11,062
    
    
    
    
    
    
    
    13,016Intangibles, net
    
    
    1,235
    
    
    
    346,077
    
    
    
    
    
    
    
    
    
    
    
    347,312Other assets
    
    
    2,411
    
    
    
    11,001
    
    
    
    112
    
    
    
    
    
    
    
    13,524Total assets
    
    $
    159,015
    
    
    $
    333,295
    
    
    $
    29,199
    
    
    $
    (19,850
    )
    
    $
    501,659LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Current maturities of long-term debt
    
    $
    
    
    
    $
    7,889
    
    
    $
    
    
    
    $
    
    
    
    $
    7,889Accounts payable
    
    
    8,404
    
    
    
    13,490
    
    
    
    1,681
    
    
    
    
    
    
    
    23,575Customer advances
    
    
    5,631
    
    
    
    7,152
    
    
    
    4,966
    
    
    
    (2,156
    )
    
    
    15,593Accrued wages and benefits
    
    
    3,865
    
    
    
    1,959
    
    
    
    1,510
    
    
    
    
    
    
    
    7,334Interest payable
    
    
    
    
    
    
    10,212
    
    
    
    
    
    
    
    
    
    
    
    10,212Deferred product revenue
    
    
    
    
    
    
    37,861
    
    
    
    
    
    
    
    
    
    
    
    37,861Other accrued liabilities
    
    
    (567
    )
    
    
    35,156
    
    
    
    (332
    )
    
    
    2,862
    
    
    
    37,119Total current liabilities
    
    
    17,333
    
    
    
    113,719
    
    
    
    7,825
    
    
    
    706
    
    
    
    139,583Long-term debt, less current portion
    
    
    
    
    
    
    329,761
    
    
    
    
    
    
    
    
    
    
    
    329,761Deferred tax liability
    
    
    2,246
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,246Other liabilities
    
    
    118
    
    
    
    2,023
    
    
    
    
    
    
    
    
    
    
    
    2,141Investments in and advances to subsidiaries
    
    
    149,100
    
    
    
    (155,023
    )
    
    
    5,604
    
    
    
    319
    
    
    
    Total stockholders equity
    
    
    (9,782
    )
    
    
    42,815
    
    
    
    15,770
    
    
    
    (20,875
    )
    
    
    27,928Total liabilities and stockholders equity
    
    $
    159,015
    
    
    $
    333,295
    
    
    $
    29,199
    
    
    $
    (19,850
    )
    
    $
    501,659
 23




---



##### 



aaiPharma Inc.
CONSOLIDATING BALANCE SHEET
(In thousands) December 31, 2003Guarantor
    
    Non-GuarantorIssuer
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedASSETSCurrent assets:Cash and cash equivalents
    
    $
    8,161
    
    
    $
    192
    
    
    $
    432
    
    
    $
    
    
    
    $
    8,785Accounts receivable, net
    
    
    11,242
    
    
    
    16,785
    
    
    
    4,587
    
    
    
    
    
    
    
    32,614Work-in-progress
    
    
    3,688
    
    
    
    5,337
    
    
    
    7,793
    
    
    
    (4,315
    )
    
    
    12,503Inventories
    
    
    4,588
    
    
    
    8,909
    
    
    
    1,196
    
    
    
    
    
    
    
    14,693Deferred tax assets
    
    
    19,184
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    19,184Prepaid and other current assets
    
    
    1,872
    
    
    
    8,304
    
    
    
    222
    
    
    
    
    
    
    
    10,398Total current assets
    
    
    48,735
    
    
    
    39,527
    
    
    
    14,230
    
    
    
    (4,315
    )
    
    
    98,177Investments in and advances to subsidiaries
    
    
    66,061
    
    
    
    (46,202
    )
    
    
    
    
    
    
    (19,859
    )
    
    
    Property and equipment, net
    
    
    39,011
    
    
    
    13,954
    
    
    
    4,271
    
    
    
    
    
    
    
    57,236Goodwill, net
    
    
    725
    
    
    
    1,229
    
    
    
    11,407
    
    
    
    
    
    
    
    13,361Intangibles, net
    
    
    1,209
    
    
    
    350,106
    
    
    
    
    
    
    
    
    
    
    
    351,315Other assets
    
    
    2,419
    
    
    
    11,974
    
    
    
    115
    
    
    
    
    
    
    
    14,508Total assets
    
    $
    158,160
    
    
    $
    370,588
    
    
    $
    30,023
    
    
    $
    (24,174
    )
    
    $
    534,597LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Current maturities of long-term debt
    
    $
    
    
    
    $
    4,000
    
    
    $
    
    
    
    $
    
    
    
    $
    4,000Accounts payable
    
    
    5,082
    
    
    
    14,292
    
    
    
    2,505
    
    
    
    
    
    
    
    21,879Customer advances
    
    
    6,441
    
    
    
    8,101
    
    
    
    4,807
    
    
    
    (1,719
    )
    
    
    17,630Accrued wages and benefits
    
    
    2,575
    
    
    
    1,517
    
    
    
    1,228
    
    
    
    
    
    
    
    5,320Interest payable
    
    
    7
    
    
    
    5,504
    
    
    
    
    
    
    
    
    
    
    
    5,511Deferred product revenue
    
    
    
    
    
    
    45,664
    
    
    
    
    
    
    
    
    
    
    
    45,664Other accrued liabilities
    
    
    8,640
    
    
    
    4,332
    
    
    
    (448
    )
    
    
    (1,391
    )
    
    
    11,133Total current liabilities
    
    
    22,745
    
    
    
    83,410
    
    
    
    8,092
    
    
    
    (3,110
    )
    
    
    111,137Long-term debt, less current portion
    
    
    8,000
    
    
    
    330,844
    
    
    
    
    
    
    
    
    
    
    
    338,844Deferred tax liability
    
    
    2,246
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,246Other liabilities
    
    
    196
    
    
    
    7,451
    
    
    
    
    
    
    
    
    
    
    
    7,647Investments in and advances to subsidiaries
    
    
    127,363
    
    
    
    (133,182
    )
    
    
    6,212
    
    
    
    (393
    )
    
    
    Total stockholders equity
    
    
    (2,390
    )
    
    
    82,065
    
    
    
    15,719
    
    
    
    (20,671
    )
    
    
    74,723Total liabilities and stockholders equity
    
    $
    158,160
    
    
    $
    370,588
    
    
    $
    30,023
    
    
    $
    (24,174
    )
    
    $
    534,597
 24




---



##### 



aaiPharma Inc.
CONSOLIDATING STATEMENT OF CASH FLOWS
(In thousands) Three Months Ended March 31, 2004Guarantor
    
    Non-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
    
    
    
    
    
    
    
    5,984Other
    
    
    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
    )Interest payable
    
    
    (8
    )
    
    
    4,708
    
    
    
    
    
    
    
    
    
    
    
    4,700Deferred product revenue
    
    
    
    
    
    
    (7,803
    )
    
    
    
    
    
    
    
    
    
    
    (7,803
    )Accrued wages and benefits and other accrued
Liabilities
    
    
    (7,993
    )
    
    
    31,266
    
    
    
    608
    
    
    
    4,253
    
    
    
    28,134Intercompany receivables and payables
    
    
    60,319
    
    
    
    (21,842
    )
    
    
    (607
    )
    
    
    (37,870
    )
    
    
    Net cash provided by operating activities
    
    
    7,643
    
    
    
    3,974
    
    
    
    138
    
    
    
    
    
    
    
    11,755Cash 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
    )Proceeds from interest rate swaps, net
    
    
    
    
    
    
    (488
    )
    
    
    
    
    
    
    
    
    
    
    (488
    )Proceeds from stock option exercises
    
    
    3,596
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,596Other
    
    
    
    
    
    
    (308
    )
    
    
    
    
    
    
    
    
    
    
    (308
    )Net cash used in financing activities
    
    
    (4,404
    )
    
    
    (2,966
    )
    
    
    
    
    
    
    
    
    
    
    (7,370
    )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
 25




---



##### 



aaiPharma Inc.
CONSOLIDATING STATEMENT OF CASH FLOWS
(In thousands) Three Months Ended March 31, 2003Non-Guarantor
    
    GuarantorIssuer
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedCash flows from operating activities:Net (loss) income
    
    $
    (2,468
    )
    
    $
    3,129
    
    
    $
    639
    
    
    $
    (3,768
    )
    
    $
    (2,468
    )Adjustments to reconcile net (loss) income
to net cash provided by operating activities:Depreciation and amortization
    
    
    1,241
    
    
    
    3,362
    
    
    
    253
    
    
    
    
    
    
    
    4,856Other
    
    
    
    
    
    
    
    
    
    
    52
    
    
    
    
    
    
    
    52Changes in operating assets and liabilities:Accounts receivable, net
    
    
    1,050
    
    
    
    5,345
    
    
    
    (682
    )
    
    
    
    
    
    
    5,713Work-in-progress
    
    
    (483
    )
    
