##### 



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  [  ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934 
 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    [X]    No    [  ] Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2)    Yes    [X]    No    [  ] The number of shares of the registrants common stock outstanding as of July 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 June 30, 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, collectively. We also
reference trademarks owned by other companies. M.V.I.®, M.V.I.-12®, M.V.I.
Pediatric®, M.V.I. Adult, Aquasol®, Aquasol A® and Aquasol E® are registered
and unregistered trademarks owned by Mayne Pharma (USA) Inc. Prilosec® is a
registered trademark owned by AstraZeneca. Unless the context otherwise
requires, references to M.V.I. are to M.V.I.-12®, M.V.I. Pediatric® and M.V.I.
Adult, collectively, and references to Aquasol are to Aquasol A® and Aquasol
E®, collectively. Duraclon® is a registered trademark owned by Fujisawa
Healthcare, Inc. and licensed to us. All references in this document to any of
these terms lacking the ® or  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 INFORMATION
    
    
    4Item 1. Financial Statements(unaudited)
    
    
    4Consolidated Statements of Operations
    
    
    4Consolidated Balance Sheets
    
    
    6Consolidated Statements of Cash Flows
    
    
    7Consolidated Statements of Comprehensive Income (Loss)
    
    
    8Notes to Consolidated Financial Statements
    
    
    9Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    31Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    46Item 4. Controls and Procedures
    
    
    46PART II. OTHER INFORMATION
    
    
    48Item 1. Legal Proceedings
    
    
    48Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
    
    
    54
 2




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Page No.Item 6. Exhibits and Reports on Form 8-K
    
    
    54SIGNATURES
    
    
    56EXHIBIT INDEX
    
    
    57
  3




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PART I. FINANCIAL INFORMATION 
 Item 1. Financial Statements.
 aaiPharma Inc. 
 CONSOLIDATED STATEMENTS OF OPERATIONS
 (In thousands, except per share amounts)
(Unaudited)
 Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net revenues:Product sales
    
    $
    21,781
    
    
    $
    40,525
    
    
    $
    46,214
    
    
    $
    64,764Product development (royalties and fees)
    
    
    5,126
    
    
    
    3,897
    
    
    
    10,041
    
    
    
    7,707Development services
    
    
    24,581
    
    
    
    21,674
    
    
    
    49,475
    
    
    
    42,61251,488
    
    
    
    66,096
    
    
    
    105,730
    
    
    
    115,083Operating costs and expenses:Direct costs (excluding depreciation and royalty expense):Product sales (includes product rights
amortization
of $3,972, $2,969, $7,944 and $5,937)
    
    
    10,943
    
    
    
    15,777
    
    
    
    25,090
    
    
    
    26,862Development services
    
    
    14,751
    
    
    
    12,587
    
    
    
    29,499
    
    
    
    24,776Total direct costs
    
    
    25,694
    
    
    
    28,364
    
    
    
    54,589
    
    
    
    51,638Selling expenses
    
    
    11,074
    
    
    
    8,201
    
    
    
    24,101
    
    
    
    15,935General and administrative expenses
    
    
    12,700
    
    
    
    11,289
    
    
    
    25,840
    
    
    
    21,319Research and development
    
    
    4,306
    
    
    
    5,588
    
    
    
    10,713
    
    
    
    10,074Depreciation
    
    
    2,025
    
    
    
    1,947
    
    
    
    4,037
    
    
    
    3,835Professional fees - internal inquiry
    
    
    5,103
    
    
    
    
    
    
    
    8,303
    
    
    
    M.V.I. contingent payment/(gain on sale)
    
    
    (37,546
    )
    
    
    
    
    
    
    (6,545
    )
    
    
    Restructuring charges
    
    
    3,400
    
    
    
    
    
    
    
    3,400
    
    
    
    Royalty expense
    
    
    509
    
    
    
    127
    
    
    
    1,009
    
    
    
    127Total operating costs and expenses
    
    
    27,265
    
    
    
    55,516
    
    
    
    125,447
    
    
    
    102,928Income (loss) from operations
    
    
    24,223
    
    
    
    10,580
    
    
    
    (19,717
    )
    
    
    12,155Other income (expense):Interest, net
    
    
    (8,752
    )
    
    
    (4,931
    )
    
    
    (14,397
    )
    
    
    (10,481
    )Loss from extinguishment from debt
    
    
    (6,229
    )
    
    
    
    
    
    
    (6,229
    )
    
    
    Other
    
    
    (1,855
    )
    
    
    226
    
    
    
    (1,836
    )
    
    
    143(16,836
    )
    
    
    (4,705
    )
    
    
    (22,462
    )
    
    
    (10,338
    )Income (loss) before income taxes
    
    
    7,387
    
    
    
    5,875
    
    
    
    (42,179
    )
    
    
    1,817Provision for income taxes
    
    
    169
    
    
    
    2,383
    
    
    
    175
    
    
    
    793Net income (loss)
    
    $
    7,218
    
    
    $
    3,492
    
    
    $
    (42,354
    )
    
    $
    1,024Basic earnings (loss) per share:
    
    $
    0.25
    
    
    $
    0.13
    
    
    $
    (1.48
    )
    
    $
    0.04Weighted average shares outstanding
    
    
    28,586
    
    
    
    27,621
    
    
    
    28,544
    
    
    
    27,590Diluted earnings (loss) per share
    
    $
    0.25
    
    
    $
    0.12
    
    
    $
    (1.48
    )
    
    $
    0.04
 4




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Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Weighted average shares outstanding
    
    
    28,653
    
    
    
    28,682
    
    
    
    28,544
    
    
    
    28,643
 The accompanying notes are an integral part of these financial statements. 5




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aaiPharma Inc. 
 CONSOLIDATED BALANCE SHEETS
 (In thousands)
 June 30,
    
    December 31,2004
    
    2003(Unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    7,677
    
    
    $
    8,785Accounts receivable, net
    
    
    
    
    
    
    32,614Work-in-progress
    
    
    11,808
    
    
    
    12,503Inventories, net
    
    
    14,027
    
    
    
    14,693Deferred tax assets
    
    
    19,184
    
    
    
    19,184Prepaid and other current assets
    
    
    10,400
    
    
    
    10,398Total current assets
    
    
    63,096
    
    
    
    98,177Property and equipment, net
    
    
    57,650
    
    
    
    57,236Goodwill, net
    
    
    12,933
    
    
    
    13,361Intangible assets, net
    
    
    292,523
    
    
    
    351,315Other assets
    
    
    15,445
    
    
    
    14,508Total assets
    
    $
    441,647
    
    
    $
    534,597LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Current maturities of long-term debt
    
    $
    
    
    
    $
    4,000Accounts payable
    
    
    22,521
    
    
    
    21,879Customer advances
    
    
    12,765
    
    
    
    17,630Accrued wages and benefits
    
    
    6,351
    
    
    
    5,320Interest payable
    
    
    5,155
    
    
    
    5,511Deferred product revenue
    
    
    25,236
    
    
    
    45,664Other accrued liabilities
    
    
    23,665
    
    
    
    11,133Total current liabilities
    
    
    95,693
    
    
    
    111,137Long-term debt, less current portion
    
    
    308,754
    
    
    
    338,844Deferred tax liability
    
    
    2,246
    
    
    
    2,246Other liabilities
    
    
    36
    
    
    
    7,647Stockholders equity:Common stock
    
    
    29
    
    
    
    28Paid-in capital
    
    
    91,622
    
    
    
    88,049Accumulated deficit
    
    
    (58,661
    )
    
    
    (16,307
    )Accumulated other comprehensive income
    
    
    2,149
    
    
    
    3,197Deferred compensation
    
    
    (221
    )
    
    
    (244
    )Total stockholders equity
    
    
    34,918
    
    
    
    74,723Total liabilities and stockholders equity
    
    $
    441,647
    
    
    $
    534,597
 The accompanying notes are an integral part of these financial statements. 6




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##### 



aaiPharma Inc. 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
 (In thousands)
(Unaudited)
 Six Months Ended June 30,2004
    
    2003Cash flows from operating activities:Net (loss) income
    
    $
    (42,354
    )
    
    $
    1,024Adjustments to reconcile net (loss) income to
net cash (used in) provided by operating activities:Depreciation and amortization
    
    
    11,981
    
    
    
    9,772Write-off of deferred financing and other costs
    
    
    6,229
    
    
    
    Net gain from asset sale
    
    
    (37,546
    )
    
    
    Other
    
    
    148
    
    
    
    (78
    )Changes in operating assets and liabilities:Accounts receivable, net
    
    
    32,442
    
    
    
    (1,766
    )Work-in-progress
    
    
    403
    
    
    
    (1,319
    )Inventories
    
    
    (2,366
    )
    
    
    94Prepaid and other assets
    
    
    (7,181
    )
    
    
    1,038Accounts payable
    
    
    736
    
    
    
    (607
    )Customer advances
    
    
    (4,685
    )
    
    
    3,437Interest payable
    
    
    (356
    )
    
    
    (206
    )Deferred product revenue
    
    
    (20,427
    )
    
    
    11,729Accrued wages and benefits and other accrued liabilities
    
    
    13,666
    
    
    
    (2,385
    )Net cash (used in) provided by operating activities
    
    
    (49,310
    )
    
    
    20,733Cash flows from investing activities:Purchases of property and equipment
    
    
    (4,719
    )
    
    
    (6,482
    )Proceeds from sales of property and equipment
    
    
    88
    
    
    
    389Product line disposals (acquisitions)
    
    
    91,377
    
    
    
    (600
    )Other
    
    
    (133
    )
    
    
    (287
    )Net cash provided by (used in) investing activities
    
    
    86,613
    
    
    
    (6,980
    )Cash flows from financing activities:Proceeds from long-term borrowings
    
    
    132,500
    
    
    
    Payments on long-term borrowings
    
    
    (164,000
    )
    
    
    (17,000
    )(Payments on) proceeds from interest rate swaps, net
    
    
    (10,112
    )
    
    
    2,678Proceeds from stock option exercises
    
    
    3,596
    
    
    
    1,091Other
    
    
    (379
    )
    
    
    1,018Net cash used in financing activities
    
    
    (38,395
    )
    
    
    (12,213
    )Net (decrease) increase in cash and cash equivalents
    
    
    (1,092
    )
    
    
    1,540Effect of exchange rate changes on cash
    
    
    (16
    )
    
    
    60Cash and cash equivalents, beginning of period
    
    
    8,785
    
    
    
    6,532Cash and cash equivalents, end of period
    
    $
    7,677
    
    
    $
    8,132Supplemental information, cash paid for:Interest
    
    $
    14,702
    
    
    $
    12,142Income taxes
    
    $
    10,372
    
    
    $
    2,979
 The accompanying notes are an integral part of these financial statements. 7




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aaiPharma Inc. 
 CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
 (In thousands)
(Unaudited)
 Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net income (loss)
    
    $
    7,218
    
    
    $
    3,492
    
    
    $
    (42,354
    )
    
    $
    1,024Currency translation
adjustments, net of tax
    
    
    (228
    )
    
    
    1,292
    
    
    
    (1,048
    )
    
    
    2,023Comprehensive income (loss)
    
    $
    6,990
    
    
    $
    4,784
    
    
    $
    (43,402
    )
    
    $
    3,047
 The accompanying notes are an integral part of these financial statements. 8




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aaiPharma Inc. 
   1. Basis of presentation and other matters aaiPharma Inc. (aaiPharma or the Company) is a science-based 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 and six months ended June
30, 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
income (loss) and income (loss) per share would have been changed to the pro
forma amounts indicated below: 9




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Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003(In thousands, except per share data)Net income (loss), as reported
    
    $
    7,218
    
    
    $
    3,492
    
    
    $
    (42,354
    )
    
    $
    1,024Less pro forma stock-based
compensation cost, net of tax
    
    
    2,720
    
    
    
    1,805
    
    
    
    5,792
    
    
    
    3,649Pro forma net income (loss)
    
    
    4,498
    
    
    
    1,687
    
    
    
    (48,146
    )
    
    
    (2,625
    )Earnings (loss) per share:As reported -Basic
    
    $
    0.25
    
    
    $
    0.13
    
    
    $
    (1.48
    )
    
    $
    0.04Diluted
    
    $
    0.25
    
    
    $
    0.12
    
    
    $
    (1.48
    )
    
    $
    0.04Pro forma -Basic
    
    $
    0.16
    
    
    $
    0.06
    
    
    $
    (1.69
    )
    
