Table of Contents

 

 

 

**UNITED STATES SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 
| **x**                                                 | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE  ACT OF 1934** |
|-------------------------------------------------------|-------------------------------------------------------------------------------------------------------------|
| ** **                                            | ** **                                                                                                  |
| **FOR THE  QUARTERLY PERIOD ENDED DECEMBER 31, 2009** |
| ** **                                            | ** **                                                                                                  |
| **o**                                                 | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934** |

 

**FOR THE TRANSITION PERIOD FROM                        TO                         .**

 

**Commission File No. 001-31298**

 

**LANNETT COMPANY, INC.**

(Exact Name of Registrant as Specified in its Charter)

 

| **State  of Delaware**    | ** ** | **23-0787699**              |
|---------------------------|------------|-----------------------------|
| (State of  Incorporation) |       | (I.R.S. Employer  I.D. No.) |

 

**9000 State Road**

**Philadelphia, PA 19136**

**(215) 333-9000**

(Address of principal executive offices and telephonenumber)

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filedby Section 13 or 15(d) of the Exchange Act during the past 12 months(or for such shorter period that the registrant was required to file suchreports), and (2) has been subject to such filing requirements for thepast 90 days. **Yes****x****  No****o**

 

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer,a non-accelerated filer, or a smaller reporting company. See the definitions of“large accelerated filer,” “accelerated filer” and “smaller reporting company”in Rule 12b-2 of the Exchange Act. (Check one):

 

| Large  accelerated filer o                     |   | Accelerated  filer o               |
|------------------------------------------------|--------|------------------------------------|
|                                           |   |                               |
| Non-accelerated  filer o                       |   | Smaller  reporting company  x |
| (Do not check if  a smaller reporting company) |   |                               |

 

Indicate by check markwhether the registrant has submitted electronically and posted on its corporateWeb site, if any, every Interactive Data File required to be submitted andposted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter)during the preceding 12 months (or for such shorter period that the registrantwas required to submit and post such files). Yes  o No  o

 

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12B-12of the Exchange Act). **Yes ****o****No****x**

 

Indicate thenumber of shares outstanding of each class of the registrant’s common stock, asof the latest practical date.

 
| **Class**                                 | ** ** | **Outstanding as of February 10, 2010** |
|-------------------------------------------|------------|-----------------------------------------|
| Common stock,  par value $0.001 per share |       | 25,186,862  shares                      |

 

 

 

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Table of Contents

 

**Table ofContents**

 
| ** **                                                                    | **Page No.**                                                                                                       |
|-------------------------------------------------------------------------------|-------------------------------------------------------------------------------------------------------------------------|
|                                                                          |                                                                                                                    |
| **PART I. FINANCIAL INFORMATION**                                        |                                                                                                                    |
|                                                                          |                                                                                                                    |
| **ITEM  1.**                                                                  | **FINANCIAL STATEMENTS**                                                                                                |   |
|                                                                          |                                                                                                                    |   |
|                                                                          | Consolidated  Balance Sheets  as of December 31, 2009 (unaudited) and June 30, 2009                                     | 1 |
|                                                                          |                                                                                                                    |   |
|                                                                          | Consolidated  Statements of Operations (unaudited)  for the three and six months ended December 31, 2009 and 2008       | 2 |
|                                                                          |                                                                                                                    |   |
|                                                                          | Consolidated  Statement of Changes in Shareholders’ Equity (unaudited)  for the six months ended December 31, 2009 | 3 |
|                                                                          |                                                                                                                    |   |
|                                                                          | Consolidated  Statements of Cash Flows (unaudited)  for the six months ended December 31, 2009 and 2008                 | 4 |
|                                                                          |                                                                                                                    |   |
|                                                                          | Notes to Consolidated Financial Statements (unaudited)                                                                  | 5 |
|                                                                          |                                                                                                                    |   |
| **ITEM 2.**                                                                   | **MANAGEMENT’S DISCUSSION AND ANALYSIS OF  FINANCIAL CONDITION AND RESULTS OF OPERATIONS**                         | 27 |
|                                                                          |                                                                                                                    |   |
|                                                                          |                                                                                                                    |   |
| **ITEM 3.**                                                                   | **QUANTITATIVE AND QUALITATIVE DISCLOSURES  ABOUT MARKET RISK**                                                         | 40 |
|                                                                          |                                                                                                                    |   |
| **ITEM 4.**                                                                   | **CONTROLS AND  PROCEDURES**                                                                                            | 40 |
|                                                                          |                                                                                                                    |   |
| **PART II.  OTHER INFORMATION**                                          |                                                                                                                    |
|                                                                          |                                                                                                                    |   |
| **ITEM 1.**                                                                   | **LEGAL PROCEEDINGS**                                                                                                   | 41 |
|                                                                          |                                                                                                                    |   |
| **ITEM 4.**                                                                   | **SUBMISSION OF  MATTERS TO A VOTE OF SECURITY HOLDERS**                                                                | 41 |
|                                                                          |                                                                                                                    |   |
| **ITEM  6.**                                                                  | **EXHIBITS**                                                                                                            | 41 |
|                                                                          |                                                                                                                    |   |
| **CERTIFICATION OF  PRESIDENT & CHIEF EXECUTIVE OFFICER**            |                                                                                                                    |
|                                                                          |                                                                                                                    |
| **CERTIFICATION OF CHIEF  FINANCIAL OFFICER**                                 |                                                                                                                    |
|                                                                          |                                                                                                                    |
| **CERTIFICATION PURSUANT TO SECTION 906 OF SARBANES OXLEY ACT OF  2002** |                                                                                                                    |