    
    (1,026
    )
    
    
    82
    
    
    
    (213
    )
    
    
    (1,640
    )Inventories
    
    
    829
    
    
    
    (4,551
    )
    
    
    
    
    
    
    (311
    )
    
    
    (4,033
    )Prepaid and other assets
    
    
    573
    
    
    
    478
    
    
    
    (195
    )
    
    
    
    
    
    
    856Accounts payable
    
    
    (229
    )
    
    
    712
    
    
    
    (346
    )
    
    
    
    
    
    
    137Customer advances
    
    
    (331
    )
    
    
    (433
    )
    
    
    (292
    )
    
    
    213
    
    
    
    (843
    )Interest payable
    
    
    (4
    )
    
    
    4,712
    
    
    
    
    
    
    
    
    
    
    
    4,708Deferred product revenue
    
    
    
    
    
    
    10,211
    
    
    
    
    
    
    
    
    
    
    
    10,211Accrued wages and benefits and other accrued
liabilities
    
    
    (3,548
    )
    
    
    1,357
    
    
    
    190
    
    
    
    (222
    )
    
    
    (2,223
    )Intercompany receivables and payables
    
    
    14,930
    
    
    
    (19,685
    )
    
    
    454
    
    
    
    4,301
    
    
    
    Net cash provided by operating activities
    
    
    11,560
    
    
    
    3,611
    
    
    
    155
    
    
    
    
    
    
    
    15,326Cash flows from investing activities:Purchases of property and equipment
    
    
    (1,061
    )
    
    
    (1,965
    )
    
    
    (186
    )
    
    
    
    
    
    
    (3,212
    )Acquisitions of product rights and other intangibles
    
    
    
    
    
    
    (500
    )
    
    
    
    
    
    
    
    
    
    
    (500
    )Other
    
    
    (232
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (232
    )Net cash used in investing activities
    
    
    (1,293
    )
    
    
    (2,465
    )
    
    
    (186
    )
    
    
    
    
    
    
    (3,944
    )Cash flows from financing activities:Payments on long-term borrowings
    
    
    (6,500
    )
    
    
    (2,000
    )
    
    
    
    
    
    
    
    
    
    
    (8,500
    )Proceeds from interest rate swaps, net
    
    
    
    
    
    
    435
    
    
    
    
    
    
    
    
    
    
    
    435Proceeds from stock option exercises
    
    
    428
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    428Other
    
    
    
    
    
    
    409
    
    
    
    
    
    
    
    
    
    
    
    409Net cash used in financing activities
    
    
    (6,072
    )
    
    
    (1,156
    )
    
    
    
    
    
    
    
    
    
    
    (7,228
    )Net increase (decrease) in cash and cash equivalents
    
    
    4,195
    
    
    
    (10
    )
    
    
    (31
    )
    
    
    
    
    
    
    4,154Effect of exchange rate changes on cash
    
    
    
    
    
    
    
    
    
    
    19
    
    
    
    
    
    
    
    19Cash and cash equivalents, beginning of period
    
    
    5,725
    
    
    
    180
    
    
    
    627
    
    
    
    
    
    
    
    6,532Cash and cash equivalents, end of period
    
    $
    9,920
    
    
    $
    170
    
    
    $
    615
    
    
    $
    
    
    
    $
    10,705
 26




---



##### 



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, 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, 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, and changes in the mix of products and services.
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, 2003 (the 2003 Form 10-K). 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 expense 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. Summary Our consolidated net revenues for the first quarter of 2004 were up 11% over the first
quarter of 2003. However, despite the addition of the Roxicodone and Oramorph product lines
that we acquired in December, we sold less pharmaceutical product to wholesalers in the first
quarter, primarily due to the excess amount of our Darvon/Darvocet and Brethine products in
the distribution channel. Revenues from our product development and development services
businesses were up significantly quarter-over-quarter. We recorded an expense of $31.0 million in the first quarter for a contingent payment to
AstraZeneca 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 the
reformulation of this product created an obligation under our product line acquisition agreement
for us to make the M.V.I. Contingent Payment. Previously, this payment had not been recorded
on our books. We made the M.V.I. Contingent Payment in the second quarter of 2004.
We also sold our entire M.V.I. and Aquasol product lines in the second quarter of 2004,
which resulted in a gain of approximately $37 million that we will record in the second
quarter of 2004. Our selling expenses in the first quarter included $3.6 million to a contract sales group that
was promoting our Darvocet A500 product. Our sales of this product were below the payments
we made to this contract sales group. We terminated this contract in the second quarter
and are refocusing our pharmaceutical sales efforts. For additional information related to
this contract and the related litigation, see Part II, Item 1, Legal Proceedings - Contract Sales Force Litigation, below. In addition, a number of important events and developments affected us in the first quarter
of 2004. During this quarter, our Board of Directors appointed a special committee of all
non-employee directors (the Special Committee) to conduct an inquiry into
certain unusual sales transactions in the second half of 2003.
We incurred professional fees of approximately $3.2 million in the first quarter of 2004
associated with the Special Committees investigation.
A discussion of the Special Committees findings is set forth in Item 7, Managements
Discussion and Analysis of Financial Condition and Results of Operations-Special
Committee Investigation of our 2003 Form 10-K, and we encourage you to read that
information. 27




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In connection with the Special Committees inquiry, we determined that certain matters
identified by the Special Committee, along with certain other adjustments identified by us,
required material adjustments to the 2003 financial information included in our February 5, 2004
press release and the financial information previously reported for the periods ended
March 31, June 30, and September 30, 2003. We have since separately determined to restate
financial information previously reported for all periods of 2002. The Special Committees
investigation, together with these adjustments, delayed the filing of our 2003 Form 10-K
and this Quarterly Report on Form 10-Q. At the end of the first quarter, we were in default under our then existing senior
secured credit facility and our senior subordinated notes due 2010 and were in the
process of restructuring our debt. We accomplished the restructuring in the second quarter.
On March 31, 2004, each of Moodys Investors Service and Standard & Poors Ratings
Services announced that it had lowered the Companys corporate credit rating. Also on March 30, 2004, we received notice from the NASDAQ Stock Market that our common
stock was subject to delisting. We requested and participated in a hearing with NASDAQ,
and NASDAQ has recently advised us that our common stock may remain listed, subject to
satisfaction of certain conditions. Results of Operations The following table presents the net revenues for each of our business units
and our consolidated expenses and net loss for the first quarter of
2004, with each item expressed as a
percentage of consolidated net revenues: Three Months Ended March 31,2004
    
    2003(Dollars in thousands)Net revenues:Product sales
    
    $
    24,886
    
    
    
    46
    %
    
    $
    24,965
    
    
    
    51
    %Product development
    
    
    4,915
    
    
    
    9
    
    
    
    3,810
    
    
    
    8Development services
    
    
    24,441
    
    
    
    45
    
    
    
    20,212
    
    
    
    41$
    54,242
    
    
    
    100
    %
    
    $
    48,987
    
    
    
    100
    %Direct costs (excluding depreciation and
royalty expense)
    
    $
    28,895
    
    
    
    53
    %
    
    $
    23,274
    
    
    
    48
    %Selling
    
    
    13,027
    
    
    
    24
    
    
    
    7,734
    
    
    
    16General and administrative
    
    
    16,340
    
    
    
    30
    
    
    
    10,030
    
    
    
    20Research and development
    
    
    6,407
    
    
    
    12
    
    
    
    4,486
    
    
    
    9Depreciation
    
    
    2,012
    
    
    
    4
    
    
    
    1,888
    
    
    
    4M.V.I. contingent payment
    
    
    31,001
    
    
    
    57
    
    
    
    
    
    
    
    Royalty expense
    
    
    500
    
    
    
    1
    
    
    
    
    
    
    
    (Loss) income from operations
    
    
    (43,940
    )
    
    
    (81
    )
    
    
    1,575
    
    
    
    3Interest expense, net
    
    
    (5,645
    )
    
    
    (10
    )
    
    
    (5,550
    )
    
    
    (11
    )Other income (expense), net
    
    
    19
    
    
    
    
    
    
    
    (83
    )
    
    
    
 28




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##### 



Three Months Ended March 31,2004
    
    2003(Dollars in thousands)Provision for (benefit from) income taxes
    
    
    6
    
    
    
    
    
    
    
    (1,590
    )
    
    
    (3
    )Net loss
    
    
    (49,572
    )
    
    
    (91
    )
    
    
    (2,468
    )
    
    
    (5
    )
 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 31,2004
    
    2003Gross revenues
    
    $
    71,988
    
    
    $
    67,275Allowance for customer credits
    
    
    17,746
    
    
    