    $
    (0.10
    )Diluted
    
    $
    0.16
    
    
    $
    0.06
    
    
    $
    (1.69
    )
    
    $
    (0.10
    )
 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. NASDAQ Listing Status 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 was 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. 10




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##### 



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 met 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,
the Quarterly Report on Form 10-Q for the period ended March 31, 2004 was filed
on June 25, 2004 and the Company provided NASDAQ the required additional
information on June 30, 2004. As a result, NASDAQ notified us that we were in
compliance and would continue to be listed subject to the conditions identified
in its June 21, 2004 notification. 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 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 in compliance with the indenture
covenants at June 30, 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 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 termination
obligations under this interest rate hedging agreement were approximately $9.4
million, which were paid 11




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##### 



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 and the Securities
and Exchange Commission (SEC) that it may
receive a subpoena from the SEC. A former officer of the Company,
David M. Hurley, has been advised by the U.S. Attorneys Office
that he is a target of the investigation. The Company and the Special Committee have
agreed to cooperate fully with the government investigations, and the Special
Committee has agreed to share all results of its investigation with the SEC and
the U.S. Attorneys Office. To that end, three meetings between outside counsel
and 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. The Company and the Special Committee intend to
facilitate any interviews of employees or officers that may be requested by
these government agencies. 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. 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. In May 2004, the Company ceased making payments under the Athlon Service
Agreement, and on June 4, 2004, the Company sent a notice of termination of
agreement to Athlon. On July 7, 2004, the Company amended the lawsuit to
assert claims of fraud and breaches of contract and implied covenants, seeking
to recover compensatory and punitive damages and attorneys
fees. Athlon has amended its counterclaim to assert fraud claims and
to seek punitive damages. 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 April 2004, the first of
three generic versions of injectable Brethine was approved for sale. 3. M.V.I. and Aquasol Product Line Sale and Contingent Payment 12




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##### 



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 $37.5 million that the Company recorded in the second
quarter of 2004. The gain on the sale was based on the net cash received from
the sale less the book value of the intangible assets, inventories and other
items related to the product lines sold. The Companys M.V.I. and Aquasol product line acquisition agreement with
AstraZeneca AB, as amended, provided for a future contingent payment of $43.5
million potentially due in August 2004, depending on the status of certain
reformulation activities being carried out by the seller and regulatory
approval of the reformulations by the U.S. Food and Drug Administration. The
amount of the $43.5 million contingent payment was to be reduced by $1 million
per month if the conditions for the contingent payment had not occurred by
December 31, 2002. The amount of the contingent payment had decreased by $12.0
million by December 31, 2003. Such conditions were satisfied in January and
February 2004, fixing the previously contingent liability under the amendment
at $31.5 million. The Company recorded this expense in the first quarter of
2004. As a result of an amendment to the original acquisition agreement, the
Company was precluded from recognizing this obligation (the M.V.I. Contingent
Payment) as additional purchase price for the M.V.I. and Aquasol product lines
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 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 sale transaction in the second quarter of 2004
offsets the expense discussed in this Note in determining the net loss for the
six months ended June 30, 2004. Concurrently with the closing of the M.V.I.
and Aquasol Sale on April 26, 2004, the Company paid to AstraZeneca AB the
M.V.I. Contingent Payment, which was discounted to approximately $31.0 million
as a result of the early payment. 4. Income taxes The Company recorded a tax expense of approximately $3 million in the second
quarter of 2004. This expense was offset by a tax benefit from the utilization
of net operating loss carryforwards from the first quarter of 2004
resulting in net $0.2 million tax expense. The
Company recorded a tax benefit of approximately $17 million in the six months
ended June 30, 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 this benefit will not be realized.
The Companys effective tax rates for both the three and six months ended June
30, 2004 was less than 1%. Its effective tax rates for the three and six
months ended June 30, 2003 was 41% and 44%, respectively. 5. Earnings (loss) per share Basic earnings (loss) per share are based on the weighted average number of
common shares outstanding during the year. Diluted earnings (loss) per share
are computed assuming that the weighted average number of common shares was
increased by the conversion of stock options issued to employees and members of
the Companys Board of Directors. The diluted per share amounts reflect a
change in the number of shares outstanding (the denominator) to include the
options as if they were converted to shares and issued, unless their inclusion
would be anti-dilutive. During the six months ended June 30, 2004,
approximately 360,000 options were exercised for aggregate proceeds to 13




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##### 



the Company of $3.6 million. In the three and six months ended June 30, 2004, 4.6
million and 3.5 million options, respectively, were excluded as they were
anti-dilutive. In the three and six months ended June 30, 2003, 1.7 million
and 1.6 million options, respectively, were excluded as they were
anti-dilutive. In each period presented, the net income (loss) (the
numerator) is the same for both basic and diluted per share computations. The following table provides a reconciliation of the denominator for the basic
and diluted earning per share computations (in thousands): Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Basic earnings per share:Weighted average number of shares
    
    
    28,586
    
    
    
    27,621
    
    
    
    28,544
    
    
    
    27,590Effect of dilutive securities:Stock options
    
    
    67
    
    
    
    1,061
    
    
    
    
    
    
    
    1,053Diluted earnings per share:Adjusted weighted average number of shares
and assumed conversions
    
    
    28,653
    
    
    
    28,682
    
    
    
    28,544
    
    
    
    28,643
 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. 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
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net revenues:Product sales
    
    $
    21,781
    
    
    $
    40,525
    
    
    $
    46,214
    
    
    $
    64,764Product development
    
    
    5,126
    
    
    
    3,897
    
    
    
    10,041
    
    
    
    7,707
 14




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##### 



Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Development services
    
    
    24,581
    
    
    
    21,674
    
    
    
    49,475
    
    
    
    42,612$
    51,488
    
    
    $
    66,096
    
    
    $
    105,730
    
    
    $
    115,083United States
    
    $
    45,193
    
    
    $
    61,351
    
    
    $
    93,503
    
    
    $
    105,670Germany
    
    
    6,367
    
    
    
    5,232
    
    
    
    12,482
    
    
    
    10,543Other
    
    
    350
    
    
    
    283
    
    
    
    904
    
    
    
    608Less intercompany
    
    
    (422
    )
    
    
    (770
    )
    
    
    (1,159
    )
    
    
    (1,738
    )$
    51,488
    
    
    $
    66,096
    
    
    $
    105,730
    
    
    $
    115,083Income (loss) from operations:Product sales
    
    $
    33,919
    
    
    $
    17,638
    
    
    $
    (6
    )
    
    $
    24,692Product development
    
    
    5,126
    
    
    
    3,897
    
    
    
    10,041
    
    
    
    7,707Development services
    
    
    735
    
    
    
    37
    
    
    
    836
    
    
    
    63339,780
    
    
    
    21,572
    
    
    
    10,871
    
    
    
    33,032Research and development
    
    
    (4,406
    )
    
    
    (5,698
    )
    
    
    (10,915
    )
    
    
    (10,284
    )Corporate
    
    
    (11,151
    )
    
    
    (5,294
    )
    
    
    (19,673
    )
    
    
    (10,593
    )$
    24,223
    
    
    $
    10,580
    
    
    $
    (19,717
    )
    
    $
    12,155United States
    
    $
    23,431
    
    
    $
    10,401
    
    
    $
    (21,149
    )
    
    $
    11,268Germany
    
    
    805
    
    
    
    291
    
    
    
    1,359
    
    
    
    1,020Other
    
    
    (13
    )
    
    
    (112
    )
    
    
    73
    
    
    
    (133
    )$
    24,223
    
    
    $
    10,580
    
    
    $
    (19,717
    )
    
    $
    12,155Depreciation and amortization:Product sales
    
    $
    4,198
    
    
    $
    3,060
    
    
    $
    8,389
    
    
    $
    6,106Development services
    
    
    1,198
    
    
    
    1,220
    
    
    
    2,381
    
    
    
    2,392Product development
    
    
    100
    
    
    
    109
    
    
    
    202
    
    
    
    209Corporate
    
    
    501
    
    
    
    527
    
    
    
    1,009
    
    
    
    1,065$
    5,997
    
    
    $
    4,916
    
    
    $
    11,981
    
    
    $
    9,772
 June 30,
    
    December 31,2004
    
    2003Total assets:Product sales
    
    $
    327,980
    
    
    $
    424,452Product development
    
    
    13,428
    
    
    
    13,062Development services
    
    
    56,834
    
    
    
    55,791Corporate
    
    
    43,405
    
    
    
    41,292$
    441,647
    
    
    $
    534,597United States
    
    $
    411,991
    
    
    $
    504,575Germany
    
    
    27,907
    
    
    
    28,242Other
    
    
    1,749
    
    
    
    1,780$
    441,647
    
    
    $
    534,597Goodwill, net:Development services
    
    $
    12,933
    
    
    $
    13,361
 15




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##### 



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 June 30, 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 its stockholders, including the Company. No revenues were recognized from
Aesgen for the three and six months ended June 30, 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 and $0.2
million under that agreement in the three and six months ended June 30, 2004
and expensed $0.1 million in the second quarter of 2003. Revenues recognized
from Endeavor totaled $0.3 million and $0.6 million for the three and six
months ended June 30, 2003. Certain services performed by the Company for
Endeavor were covered by a Securities Payment Agreement between the Company and
Endeavor, whereby the Company would receive Endeavor preferred stock in lieu of
cash for services performed. At June 30, 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 (in thousands): December 31,June 30, 2004
    
    2003Gross accounts receivable
    
    $
    34,879
    
    
    $
    85,726Allowance for uncollectible accounts
    
    
    (1,778
    )
    
    
    (1,130
    )Allowance for customer credits
    
    
    (36,821
    )
    
    
    (51,982
    )Subtotal
    
    
    (3,720
    )
    
    
    32,614Net customer credits reclassed to other current liabilities
    
    
    3,720
    
    
    
    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 June 30, 2004 has been reclassed to other current
liabilities. 9. Inventories, net The following table presents the components of inventories (in thousands): 16




---



##### 



June 30, 2004
    
    December 31, 2003Finished goods (including
consigned inventory of
$4,014 in 2004 and $4,792
in 2003)
    
    $
    15,686
    
    
    $
    18,579Work-in-process
    
    
    2,638
    
    
    
    1,865Raw materials and supplies
    
    
    5,218
    
    
    
    5,007Inventory reserves
    
    
    (9,515
    )
    
    
    (10,758
    )Total inventories, net
    
    $
    14,027
    
    
    $
    14,693
 10. Debt The following table presents the components of current maturities of long-term debt (in thousands): June 30, 2004
    
    December 31, 2003Current maturities of long-term debt
    
    $
    
    
    
    $
    4,000
 The following table presents the components of long-term debt (in thousands): June 30, 2004
    
    December 31, 2003U.S. bank term loan
    
    $
    125,000
    
    
    $
    156,000U.S. revolving credit facility
    
    
    7,500
    
    
    
    8,000111⁄2% senior subordinated notes due 2010, net of original issue discount
    
    
    174,177
    
    
    
    174,106Interest rate swap monetization deferred income
    
    
    2,077
    
    
    
    12,189Fair value of interest rate swap
    
    
    
    
    
    
    (7,451
    )Less current maturities of long-term debt
    
    
    
    
    
    
    (4,000
    )Total long-term debt due after one year
    
    $
    308,754
    
    
    $
    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 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. 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. 17




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##### 



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. When issued, the notes
were not secured. Prior to the third anniversary of the date of issuance of
the notes, up to 35% of the notes 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. In April 2004, the Company paid $9.4 million to terminate
the interest rate hedging agreement. The amounts received, less the termination
payment and the interest benefits earned through the dates of sale, have been
recorded as premiums to the carrying amount of the notes and are being amortized into
interest income over their remaining life. 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. As part of this transaction, the
Company recorded a $6.2 million loss for the early extinguishment of debt
related to the write-off of financing fees related to the previous senior
credit facility. 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 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 18