 

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Tableof Contents

 

**PARTI.  FINANCIAL INFORMATION**

 

## ***ITEM 1.  FINANCIAL STATEMENTS***

 

**LANNETTCOMPANY, INC. AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                              | ** ** | **(Unaudited)**            | ** **  | ** **             | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|-------------|------------------------|------------|
| ** **                                                                                                                              | ** ** | **December 31, 2009** | ** **  | **June 30, 2009** | ** ** |
| **ASSETS**                                                                                                                              |       |                       |        |                   |       |
| Current Assets                                                                                                                          |       |                       |        |                   |       |
| Cash and cash  equivalents                                                                                                              |       | $                          | 19,653,294  |                   | $          | 25,832,456 |   |
| Investment securities -  available for sale                                                                                             |       | 741,869                    |        | 347,921                |       |
| Trade accounts  receivable (net of allowance of $130,291 and $132,000, respectively)                                                    |       | 28,919,488                 |        | 29,945,748             |       |
| Inventories, net                                                                                                                        |       | 18,775,851                 |        | 16,195,361             |       |
| Interest receivable                                                                                                                     |       | 94,593                     |        | 90,425                 |       |
| Prepaid taxes                                                                                                                           |       | 808,522                    |        | —                 |       |
| Deferred tax assets                                                                                                                     |       | 4,232,572                  |        | 4,296,929              |       |
| Other current assets                                                                                                                    |       | 1,031,744                  |        | 602,335                |       |
| **Total  Current Assets**                                                                                                               |       | 74,257,933                 |        | 77,311,175             |       |
|                                                                                                                                    |       |                       |        |                   |       |
| Property, plant and  equipment                                                                                                          |       | 46,922,895                 |        | 41,431,158             |       |
| Less accumulated  depreciation                                                                                                          |       | (19,920,946                | )           | (18,533,773            | )          |
|                                                                                                                                    |       | 27,001,949                 |        | 22,897,385             |       |
|                                                                                                                                    |       |                       |        |                   |       |
| Construction in  progress                                                                                                               |       | 1,424,042                  |        | 591,685                |       |
| Investment securities -  available for sale                                                                                             |       | 396,713                    |        | 801,748                |       |
| Intangible assets  (product rights) - net of accumulated amortization                                                                   |       | 8,702,004                  |        | 9,118,710              |       |
| Deferred tax assets                                                                                                                     |       | 12,560,834                 |        | 13,757,545             |       |
| Other assets                                                                                                                            |       | 165,943                    |        | 98,873                 |       |
| **Total  Assets**                                                                                                                       |       | $                          | 124,509,418 |                   | $          | 124,577,121 |   |
|                                                                                                                                    |       |                       |        |                   |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                          |       |                       |        |                   |       |
| **LIABILITIES**                                                                                                                         |       |                       |        |                   |       |
| Current Liabilities                                                                                                                     |       |                       |        |                   |       |
| Accounts payable                                                                                                                        |       | $                          | 14,388,197  |                   | $          | 16,805,468 |   |
| Accrued expenses                                                                                                                        |       | 2,125,144                  |        | 1,842,434              |       |
| Accrued payroll and  payroll related                                                                                                    |       | 2,558,955                  |        | 5,150,104              |       |
| Income taxes payable                                                                                                                    |       | —                     |        | 711,073                |       |
| Current portion of  long-term debt                                                                                                      |       | 359,971                    |        | 435,386                |       |
| Rebates, chargebacks  and returns payable                                                                                               |       | 14,283,623                 |        | 13,734,540             |       |
| **Total  Current Liabilities**                                                                                                          |       | 33,715,890                 |        | 38,679,005             |       |
|                                                                                                                                    |       |                       |        |                   |       |
| Long-term debt, less  current portion                                                                                                   |       | 7,585,473                  |        | 7,703,382              |       |
| Unearned grant funds                                                                                                                    |       | 500,000                    |        | 500,000                |       |
| Other long-term  liabilities                                                                                                            |       | 10,339                     |        | 47,111                 |       |
| **Total  Liabilities**                                                                                                                  |       | 41,811,702                 |        | 46,929,498             |       |
| Commitment and  Contingencies, See notes 10 and 11                                                                                      |       |                       |        |                   |       |
|                                                                                                                                    |       |                       |        |                   |       |
| **SHAREHOLDERS’  EQUITY**                                                                                                          |       |                       |        |                   |       |
| Common stock -  authorized 50,000,000 shares, par value $0.001; issued and outstanding,  24,799,154 and 24,517,696 shares, respectively |       | 24,799                     |        | 24,518                 |       |
| Additional paid in capital                                                                                                              |       | 78,431,215                 |        | 76,250,309             |       |
| Retained earnings                                                                                                                       |       | 4,655,527                  |        | 1,743,565              |       |
| Noncontrolling interest                                                                                                                 |       | 115,471                    |        | 93,654                 |       |
| Accumulated other  comprehensive income                                                                                                 |       | 28,998                     |        | 24,751                 |       |
|                                                                                                                                    |       | 83,256,010                 |        | 78,136,797             |       |
| Less: Treasury stock at  cost - 90,160 and 82,228 shares, respectively                                                                  |       | (558,294                   | )           | (489,174               | )          |
| **TOTAL  SHAREHOLDERS’ EQUITY**                                                                                                    |       | 82,697,716                 |        | 77,647,623             |       |
|                                                                                                                                    |       |                       |        |                   |       |
| **TOTAL  LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                    |       | $                          | 124,509,418 |                   | $          | 124,577,121 |   |