    18,288Net revenues
    
    $
    54,242
    
    
    $
    48,987
 First Quarter 2004 Compared to First Quarter 2003 Our consolidated net revenues for the quarter ended March 31, 2004 increased
11% to $54.2 million from $49.0 million in the first quarter of 2003. Net
revenues from product sales decreased slightly in the first quarter of 2004 to
$24.9 million from $25.0 million in the first quarter of 2003. The decrease
resulted from decreases in sales of our Darvon/Darvocet and Brethine product
lines, primarily due to the excess amount of these products in the distribution
channel, and from a decrease in sales of our M.V.I. product line. These
decreases were partially offset by contributions from our Roxicodone and
Oramorph product lines, which we acquired in December 2003. We
recorded $5.1 million in net revenues in the first quarter of 2004 from deferred product revenue
on products that are accounted for using a consignment model. We did not
receive any additional cash payments from our customers related to these
revenues. Net revenues from commercial manufacturing of products marketed by
other pharmaceutical companies, which is included in product sales, contributed
$1.5 million and $1.4 million to net revenues from product sales in the first
quarters of 2004 and 2003, respectively. Net revenues from product development increased 29% in the first quarter of
2004 to $4.9 million, or 9% of net revenues, from $3.8 million, or 8% of net
revenues, in the 2003 period, primarily due to product development revenues
under our significant development agreement, which increased from $3.5 million
in the first quarter of 2003 to $4.8 million in the first quarter of 2004.
This development agreement is described in the Managements Discussion and
Analysis of Financial Condition and Results of Operations section of our 2003
Form 10-K. Net revenues from our development services business increased 21% in the first
quarter of 2004 to $24.4 million, from $20.2 million in 2003. This increase
was principally attributable to higher demand for our analytical and clinical
capabilities, partially offset by lower fee-for-service revenues under our
significant development agreement. 29




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Direct costs (excluding depreciation and royalty expense) increased $5.6
million, or 24%, to $28.9 million in the first quarter of 2004, from $23.3
million in the same period in 2003. This increase in direct costs resulted
from an increase in direct costs of our development services division,
primarily in our manufacturing operations (primarily personnel and material
costs), a mix change in the quarter away from higher margin components of our
product portfolio (lower Darvon/Darvocet and Brethine revenues, as discussed
above) and an increase in amortization expense related to product rights for
products we acquired in December 2003. Direct costs as a percentage of net
revenues were 53% in the first quarter of 2003 as compared to 48% in the first
quarter of 2003. Selling expenses increased 68% in the first quarter of 2004 to $13.0 million,
or 24% of net revenues, from $7.7 million, or 16% of net revenues, in 2003.
This increase is primarily due to expenses incurred by our product sales
business associated with sales force related expenses under an agreement with
Athlon Pharmaceuticals, from whom we acquired our Darvocet A500 product (see
Legal Proceedings for additional information about this agreement),
developing our product sales force and marketing and promoting our new
products. General and administrative costs increased 63% in the first quarter of 2004 to
$16.3 million, or 30% of net revenues, from $10.0 million, or 20% of net
revenues, in 2003. This increase was primarily due to $3.2 million of
professional fees related to the Special Committee inquiry (as discussed
above), additional product liability insurance expense for the products we
acquired in December 2003, and increased employee benefits expenses, primarily
due to the timing of accruals for vacation and health insurance expenses. Research and development expenses were $6.4 million, or 12% of net revenues, in
the first quarter of 2004 compared to $4.5 million, or 9% of net revenues, in
the first quarter of 2003. In the first quarter of 2004, significant project
spending was related to our ProSorb-D pain management product, the transfer of manufacturing of our
Darvon and Darvocet products from a third party to our manufacturing facilities and development
work on line extensions for our pain management and critical care products. In the first quarter of 2004, we recognized a $31.0 million expense due to the
M.V.I. Contingent Payment because the conditions for the contingent obligations
were satisfied and the obligation was recorded in this quarter. Royalty expenses for the first quarter of 2004 were $0.5 million. We accrue
royalties based on revenues generated by certain acquired products. No similar
royalty expenses were incurred in the comparable period of 2003. Consolidated loss from operations was $43.9 million in the first quarter of
2004, as compared to income from operations of $1.6 million in the first
quarter of 2003. This decrease is primarily due to the $31.0 million expense
related to the M.V.I. Contingent Payment and the increases in selling, general
and administrative and research and development expenses, as discussed above. The loss from operations for our product sales business was $34.0 million in
the first quarter of 2004, compared to income from operations of $7.3 million
in the first quarter of 2003. This decrease is attributable to the $31.0
million expense related to the M.V.I. Contingent Payment and the revenue mix
changes and the increased selling expenses, as discussed above. 30




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Income from operations for our product development business was $4.9 million in
the first quarter of 2004, compared to income from operations of $3.8 million
in 2003. This change resulted from the increased revenues from our significant
development agreement, as discussed above. Income from operations for our development services business was $0.1 million
in the first quarter of 2004, compared to $0.3 million in the first quarter of
2003. This change is primarily due to the increase in general overhead
allocations, partially offset by the higher revenues, as discussed above. Unallocated corporate expenses increased in the first quarter of 2004 to $8.5
million, from $5.3 million in 2003. This increase is primarily related to the
professional fees related to the Special Committee inquiry as discussed above. Net interest expense remained flat at $5.6 million in the first quarter of 2004
and 2003, see Liquidity and Capital Resources for additional information on
subsequent changes to our debt. We recorded a tax benefit of
approximately $19 million in the first quarter of 2004 as a
result of current period operating losses, offset by a valuation allowance for
the entire amount because it is more likely than not that the deferred tax
asset resulting from that benefit will not be realized. Our effective tax rate
for the first quarter of 2004 was less than 1%. Our effective tax for the
first quarter of 2003 was 39%. Liquidity and Capital Resources Historically, we have funded our businesses with cash flows provided by
operations and proceeds from borrowings. Cash flow provided by operations in
the first three months of 2004 was $11.8 million, compared to cash flow
provided by operations of $15.3 million in the first three months of 2003.
This decrease was primarily due to a significant increase in net loss and a
decrease in deferred revenues on products accounted for under the consignment
model, partially offset by a significant decrease in the gross amount of our
accounts receivable and other positive cash-flow changes in working capital. The gross amount of our accounts receivable decreased by $40.5 million, or 47%,
in the first quarter of 2004 due to significant collections in the first
quarter of 2004 for pharmaceutical products shipped during the fourth quarter
of 2003 and a significant decrease in the amount of pharmaceutical products
shipped during the first quarter of 2004. Additionally, as of March 31, 2004,
our $45.2 million in gross accounts receivable were more than offset by $48.5
million in allowances for customer credits, which primarily consist of reserves
we established to cover estimated future chargebacks and estimated future
product returns. These reserves are necessary because we must either issue a
credit on future sales or make a cash payment when a chargeback is issued or
when wholesalers exercise their rights of return for our pharmaceutical
products. We reclassed the negative $4.8 million net accounts receivable balance to
other current liabilities. Cash used in investing activities was $2.6 million in the first three months of
2004, primarily related to capital spending. Cash used in investing activities
was $3.9 million in the first three months of 2003, which included $3.2 million
related to capital spending. 31




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##### 



Net cash used in financing activities during the first three months of 2004 was
$7.4 million, primarily representing debt payments of $10.2 million, partially
offset by $3.6 million in proceeds from the issuance of common stock related to
the exercise of stock options. M.V.I. Contingent Payment Our M.V.I. and Aquasol product line acquisition agreement was amended in July
2003. As amended, it provided for two $1.0 million guaranteed payments, which
were made in August 2002 and 2003, eliminated a contingent payment of $2.0
million that was potentially due in August 2003 under the original agreement,
and provided for a future contingent payment of $43.5 million, which we refer
to as the M.V.I. Contingent Payment, potentially due in August 2004, depending
on the status of certain reformulation activities being carried out by the
seller and regulatory approval of the reformulations by the U.S. Food and Drug
Administration (FDA). The amount of the M.V.I. 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 M.V.I. 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.
Accordingly, the obligation for the M.V.I. Contingent Payment has been recorded as a liability
on our consolidated balance sheet as of March 31, 2004. As a result of an amendment to
the original acquisition agreement, we were precluded from recognizing the obligation for this
M.V.I. Contingent Payment as additional purchase price for the M.V.I. and Aquasol product
line; therefore, we expensed this payment obligation in the first quarter of 2004.
We sold the M.V.I. and Aquasol product lines on April 26, 2004. Because the $31.5 million
contingent payment was not included in the basis of the assets sold, the gain from the sales
transaction in the second quarter of 2004, which we anticipate will
be approximately $37 million,
will offset the expense for the M.V.I. Contingent Payment. We made the M.V.I. Contingent Payment,
discounted to approximately $31.0 million, in April 2004. Other Commitments and Contingencies We may have to make contingent payments of $4.7 million over four years in
connection with the purchase of our Charleston, South Carolina manufacturing
facility, based on the level of manufacturing revenues at this facility. At
March 31, 2004 these contingent payment obligations had not yet been recorded
as a liability on our consolidated balance sheet. At March 31, 2004, we had
$7.9 million of principal repayments due in the next twelve months under our
senior credit facilities. We made interest payments on the senior subordinated
notes of $9.6 million in October 2003 and $9.7 million in April 2004, and
a payment of $10.1 million will be due in October 2004. For additional information about other contingencies to which we are subject,
including litigation and governmental investigations, see Part II, Item 1,
Legal Proceedings, below, and Managements Discussion and Analysis of
Financial Condition and Results of OperationsLiquidity and Capital
ResourcesCommitments and Contingencies in our 2003 Form 10-K. Analysis of Liquidity Our liquidity needs increased during 2003, and our annual net interest expense
may exceed $29 million in 2004, including the interest payment on our senior
subordinated notes of $10.1 million due in October 2004. 32