---



##### 



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. At June 30, 2004, the Companys applicable
interest rate on its term loan was 8.25% and on its revolving credit facility
was 9.25%. 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 above), (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. On
August 9, 2004, the Company entered into an amendment to its senior secured
credit facility to, among other things, increase the amount of the term loans
by up to $10 million, extend the maturity date of the facilities by one year to
April 21, 2007, increase the interest rate on the loans by an additional 1.5%
subject to potential incremental reduction based on the Companys financial
performance, and
adjust certain covenants under the facilities. Under the amended credit
facility, the Company is permitted to borrow up to an additional $10 million in
term loans on August 13, 2004. Subject to availability limitations
under the revolving credit facility, until December 31, 2004 the Company may
pay the additional 1.5% incremental interest amount by delivery of promissory
notes, having the same terms as the notes evidencing the loans under the
facilities. The amendment adjusted both the percentages of proceeds of certain
transactions that are required to be applied to prepay the loans and the fees
to be paid upon optional reductions of the credit facility. As amended,
optional reductions in revolving credit commitments and optional prepayments of
term loans are subject to a prepayment fee equal to 3.5% until August 9, 2005,
2.5% for the subsequent 12 months, and 1.5% for the next 6 months (with no
prepayment penalty payable for the remainder of the term). As of June 30, 2004, scheduled maturities of long-term debt for the years
ending December 31, 2004 through 2010 were as follows (in thousands): 2004
    
    $
    2005
    
    
    2006
    
    
    132,5002007
    
    
    2008
    
    
    2009
    
    
    2010
    
    
    175,000Total
    
    $
    307,500
 The Companys new senior credit facilities, as amended, 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, 19




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##### 



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 and revolver availability. At June 30, 2004,
the Company was in compliance with the covenants under the new senior credit facilities.
As amended, the Companys new
senior credit facilities include a covenant requiring the Company to maintain
availability under the revolving credit facility and cash and cash equivalents
in the aggregate amount of $5.0 million plus certain other amounts related to
payables, bank overdrafts and interest payments on the loans paid in
the form of additional notes. 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 notes 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 effect these amendments and waivers and made the
interest payments that had been due on April 1, 2004, together with default
interest. 20




---



##### 



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. 11. Restructuring Charges In June 2004, the Company announced and implemented a work force reduction
intended to rationalize the expense base in relation to its revenue. The
Company recorded a $3.4 million expense in the three months ended June 30,
2004, representing severance costs and related employee-benefit expenses for
those affected by the reduction. The related liability is included in other
current liabilities on the Companys consolidated balance sheet. Substantially
all of this restructuring liability will be paid during the second half of
2004. As part of the restructuring plan, the Company announced it would close
its New Jersey facility in August 2004. On-going lease and facility costs for
this location are not included in this quarters restructuring charge, and the
Company is currently seeking to sub-lease all or a portion of this facility.
In accordance with Statement of Financial Accounting Standard
No. 146, Accounting for Costs Associated with Exit or Disposal
Activities (SFAS
146), the Company will record facility closure costs in the third quarter of
2004. 12. Commitments and Contingencies The Company may have to make contingent payments of $4.7 million over three
years in connection with the purchase of its Charleston, South Carolina
manufacturing facility, based on the level of
manufacturing revenues at this facility. At June 30, 2004, these contingent
payment obligations are not liabilities and have not been recorded on the
Companys consolidated balance sheet. 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 payments of $10.1
million will be due in October 2004 and April 2005. 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. 13. 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. 21




---



##### 



The following information presents consolidating statements of operations,
balance sheets and cash flows for the periods and as of the dates indicated: 22




---



##### 



aaiPharma Inc.
CONSOLIDATING STATEMENT OF OPERATIONS
(In thousands) Three Months Ended June 30, 2004Non-Guarantor
    
    GuarantorIssuer
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedNet revenues
    
    $
    11,772
    
    
    $
    33,419
    
    
    $
    6,719
    
    
    $
    (422
    )
    
    $
    51,488Equity earnings from subsidiaries
    
    
    26,209
    
    
    
    
    
    
    
    
    
    
    
    (26,209
    )
    
    
    Total revenues
    
    
    37,981
    
    
    
    33,419
    
    
    
    6,719
    
    
    
    (26,631
    )
    
    
    51,488Operating costs and expenses:Direct costs
    
    
    8,001
    
    
    
    13,949
    
    
    
    3,915
    
    
    
    (171
    )
    
    
    25,694Selling expenses
    
    
    1,807
    
    
    
    8,626
    
    
    
    641
    
    
    
    
    
    
    
    11,074General and administrative
    
    
    13,966
    
    
    
    (2,321
    )
    
    
    1,055
    
    
    
    
    
    
    
    12,700Research and development
    
    
    (2
    )
    
    
    4,308
    
    
    
    
    
    
    
    
    
    
    
    4,306Depreciation
    
    
    1,301
    
    
    
    410
    
    
    
    314
    
    
    
    
    
    
    
    2,025Professional fees - internal inquiry
    
    
    
    
    
    
    5,103
    
    
    
    
    
    
    
    
    
    
    
    5,103M.V.I. contingent payment/(gain on
sale)
    
    
    
    
    
    
    (37,546
    )
    
    
    
    
    
    
    
    
    
    
    (37,546
    )Restructuring charges
    
    
    
    
    
    
    3,400
    
    
    
    
    
    
    
    
    
    
    
    3,400Royalty expense
    
    
    
    
    
    
    509
    
    
    
    
    
    
    
    
    
    
    
    50925,073
    
    
    
    (3,562
    )
    
    
    5,925
    
    
    
    (171
    )
    
    
    27,265Income (loss) from operations
    
    
    12,908
    
    
    
    36,981
    
    
    
    794
    
    
    
    (26,460
    )
    

    
    24,223Other income (expense):Interest, net
    
    
    
    
    
    
    (8,817
    )
    
    
    65
    
    
    
    
    
    
    
    (8,752
    )Net intercompany interest
    
    
    (464
    )
    
    
    532
    
    
    
    (68
    )
    
    
    
    
    
    
    Other expense, net
    
    
    (5,196
    )
    
    
    (2,815
    )
    
    
    (73
    )
    
    
    
    
    
    
    (8,084
    )(5,660
    )
    
    
    (11,100
    )
    
    
    (76
    )
    
    
    
    
    
    
    (16,836
    )Income (loss) before income taxes
    
    
    7,248
    
    
    
    25,881
    
    
    
    718
    
    
    
    (26,460
    )
    
    
    7,387Provision for (benefit from) income taxes
    
    
    30
    
    
    
    141
    
    
    
    (2
    )
    
    
    
    
    
    
    169Net income (loss)
    
    $
    7,218
    
    
    $
    25,740
    
    
    $
    720
    
    
    $
    (26,460
    )
    
    $
    7,218
 23




---



##### 



aaiPharma Inc.
CONSOLIDATING STATEMENT OF OPERATIONS
(In thousands) Three Months Ended June 30, 2003Non-Guarantor
    
    GuarantorIssuer
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedNet revenues
    
    $
    11,631
    
    
    $
    49,721
    
    
    $
    5,514
    
    
    $
    (770
    )
    
    $
    66,096Equity earnings from subsidiaries
    
    
    12,444
    
    
    
    
    
    
    
    
    
    
    
    (12,444
    )
    
    
    Total revenues
    
    
    24,075
    
    
    
    49,721
    
    
    
    5,514
    
    
    
    (13,214
    )
    
    
    66,096Operating costs and expenses:Direct costs
    
    
    6,528
    
    
    
    19,096
    
    
    
    3,420
    
    
    
    (680
    )
    
    
    28,364Selling expenses
    
    
    1,637
    
    
    
    5,955
    
    
    
    609
    
    
    
    
    
    
    
    8,201General and administrative
    
    
    8,070
    
    
    
    2,210
    
    
    
    1,009
    
    
    
    
    
    
    
    11,289Research and development
    
    
    
    
    
    
    5,588
    
    
    
    
    
    
    
    
    
    
    
    5,588Depreciation
    
    
    1,345
    
    
    
    306
    
    
    
    296
    
    
    
    
    
    
    
    1,947Royalty expense
    
    
    
    
    
    
    127
    
    
    
    
    
    
    
    
    
    
    
    12717,580
    
    
    
    33,282
    
    
    
    5,334
    
    
    
    (680
    )
    
    
    55,516Income (loss) from operations
    
    
    6,495
    
    
    
    16,439
    
    
    
    180
    
    
    
    (12,534
    )
    
    
    10,580Other income (expense):Interest, net
    
    
    (352
    )
    
    
    (4,581
    )
    
    
    2
    
    
    
    
    
    
    
    (4,931
    )Net intercompany interest
    
    
    (520
    )
    
    
    564
    
    
    
    (44
    )
    
    
    
    
    
    
    Other income (expense), net
    
    
    220
    
    
    
    13
    
    
    
    (7
    )
    
    
    
    
    
    
    226(652
    )
    
    
    (4,004
    )
    
    
    (49
    )
    
    
    
    
    
    
    (4,705
    )Income (loss) before income taxes
    
    
    5,843
    
    
    
    12,435
    
    
    
    131
    
    
    
    (12,534
    )
    
    
    5,875Provision for income taxes
    
    
    2,351
    
    
    
    32
    
    
    
    
    
    
    
    
    
    
    
    2,383Net income (loss)
    
    $
    3,492
    
    
    $
    12,403
    
    
    $
    131
    
    
    $
    (12,534
    )
    
    $
    3,492
 24




---



##### 



aaiPharma Inc.
CONSOLIDATING STATEMENT OF OPERATIONS
(In thousands) Six Months Ended June 30, 2004Non-Guarantor
    
    GuarantorIssuer
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedNet revenues
    
    $
    24,058
    
    
    $
    69,445
    
    
    $
    13,386
    
    
    $
    (1,159
    )
    
    $
    105,730Equity earnings from subsidiaries
    
    
    (12,373
    )
    
    
    
    
    
    
    
    
    
    
    12,373
    
    
    
    Total revenues

    
    
    11,685
    
    
    
    69,445
    
    
    
    13,386
    
    
    
    11,214
    
    
    
    105,730Operating costs and expenses:Direct costs (excluding depreciation)
    
    
    15,713
    
    
    
    31,602
    
    
    
    7,978
    
    
    
    (704
    )
    
    
    54,589Selling expenses
    
    
    3,535
    
    
    
    19,302
    
    
    
    1,264
    
    
    
    
    
    
    
    24,101General and administrative
    
    
    26,077
    
    
    
    (2,363
    )
    
    
    2,126
    
    
    
    
    
    
    
    25,840Research and development
    
    
    6
    
    
    
    10,707
    
    
    
    
    
    
    
    
    
    
    
    10,713Depreciation
    
    
    2,624
    
    
    
    827
    
    
    
    586
    
    
    
    
    
    
    
    4,037Professional fees - internal inquiry
    
    
    
    
    
    
    8,303
    
    
    
    
    
    
    
    
    
    
    
    8,303M.V.I. contingent payment/(gain on
sale)
    
    
    
    
    
    
    (6,545
    )
    
    
    
    
    
    
    
    
    
    
    (6,545
    )Restructuring charges
    
    
    
    
    
    
    3,400
    
    
    
    
    
    
    
    
    
    
    
    3,400Royalty expense
    
    
    
    
    
    
    1,009
    
    
    
    
    
    
    
    
    
    
    
    1,00947,955
    
    
    
    66,242
    
    
    
    11,954
    
    
    
    (704
    )
    
    
    125,447(Loss) income from operations
    
    
    (36,270
    )
    
    
    3,203
    
    
    
    1,432
    
    
    
    11,918
    
    
    
    (19,717
    )Other income (expense):Interest, net
    
    
    (17
    )
    
    
    (14,483
    )
    
    
    103
    
    
    
    
    
    
    
    (14,397
    )Net intercompany interest
    
    
    (957
    )
    
    
    1,064
    
    
    
    (107
    )
    
    
    
    
    
    
    Other expense, net
    
    
    (5,074
    )
    
    
    (2,808
    )
    
    
    (183
    )
    
    
    
    
    
    
    (8,065
    )(6,048
    )
    
    
    (16,227
    )
    
    
    (187
    )
    
    
    
    
    
    
    (22,462
    )(Loss) income before income taxes
    
    
    (42,318
    )
    
    
    (13,024
    )
    
    
    1,245
    
    
    
    11,918
    
    
    
    (42,179
    )Provision for (benefit from) income taxes
    
    
    36
    
    
    
    141
    
    
    
    (2
    )
    
    
    
    
    
    
    175Net (loss) income
    
    $
    (42,354
    )
    
    $
    (13,165
    )
    
    $
    1,247
    
    
    $
    11,918
    
    
    $
    (42,354
    )
 25




---



##### 



aaiPharma Inc.
CONSOLIDATING STATEMENT OF OPERATIONS
(In thousands) Six Months Ended June 30, 2003Non-Guarantor
    