### ** **

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

 

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**LANNETTCOMPANY, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS (UNAUDITED)**

 
| ** **                                                    | ** ** | **Three months ended** | ** ** | **Six months ended**  | ** ** |
|---------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                    | ** ** | **December  31,** | ** ** | **December 31,** | ** ** |
| ** **                                                    | ** ** | **2009**               | ** ** | **2008**              | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                                    | ** ** | ** **             | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                                                     |       | $                      | 28,716,713 |                  | $          | 29,224,372 |   | $ | 60,151,702 |   | $ | 54,792,025 |   |
| Cost of sales                                                 |       | 19,892,781             |       | 17,712,370            |       | 38,905,099 |   | 33,832,565 |   |
| Amortization of  intangible assets                            |       | 448,666                |       | 446,167               |       | 897,333 |   | 892,333 |   |
| Product royalties                                             |       | 298,288                |       | 42,997                |       | 738,062 |   | 42,997 |   |
|                                                          |       |                   |       |                  |       |   |   |   |   |
| Gross profit                                                  |       | 8,076,978              |       | 11,022,838            |       | 19,611,208 |   | 20,024,130 |   |
|                                                          |       |                   |       |                  |       |   |   |   |   |
| Research and  development expenses                            |       | 2,730,112              |       | 1,840,717             |       | 5,757,953 |   | 3,703,830 |   |
| Selling, general, and  administrative expenses                |       | 4,049,391              |       | 6,675,472             |       | 7,812,552 |   | 11,624,616 |   |
| Gain on sale of assets                                        |       | (235                   | )          | (26,940               | )          | (235 | ) | (22,009 | ) |
|                                                          |       |                   |       |                  |       |   |   |   |   |
| Operating income                                              |       | 1,297,710              |       | 2,533,589             |       | 6,040,938 |   | 4,717,693 |   |
|                                                          |       |                   |       |                  |       |   |   |   |   |
| Other income (expense):                                       |       |                   |       |                  |       |   |   |   |   |
| Foreign currency gain                                         |       | 708                    |       | —                |       | 708 |   | — |   |
| Interest income                                               |       | 21,184                 |       | 91,883                |       | 44,283 |   | 137,650 |   |
| Interest expense                                              |       | (84,091                | )          | (117,431              | )          | (154,504 | ) | (183,640 | ) |
|                                                          |       | (62,199                | )          | (25,548               | )          | (109,513 | ) | (45,990 | ) |
|                                                          |       |                   |       |                  |       |   |   |   |   |
| Income before income  tax expense                             |       | 1,235,511              |       | 2,508,041             |       | 5,931,425 |   | 4,671,703 |   |
| Income tax expense                                            |       | 1,169,996              |       | 925,433               |       | 2,997,646 |   | 1,845,423 |   |
| Consolidated net income                                       |       | 65,515                 |       | 1,582,608             |       | 2,933,779 |   | 2,826,280 |   |
| Less net income from  noncontrolling interest                 |       | (10,923                | )          | (9,546                | )          | (21,817 | ) | (27,053 | ) |
|                                                          |       |                   |       |                  |       |   |   |   |   |
| Net income attributable  to Lannett Company, Inc.        |       | $                      | 54,592     |                  | $          | 1,573,062 |   | $ | 2,911,962 |   | $ | 2,799,227 |   |
|                                                          |       |                   |       |                  |       |   |   |   |   |
| Basic income per common  share - Lannett Company, Inc.   |       | $                      | 0.00       |                  | $          | 0.06 |   | $ | 0.12 |   | $ | 0.11 |   |
| Diluted income per  common share - Lannett Company, Inc. |       | $                      | 0.00       |                  | $          | 0.06 |   | $ | 0.12 |   | $ | 0.11 |   |
|                                                          |       |                   |       |                  |       |   |   |   |   |
| Basic weighted average  number of shares                      |       | 24,713,006             |       | 24,468,149            |       | 24,623,284 |   | 24,385,818 |   |