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We believe, subject to the conditions and contingencies described above and in
Managements Discussion and Analysis of Financial Condition and Results of
OperationsLiquidity and Capital ResourcesCommitments and Contingencies, in
our 2003 Form 10-K, that our cash flow from operations and borrowing capacity
under our new senior credit facilities described below will be adequate to meet
our needs for working capital and anticipated capital expenditures. Income tax
refunds will be a source of near-term liquidity. We anticipate receiving $4.5
million due on our 2003 tax filing and $0.5 million for the amended 2002 tax
filing. In addition, we have recently reduced
our internal sales force by approximately 30%, and
refocused our sales and marketing efforts to the hospital market. We are currently reviewing our operations in order to develop a restructuring
plan that will rationalize our expense base in relation to our
revenue. As part of this restructuring plan, we expect in the
very near future to implement a reduction in our workforce and to sell
non-revenue-generating assets in order to supplement our cash flow and to facilitate the
availability of cash to coincide with anticipated cash needs. Sales of assets
above specific thresholds will require the consent of the lenders under our
senior credit facilities. If results of operations do not meet our forecasts, our actual cash flow from
operations may be less than we anticipate. In addition, in those circumstances
covenant violations under our senior credit facilities could occur. If we
violate covenants under our senior credit facilities, we would seek waivers and
amendments from our lenders, but we can give no assurance that any such
necessary waivers and amendments would be available at all or on acceptable
terms. If we were unable to obtain a waiver of future covenant violations, the
lenders would be entitled to require immediate repayment of all amounts
outstanding under the senior credit facilities. An acceleration of outstanding
amounts under the senior credit facilities would also cause a default under,
and could permit acceleration of, our senior subordinated notes due 2010. In
the event of one or more such defaults, the Company may seek additional sources
of financing or access to the capital market, although there can be no
assurance that either source will be available on terms acceptable to us or at
all. For additional information, see Managements Discussion and Analysis of
Financial Condition and Results of OperationsLiquidity and Capital
ResourcesImpact of Recent Events on 2004 Results in our 2003 Form 10-K. Senior Credit Facilities In December 2003, we amended the terms of our senior secured credit facility by
entering into a new $160 million term loan facility and
increasing our $75 million five-year revolving credit facility
to $85 million. The revolving credit facility was then increased to $100 million in January
2004. The availability of borrowings under the revolving credit facility was
not limited by a borrowing base. Both the term loans and the revolving credit
facility provided for variable interest rates based on LIBOR or an alternate
base rate, at our option. At March 31, 2004, our applicable interest rate on
our term loan borrowings, including default interest, was 7.47%. The revolving
credit facility had no outstanding balance at March 31, 2004. The senior
secured credit facility was guaranteed by all domestic subsidiaries and secured
by a security interest on substantially all domestic assets, all of the stock
of domestic subsidiaries and 65% of the stock of material foreign subsidiaries.
The facility required the payment of certain commitment fees based on the
unused portion of the revolving credit facility and could be prepaid at any
time without a premium. As a result of our failure to timely file our 2003 Form 10-K, among other
matters, we were in default under the December 2003 term loan and revolving
credit facilities. On April 23, 2004, we refinanced these facilities with a
portion of the proceeds from M.V.I. and Aquasol Sale and with $140 million of
senior credit facilities with a syndicate of lenders, Silver Point Finance LLC
(Silver Point) as collateral agent, and Bank of America, N.A., as
administrative agent. Our new senior credit facilities consist of a two-year,
$125 million senior secured term loan facility (which was fully drawn at
closing) and a two-year, $15 million senior secured revolving credit facility,
of which the full amount was available for borrowing on June 9, 2004. The
outstanding loans under our new senior credit facilities are payable in full on
the two-year anniversary date of the closing of the facilities. Our new senior
credit facilities are secured by a security interest on substantially all
domestic assets, all of the stock of domestic subsidiaries and 65% of the stock
of material foreign subsidiaries. Subject to exceptions set forth in the
definitive documentation, loans under our new senior credit facilities are also
required to be prepaid with a negotiated percentage of: 33




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##### 




    
    excess cash flow, as defined;
    
    non-ordinary course assets sales;
    
    net proceeds from the sale of subordinated indebtedness;
    
    net proceeds from the issuance of equity issuances; and
    
    extraordinary receipts, as defined. Optional reductions in revolving credit commitments and optional prepayments of
term loans are subject to a prepayment fee equal to 3% for the first 9 months
of the term of the facilities, 1.5% for the subsequent 9 months of such term,
and 0.75% for the next 3 months of such term (with no prepayment penalty
payable for the last 3 months of the term). Outstanding loans under the
facilities bear interest at a rate per annum equal to a defined LIBOR rate
(with a floor of 2%), plus 6.25%, or a defined reference rate (with a floor of
4%), plus 5.25%, in each case payable monthly in arrears. An additional 1% per
annum unused line fee is payable on unused revolving credit commitments,
payable quarterly in arrears. The proceeds of the loans were used, together with the net cash proceeds from
the M.V.I. and Aquasol Sale, to (i) fund payment of termination obligations
with respect to our interest rate hedging agreement (discussed below), (ii)
refinance our then-existing senior credit facility, (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
for fees, costs and expenses in connection with the new senior credit
facilities and other corporate transactions. Our new senior credit facilities include customary representations and
warranties and customary affirmative and negative covenants, including
limitations on liens, indebtedness, fundamental transactions, dispositions of
assets, changes in the nature of our business, investments, acquisitions,
capital and operating leases, capital expenditures, dividends, redemptions or
other acquisitions of capital stock, redemptions or prepayments of other debt,
transactions with affiliates, issuances of capital stock, modifications of
indebtedness, organizational documents and other agreements, and retention of
excess cash. The facilities also provide for financial covenants, including a
minimum fixed charge ratio, a maximum senior debt to trailing twelve-month
EBITDA ratio, and a covenant requiring a certain level of cash or revolver
availability. Our new senior credit facilities include a covenant requiring us
to file with the Securities and Exchange Commission (the SEC) by September
30, 2004 our 2003 Form 10-K and other periodic reports then required to be
filed under the Securities Exchange Act of 1934. Events of default under the
facilities include, among others, nonpayment of principal, interest or fees,
violations of covenants, inaccuracy of representations and warranties, a
cross-default to our senior subordinated notes due 2010 and other material
indebtedness, bankruptcy events, and a change in control. Subordinated Notes Due 2010 In March 2002, we issued $175 million of senior subordinated unsecured notes
due 2010. The proceeds from the issuance of these notes were $173.9 million,
which was net of the original issue discount. This discount will be charged to
interest expense over the term of the notes. These notes had a fixed interest
rate of 11% per annum and are guaranteed on a subordinated basis by all of our
existing domestic 34




---



##### 



subsidiaries and all of our future domestic subsidiaries of which we own 80% or
more of the equity interests. Prior to March 28, 2005, up to 35% of the notes
are redeemable with the proceeds of qualified sales of equity at 111% of par
value. The terms of our senior credit facilities require us to repay all of
the indebtedness under these facilities before we 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. We were not in compliance with certain of these
covenants at March 31, 2004, however defaults under these covenants have been
subsequently waived. On March 31, 2004, the lenders under our then-existing credit agreement, which
was then in default as described above, exercised their right to block us from
making the interest payment to holders of our senior subordinated notes due on
April 1, 2004. Accordingly, we did not make that interest payment on April 1,
2004. In addition, our failure to timely file our 2003 Form 10-K constituted a
default under the indenture governing the senior subordinated notes. On April 20, 2004, we completed a solicitation seeking the consent from holders
of our senior subordinated notes to approve a refinancing or replacement of our
then existing the credit facilities with our new senior credit facilities and
certain amendments to, and waivers under, the indenture governing the senior
subordinated notes to, among other things:  
    
    grant a lien to secure our obligations under the senior
subordinated notes, which lien is junior to the liens securing our
new senior credit facilities but covers the same collateral;
    
    increase the interest rate of the senior subordinated from 11%
per annum to 11.5% per annum effective April 1, 2004;
    
    suspend our obligation under the indenture to file periodic
reports with the SEC until the earlier of the date that our 2003 Form
10-K is filed with the SEC or September 30, 2004, and suspend our
obligation under the indenture to furnish annual written statements
of our accountants until the fifth day after the earlier of the date
that our 2003 Form 10-K is filed with the SEC and September 30, 2004;
    
    further limit our ability to grant liens to secure certain
obligations unless the liens are subordinate to the liens securing
the senior subordinated notes or are otherwise permitted under the
indenture; and
    
    limit our ability to incur up to $10 million of indebtedness,
and to grant liens to secure that amount of indebtedness, not
otherwise specifically permitted by the indenture, until our 2003
10-K is filed with the SEC or unless the indebtedness is incurred to
fund an interest payment with respect to the senior subordinated
debt. Following the completion of this consent solicitation, we entered into a
supplemental indenture to affect these amendments and waivers and made the
interest payments that had been due on April 1, 2004, together with default
interest. 35