    GuarantorIssuer
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedNet revenues
    
    $
    22,261
    
    
    $
    83,410
    
    
    $
    11,150
    
    
    $
    (1,738
    )
    
    $
    115,083Equity earnings from subsidiaries
    
    
    15,987
    
    
    
    
    
    
    
    
    
    
    
    (15,987
    )
    
    
    Total revenues
    
    
    38,248
    
    
    
    83,410
    
    
    
    11,150
    
    
    
    (17,725
    )
    
    
    115,083Operating costs and expenses:Direct costs (excluding
depreciation)
    
    
    13,049
    
    
    
    33,420
    
    
    
    6,592
    
    
    
    (1,423
    )
    
    
    51,638Selling expenses
    
    
    2,946
    
    
    
    11,868
    
    
    
    1,121
    
    
    
    
    
    
    
    15,935General and administrative
    
    
    15,847
    
    
    
    3,470
    
    
    
    2,002
    
    
    
    
    
    
    
    21,319Research and development
    
    
    
    
    
    
    10,074
    
    
    
    
    
    
    
    
    
    
    
    10,074Depreciation
    
    
    2,701
    
    
    
    585
    
    
    
    549
    
    
    
    
    
    
    
    3,835Royalty expense
    
    
    
    
    
    
    127
    
    
    
    
    
    
    
    
    
    
    
    12734,543
    
    
    
    59,544
    
    
    
    10,264
    
    
    
    (1,423
    )
    
    
    102,928Income (loss) from operations
    
    
    3,705
    
    
    
    23,866
    
    
    
    886
    
    
    
    (16,302
    )
    
    
    12,155Other income (expense):Interest, net
    
    
    (1,044
    )
    
    
    (9,440
    )
    
    
    3
    
    
    
    
    
    
    
    (10,481
    )Net intercompany interest
    
    
    (1,036
    )
    
    
    1,123
    
    
    
    (87
    )
    
    
    
    
    
    
    Other income (expense), net
    
    
    160
    
    
    
    15
    
    
    
    (32
    )
    
    
    
    
    
    
    143(1,920
    )
    
    
    (8,302
    )
    
    
    (116
    )
    
    
    
    
    
    
    (10,338
    )Income (loss) before income taxes
    
    
    1,785
    
    
    
    15,564
    
    
    
    770
    
    
    
    (16,302
    )
    
    
    1,817Provision for income taxes
    
    
    761
    
    
    
    32
    
    
    
    
    
    
    
    
    
    
    
    793Net income (loss)
    
    $
    1,024
    
    
    $
    15,532
    
    
    $
    770
    
    
    $
    (16,302
    )
    
    $
    1,024
 26




---



##### 



aaiPharma Inc.
CONSOLIDATING BALANCE SHEET
(In thousands) June 30, 2004Guarantor
    
    Non-GuarantorIssuer
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedASSETSCurrent assets:Cash and cash equivalents
    
    $
    7,071
    
    
    $
    169
    
    
    $
    437
    
    
    $
    
    
    
    $
    7,677Accounts receivable, net
    
    
    8,844
    
    
    
    (15,683
    )
    
    
    3,118
    
    
    
    3,721
    
    
    
    Work-in-progress
    
    
    2,661
    
    
    
    4,907
    
    
    
    9,264
    
    
    
    (5,024
    )
    
    
    11,808Inventories
    
    
    5,176
    
    
    
    7,687
    
    
    
    1,164
    
    
    
    
    
    
    
    14,027Deferred tax assets
    
    
    19,184
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    19,184Prepaid and other current assets
    
    
    1,868
    
    
    
    8,248
    
    
    
    284
    
    
    
    
    
    
    
    10,400Total current assets
    
    
    44,804
    
    
    
    5,328
    
    
    
    14,267
    
    
    
    (1,303
    )
    
    
    63,096Investments in and advances to subsidiaries
    
    
    66,061
    
    
    
    (46,202
    )
    
    
    
    
    
    
    (19,859
    )
    
    
    Property and equipment, net
    
    
    38,605
    
    
    
    14,746
    
    
    
    4,299
    
    
    
    
    
    
    
    57,650Goodwill, net
    
    
    725
    
    
    
    1,229
    
    
    
    10,979
    
    
    
    
    
    
    
    12,933Intangibles, net
    
    
    1,270
    
    
    
    291,253
    
    
    
    
    
    
    
    
    
    
    
    292,523Other assets
    
    
    2,402
    
    
    
    12,932
    
    
    
    111
    
    
    
    
    
    
    
    15,445Total assets
    
    $
    153,867
    
    
    $
    279,286
    
    
    $
    29,656
    
    
    $
    (21,162
    )
    
    $
    441,647LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Current maturities of long-term debt
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Accounts payable
    
    
    8,567
    
    
    
    12,343
    
    
    
    1,611
    
    
    
    
    
    
    
    22,521Customer advances
    
    
    4,001
    
    
    
    5,975
    
    
    
    5,509
    
    
    
    (2,720
    )
    
    
    12,765Accrued wages and benefits
    
    
    3,102
    
    
    
    1,535
    
    
    
    1,714
    
    
    
    
    
    
    
    6,351Interest payable
    
    
    3
    
    
    
    5,152
    
    
    
    
    
    
    
    
    
    
    
    5,155Deferred product revenue
    
    
    
    
    
    
    25,236
    
    
    
    
    
    
    
    
    
    
    
    25,236Other accrued liabilities
    
    
    2,874
    
    
    
    19,569
    
    
    
    (348
    )
    
    
    1,570
    
    
    
    23,665Total current liabilities
    
    
    18,547
    
    
    
    69,810
    
    
    
    8,486
    
    
    
    (1,150
    )
    
    
    95,693Long-term debt, less current portion
    
    
    7,500
    
    
    
    301,254
    
    
    
    
    
    
    
    
    
    
    
    308,754Deferred tax liability
    
    
    2,246
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,246Other liabilities
    
    
    36
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    36Investments in and advances to subsidiaries
    
    
    154,311
    
    
    
    (160,228
    )
    
    
    4,803
    
    
    
    1,114
    
    
    
    Total stockholders equity
    
    
    (28,773
    )
    
    
    68,450
    
    
    
    16,367
    
    
    
    (21,126
    )
    
    
    34,918Total liabilities and stockholders equity
    
    $
    153,867
    
    
    $
    279,286
    
    
    $
    29,656
    
    
    $
    (21,162
    )
    
    $
    441,647
 27




---



##### 



aaiPharma Inc.
CONSOLIDATING BALANCE SHEET
(In thousands) December 31, 2003Non-Guarantor
    
    GuarantorIssuer
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedASSETSCurrent assets:Cash and cash equivalents
    
    $
    8,161
    
    
    $
    192
    
    
    $
    432
    
    
    $
    
    
    
    $
    8,785Accounts receivable, net
    
    
    11,242
    
    
    
    16,785
    
    
    
    4,587
    
    
    
    
    
    
    
    32,614Work-in-progress
    
    
    3,688
    
    
    
    5,337
    
    
    
    7,793
    
    
    
    (4,315
    )
    
    
    12,503Inventories
    
    
    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
 28




---



##### 



aaiPharma Inc.CONSOLIDATING STATEMENT OF CASH FLOWS(In thousands) Six Months Ended June 30, 2004Non-Guarantor
    
    GuarantorIssuer
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedCash flows from operating activities:Net (loss) income
    
    $
    (42,354
    )
    
    $
    (13,165
    )
    
    $
    1,247
    
    
    $
    11,918
    
    
    $
    (42,354
    )Adjustments to reconcile net (loss) income
to net cash provided by operating activities:Depreciation and amortization
    
    
    2,471
    
    
    
    8,924
    
    
    
    586
    
    
    
    
    
    
    
    11,981Write-off of deferred financing and other costs
    
    
    
    
    
    
    6,229
    
    
    
    
    
    
    
    
    
    
    
    6,229Net gain from asset sale
    
    
    
    
    
    
    (37,546
    )
    
    
    
    
    
    
    
    
    
    
    (37,546
    )Other
    
    
    1
    
    
    
    
    
    
    
    147
    
    
    
    
    
    
    
    148Changes in operating assets and liabilities:Accounts receivable, net
    
    
    2,399
    
    
    
    32,467
    
    
    
    1,297
    
    
    
    (3,721
    )
    
    
    32,442Work-in-progress
    
    
    1,027
    
    
    
    430
    
    
    
    (1,763
    )
    
    
    709
    
    
    
    403Inventories
    
    
    (589
    )
    
    
    (1,765
    )
    
    
    (12
    )
    
    
    
    
    
    
    (2,366
    )Prepaid and other assets
    
    
    21
    
    
    
    (7,132
    )
    
    
    (70
    )
    
    
    
    
    
    
    (7,181
    )Accounts payable
    
    
    3,485
    
    
    
    (1,948
    )
    
    
    (801
    )
    
    
    
    
    
    
    736Customer advances
    
    
    (2,439
    )
    
    
    (2,126
    )
    
    
    882
    
    
    
    (1,002
    )
    
    
    (4,685
    )Interest payable
    
    
    (5
    )
    
    
    (351
    )
    
    
    
    
    
    
    
    
    
    
    (356
    )Deferred product revenue
    
    
    
    
    
    
    (20,427
    )
    
    
    
    
    
    
    
    
    
    
    (20,427
    )Accrued wages and benefits and other accrued
liabilities
    
    
    (5,397
    )
    
    
    15,253
    
    
    
    848
    
    
    
    2,962
    
    
    
    13,666Intercompany receivables and payables
    
    
    39,322
    
    
    
    (27,046
    )
    
    
    (1,410
    )
    
    
    (10,866
    )
    
    
    Net cash (used in) provided by operating activities
    
    
    (2,058
    )
    
    
    (48,203
    )
    
    
    951
    
    
    
    
    
    
    
    (49,310
    )Cash flows from investing activities:Purchases of property and equipment
    
    
    (1,995
    )
    
    
    (1,794
    )
    
    
    (930
    )
    
    
    
    
    
    
    (4,719
    )Proceeds from sales of property and equipment
    
    
    
    
    
    
    88
    
    
    
    
    
    
    
    
    
    
    
    88Product line disposal
    
    
    
    
    
    
    91,377
    
    
    
    
    
    
    
    
    
    
    
    91,377Other
    
    
    (133
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (133
    )Net cash (used in) provided by investing activities
    
    
    (2,128
    )
    
    
    89,671
    
    
    
    (930
    )
    
    
    
    
    
    
    86,613Cash flows from financing activities:Proceeds from long-term borrowings
    
    
    7,500
    
    
    
    125,000
    
    
    
    
    
    
    
    
    
    
    
    132,500Payments on long-term borrowings
    
    
    (8,000
    )
    
    
    (156,000
    )
    
    
    
    
    
    
    
    
    
    
    (164,000
    )Proceeds from interest rate swaps, net
    
    
    
    
    
    
    (10,112
    )
    
    
    
    
    
    
    
    
    
    
    (10,112
    )Proceeds from stock option exercises
    
    
    3,596
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,596Other
    
    
    
    
    
    
    (379
    )
    
    
    
    
    
    
    
    
    
    
    (379
    )Net cash provided by (used in) financing activities
    
    
    3,096
    
    
    
    (41,491
    )
    
    
    
    
    
    
    
    
    
    
    (38,395
    )Net (decrease) increase in cash and cash equivalents
    
    
    (1,090
    )
    
    
    (23
    )
    
    
    21
    
    
    
    
    
    
    
    (1,092
    )Effect of exchange rate changes on cash
    
    
    
    
    
    
    
    
    
    
    (16
    )
    
    
    
    
    
    
    (16
    )Cash and cash equivalents, beginning of period
    
    
    8,161
    
    
    
    192
    
    
    
    432
    
    
    
    
    
    
    
    8,785Cash and cash equivalents, end of period
    
    $
    7,071
    
    
    $
    169
    
    
    $
    437
    
    
    $
    
    
    
    $
    7,677
 29




---



##### 



aaiPharma Inc.
CONSOLIDATING STATEMENT OF CASH FLOWS
(In thousands) Six Months Ended June 30, 2003Non-Guarantor
    
    GuarantorIssuer
    
    Subsidiaries
    
    Subsidiaries
    
    Eliminations
    
    ConsolidatedCash flows from operating activities:Net income (loss)
    