| Diluted weighted  average number of shares                    |       | 25,207,764             |       | 24,546,787            |       | 25,152,455 |   | 24,510,726 |   |

 

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

 

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**LANNETT COMPANY, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY**

(UNAUDITED)

 
| ** **                                                     | ** ** | **Common  Stock** | ** ** | **Additional** | ** ** | ** **  | ** ** | ** **   | ** ** | ** **   | ** ** | **Accum.  Other**  | ** ** | ** **        | ** ** |
|----------------------------------------------------------------|------------|-------------------|------------|----------------|------------|-------------|------------|--------------|------------|--------------|------------|--------------------|------------|-------------------|------------|
| ** **                                                     | ** ** | **Shares**        | ** ** | ** **     | ** ** | **Paid-in** | ** ** | **Retained** | ** ** | **Treasury** | ** ** | **Noncontrolling** | ** ** | **Comprehensive** | ** ** | **Shareholders’** | ** ** |
| ** **                                                     | ** ** | **Issued**        | ** ** | **Amount**     | ** ** | **Capital** | ** ** | **Earnings** | ** ** | **Stock**    | ** ** | **Interest**       | ** ** | **Income**        | ** ** | **Equity** | ** ** |
|                                                           |       |              |       |           |       |        |       |         |       |         |       |               |       |              |       |   |   |
| **Balance,  June  30, 2009**                              |       | 24,517,696        |       | $              | 24,518     |        | $          | 76,250,309   |       | $            | 1,743,565  |               | $          | (489,174          | )          | $ | 93,654 |   | $ | 24,751 |   | $ | 77,647,623 |   |
|                                                           |       |              |       |           |       |        |       |         |       |         |       |               |       |              |       |   |   |
| Exercise of stock options                                      |       | 123,600           |       | 123            |       | 558,600     |       | —       |       | —       |       | —             |       | —            |       | 558,723 |   |
| Shares issued in  connection with employee stock purchase plan |       | 15,633            |       | 16             |       | 78,813      |       | —       |       | —       |       | —             |       | —            |       | 78,829 |   |
| Share based compensation                                       |       |              |       |           |       |        |       |         |       |         |       |               |       |              |       |   |   |
| Restricted stock                                               |       | —            |       | —         |       | 176,103     |       | —       |       | —       |       | —             |       | —            |       | 176,103 |   |
| Stock options                                                  |       | —            |       | —         |       | 530,593     |       | —       |       | —       |       | —             |       | —            |       | 530,593 |   |
| Employee stock purchase  plan                                  |       | —            |       | —         |       | 33,076      |       | —       |       | —       |       | —             |       | —            |       | 33,076 |   |
| Shares issued in  connection with restricted stock grant       |       | 142,225           |       | 142            |       | 758,571     |       | —       |       | —       |       | —             |       | —            |       | 758,713 |   |
| Tax benefit on stock  options exercised                        |       |              |       |           |       | 45,150      |       |         |       |         |       |               |       |              |       | 45,150 |   |
| Purchase of treasury  stock                                    |       | —            |       | —         |       | —      |       | —       |       | (69,120      | )          | —             |       | —            |       | (69,120 | ) |
| Income from  noncontrolling interest                           |       | —            |       | —         |       | —      |       | —       |       | —       |       | 21,817             |       | —            |       | 21,817 |   |
| Other comprehensive  income, net of income tax                 |       | —            |       | —         |       | —      |       | —       |       | —       |       | —             |       | 4,247             |       | 4,247 |   |
| Net income - Lannett  Company, Inc.                       |       | —            |       | —         |       | —      |       | 2,911,962    |       | —       |       | —             |       | —            |       | 2,911,962 |   |
|                                                           |       |              |       |           |       |        |       |         |       |         |       |               |       |              |       |   |   |
| **Balance,  December 31, 2009**                           |       | 24,799,154        |       | $              | 24,799     |        | $          | 78,431,215   |       | $            | 4,655,527  |               | $          | (558,294          | )          | $ | 115,471 |   | $ | 28,998 |   | $ | 82,697,716 |   |