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##### 



We made an interest payment on the senior subordinated notes of $9.7 million in
April 2004. The April 2004 interest payment was offset by approximately $1.7
million received under our interest rate hedging agreement, described below. Interest Rate Hedging Agreement Concurrently with the issuance of our senior subordinated notes, we entered
into an interest rate hedging agreement to effectively convert interest expense
on a portion of the senior subordinated notes for the term of the notes from an
11% fixed annual rate to a floating annual rate equal to 6-month LIBOR plus a
base rate. In 2003, we sold the then outstanding hedging agreement, and
replaced it with a similar interest rate hedging agreement. The amounts we
received, less the interest benefits earned through the dates of sale, have
been recorded as premiums to the carrying amount of the notes and are being
amortized into interest income over their remaining life. This amortization
will be approximately $2.0 million annually. At March 31, 2004, we had an
interest rate hedging agreement in place covering $150 million of the notes, at
a rate of 6-month LIBOR plus 7.41%. On March 31, 2004, 6-month LIBOR was
1.16%, giving us an estimated all-in rate of 8.57%. The terms of the interest
rate hedging agreements, other than the base rate, were identical and were
perfectly matched with the terms of the related hedged instrument. Our obligations under the interest rate hedging agreement were secured by
collateral under our then-existing senior credit facilities. As a condition to establishing our new senior credit facilities, we terminated
the interest rate hedging agreement in April 2004. Our termination obligations
under the interest rate hedging agreement were approximately $9.4 million,
which amount was paid upon termination of that agreement. Credit Ratings Downgrade On March 31, 2004, each of Moodys Investors Service and Standard & Poors
Ratings Services announced that it had lowered the Companys corporate credit
rating: Moodys to Caa2 from B2 and Standard & Poors to CCC from B+. At the
same time, Moodys lowered its rating of aaiPharmas senior subordinated notes
to Ca from Caa1 and aaiPharmas senior unsecured issuer rating to Caa3 from B3.
Standard & Poors lowered its senior secured debt rating to CCC+ from BB-, and
its subordinated debt rating to CC from B-. Potential NASDAQ Delisting We received notice on March 30, 2004 from the NASDAQ Stock Market
that, due to the delay in filing of our 2003 Form 10-K, we are not in
compliance with certain NASDAQ marketplace rules and that our common stock
would be subject to delisting at the opening of business on April 8, 2004,
unless we requested a hearing pursuant to NASDAQ rules. We
requested and participated in a hearing before a NASDAQ listing qualifications
panel on April 29, 2004 in which we committed to filing our 2003 Form
10-K on or before June 15, 2004 and to filing amended Quarterly Reports on Form
10-Q for each of the first three quarters of 2003 and our Quarterly Report on
Form 10-Q for the period ended March 31, 2004 on or before June 30, 2004. On May 18,
2004, we received notice from the NASDAQ Stock Market that we were delinquent in the filing of this Quarterly Report on Form 10-Q for the
period ended March 31, 2004. The 2003 Form 10-K was filed on June 15, 2004. On June 21, 2004, NASDAQ
notified us that the listing qualifications panel has determined to
continue the listing of the Companys common stock if we meet certain
conditions, including providing NASDAQ with additional 36




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information, filing the
Quarterly Reports on Form 10-Q/A for each of
the first three quarters of 2003 and the Quarterly Report on Form 10-Q for the
first quarter of 2004 by the June 30, 2004 deadline, and filing
on a timely basis all periodic reports for reporting periods ending
on or before June 30, 2005. The amended Quarterly
Reports on Form 10-Q for 2003 were filed on June 24, 2004. Recent Developments Since the first quarter of 2004, a number of other developments have affected
our financial condition, including the sale of our M.V.I. and Aquasol product
lines to Mayne Pharma (USA) in April, the prepayment to us of certain royalties under
our significant development agreement and the approval of generic versions of
our Roxicodone and Brethine injectable products. See Note 2 to the Notes to
Consolidated Financial Statements included in this Quarterly Report and
Managements Discussion and Analysis of Financial Condition and Results of
Operations in our 2003 Form 10-K. Forward-Looking Statements, Risk Factors and Safe Harbor Language This document contains forward-looking statements within the meaning of the
safe harbor provisions of the Private Securities Litigation Reform Act of
1995. Words such as estimate, project, intend, anticipate, believe
and similar expressions are intended to identify forward-looking statements.
The forward-looking statements contained in this document include statements
about future financial and operating results, including the anticipated
financial condition, results of operations, business strategies, operating
efficiencies, competitive positions, growth opportunities for existing
products, plans and objectives of management and markets for our common stock.
These statements are based on the current expectations and beliefs of our
management and are subject to a number of factors and uncertainties, including
the matters noted above, that could cause actual results to differ materially
from those described in the forward-looking statements. These statements are
not guarantees of future performance, involve certain risks, uncertainties and
assumptions that are difficult to predict, and are based upon assumptions as to
future events that may not prove accurate. Therefore, actual outcomes and
results may differ materially from what is expressed in the forward-looking
statement. In any forward-looking statement in which we express an expectation
or belief as to future results, that expectation or belief is expressed in good
faith and believed to have a reasonable basis, but there can be no assurance
that the statement or expectation or belief will result or be achieved or
accomplished. Additional risks and uncertainties pertaining to the following
factors, among others, could cause actual results to differ materially from
those described in the forward-looking statements:  
    
    demand by consumers for our products and the products we produces for others;  
    
    the prices that we can obtain for such products;  
    
    the level of product and price competition;  
    
    competitive new product introductions, including generic competition;  
    
    distributors and wholesalers ordering patterns;  
    
    levels of our products in the distribution channels;  
    
    the outcome and costs of governmental investigations;  
    
    the outcome and costs of litigation brought by and against us;  
    
    timely success in product development and regulatory approvals for
new products and line extensions;  
    
    actions by the FDA in connection with submissions related to our
products or those of our competitors; 37




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
    
    other governmental regulations and actions affecting our products or
those of our competitors;  
    
    third-party payer decisions and actions affecting our products or those of our competitors; and  
    
    developments in patent or other proprietary rights owned by us or others. Additional factors that may cause the actual results to differ materially are
discussed in our recent filings with the SEC, including, but not limited to,
Item 7, Managements Discussion and Analysis of Financial Condition and
Results of OperationsRisk Factors and Forward Looking Statements of our 2003
Form 10-K, our Current Reports on Form 8-K, and other periodic filings.
Whenever you read or hear any subsequent written or oral forward-looking
statements attributable to us or any person acting on our behalf, you should
keep in mind the cautionary statements contained or referred to in this
section. We do not undertake any obligation to (and expressly disclaim any obligation
to) update or alter our forward-looking statements, whether as a result of new
information, future events or otherwise. Item 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 change.
If foreign exchange rates were to increase by 10%, our net income would have
been lower by less than $0.1 million in the three months ended March 31, 2004 due to the
reduction in reported results from European operations. We were also exposed to fluctuations in interest rates on borrowings under our
senior credit facilities and on $150 million of our senior subordinated notes,
due to our entering into the interest rate swap agreement discussed in Item 2,
Managements Discussion and Analysis of Financial Condition and Results of
OperationsLiquidity and Capital ResourcesInterest Rate Hedging Agreement.
The interest rates payable on these borrowings were based on LIBOR. If LIBOR
rates were to increase by 1%, annual interest expense on variable rate debt
would increase by approximately $1.6 million, or $0.4 million per quarter. Item 4. Controls and Procedures. The Company has carried out an evaluation, under the supervision and with the
participation of its newly appointed Chief Executive Officer and interim Chief
Financial Officer, pursuant to Rule 13a-15 promulgated under the Securities
Exchange Act of 1934, as amended, of the effectiveness of the design and
operation of its disclosure controls and procedures as of March 31, 2004.
Disclosure controls and procedures are to be designed to ensure that material
information the Company must disclose in its reports filed or submitted under
the Securities Exchange Act of 1934 is recorded, processed, summarized and
reported on a timely basis. As a result of that review, our Chief Executive
Officer and interim Chief Financial Officer have concluded that, as of March
31, 2004, the Companys disclosure controls and procedures were not adequate. The internal control deficiencies related to, among other things, a lack of
adequate policies with respect to revenue recognition, and a lack of sufficient
control processes and procedures to effectively monitor and manage wholesaler
inventory levels, to ensure adequate contract-approval oversight, and to ensure 38