    $
    1,024
    
    
    $
    15,532
    
    
    $
    770
    
    
    $
    (16,302
    )
    
    $
    1,024Adjustments to reconcile net income (loss) to net cash
provided by operating activities:Depreciation and amortization
    
    
    2,470
    
    
    
    6,754
    
    
    
    548
    
    
    
    
    
    
    
    9,772Other
    
    
    (163
    )
    
    
    1
    
    
    
    84
    
    
    
    
    
    
    
    (78
    )Changes in operating assets and liabilities:Accounts receivable, net
    
    
    974
    
    
    
    (2,396
    )
    
    
    (344
    )
    
    
    
    
    
    
    (1,766
    )Work-in-progress
    
    
    651
    
    
    
    (538
    )
    
    
    (1,381
    )
    
    
    (51
    )
    
    
    (1,319
    )Inventories
    
    
    1,569
    
    
    
    (1,164
    )
    
    
    
    
    
    
    (311
    )
    
    
    94Prepaid and other assets
    
    
    681
    
    
    
    531
    
    
    
    (174
    )
    
    
    
    
    
    
    1,038Accounts payable
    
    
    1,159
    
    
    
    (1,690
    )
    
    
    (76
    )
    
    
    
    
    
    
    (607
    )Customer advances
    
    
    3,275
    
    
    
    (352
    )
    
    
    464
    
    
    
    50
    
    
    
    3,437Interest payable
    
    
    (130
    )
    
    
    (76
    )
    
    
    
    
    
    
    
    
    
    
    (206
    )Deferred product revenue
    
    
    
    
    
    
    11,729
    
    
    
    
    
    
    
    
    
    
    
    11,729Accrued wages and benefits and other accrued liabilities
    
    
    (2,350
    )
    
    
    419
    
    
    
    (173
    )
    
    
    (281
    )
    
    
    (2,385
    )Intercompany receivables and payables
    
    
    6,228
    
    
    
    (23,429
    )
    
    
    306
    
    
    
    16,895
    
    
    
    Net cash provided by operating activities
    
    
    15,388
    
    
    
    5,321
    
    
    
    24
    
    
    
    
    
    
    
    20,733Cash flows from investing activities:Purchases of property and equipment
    
    
    (1,696
    )
    
    
    (4,404
    )
    
    
    (382
    )
    
    
    
    
    
    
    (6,482
    )Proceeds from sales of property and equipment
    
    
    389
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    389Product line acquisitions
    
    
    
    
    
    
    (600
    )
    
    
    
    
    
    
    
    
    
    
    (600
    )Other
    
    
    (287
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (287
    )Net cash used in investing activities
    
    
    (1,594
    )
    
    
    (5,004
    )
    
    
    (382
    )
    
    
    
    
    
    
    (6,980
    )Cash flows from financing activities:Payments on long-term borrowings
    
    
    (13,000
    )
    
    
    (4,000
    )
    
    
    
    
    
    
    
    
    
    
    (17,000
    )Proceeds from interest rate swaps, net
    
    
    
    
    
    
    2,678
    
    
    
    
    
    
    
    
    
    
    
    2,678Proceeds from stock option exercises
    
    
    1,091
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,091Other
    
    
    
    
    
    
    1,018
    
    
    
    
    
    
    
    
    
    
    
    1,018Net cash used in financing activities
    
    
    (11,909
    )
    
    
    (304
    )
    
    
    
    
    
    
    
    
    
    
    (12,213
    )Net increase (decrease) in cash and cash equivalents
    
    
    1,885
    
    
    
    13
    
    
    
    (358
    )
    
    
    
    
    
    
    1,540Effect of exchange rate changes on cash
    
    
    
    
    
    
    
    
    
    
    60
    
    
    
    
    
    
    
    60Cash and cash equivalents, beginning of period
    
    
    5,725
    
    
    
    180
    
    
    
    627
    
    
    
    
    
    
    
    6,532Cash and cash equivalents, end of period
    
    $
    7,610
    
    
    $
    193
    
    
    $
    329
    
    
    $
    
    
    
    $
    8,132
 30




---



##### 



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 In the second quarter of 2004, we replaced our senior credit facility and
divested our M.V.I. and Aquasol product lines. In addition, we conducted a
reduction-in-force affecting over 10% of our employee base and redirected the
focus of our pharmaceutical sales group. These efforts allowed us to stabilize
the Companys liquidity and cash flow position. On the regulatory front, our
inability to timely file our periodic reports with the Securities and Exchange
Commission (the SEC) created a default under our then existing credit
facility and our bond indenture, and resulted in NASDAQ providing us with a
delisting notice. We filed all required reports before June 30, 2004. As a
result of these filings, and our furnishing of additional requested
information, NASDAQ notified us that we were in compliance with NASDAQ listing
requirements and that we would continue to be listed subject to certain
conditions. On July 9, 2004, the Companys ticker symbol reverted back to
AAII. As a result of our default under our senior credit facility, we refinanced our
former senior credit facility with a new $140 million senior credit facility in
the second quarter. The refinancing coincided with the sale of our M.V.I. and
Aquasol product lines, the receipt of accelerated royalties under our
significant development agreement, the termination of our interest rate hedging
agreement and the implementation of various amendments to our bond indenture,
including increasing the interest rate on our senior subordinated notes by
0.5%. The replacement of our senior credit facility, the amendments to our
bond indenture and our filing of past due periodic reports with the SEC cured
the defaults. The Company was in compliance with the covenants under the new
credit facility and bond indenture at June 30, 2004. During the second quarter, we continued to invest time and resources into our
Research and Development program. We continue to use the significant
scientific capabilities that our Company has developed over the past 24 years
to serve as the platform to develop and commercialize enhancements 31




---



##### 



to existing
products. In addition, we redirected our pharmaceutical sales focus during the
quarter away from a retail sales approach and back to a hospital-based focus.
We are retraining the sales force to perform in a hospital environment through
an intensive series of educational programs and training on
various medical, pharmacological and scientific subjects. These programs are
designed to enable our sales team to better interact with medical professionals
in the pain management area. We have also begun aligning our group purchasing
organization contracts with these sales efforts to facilitate the effectiveness
of our sales force in hospitals and pain clinics. We funded these programs with proceeds generated by our underlying businesses,
including the sale of our M.V.I. and Aquasol product lines. In the second
quarter, we recorded net revenues of $51.5 million and earnings per share of
$0.25. Several events occurred in the quarter which had a material impact on
our financial results. We sold our M.V.I. and Aquasol product lines to Mayne
Pharma (USA) Inc., which included two recently approved Supplemental New Drug
Applications, and recorded a net gain of $37.5 million on the sale. The
development work supporting the Supplemental New Drug Applications was
performed by our Development Services Division. This gain was partially offset
by $5.1 million in professional fees associated with the investigation
conducted by the Special Committee, $3.4 million in expenses accrued in
connection with restructuring the employee base, and a $6.2 million charge for
the extinguishment of debt in the refinancing. We recognized $21.8 million in pharmaceutical product revenues in the second
quarter. Of the $21.8 million in pharmaceutical product revenues, we
recognized $4.7 million in revenues recorded under the consignment method. For
these revenues, we had received cash for the products from the wholesalers,
principally in late 2003 or in the first quarter of 2004. Our revenues to
wholesalers in the quarter were significantly reduced from prior periods due to
the levels of Brethine and Darvon/Darvocet products on hand at wholesalers at
the beginning of the quarter. During the first six months of 2004, we reduced
the aggregate amount of units of our products at the wholesalers and chain
pharmacies by approximately 55%. This comparison excludes M.V.I. product at all
relevant times. In addition, in June 2004 we exchanged certain products at one
wholesaler which were approaching expiration for the same product with a longer
remaining shelf life. The treatment of this exchange was in accordance with
our revenue recognition policy and reduced our returns reserve by $3.9 million,
which is reflected in net revenues. The introduction of generic competition to our Brethine injectable and
Roxicodone products also had a negative impact on sales. Although generic
competition eroded the Brethine and Roxicodone product lines, end-user demand
for our Oramorph SR has increased over the comparable period in 2003. We
acquired Oramorph in December 2003 and sell the product mainly into the
non-retail sector. Our Development Services Division recorded $24.6 million in net sales during
the quarter. We continue to experience strong demand for Phase I services in
both the United States and Europe, as well as for Phase II-IV and bioanalytical
services. The Development Services Division was able to dedicate more capacity
to outside clients during the quarter due to reduced utilization of resources
on internally driven Research and Development projects. The gross margin
dollar contribution from the Development Services Division in the second
quarter of 2004 was higher than the second quarter of 2003 due to increased
clinical and bioanalytical contributions, partially offset by lower gross
margins from our manufacturing facility in Charleston. The manufacturing
capacity for the Charleston facility 32




---



##### 



was planned to cover the manufacturing
needs of our Brethine injectable product. The introduction of a generic
competitor eliminated the near-term need for manufacturing additional Brethine
injectable products and created for us an excess in sterile manufacturing
capacity which we were not able to sell to third parties in the quarter. The
gross margin provided by the non-manufacturing services of the
Development Services Division increased 3 percentage points in the second
quarter of 2004 when compared to the second quarter of 2003. We recorded $4.3 million in research and development expenses during the
quarter. The expenses primarily related to our ProSorb-D and proton pump
inhibitor development programs. We expect to file a NDA on the ProSorb-D
product in 2004. We also continued development for Darvon and Darvocet
modified-release line extensions which we believe will provide meaningful and
patentable line extensions to our franchise. Other products in our Research
and Development pipeline include four new chemical entities and an additional
gastrointestinal product. Results of Operations The following table presents the net revenues for each of our business units
and our consolidated expenses and net income (loss) for the three and six
months ended June 30, 2004 and 2003, with each item expressed as a percentage
of consolidated net revenues: Three Months Ended June 30,
    
    Six Months Ended June 30,2004
    
    2003
    
    2004
    
    2003(dollars in thousands)Net revenues:Product sales
    
    $
    21,781
    
    
    
    42
    %
    
    $
    40,525
    
    
    
    61
    %
    
    $
    46,214
    
    
    
    44
    %
    
    $
    64,764
    
    
    
    56
    %Product development
    
    
    5,126
    
    
    
    10
    
    
    
    3,897
    
    
    
    6
    
    
    
    10,041
    
    
    
    9
    
    
    
    7,707
    
    
    
    7Development services
    
    
    24,581
    
    
    
    48
    
    
    
    21,674
    
    
    
    33
    
    
    
    49,475
    
    
    
    47
    
    
    
    42,612
    
    
    
    37$
    51,488
    
    
    
    100
    %
    
    $
    66,096
    
    
    
    100
    %
    
    $
    105,730
    
    
    
    100
    %
    
    $
    115,083
    
    
    
    100
    %Direct costs (excluding
depreciation and royalty
expense)
    
    $
    25,694
    
    
    
    50
    %
    
    $
    28,364
    
    
    
    43
    %
    
    $
    54,589
    
    
    
    52
    %
    
    $
    51,638
    
    
    
    45
    %Selling
    
    
    11,074
    
    
    
    22
    
    
    
    8,201
    
    
    
    12
    
    
    
    24,101
    
    
    
    23
    
    
    
    15,935
    
    
    
    14General and administrative
    
    
    12,700
    
    
    
    25
    
    
    
    11,289
    
    
    
    17
    
    
    
    25,840
    
    
    
    24
    
    
    
    21,319
    
    
    
    19Research and development
    
    
    4,306
    
    
    
    8
    
    
    
    5,588
    
    
    
    8
    
    
    
    10,713
    
    
    
    10
    
    
    
    10,074
    
    
    
    9Depreciation
    
    
    2,025
    
    
    
    4
    
    
    
    1,947
    
    
    
    3
    
    
    
    4,037
    
    
    
    4
    
    
    
    3,835
    
    
    
    3Professional fees 
internal inquiry
    
    
    5,103
    
    
    
    10
    
    
    
    
    
    
    
    
    
    
    
    8,303
    
    
    
    8
    
    
    
    
    
    
    
    M.V.I. contingent payment/
(gain on sale)
    
    
    (37,546
    )
    
    
    (73
    )
    
    
    
    
    
    
    
    
    
    
    (6,545
    )
    
    
    (6
    )
    
    
    
    
    
    
    Restructuring charges
    
    
    3,400
    
    
    
    7
    
    
    
    
    
    
    
    
    
    
    
    3,400
    
    
    
    3
    
    
    
    
    