 

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

 

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**LANNETTCOMPANY, INC. AND SUBSIDIARIES**

### **CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

(UNAUDITED)

 
| ** **                                                                        | ** ** | **For the six months ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                                        | ** ** | **2009**                                       | ** ** | **2008** | ** ** |
|                                                                              |       |                                           |       |   |   |
| OPERATING ACTIVITIES:                                                             |       |                                           |       |   |   |
| Net income - Lannett  Company, Inc.                                          |       | $                                              | 2,911,962  |   | $ | 2,799,227 |   |
| Adjustments to  reconcile net income tonet cash provided by operating activities: |       |                                           |       |   |   |
| Depreciation and  amortization                                                    |       | 2,313,014                                      |       | 2,577,146 |   |
| Deferred tax expense                                                              |       | 1,265,503                                      |       | 2,923,575 |   |
| Stock compensation  expense                                                       |       | 739,772                                        |       | 656,698 |   |
| Other noncash (income)  expenses                                                  |       | (18,717                                        | )          | 17,074 |   |
| Gain on sale of assets                                                            |       | (235                                           | )          | (22,010 | ) |
| Income from  noncontrolling interest                                              |       | 21,817                                         |       | 27,052 |   |
| Changes in assets and  liabilities which provided (used) cash:                    |       |                                           |       |   |   |
| Trade accounts  receivable                                                        |       | 685,275                                        |       | (1,096,522 | ) |
| Inventories                                                                       |       | (2,580,490                                     | )          | (2,345,270 | ) |
| Prepaid and income  taxes payable                                                 |       | (1,519,595                                     | )          | (338,670 | ) |
| Prepaid expenses and  other assets                                                |       | (518,702                                       | )          | (476,813 | ) |
| Accounts payable                                                                  |       | (2,417,271                                     | )          | (500,550 | ) |
| Accrued expenses                                                                  |       | 282,710                                        |       | 12,485 |   |
| Rebates, chargebacks  and returns payable                                         |       | 890,068                                        |       | 2,304,504 |   |
| Accrued payroll and payroll  related                                              |       | (1,832,436                                     | )          | 700,056 |   |
| Deferred revenue                                                                  |       | —                                         |       | (339,133 | ) |
| Net cash provided by  operating activities                                        |       | 222,675                                        |       | 6,898,849 |   |
|                                                                              |       |                                           |       |   |   |
| INVESTING ACTIVITIES:                                                             |       |                                           |       |   |   |
| Purchases of property,  plant and equipment (including construction in progress)  |       | (6,342,994                                     | )          | (418,962 | ) |
| Proceeds from sale of  property, plant and equipment                              |       | 10,000                                         |       | 1,500 |   |
| Purchase of intangible  asset (product rights)                                    |       | (500,000                                       | )          | — |   |
| Proceeds from sale of  investment securities - available for sale                 |       | —                                         |       | 5,525,349 |   |
| Purchase of investment securities  - available for sale                           |       | —                                         |       | (5,549,604 | ) |
| Net cash used in  investing activities                                            |       | (6,832,994                                     | )          | (441,717 | ) |
|                                                                              |       |                                           |       |   |   |
| FINANCING ACTIVITIES:                                                             |       |                                           |       |   |   |
| Repayments of debt                                                                |       | (193,324                                       | )          | (295,944 | ) |
| Proceeds from issuance  of stock                                                  |       | 637,552                                        |       | 57,924 |   |
| Tax benefit on stock  options exercised                                           |       | 45,150                                         |       | — |   |
| Purchase of treasury  stock                                                       |       | (69,120                                        | )          | (20,228 | ) |
| Net cash provided by  (used in) financing activities                              |       | 420,258                                        |       | (258,248 | ) |
|                                                                              |       |                                           |       |   |   |
| Effect of foreign  currency rates on cash and cash equivalents                    |       | 10,899                                         |       | — |   |
|                                                                              |       |                                           |       |   |   |
| NET (DECREASE) INCREASE  IN CASH AND CASH EQUIVALENTS                             |       | (6,179,162                                     | )          | 6,198,884 |   |
|                                                                              |       |                                           |       |   |   |
| CASH AND CASH  EQUIVALENTS, BEGINNING OF PERIOD                                   |       | 25,832,456                                     |       | 6,256,712 |   |
|                                                                              |       |                                           |       |   |   |
| CASH AND CASH  EQUIVALENTS, END OF PERIOD                                         |       | $                                              | 19,653,294 |   | $ | 12,455,596 |   |
|                                                                              |       |                                           |       |   |   |
| SUPPLEMENTAL DISCLOSURE  OF CASH FLOW INFORMATION -                               |       |                                           |       |   |   |
| Interest paid                                                                     |       | $                                              | 97,392     |   | $ | 137,866 |   |
| Income taxes paid                                                                 |       | $                                              | 3,227,383  |   | $ | 250,000 |   |
| Lannett stock issued -  contingent consideration - Cody Labs acquistion           |       | $                                              | —     |   | $ | 581,175 |   |