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effective and timely communication among sales, marketing, finance and legal
staff regarding the terms and conditions of certain transactions, including new
product launches. Also, with respect to the sales of pharmaceutical products,
the Companys finance and accounting personnel lacked adequate training on the
application of revenue recognition principles and the establishment of product
return reserves. In addition, in April 2004, in connection with their audit of the Companys
consolidated financial statements for the year ended December 31, 2003, the
Companys independent auditors identified and communicated to the Company and
the Audit Committee two material weaknesses (as defined under standards
established by the American Institute of Certified Public Accountants) relating
to the Companys accounting and public financial reporting of significant
matters and to its initial recording and management review and oversight of
certain accounting matters. The material weaknesses were with respect to the
calculation and procedures for the analysis of revenue reserves for product
sales and lack of procedures for timely communications from the Legal
Department and operating divisions to the Finance Department impairing the
ability to properly evaluate the accounting treatment for certain transactions
the Company had entered into and assess the impact of such transactions in a
timely manner. In addition, at that time, the Companys independent auditors
identified and communicated to the Company and the Audit Committee a
reportable condition (as defined under standards established by the American
Institute of Certified Public Accountants) relating to the Companys internal
controls over its financial reporting for investments. The reportable
condition identified the Companys failure to perform a formal review of its
investments and its failure to timely record patents or trademarks or to timely
analyze the patents and trademarks for usefulness and possible impairment. In view of the fact that the financial information presented in this Quarterly
Report on Form 10-Q was prepared in the absence of adequate internal controls
over financial reporting as of March 31, 2004, the Company devoted a
significant amount of time and resources to the analysis of the financial
information and documentation underlying the financial statements contained in
this Quarterly Report. In particular, the Company reviewed significant product
sales transactions to confirm the terms of the transaction and our accounting
for the transaction, including whether all criteria for the recognition of
revenue had been satisfied and whether we had properly estimated allowances for
returns and other customer credits. In addition, the Company reviewed in
detail each of the matters identified by the Special Committee of the Companys
Board of Directors and its independent counsel and independent forensic
accountants. The investigation of the Special Committee is discussed in Item
7, Managements Discussion and Analysis of Financial Condition and Results of
OperationsSpecial Committee Investigation of the Companys 2003 Form 10-K. In light of the foregoing, the Company has taken the following actions, in
addition to those described above, after the end of 2003 to address the
deficiencies as described above:  
    
    reassigned all financial controllers from operating units into
the Finance Department reporting to the Companys Controller and
Chief Accounting Officer who reports directly to the Chief Financial
Officer;  
    
    commenced a company-wide education effort regarding our Code of
Conduct and contract-approval policies;  
    
    implemented a more vigorous contract-approval process;   39




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##### 




    
    implemented formal revenue recognition protocols and training programs; and  
    
    contracted with a third-party consulting group, FTI Consulting,
to provide transitional management services in the area of operations
and finance. In addition, since December 31, 2003, the Companys then Chief Executive
Officer, Chief Operating Officer and Chief Financial Officer have left the
Company. In March of 2004, Dr. Sancilio, the Companys Executive Chairman and
Chief Scientific Officer, was appointed Chief Executive Officer, and Gregory F.
Rayburn, a senior managing director with FTI Consulting, was appointed Interim
Chief Operating Officer. In April 2004, Timothy R. Wright was appointed
President of the Companys Pharmaceuticals Products Division. Gina Gutzeit, a
senior managing director with FTI Consulting, was appointed as interim Chief
Financial Officer in May 2004. The Company is fully committed to implementing controls identified by the
Companys independent auditors and the Special Committee. The Companys
efforts to strengthen its financial and internal controls continue, and the
Company expects to complete remediation of the material weaknesses and
reportable condition identified by its independent auditors by the end of 2004. PART II. OTHER INFORMATION Item 1. Legal Proceedings. We are party to lawsuits and administrative proceedings incidental to the
normal course of our business. Our material legal proceedings are described
below. We cannot predict the outcomes of these matters. However, except as
noted below, we do not believe that any liabilities related to such lawsuits or
proceedings will have a material adverse effect on our consolidated financial
condition, results of operations or cash flows. Prosecuting and defending
these material legal proceedings, including responding to governmental
inquiries, has resulted, and is expected to continue to result, in a
significant diversion of managements attention and resources and an increase
in professional fees. Government Investigations On August 7, 2003 we received a letter from the staff of the Enforcement
Division of the SEC (the Enforcement Division) requesting voluntary
production of certain documents. We responded to this letter on August 21,
2003 and supplemented our response on August 29, 2003. Independent of the August 7, 2003 inquiry letter, on September 26, 2003,
certain members of our board and management voluntarily met with, and provided
documents to, the staff of the Enforcement Division. As a follow-up to this
September 26, 2003 meeting and as part of the inquiry initiated on August 7,
2003, on October 8, 2003, we received a further request from staff of the
Enforcement Division for voluntary production of certain documents, to which we
responded on October 30, 2003. On January 14, 2004 and April 26, 2004, we received letters from the SECs
Division of Corporate Finance commenting on, asking questions about, and
seeking additional disclosure with respect to certain of our periodic reports.
We have responded to these letters. 40




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In April 2004, in connection with an investigation conducted by the United
States Attorneys Office for the Western District of North Carolina (the U.S.
Attorneys Office), we received five federal grand jury subpoenas for document
production and potential testimony related to, among other things, certain
transactions regarding our 2002 and 2003 financial information, the terms,
conditions of employment and compensation arrangements of certain of our senior
management personnel, compensation and incentive arrangements for employees
responsible for the sale of our Brethine, Darvocet, calcitriol, azathioprine
and Darvon Compound products, quantities of the foregoing products in
distribution channels, financial benefits with respect to specified corporate
transactions to our senior management and others, certain loans obtained by us,
extensions of credit, if any, by us to officers or directors, accounting for
sales and returns of our foregoing products, our analysts conference calls on
financial results, internal and external investigations of pharmaceutical
product sales activities, and related matters. We have also been advised that
the SEC has initiated an inquiry into at least the same issues investigated by
the Special Committee. The U.S. Attorneys Office has advised that we may also
receive a subpoena from the SEC. We and the Special Committee have agreed to cooperate fully with the government
investigations, and the Special Committee has agreed to share all results of
its investigation with the SEC and the U.S. Attorneys Office. To that end, two
meetings of our outside counsel with attorneys for the U.S. Attorneys Office
and the SEC have taken place and numerous documents as requested by these
government agencies have been voluntarily produced. We have scheduled a third
meeting with the U.S. Attorneys Office and the SEC in July in order to provide
additional information related to the Special Committees investigation to
these government agencies. We and the Special Committee intend to facilitate
any interviews of our employees or officers that may be requested by these
government agencies. The Department of Justice, SEC and other government agencies that are
investigating or might commence an investigation of aaiPharma could impose,
based on a claim of fraud, material misstatements, violation of false claims
law or otherwise, civil and/or criminal sanctions, including fines, penalties,
and/or administrative remedies. If any government sanctions are imposed, which
we cannot predict or reasonably estimate at this time, our business, financial
condition, results of operations or cash flows could be materially adversely
affected. These matters have resulted, and are expected to continue to result,
in a significant diversion of managements attention and resources and in
significant professional fees. On January 2, 2004, we received separate letters from the Kentucky Office of
Attorney General and the Florida Office of Attorney General advising that each
was currently investigating allegations regarding our pricing practices related
to our average manufacturer price and best price calculations that are used by
the government to set Medicaid reimbursement rates. Neither letter requested
that we provide any information, and each letter merely requested that we
retain all documents with respect to these calculations pursuant to a newly
adopted federal regulation that would have permitted the destruction of these
documents three years after the applicable prices were reported, except to the
extent we were aware of an ongoing investigation. It is our understanding that
many other pharmaceutical companies received similar letters at that time from
attorneys general in a number of states and that such letters may have been in
response to the new federal regulation that would have otherwise allowed the
destruction of documents reflecting these pricing calculations. A number of
attorneys general, including the Florida and Kentucky attorneys general,
petitioned the U.S. Secretary of Health and Human Services to withdraw the new
regulation. We are not aware of any further developments in these
investigations. 41