    
    
    Royalty expense
    
    
    509
    
    
    
    1
    
    
    
    127
    
    
    
    
    
    
    
    1,009
    
    
    
    1
    
    
    
    127
    
    
    
    Income (loss) from
operations
    
    
    24,223
    
    
    
    47
    
    
    
    10,580
    
    
    
    16
    
    
    
    (19,717
    )
    
    
    (19
    )
    
    
    12,155
    
    
    
    11
 33




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##### 



Three Months Ended June 30,
    
    Six Months Ended June 30,2004
    
    2003
    
    2004
    
    2003(dollars in thousands)Interest expense, net
    
    
    (8,752
    )
    
    
    (17
    )
    
    
    (4,931
    )
    
    
    (7
    )
    
    
    (14,397
    )
    
    
    (14
    )
    
    
    (10,481
    )
    
    
    (9
    )Loss from extinguishment
of debt
    
    
    (6,229
    )
    
    
    (12
    )
    
    
    
    
    
    
    
    
    
    
    (6,229
    )
    
    
    (6
    )
    
    
    
    
    
    
    Other (expense) income, net
    
    
    (1,855
    )
    
    
    (4
    )
    
    
    226
    
    
    
    
    
    
    
    (1,836
    )
    
    
    (2
    )
    
    
    143
    
    
    
    Provision for income taxes
    
    
    169
    
    
    
    
    
    
    
    2,383
    
    
    
    4
    
    
    
    175
    
    
    
    
    
    
    
    793
    
    
    
    1Net income (loss)
    
    $
    7,218
    
    
    
    14
    %
    
    $
    3,492
    
    
    
    5
    %
    
    $
    (42,354
    )
    
    
    (40
    )%
    
    $
    1,024
    
    
    
    1
    %
 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 Ended June 30,
    
    Six Months Ended June 30,2004
    
    2003
    
    2004
    
    2003(in thousands)Gross revenues
    
    $
    65,796
    
    
    $
    97,758
    
    
    $
    137,784
    
    
    $
    165,033Allowance for customer credits
    
    
    14,308
    
    
    
    31,662
    
    
    
    32,054
    
    
    
    49,950Net revenues
    
    $
    51,488
    
    
    $
    66,096
    
    
    $
    105,730
    
    
    $
    115,083
 Second Quarter 2004 Compared to Second Quarter 2003 Our consolidated net revenues for the quarter ended June 30, 2004 decreased 22%
to $51.5 million, from $66.1 million in the second quarter of 2003. Net
revenues from product sales decreased in 2004, to $21.8 million, from $40.5
million in 2003. The decrease resulted from decreased sales volumes in our
Darvon/Darvocet and Brethine product lines, as discussed above, as well as the
divestiture of our M.V.I. product line, which was partially offset by
contributions from our Roxicodone and Oramorph product lines. Roxicodone and
Oramorph were acquired in December 2003. The introduction of generic versions
of our Brethine product also caused erosion in the price for this product. In
addition, in June 2004 we exchanged certain products at one wholesaler which
were approaching expiration for the same product with a longer remaining shelf
life. This reduced our returns reserve by $3.9 million and is reflected in net
revenue. Our net revenues for the quarter ended June 30, 2004 included $4.7
million recognized under the consignment sales method. Net revenues from product development increased 32% in the second quarter of
2004 to $5.1 million, or 10% of net revenues, from $3.9 million, or 6% of net
revenues, in the 2003 period, primarily due to product development revenues
under our significant development agreement. This development agreement is
described in the Managements Discussion and Analysis of Financial Condition
and Results of Operations section of our Annual Report on Form 10-K for the
fiscal year ended December 31, 2003. We expect product development revenues
under this agreement to be approximately $17 million in 2004. We received
payment associated with this revenue during the quarter ended June 30, 2004. 34




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Net revenues from our development services business increased 13% in the second
quarter of 2004 to $24.6 million, from $21.7 million in 2003. The increase was
principally attributable to higher demand for our Phase I clinical capabilities
in both the United States and Europe, as well as for Phase II-IV and
bioanalytical services, partially offset by lower fee-for-service revenues
under our significant development agreement. Direct costs (excluding depreciation and royalty expense) decreased $2.7
million, or 9%, to $25.7 million in the second quarter of 2004 from $28.4
million in the same period in 2003. This decrease in direct costs resulted
from lower product direct costs related to the decreased product revenue,
partially offset by an increase in direct costs of our development services
division, primarily in our manufacturing capabilities,
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 50% in the second quarter of 2004 as compared to 43% in the second quarter
of 2003. Selling expenses increased 35% in the second quarter of 2004 to $11.1 million,
or 22% of net revenues, from $8.2 million, or 12% 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 $1.4 million in the second quarter
of 2004 to $12.7 million, or 25% of net revenues, from $11.3 million, or 17% of
net revenues, in 2003. This increase was primarily due to additional product
liability insurance expense for the products we acquired in December 2003,
increased accruals for employee benefits expenses and litigation related
expenses. Research and development expenses were $4.3 million, or 8% of net revenues, in
the second quarter of 2004, compared to $5.6 million, or 8% of net revenues, in
2003. In the second quarter of 2004, significant project spending was related
to our ProSorb-D pain management product and development work on line
extensions for our pain management and critical care products. In the second quarter of 2004, we recorded $5.1 million of legal, financial and
consulting professional fees associated with the investigation conducted by the
Special Committee. In April 2004, we sold our 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. A portion of the closing
payment is held in escrow to satisfy post-closing obligations under the
agreement. The sale resulted in a gain of $37.5 million that we recorded in
the second quarter of 2004. In June 2004, we announced and implemented a work force reduction intended to
rationalize our expense base in relation to our revenue. We recorded a $3.4
million restructuring expense representing severance costs and related employee
benefit expenses for those affected by the reduction. As part of this
restructuring plan, we announced we would close our New Jersey facility in
August 2004. On-going lease and facility costs for this location are not
included in this quarters 35




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##### 



restructuring charge, and we are currently seeking
to sub-lease all or a portion of this facility. In accordance with
SFAS 146,
we will record facility closures costs in the third quarter of 2004. Royalty expenses for the second quarter of 2004 were $0.5 million. We accrue
royalties based on revenues generated by certain acquired products. Royalty
expenses were $0.1 million for the same period in 2003. Consolidated income from operations was $24.2 million in the second quarter of
2004, as compared to income from operations of $10.6 million in the second
quarter of 2003. This increase is primarily attributable to the gain on the
sale of the M.V.I. and Aquasol product lines. Income from operations for our product sales business was $33.9 million in the
second quarter of 2004, compared to $17.6 million in the second quarter of
2003. This increase is attributable to the gain on the sale of our M.V.I. and
Aquasol product lines, partially offset by the decrease in revenue and the
increased selling expenses, as discussed above. Income from operations for our product development business was $5.1 million in
the second quarter of 2004, compared to $3.9 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 $0.7 million
in the second quarter of 2004, compared to breakeven in the second quarter of
2003. This change is primarily due to the higher revenues, as discussed above,
partially offset by the increase in direct costs and general overhead
allocations. Unallocated corporate expenses increased in the second quarter of 2004 to $11.2
million, from $5.3 million in 2003. This increase is primarily related to the
$5.1 million of professional fees related to the Special Committee
investigation. Net interest expense increased to $8.8 million in the second quarter of 2004
from $4.9 million in 2003 due to charges related to the refinancing of our
senior credit facility, see Liquidity and Capital Resources for additional
information on subsequent changes to our debt. In addition, we recorded a $6.2
million expense for the extinguishment of debt related to our previous senior
credit facility. Other expense includes $1.6 million representing the fee we paid to terminate
an asset purchase agreement for a product that we no longer believe is
commercially viable. Terminating the agreement eliminated a contingent payment
obligation of $13.8 million. No future obligations remain under this
terminated agreement. Minimal tax expense was recorded for the second quarter of 2004 as we operated
at a cumulative net loss for the first two quarters of 2004 and anticipate
operating at a loss for 2004. We currently believe that it is more likely than
not that any deferred tax assets generated during 2004 will not be utilized.
Our effective tax rate for the first half of 2004 was less than 1%. Our
effective tax rate for the second quarter of 2003 was 41%. 36




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##### 



Six Months Ended June 30, 2004 Compared to Six Months Ended June 30, 2003 Our consolidated net revenues for the six months ended June 30, 2004, decreased
8% to $105.7 million, from $115.1 million in the same period of 2003. Net
revenues from product sales decreased in 2004, to $46.2 million, from $64.8
million in 2003. The decrease resulted from decreased sales volumes in our
Darvon/Darvocet and Brethine product lines, as discussed above, as well as the
divestiture of our M.V.I. and Aquasol product lines in the second quarter of
2004, which was partially offset by contributions from our Roxicodone and
Oramorph product lines. Roxicodone and Oramorph were acquired in December
2003. As discussed above, in June 2004, we exchanged certain products at one
wholesaler which reduced our returns reserve by $3.9 million and is reflected
in net revenue. Our net revenues for the six months ended June 30, 2004
included $9.0 million recognized under the consignment sales method. Net revenues from product development increased 30% in the first six months of
2004 to $10.0 million, or 9% of net revenues, from $7.7 million, or 7% of net
revenues, in the 2003 period, primarily due to product development revenues
under our significant development agreement. Net revenues from our development services business increased 16% in the first
six months of 2004 to $49.5 million from $42.6 million in 2003. The increase
was principally attributable to higher demand for our Phase I clinical
capabilities in both the United States and Europe, as well as for Phase II-IV
and bioanalytical services, partially offset by lower fee-for-service revenues
under our significant development agreement. Direct costs (excluding depreciation and royalty expense) increased $3.0
million, or 6%, to $54.6 million in the six-month period ended June 30, 2004,
from $51.6 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 and clinical capabilities, and an increase in
amortization expense related to product rights for products we acquired in
December 2003, partially offset by the lower product costs resulting from the
decreased product revenue. Direct costs as a percentage of net revenues were
52% in the first six months of 2003 as compared to 45% in the same period of
2003. Selling expenses increased 51% in the first six months of 2004 to $24.1
million, or 23% of net revenues, from $15.9 million, or 14% 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, developing our product sales force and marketing and
promoting our new products. General and administrative costs increased $4.5 million in the first six months
of 2004 to $25.8 million, or 24% of net revenues, from $21.3 million, or 19% of
net revenues, in 2003. This increase was primarily due to additional product
liability insurance expense for the products we acquired in December 2003,
increased accruals for employee benefits expenses and litigation related
expenses. Research and development expenses were $10.7 million, or 10% of net revenues,
in the first six months of 2004, compared to $10.1 million, or 9% of net
revenues, in 2003. In the first six months 37




---



##### 



of 2004, significant project
spending was related to our ProSorb-D pain management product and development
work on line extensions for our pain management and critical care products. In the first half of 2004, we recorded $8.3 million of legal, financial and
consulting professional fees associated with the investigation conducted by the
Special Committee. As discussed above, in April 2004, we sold our M.V.I. and Aquasol product lines
to Mayne Pharma (USA) Inc. for $105 million, subject to certain adjustments.
The sale resulted in a gain of $37.5 million that we recorded in the second
quarter of 2004. The gain was partially offset by a $31.0 million expense we
recorded in the first quarter of 2004 for a contingent payment to AstraZeneca
AB based on the status of the reformulation of our M.V.I.-12 product (the
M.V.I. Contingent Payment). The FDAs approval in the first quarter of the
reformulation of this product created an obligation under our product line
acquisition agreement for us to make the M.V.I. Contingent Payment. As discussed above, in June 2004, we announced and implemented a work force
reduction intended to rationalize our expense base in relation to our revenue
and recorded a $3.4 million restructuring expense representing severance costs
and related employee benefit expenses for those affected by the reduction. Royalty expenses for the six-month period ended June 30, 2004 were $1.0
million. We accrue royalties based on revenues generated by certain acquired
products. Royalty expenses were $0.1 for the same period in 2003. The consolidated loss from operations was $19.7 million in the first six months
of 2004, as compared to income from operations of $12.2 million in the same
period of 2003. This decrease is primarily attributable to the items discussed
above, including the decrease in product sales revenue, higher selling, general
and administrative expenses, professional fees related to the Special Committee
investigation and the restructuring charges, partially offset by the higher
development services and product development revenues and the gain on the sale
of the M.V.I. and Aquasol product lines, net of the expenses associated with
the M.V.I. Contingent Payment. Income from operations for our product sales business was breakeven in the
first six months of 2004, compared to income from operations of $24.7 million
in the same period of 2003. This decrease is attributable to a decrease in
revenue due to the divestiture of our M.V.I. and Aquasol product lines, the
reduction in sales volumes of our Darvocet and Brethine products and the
increased selling expenses, as discussed above. Income from operations for our product development business was $10.0 million
in the period ended June 30, 2004, compared to income from operations of $7.7
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 $0.8 million
in the first six months of 2004, compared to $0.6 million in 2003. This change
is primarily due to the higher revenues, as discussed above, partially offset
by the increase in direct costs and general overhead allocations. 38