 

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

 

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Table ofContents

 

**LANNETT COMPANY, INC.  AND SUBSIDIARIES**

### **NOTES TOCONSOLIDATED FINANCIAL STATEMENTS - UNAUDITED**

### ** **

**Note 1.  Interim FinancialInformation**

 

The accompanying unaudited financial statements have been prepared inaccordance with U.S. generally accepted accounting principles for presentationof interim financial statements and with the instructions to Form 10-Q andArticle 10 of Regulation S-X. Accordingly, the unaudited financialstatements do not include all the information and footnotes necessary for acomprehensive presentation of the financial position, results of operations,and cash flows for the periods presented. In the opinion of management, theunaudited financial statements include all the normal recurring adjustmentsthat are necessary for a fair presentation of the financial position, resultsof operations, and cash flows for the periods presented.  Operating results for the three and sixmonths ended December 31, 2009 are not necessarily indicative of theresults that may be expected for the fiscal year ending June 30, 2010. Youshould read these unaudited financial statements in combination with the otherNotes in this section; “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” appearing in Item 2; and the FinancialStatements, including the Notes to the Financial Statements, included in ourAnnual Report on Form 10-K for the fiscal year ended June 30, 2009.

 

**Note2.  Summary of Significant AccountingPolicies**

 

Lannett Company, Inc., a Delaware corporation, andsubsidiaries (the “Company” or “Lannett”), develop, manufacture, package,market, and distribute active pharmaceutical ingredients as well aspharmaceutical products sold under generic chemical names.  The Company primarily manufactures solidoral dosage forms, including tablets and capsules, and is pursuing partnershipsand research contracts for the development and production of other dosageforms, including liquids, nasal and injectable products.

 

***Use of Estimates —***The preparationof financial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period.  Actual results coulddiffer from those estimates.  Asapplicable to these consolidated financial statements, the most significantestimates and assumptions relate to sales reserves and allowances, incometaxes, inventories, contingencies and valuation of intangible assets.