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Federal Securities and ERISA Litigation We and certain of our current and former officers have been named as defendants
in purported shareholder class action lawsuits alleging violations of federal
securities laws. These lawsuits were filed beginning in February 2004 and are
pending in the U.S. District Court for the Eastern District of North Carolina.
These lawsuits assert claims under Sections 10(b) and 20(a) of the Securities
Exchange Act of 1934 and Rule 10b-5 there under on behalf of a class of
purchasers of our common stock during the period from January 31, 2002 through
and including March 1, 2004 (the Class Period). The complaints allege
generally that the defendants knowingly or recklessly made false or misleading
statements during the Class Period concerning our financial condition and that
our financial statements did not present our true financial condition and were
not prepared in accordance with generally accepted accounting principles. The
complaints seek certification as a class action, unspecified compensatory
damages, attorneys fees and costs, and other relief. By order dated April 16,
2004, the district court consolidated the securities lawsuits into one
consolidated action. We expect that the plaintiffs will file a consolidated,
amended complaint later in 2004, to which we will respond in lieu of responding
to the individual complaints. In addition, we, one of our former officers, certain of our employees and
others have been named in a purported class action brought by an aaiPharma
retirement plan participant and beneficiary asserting claims under the Employee
Retirement Income Security Act of 1974, as amended (ERISA) on behalf of a
class of all persons who are or were participants or beneficiaries of the
aaiPharma Inc. Retirement and Savings Plan (the Plan) during the period from
April 24, 2002 to March 31, 2004. The complaint alleges generally that the
defendants breached fiduciary duties owed under ERISA with respect to the
investment of Plan assets in aaiPharma stock by misleading participants and
beneficiaries of the Plan regarding our earnings, prospects, and business
condition. The complaint seeks certification as a class action, unspecified
compensatory damages, attorneys fees and costs, and other relief. This ERISA
lawsuit is pending in U.S. District Court for the Eastern District of North
Carolina. These securities and ERISA lawsuits are at an early stage, and no lead
plaintiff has yet been appointed, nor a consolidated amended complaint served,
in the federal securities litigation. We are not required to file an answer or
motion to dismiss in the federal lawsuits until after service of the
consolidated amended complaint on us and no discovery has yet occurred in these
lawsuits. By, and subject to, the terms of our bylaws, we have certain
obligations to indemnify the current and former officers and employees of the
Company who have been named as defendants in these lawsuits. We have purchased
directors and officers liability insurance (D&O insurance) that may provide
coverage for some or all of these lawsuits and governmental investigations.
There is a risk, however, that some or all of the claims or expenses will not
be covered by such policies; or that, even if covered, our ultimate liability
will exceed the available insurance. Although we intend to vigorously pursue
all defenses available in these lawsuits, an adverse determination in these
lawsuits or an inability to obtain payment under our D&O insurance policies for
litigation and indemnification costs and any damages ultimately borne by us as
a result of these lawsuits and investigations could have a material adverse
effect on our business, financial condition, results of operations or cash
flows. 42




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Patent Litigation We are a party to a number of legal actions with generic drug companies. We
are involved in four lawsuits centered on our omeprazole-related patents,
including one lawsuit brought by us against an alleged infringer of our patents
and three lawsuits which were brought by third parties against us and are
currently essentially inactive. Omeprazole is the active ingredient found in
Prilosec, a drug sold by AstraZeneca. Two omeprazole-related cases have been filed against us by Dr. Reddys
Laboratories Ltd. and Dr. Reddys Laboratories, Inc. in the U.S. District Court
for the Southern District of New York in July 2001 and November 2001. The
plaintiffs in these cases have challenged the validity of five patents that we
have obtained relating to omeprazole and are seeking a declaratory judgment
that their generic form of Prilosec does not infringe these patents.
Additionally, they have alleged misappropriation of trade secrets, tortious
interference, unfair competition and violations of the North Carolina Unfair
Trade Practice Act. We have denied the substantive allegations made in these
cases. Both of these cases against us are in early stages of litigation. However,
while these plaintiffs have sought approval from the FDA to market a generic
form of Prilosec, no such FDA approval has, as of March 14, 2004, been granted
to them. In addition, these plaintiffs omeprazole product has been found in
separate litigation to infringe certain patents of AstraZeneca and the
infringement findings have been upheld on appeal. These lawsuits are
essentially inactive at this time. Only limited discovery has occurred in
these lawsuits and no additional discovery is currently being sought. No date
has been set for trial. In the event that these lawsuits again become active,
we intend to vigorously defend the patents validity and to determine whether
or not Dr. Reddys product infringes any of our relevant patents. The third case involving our omeprazole patents was brought against us in
August 2001 by Andrx Pharmaceuticals, Inc. in the U.S. District Court for the
Southern District of New York. Andrx has challenged the validity of three of
our omeprazole patents and has also sought a declaratory judgment that its
generic omeprazole product does not infringe these patents. Furthermore, Andrx
claims violations of federal and state antitrust laws with respect to the
licensing of these omeprazole patents and has sought injunctive relief and
unspecified treble damages. We have denied the substantive allegations made by
Andrx. This case is in an early stage of litigation. While Andrx has received FDA
approval for its generic omeprazole product, to our knowledge, it is not
currently marketing this drug in the U.S. following a judicial finding that
Andrxs omeprazole product infringed certain AstraZeneca patents, which
findings have been upheld on appeal. No date has been set for trial. No
discovery is currently being sought. We have filed a motion to dismiss the
litigation on various grounds and Andrx has objected to our motion. The
lawsuit is essentially inactive at this time. As of June 1, 2004, the judge
has not decided our motion to dismiss the litigation. The fourth case involving our omeprazole patents was brought in December 2002
by us against Kremers Urban Development Co., Schwarz Pharma Inc. and Schwarz
Pharma AG (collectively, together with the other named defendants, KUDCO) in
the U.S. District Court for the Southern District of New York. KUDCO has a
generic omeprazole product with final FDA marketing approval, was found not to
infringe the AstraZeneca patents in the separate AstraZeneca patent litigation,
and is currently selling its generic substitute for Prilosec in the U.S.
marketplace. 43




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We initially brought the lawsuit under our U.S. Patent No. 6,268,385.
Following the collection of additional information concerning KUDCOs
commercially marketed product, we sought leave of the court to file an amended
complaint, adding additional claims of infringement and contributory
infringement under our U.S. Patent No. 6,326,384 and joining as defendants
Schwarz Pharma Manufacturing Inc. and Schwarz Pharma USA Holdings Inc. These
two patents include, among other claims, claims directed to compositions and
methods wherein certain characteristics of solid state omeprazole are
essentially the same in formulated drug product as in its active ingredient. In September 2003, the judge granted us leave to file the first amended
complaint adding our second patent and the additional KUDCO affiliates to the
lawsuit. Following initial discovery, we sought leave of the court to file a
second amended complaint, adding Kremers Urban Inc., another KUDCO affiliate,
to the lawsuit. On February 26, 2004, the judge granted us leave to file the
second amended complaint, adding Kremers Urban Inc. to the lawsuit. KUDCO has filed its answer to our complaint, denying our claims, asserting
various affirmative defenses to our claims, and asserting counterclaims of
patent invalidity, product non-infringement and antitrust violations under
federal and state antitrust laws. KUDCO is also contesting the personal
jurisdiction of the court over all of the defendants in this lawsuit other than
Kremers Urban Development Co., Kremers Urban Inc. and Schwarz Pharma Inc.
Motions on the jurisdictional issues are pending before the court. We have
denied the substantive allegations made by KUDCO in its counterclaims. Substantial discovery of both sides documents and of defendants product
samples has occurred in the lawsuit, although both sides asserted numerous
discovery deficiencies against the other in the lawsuit. On February 26, 2004,
the judge assigned the discovery disputes to a federal magistrate for
resolution. Discovery is continuing at this time. The parties previously had
agreed to the commencement of the trial in January 2005 but have recently moved
the trial date to June 2005. We have previously indicated to KUDCO a willingness to grant a license under
our omeprazole patents for an appropriate royalty. In the absence of KUDCO taking a royalty-bearing license, we are seeking
damages equal to a reasonable royalty on all infringing sales by the KUDCO
defendants since commercial launch of their generic substitute for Prilosec on
December 9, 2002 through the date of a judicial decision in the litigation, and
a permanent injunction on subsequent sales thereafter (unless KUDCO takes a
license), among other remedies, in the event that we ultimately prevail in the
litigation. The KUDCO defendants have publicly confirmed sales of their generic
omeprazole product during the first sixteen months after launch of their
product of approximately $1.1 billion. In the absence of a license, we intend
to vigorously prosecute the case, defend our patent rights and defend against
the foregoing defenses and counterclaims asserted by KUDCO. It is possible
that the omeprazole-related patents subject to the foregoing four lawsuits will
be found invalid, unenforceable or not infringed and, while currently stayed by
the judge in the KUDCO litigation, it is possible that the defendants
antitrust counterclaims will ultimately be allowed to proceed and be litigated
and, if adversely found, a material adverse effect on our consolidated
financial statements, results of operations or cash flow could result. 44