---



##### 



Unallocated corporate expenses increased in the first six months of 2004 to
$19.7 million, from $10.6 million in 2003. This increase is primarily related
to the $8.3 million of professional fees related to the Special Committee
investigation. Net interest expense increased to $14.4 million in the first six months of 2004
from $10.5 million in 2003 due to charges related to the refinancing of our
senior credit facility (see Liquidity and Capital Resources for additional
information on subsequent changes to our debt). In addition, we recorded a
$6.2 million expense for the extinguishment of debt related to our previous
senior credit facility. Other expense includes $1.6 million representing the fee we paid to terminate
an asset purchase agreement for a product that we no longer believe is
commercially viable. Terminating the agreement eliminated a contingent payment
obligation of $13.8 million. No future obligations remain under this
terminated agreement. We recorded a tax benefit of approximately $17 million in the first half 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 half of 2004 was less than 1%.
Our effective tax for the first half of 2003 was 44%. Liquidity and Capital Resources Historically, we have funded our businesses with cash flows provided by
operations and proceeds from borrowings. Cash flow used in operations in the
first six months of 2004 was $49.3 million, compared to cash flow provided by
operations of $20.7 million in the first six months of 2003. This decrease was
primarily due to the significant 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. The gross amount of our accounts receivable decreased by $50.8 million, or 59%,
in the first half of 2004 due to significant collections in the first half 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 half of 2004. Additionally, as of June 30, 2004, our $34.9 million
in gross accounts receivable were more than offset by $38.6 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 reclassified the negative $3.7 million net accounts receivable balance to
other current liabilities on our consolidated balance sheet. Cash provided by investing activities was $86.6 million in the first six months
of 2004, primarily related to the cash proceeds from the M.V.I. and Aquasol
sale, partially offset by $4.7 million of capital spending. Cash used in
investing activities was $7.0 million in the first six months of 2003, which
included $6.5 million related to capital spending. 39




---



##### 



Net cash used in financing activities during the first six months of 2004 was
$38.4 million, primarily representing debt repayments of $164.0 million under
the previous debt agreements and a termination payment of $9.4 million under
our previous interest rate hedging agreement, partially offset by $132.5
million of borrowings under out new senior credit facilities and $3.6 million
in proceeds from the issuance of common stock related to the exercise of stock
options. M.V.I. and Aquasol Product Line Sale and 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. As a result of an amendment to
the original
acquisition agreement, we were precluded from recognizing this obligation as
additional purchase price for the M.V.I. and Aquasol product line; therefore,
we expensed this 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, we
recorded a gain from the sale transaction in the second quarter of 2004 of
$37.5 million, which was partially offset by the expense for the M.V.I.
Contingent Payment in the first quarter of 2004. 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 three years in
connection with the purchase of our Charleston, South Carolina manufacturing
facility, based on the level of manufacturing revenues at this facility. At
June 30, 2004, these contingent payment obligations are not liabilities and
have not been recorded on our consolidated balance sheet. We made interest
payments on the senior subordinated notes of $9.6 million in October 2003 and
$9.7 million in April 2004, and payments of $10.1 million will be due in
October 2004 and April 2005. 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. We are currently working with one of our major customers to resolve a payment
issue. The customer has withheld payments to us and we, in turn, have withheld
payments due to the customer and its affiliates under a separate agreement. At
June 30, 2004, we believe the net amount due to us to be approximately $1.0
million. We continue to conduct business with the customer and its affiliates. Analysis of Liquidity 40




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##### 



Our liquidity needs increased during 2003, and our annual net interest expense
may exceed $30 million in 2004, including the interest payment on our senior
subordinated notes of $10.1 million due in October 2004. 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, as recently amended as described below,
will be adequate to meet our needs for working capital and anticipated capital
expenditures. At June 30, 2004, we had $7.5 million outstanding under our
revolving credit facility and additional borrowing capacity of $2.6 million.
Income tax refunds will be a source of near-term liquidity. In July 2004, we
received $4.5 million due on our 2003 tax filing and anticipate receiving $0.5
million for the amended 2002 tax filing. In June 2004, we announced and implemented an approximately 10% workforce
reduction, including a reduction of our internal pharmaceutical sales force by
approximately 30%, and refocused our pharmaceutical sales and marketing efforts
to the hospital market. We have also announced a restructuring plan that will
rationalize our expense base in relation to our revenue. As part of this
restructuring plan, we announced that we will close our New Jersey facility in
August 2004. We are
currently seeking to sub-lease all or a portion of this facility to mitigate
our on-going lease and facility costs. In addition, we plan 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 On April 23, 2004, we refinanced our senior credit facilities with a portion of
the proceeds from the M.V.I. and Aquasol Sale and with $140 million of new
senior credit facilities with a syndicate of lenders, Silver Point Finance LLC
(Silver Point) as collateral agent, and Bank of America, N.A., as
administrative agent. We entered into an amendment to these credit facilities
on August 9, 2004 to, 41




---



##### 



among other things, increase the amount of the term loan
by up to $10 million, extend the maturity date of the facilities by one year,
increase the interest rate on the loans by an additional 1.5% subject to
potential incremental reduction, and adjust certain covenants under the
facilities. As amended, our new senior credit facilities consist of a $135
million senior secured term loan facility (of which $125 million was fully
drawn at the initial closing in April and the remaining $10 million must be
drawn on August 13, 2004) and a $15 million senior secured revolving
credit facility. As amended, our new senior credit facilities include a
covenant requiring us to maintain combined availability under the revolving credit
facility and cash and cash equivalents in the aggregate amount of $5.0 million
plus certain other amounts related to payables, bank overdrafts and interest
payments on the loans paid in the form of additional notes. The
outstanding loans under our new senior credit facilities are payable in full on
April 21, 2007. 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. As part of
this initial borrowing under these new credit facilities, we recorded a $6.2
million loss for the early extinguishment of debt related to the write-off of
financing fees related to the previous senior credit facility. Subject to
exceptions set forth in the definitive documentation, loans under our new
senior credit facilities are also required to be prepaid with a negotiated
percentage of:  
    
    excess cash flow, as defined;  
    
    non-ordinary course assets sales;  
    
    net proceeds from the sale of subordinated indebtedness;
    
    net proceeds from equity issuances; and  
    
    extraordinary receipts, as defined. Optional reductions in revolving credit commitments and optional prepayments of
term loans are subject to a prepayment fee equal to 3.5% until August 9, 2005,
2.5% for the subsequent 12 months, and 1.5% for the next 6 months (with no
prepayment penalty payable for the remainder of the term). Prior to the August
9, 2004 amendment, outstanding loans under the facilities 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. As a result of,
and effective with, the amendment to these credit facilities, the applicable
interest rate on outstanding loans was increased by an incremental amount,
which is initially 1.5%, subject to incremental reductions based on our
financial performance. Subject to availability limitations under the revolving
credit facility, until December 31, 2004 we may pay this additional incremental
amount of interest by delivery of promissory notes, having the same terms as
the notes evidencing the loans under the facilities. An additional 1% per annum
unused line fee is payable on unused revolving credit commitments, payable
quarterly in arrears. At June 30, 2004, the applicable interest rate on our
term loan was 8.25% and on our revolving credit facility was 9.25%. The proceeds of the initial borrowings under these facilities 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 42




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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. At June 30, 2004, we were in compliance with these
covenants.  Our new senior credit facilities include a covenant requiring us
to file with 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 originally had a
fixed interest rate of 11% per annum and are guaranteed on a subordinated basis
by all of our existing domestic
subsidiaries and all of our future domestic subsidiaries of which we own 80% or
more of the equity interests. Prior to March 28, 2005, up to 35% of the notes
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 in compliance with these covenants at June
30, 2004. 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 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: 43




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
    
    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 effect these amendments and waivers and made the
interest payments that had been due on April 1, 2004, together with default
interest. 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 termination payment and the interest benefits earned through
the dates of sale, have been recorded as premiums to the carrying amount of the
notes and are being amortized into interest income over their remaining life. 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 $9.4 million, which was paid
upon termination of that agreement. NASDAQ Listing Status 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 were not in compliance with
certain NASDAQ marketplace rules and that our common stock would be subject to
delisting at the opening of business on April 8, 2004, unless we requested a
hearing pursuant to NASDAQ rules. We requested and participated in a hearing
before a NASDAQ listing qualifications panel on April 29, 2004 in which we
committed to 44




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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 its 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 the Company was delinquent in the filing of the
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 met 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, the Quarterly Report on Form
10-Q for the period ended March 31, 2004 was filed on June 25, 2004 and we
provided NASDAQ the required additional information on June 30, 2004. As a
result, NASDAQ notified us that we were in compliance and would continue to be
listed subject to the conditions identified in its June 21, 2004 notification. 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 produce 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; 45




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
    
    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;  
    
    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 $0.1 million in the six months ended June 30, 2004 due to the
reduction in reported results from European operations. We are also exposed to fluctuations in interest rates on borrowings under our
senior credit facilities. The interest rates payable on these borrowings are
based on LIBOR. If LIBOR rates were to increase by 1%, annual interest expense
on variable rate debt would increase by approximately $1.5 million. 
 Item 4. Controls and Procedures. The Company has carried out an evaluation, under the supervision and with the
participation of its 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 June 30, 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 June 30, 2004, the
Companys disclosure controls and procedures were not adequate. 46




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Internal control deficiencies were noted by the Special Committees
investigation. 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.
The internal control deficiencies related to, among other things, a lack of
adequate policies with respect to revenue recognition, and a lack of sufficient
control processes and procedures to effectively monitor and manage wholesaler
inventory levels, to ensure adequate contract-approval oversight, and to ensure
effective and timely communication among sales, marketing, finance and legal
staff regarding the terms and conditions of certain transactions, including new
product launches. Also, with respect to the sales of pharmaceutical products,
the Companys finance and accounting personnel lacked adequate training on the
application of revenue recognition principles and the establishment of product
return reserves. In addition, in April 2004, in connection with their audit of the Companys
consolidated financial statements for the year ended December 31, 2003, the
Companys independent auditors identified and communicated to the Company and
the Audit Committee two material weaknesses (as defined under standards
established by the American Institute of Certified Public Accountants) relating
to the Companys accounting and public financial reporting of significant
matters and to its initial recording and management review and oversight of
certain accounting matters. The material weaknesses were with respect to the
calculation and procedures for the analysis of revenue reserves for product
sales and lack of procedures for timely communications from the Legal
Department and operating divisions to the Finance Department impairing the
ability to properly evaluate the accounting treatment for certain transactions
the Company had entered into and assess the impact of such transactions in a
timely manner. In addition, at that time, the Companys independent auditors
identified and communicated to the Company and the Audit Committee a
reportable condition (as defined under standards established by the American
Institute of Certified Public Accountants) relating to the Companys internal
controls over its financial reporting for investments. The reportable
condition identified the Companys failure to perform a formal review of its
investments and its failure to timely record patents or trademarks or to timely
analyze the patents and trademarks for usefulness and possible impairment. In light of the foregoing, the Company has taken the following actions after
the end of 2003 to address the deficiencies as described above:  
    
    During the first quarter of 2004, contracted with a third-party
consulting group, FTI Consulting, to provide transitional management
services in the area of operations and finance.  
    
    During the first quarter of 2004, 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, training 420 employees during
the second quarter of 2004.  
    
    Implemented a more rigorous contract-approval process during the
second quarter of 2004 wherein all divisions affected by a contract
must approve of the final draft prior to execution. 47




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
    
    Implemented formal revenue recognition protocols and training
programs. In addition to a more rigorous examination of revenue
recognition under generally accepted accounting principles and
applicable Securities and Exchange Commission regulations, these
protocols provide that the level of channel inventory and demand
trends for products be considered in the analysis of revenue reserves
for product sales. Key members of management and finance have been
involved in development of these protocols. The Company intends to
complete training of other employees during the third quarter of 2004.  
    
    Initiated process enhancements to the customer credit approval
process, which the Company intends to complete during the third
quarter of 2004.  
    
    Initiated improvements to the budgeting and forecasting process, which
the Company intends to complete during the third quarter of 2004. 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. In view of the fact that the above described remedial efforts had not been
completed by June 30, 2004, 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 June 30, 2004, therefore, 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. 
 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 48




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On August 7, 2003 we received a letter from the staff of the Enforcement
Division of the SEC (the Enforcement Division) requesting voluntary
production of certain documents. We responded to this letter on August 21,
2003 and supplemented our response on August 29, 2003. Independent of the August 7, 2003 inquiry letter, on September 26, 2003,
certain members of our board and management voluntarily met with, and provided
documents to, the staff of the Enforcement Division. As a follow-up to this
September 26, 2003 meeting and as part of the inquiry initiated on August 7,
2003, on October 8, 2003, we received a further request from staff of the
Enforcement Division for voluntary production of certain documents, to which we
responded on October 30, 2003. On January 14, 2004 and April 26, 2004, we received letters from the SECs
Division of Corporate Finance commenting on, asking questions about, and
seeking additional disclosure with respect to certain of our periodic reports.
We have responded to these letters. In April 2004, in connection with an investigation conducted by the United
States Attorneys Office for the Western District of North Carolina (the U.S.
Attorneys Office), we received five federal grand jury subpoenas for document
production and potential testimony related to, among other things, certain
transactions regarding our 2002 and 2003 financial information, the terms,
conditions of employment and compensation arrangements of certain of our senior
management personnel, compensation and incentive arrangements for employees
responsible for the sale of our Brethine, Darvocet, calcitriol, azathioprine
and Darvon Compound products, quantities of the foregoing products in
distribution channels, financial benefits with respect to specified corporate
transactions to our senior management and others, certain loans obtained by us,
extensions of credit, if any, by us to officers or directors, accounting for
sales and returns of our foregoing products, our analysts conference calls on
financial results, internal and external investigations of pharmaceutical
product sales activities, and related matters. We have also been advised that
the SEC has initiated an inquiry into at least the same issues investigated by
the Special Committee. The U.S. Attorneys Office and the SEC have advised us
that we may also receive a subpoena from the SEC. A former officer of the Company,
David M. Hurley, has been advised by the U.S. Attorneys Office
that he is a target of the investigation. 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,
three 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 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 49




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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. 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 50




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other relief. This ERISA lawsuit is pending in U.S.
District Court for the Eastern District of North Carolina. These securities and ERISA lawsuits are at an early stage, and no lead
plaintiff has yet been appointed, nor a consolidated amended complaint served,
in the federal securities litigation. We are not required to file an answer or
motion to dismiss in the federal lawsuits until after service of the
consolidated amended complaint on us and no discovery has yet occurred in these
lawsuits. By, and subject to, the terms of our bylaws, we have certain
obligations to indemnify the current and former officers and employees of the
Company who have been named as defendants in these lawsuits. We have purchased
directors and officers liability insurance (D&O insurance) that may provide
coverage for some or all of these lawsuits and governmental investigations.
There is a risk, however, that some or all of the claims or expenses will not
be covered by such policies; or that, even if covered, our ultimate liability
will exceed the available insurance. Although we intend to vigorously pursue
all defenses available in these lawsuits, an adverse determination in these
lawsuits or an inability to obtain payment under our D&O insurance policies for
litigation and indemnification costs and any damages ultimately borne by us as
a result of these lawsuits and investigations could have a material adverse
effect on our business, financial condition, results of operations or cash
flows. Patent Litigation We are a party to a number of legal actions with generic drug companies. We
are involved in four lawsuits centered on our omeprazole-related patents,
including one lawsuit brought by us against an alleged infringer of our patents
and three lawsuits which were brought by third parties against us and are
currently essentially inactive. Omeprazole is the active ingredient found in
Prilosec, a drug sold by AstraZeneca. 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. 51




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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 July 20, 2004, the judge
has not decided our motion to dismiss the litigation. The fourth case involving our omeprazole patents was brought in December 2002
by us against Kremers Urban Development Co., Schwarz Pharma Inc. and Schwarz
Pharma AG (collectively, together with the other named defendants, KUDCO) in
the U.S. District Court for the Southern District of New York. KUDCO has a
generic omeprazole product with final FDA marketing approval, was found not to
infringe the AstraZeneca patents in the separate AstraZeneca patent litigation,
and is currently selling its generic substitute for Prilosec in the U.S.
marketplace. We initially brought the lawsuit under our U.S. Patent No. 6,268,385.
Following the collection of additional information concerning KUDCOs
commercially marketed product, we sought leave of the court to file an amended
complaint, adding additional claims of infringement and contributory
infringement under our U.S. Patent No. 6,326,384 and joining as defendants
Schwarz Pharma Manufacturing Inc. and Schwarz Pharma USA Holdings Inc. These
two patents include, among other claims, claims directed to compositions and
methods wherein certain characteristics of solid state omeprazole are
essentially the same in formulated drug product as in its active ingredient. In September 2003, the judge granted us leave to file the first amended
complaint adding our second patent and the additional KUDCO affiliates to the
lawsuit. Following initial discovery, we sought leave of the 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. 52




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Substantial discovery of both sides documents and of defendants product
samples has occurred in the lawsuit, although both sides asserted numerous
discovery deficiencies against the other in the lawsuit. On February 26, 2004,
the judge assigned the discovery disputes to a federal magistrate for
resolution. Discovery is continuing at this time. The parties previously had
agreed to the commencement of the trial in January 2005 but have recently moved
the trial date to June 2005. We have previously indicated to KUDCO a willingness to grant a license under
our omeprazole patents for an appropriate royalty. In the absence of KUDCO
taking a royalty-bearing license, we are seeking damages equal to a reasonable
royalty on all infringing sales by the KUDCO defendants since commercial launch
of their generic substitute for Prilosec on December 9, 2002 through the date
of a judicial decision in the litigation, and a permanent injunction on
subsequent sales thereafter (unless KUDCO takes a license), among other
remedies, in the event that we ultimately prevail in the litigation. The KUDCO
defendants have publicly confirmed sales of their generic omeprazole product
during the first sixteen months after launch of their product of approximately
$1.1 billion. In the absence of a license, we intend to vigorously prosecute
the case, defend our patent rights and defend against the foregoing defenses
and counterclaims asserted by KUDCO. It is possible that the
omeprazole-related patents subject to the foregoing four lawsuits will be found
invalid, unenforceable or not infringed and, while currently stayed by the
judge in the KUDCO litigation, it is possible that the defendants antitrust
counterclaims will ultimately be allowed to proceed and be litigated and, if
adversely found, a material adverse effect on our consolidated financial
statements, results of operations or cash flow could result. In cases where we have initiated an action, we intend to prosecute our claims
to the full extent of our rights under the law. In cases where we are named
defendants, we intend to vigorously pursue all defenses available. Contract Sales Force Litigation On April 15, 2004, we filed a lawsuit against Athlon Pharmaceuticals, Inc.
seeking a declaratory judgment that we were entitled to terminate the Service
Agreement (the Athlon Service Agreement) dated July 16, 2003, as amended,
between us and Athlon as well as damages and injunctive relief for material
breaches of the Athlon Service Agreement by Athlon. The Athlon Service
Agreement incorporated the terms and conditions pursuant to which
representatives of Athlon would promote the sale of our Darvocet A500 product
to physicians. We initially paid Athlon $3,350,000 to build its sales force to
promote the sale of our Darvocet A500, and the terms of the Athlon Service
Agreement would require us to pay Athlon an additional $1,200,000 each month
for such services for the contract period of 36 months, commencing in October
2003, subject to Athlons compliance with certain representations, warranties
and covenants, some of which are described below. 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 53




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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. In May 2004, the Company ceased making payments under the Athlon Service
Agreement, and on June 4, 2004, we sent a notice of termination of the
agreement to Athlon. On July 7, 2004, we amended the lawsuit to assert claims
of fraud and breaches of contract and implied covenants, seeking to recover
compensatory and punitive damages and attorneys fees. Athlon
has amended its counterclaim to assert fraud claims and to seek
punitive damages. The litigation is in
its early stages and discovery has commenced. 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. Other Litigation A
lawsuit was filed against us in state court in Arizona in July 2004 asserting
breach of contract with respect to certain conference hotel services and
seeking approximately $400,000 in damages plus attorneys fees. No answer has
yet been filed in this litigation. On
August 6, 2004, the Company was orally advised by a representative of
CIMA Labs Inc. that CIMA wished to hold business discussions with the
Company concerning a possible return of all or a portion of the $11.5 million termination fee
paid by CIMA to the Company in connection with CIMAs
termination in November 2003 of a then-pending merger agreement
between CIMA and the Company to enable CIMA to enter into a merger
agreement with a third party. A possible recourse to litigation was
discussed. The Company intends to vigorously
defend any such litigation if instituted. 
 Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity
Securities. (d) Maximum Number (or(c) Total Number of
    
    Approximate Dollar Value)(a)
    
    (b)
    
    Shares (or units)
    
    of Shares (or units) thatTotal Number
    
    Average Price
    
    Purchased as part of
    
    May Yet Be PurchasedShares (or units)
    
    Paid Per Share
    
    Publicly Announced
    
    Under the Plans orPeriod
    
    Purchased *
    
    (or unit)
    
    Plans or Programs
    
    ProgramsApril
    
    
    
    
    
    $
    
    
    
    
    
    
    
    
    May
    
    
    46,010
    
    
    
    5.54
    
    
    
    
    
    
    
    June
    
    
    20,958
    
    
    
    4.82
    
    
    
    
    
    
    
    Total
    
    
    66,968
    
    
    $
    5.32
    
    
    
    
    
    
    
    
  *
    
    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 6. Exhibits and Reports on Form 8-K. Exhibits: 54




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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 second quarter of 2004, we furnished or filed, as applicable, the
following Current Reports on Form 8-K:  
    
    Dated April 1, 2004, announcing we have signed a commitment letter with Bank of America for a $40 million, 15-month
priority revolving credit facility.  
    
    Dated April 9, 2004, announcing the commencement of a consent solicitation of holders of its 11% Senior Subordinated Notes
due 2010.  
    
    Dated April 12, 2004, announcing the execution of a commitment letter for a $135,000,000, two year credit facility.  
    
    Dated April 19, 2004, announcing the consent solicitation of holders of the 11% Senior Subordinated Notes due 2010, the
extension of the expiration date of the Solicitation and amendments to the terms and conditions.  
    
    Dated April 21, 2004, announcing pursuant to our previously announced solicitation of consents with respect to our 11%
Senior Subordinated Notes due 2010 that we received consents from holders of more than 98% of the Notes to adopt the
proposed amendments to the indenture governing the Notes.  
    
    Dated April 26, 2004, reporting the sale of our M.V.I and Aquasol product business to Mayne Pharma (USA) Inc.  
    
    Dated April 27, 2004, reporting the completion of several corporate transactions, including the closing on our previously
announced two-year, $140 million credit facility and the payment of our $9.6 million, April 1, 2004 interest payment on our
11% senior subordinated notes due 2010.  
    
    Dated May 7, 2004, reporting the sales agreement for the sale of our M.V.I and Aquasol product business to Mayne Pharma
(USA) Inc and unaudited financial statements as of the December 31, 2003 with respect to our M.V.I. and Aquasol product
business.  
    
    Dated May 11, 2004, announcing the departure of William L. Ginna, Jr. as Executive Vice President and Chief Financial
Officer and the appointment of Gina Gutzeit as interim Chief Financial Officer.  
    
    Dated June 16, 2004, announcing the filing of our Annual Report on Form 10-K for the year ended December 31, 2003.  
    
    Dated June 28, 2004, reporting our financial results for the quarter ended March 31, 2004. 55




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. aaiPharma Inc.Date: August 9, 2004
    
    By:
    
    /s/ Fredrick D. SancilioFredrick D. Sancilio, Ph.D.Executive Chairman of the Board,Chief Executive OfficerDate: August 9, 2004
    
    By:
    
    /s/ Gina GutzeitGina GutzeitInterim Chief Financial Officer
 56




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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 4310.8 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)
 57




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ExhibitNo.
    
    Description10.2
    
    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
 58