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In cases where we have initiated an action, we intend to prosecute our claims
to the full extent of our rights under the law. In cases where we are named
defendants, we intend to vigorously pursue all defenses available. Contract Sales Force Litigation On April 15, 2004, we filed a lawsuit against Athlon Pharmaceuticals, Inc.
seeking a declaratory judgment that we were entitled to terminate the Service
Agreement (the Athlon Service Agreement) dated July 16, 2003, as amended,
between us and Athlon as well as damages and injunctive relief for material
breaches of the Athlon Service Agreement by Athlon. The Athlon Service
Agreement incorporated the terms and conditions pursuant to which
representatives of Athlon would promote the sale of our Darvocet A500 product
to physicians. We initially paid Athlon $3,350,000 to build its sales force to
promote the sale of our Darvocet A500, and the terms of the Athlon Service
Agreement would require us to pay Athlon an additional $1,200,000 each month
for such services for the contract period of 36 months, commencing in October
2003, subject to Athlons compliance with certain representations, warranties
and covenants, some of which are described below. The lawsuit asserts that Athlon has materially breached the Athlon Service
Agreement in several ways, including failure to: (i) provide the required
number of sales representatives during our launch of Darvocet A500 commencing
in October 2003, (ii) use its best efforts to promote Darvocet A500 at the
targeted levels of first and second pharmaceutical details to physicians, (iii)
perform the services to the best of its ability, as contractually required, and
(iv) require its sales representatives to perform the contracted services, as
required, in a professional manner consistent with industry standards and in
conformance with that level of care and skill ordinarily exercised by
professional contract sales organizations in similar circumstances. The lawsuit
also asserts that Athlon breached its representation and warranty that it would
perform, and would require its sales representatives to perform, the contracted
services in substantially the same manner that it would promote Athlons own
products. Athlon has asserted several counterclaims, including breach of an implied
covenant of good faith in fair dealing and anticipatory breach of the contract.
We have filed a reply denying these allegations. On June 4, 2004, we sent a notice of termination of the Athlon Service
Agreement to Athlon. We also informed Athlon of our intent to amend the
lawsuit to assert the defense of fraud in the inducement in the formation of
the agreement on the part of Athlon and other claims. We intend to prosecute our claims, and defend against the counterclaims made by
Athlon in connection with the referenced lawsuit or related litigation, to the
full extent permitted by law. 45




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Item 2. Issuer Purchases of Equity Securities. (d) Maximum Number (or(c) Total Number of
    
    Approximate Dollar Value)(a) Total
    
    
    
    
    
    Shares (or units)
    
    of Shares (or units) thatNumber
    
    (b) 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 1- January 31
    
    
    6,315
    
    
    $
    28.68
    
    
    
    
    
    
    
    February 1 - February 29
    
    
    3,199
    
    
    
    20.36
    
    
    
    
    
    
    
    March 1 - March 31
    
    
    23,796
    
    
    
    9.37
    
    
    
    
    
    
    
    Total
    
    
    33,310
    
    
    $
    14.08
    
    
    
    
    
    
    
    
 * All of these shares were purchased on the open market by the trustee of
the Companys Retirement Savings Plan with amounts provided by the Company as
an employer match. These shares are held as assets of the plan. Item 3. Defaults Upon Senior Securities. Under the terms of the credit agreement for our senior credit facility in
effect at March 31, 2004, we were required to comply with various covenants
including, but not limited to, those pertaining to maintenance of certain
financial ratios and incurrence of additional indebtedness. We were not in
compliance with some of these covenants at March 31, 2004. See Note 10 for
additional discussion and a description of our new senior credit facility that
has replaced the credit facility in effect at March 31, 2004. Under the terms of the indenture for our senior subordinated notes due
2010, we are required to comply with various covenants including, but not
limited to a covenant relating to incurrence of additional indebtedness. We
were not in compliance with some of these covenants at March 31, 2004. See
Note 10 for additional discussion and a description of the consent solicitation
approved in April 2004 that waived all then existing defaults under such
indenture (including those in effect at March 31, 2004). Item 6. Exhibits and Reports on Form 8-K. 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. Reports on Form 8-K: During the first quarter of 2004, we furnished or filed, as applicable, the
following Current Reports on Form 8-K:  
    
    Dated February 6, 2004, reporting our financial results for the
quarter and year ended December 31, 2003.  
    
    Dated February 6, 2004, announcing the posting of Darvocet A500
prescription data on our web site. 46




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
    
    Dated February 13, 2004, reporting the unaudited financial statements
for the nine months ended September 30, 2002 and 2003 and the year ended
December 31, 2002 for the pain products we acquired from Elan in
December 2003.  
    
    Dated February 20, 2004, announcing approval of the New Drug
Application for our M.V.I. Adult product.  
    
    Dated March 1, 2004, reporting that our Board of Directors issued a
press release announcing the appointment of a committee to conduct an
inquiry into unusual sales of our Brethine and Darvocet products in the
second half of 2003. The company also issued a press release announcing
it had entered into a definitive agreement to sell the M.V.I. and
Aquasol product lines.  
    
    Dated March 9, 2004, reporting that we issued a Notice of Blackout
pursuant to regulation BTR to our executive officers and directors.  
    
    Dated March 30, 2004, announcing a change in management.  
    
    Dated March 31, 2004, reporting that we issued a press release
providing an update on the status of our financial results. 47




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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: June 24, 2004
    By:

    /s/ Frederick D. SancilioFrederick D. Sancilio, Ph.D.Executive Chairman of the Board,
Chief Executive Officer Date: June 24, 2004
    By:
    /s/ Gina GutzeitGina GutzeitInterim Chief Financial Officer 48




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aaiPharma Inc.
Exhibit Index ExhibitNo.
    
    Description3.1
    
    Amended and Restated Certificate of Incorporation of the Company, and
amendments thereto (incorporated by reference to Exhibit 3.1 to the
Companys Quarterly Report on Form 10-Q for the quarter ended June 30,
2003)3.2
    
    Amended By-laws of the Company (incorporated by reference to Exhibit 3.3
to the Companys Quarterly Report on Form 10-Q for the quarter ended June
30, 2000)4.1
    
    Indenture (which includes the form
of 11% senior subordinated note due
2010) dated as of March 28, 2002 between the Company, certain of its
subsidiaries as guarantors and Wachovia Bank, National Association
(formerly, First Union National Bank), as Trustee (incorporated by
reference to Exhibit 10.8 to the Companys Registration Statement on
Form S-1 (Registration No. 333-85602) filed with the SEC on April 5, 2002)4.2
    
    First Supplemental Indenture, dated as of April 20, 2004, among the
Company, certain of its subsidiaries as guarantor parties thereto and
Wachovia Bank, National Association (formerly, First Union National Bank),
as Trustee (incorporated by reference to Exhibit 99.4 to the Companys
Current Report on Form 8-K filed with the SEC on April 27, 2004)4.3
    
    Security Agreement, dated as of April 23, 2004, made by the Company and
certain subsidiaries of the Company as grantors in favor of Wachovia Bank,
National Association, in its capacity as collateral agent for the holders
of the Companys 11% Senior Subordinated Notes due 2010 (incorporated by
reference to Exhibit 99.5 to the Companys Current Report on Form 8-K
filed with the SEC on April 27, 2004)4.4
    
    Pledge and Security Agreement, dated as of April 23, 2004, made by the
Company and certain subsidiaries of the Company as pledgors in favor of
Wachovia Bank, National Association, in its capacity as collateral agent
for the holders of the Companys 11% Senior Subordinated Notes due 2010
(incorporated by reference to Exhibit 99.6 to the Companys Current Report
on Form 8-K filed with the SEC on April 27, 2004)10.1
    
    Financing Agreement (the
Financing Agreement), dated as of April 23, 2004, by and among the Company
and certain subsidiaries of the Company as borrowers, the financial institutions from time to
time party thereto as lenders, Silver Point Finance, LLC, as collateral agent, and Bank of
America, N.A., as administrative agent (incorporated by reference to Exhibit 99.1 to the
Companys Current Report on Form 8-K dated April 27, 2004)10.2
    
    Security Agreement, dated April 23, 2004, made by the
Company and certain subsidiaries of the Company as grantors in favor of Silver Point
Finance, LLC, as collateral agent, and the lenders party to the Financing Agreement
(incorporated by reference to Exhibit 99.2 to the Companys Current Report on Form 8-K
dated April 27, 2004)10.3
    
    Pledge and Security Agreement, dated April 23, 2004, made by the Company and certain
subsidiaries of the Company as pledgors in favor of Silver Point Finance, LLC, as
collateral agent, and the lenders party to the Financing Agreement
(incorporated by reference to Exhibit 99.3 to the Companys Current Report on Form
8-K dated April 27, 2004)10.4
    
    Intercreditor Agreement, dated as of April 23, 2004, among Silver Point Finance, LLC, as
senior collateral agent, Wachovia Bank, National Association, as noteholder collateral agent,
and the Company (incorporated by reference to Exhibit 99.7 to the Companys Current Report
on Form 8-K dated April 27, 2004)31.1
    
    Certification pursuant to Exchange Act Rule 13a  14(a) of Frederick D. Sancilio31.2
    
    Certification pursuant to Exchange Act Rule 13a  14(a) of Gina Gutzeit32.1
    
    Certification Pursuant to 18 U.S.C. Section 1350
 49