 

***Principles of Consolidation***- Theconsolidated financial statements include the accounts of the operating parentcompany, Lannett Company, Inc., and its wholly owned subsidiaries, as wellas the consolidation of Cody LCI Realty, LLC, a variable interest entity. See Note 16 regarding the consolidation of this variable interest entity.  All intercompany accounts and transactionshave been eliminated.

 

***Foreign Currency Translation -***The localcurrency is the functional currency of its newly created foreign subsidiary.Assets and liabilities of the foreign subsidiary are translated into U.S.dollars at the period-end currency exchange rate and revenues and expenses aretranslated at an average currency exchange rate for the period. The resultingtranslation adjustment is recorded in a separate component of stockholders’equity and changes to such are included in comprehensive income. Exchangeadjustments resulting from transactions denominated in foreign currencies arerecognized in the consolidated statements of operations.

 

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***Reclassifications*** -Certain prior year amounts have been reclassified to conform to the currentyear financial statement presentation.

 

***Revenue Recognition*** - The Company recognizesrevenue when its products are shipped.  At this point, title and risk ofloss have transferred to the customer and provisions for estimates, includingrebates, promotional adjustments, price adjustments, returns, chargebacks, andother potential adjustments are reasonably determinable.  Accruals forthese provisions are presented in the consolidated financial statements asrebates, chargebacks and returns payable and reductions to net sales. The changein the reserves for various sales adjustments may not be proportionally equalto the change in sales because of changes in both the product and the customermix. Increased sales to wholesalers will generally require additional accrualsas they are the primary recipient of chargebacks and rebates. Incentivesoffered to secure sales vary from product to product. Provisions for estimatedrebates and promotional credits are estimated based upon contractualterms.  Provisions for other customer credits, such as price adjustments,returns, and chargebacks, require management to make subjective judgments oncustomer mix. Unlike branded innovator drug companies, Lannett does not useinformation about product levels in distribution channels from third-party sources,such as IMS and Wolters Kluwer, in estimating future returns and other credits.Lannett calculates a chargeback/rebate rate based on contractual terms with itscustomers and applies this rate to customer sales.  The only variable iscustomer mix, and this assumption is based on historical data and salesexpectations.

 

***Chargebacks***— The provision for chargebacks is the mostsignificant and complex estimate used in the recognition of revenue.  The Company sells its products directly towholesale distributors, generic distributors, retail pharmacy chains, andmail-order pharmacies.  The Company alsosells its products indirectly to independent pharmacies, managed careorganizations, hospitals, nursing homes, and group purchasing organizations,collectively referred to as “indirect customers.”  Lannett enters into agreements with itsindirect customers to establish pricing for certain products.  The indirect customers then independentlyselect a wholesaler from which to actually purchase the products at theseagreed-upon prices.  Lannett will providecredit to the wholesaler for the difference between the agreed-upon price withthe indirect customer and the wholesaler’s invoice price if the price sold tothe indirect customer is lower than the direct price to the wholesaler.  This credit is called a chargeback.  The provision for chargebacks is based onexpected sell-through levels by the Company’s wholesale customers to theindirect customers and estimated wholesaler inventory levels.  As sales to the large wholesale customers,such as Cardinal Health, AmerisourceBergen, and McKesson increase, the reservefor chargebacks will also generally increase. However, the size of the increase depends on the product mix and the amountof those sales that end up at indirect customers with which the Company hasspecific chargeback agreements.  TheCompany continually monitors the reserve for chargebacks and makes adjustmentswhen management believes that expected chargebacks on actual sales may differfrom actual chargeback reserves.

 

***Rebates***— Rebates are offered to the Company’s key chaindrug store, distributor and wholesaler customers to promote customer loyaltyand increase product sales.  These rebateprograms provide customers with rebate credits upon attainment ofpre-established volumes or attainment of net sales milestones for a specifiedperiod.  Other promotional programs areincentive programs offered to the customers. At the time of shipment, the Company estimates reserves for rebates andother promotional credit programs based on the specific terms in eachagreement.  The reserve for rebatesincreases as sales to certain wholesale and retail customers increase.  However, since these rebate programs are notidentical for all customers, the size of the reserve will depend on the mix ofcustomers that are eligible to receive rebates.

 

***Returns —*** Consistent with industry practice, theCompany has a product returns policy that allows customers to return productwithin a specified period prior to and subsequent to the product’s lotexpiration date in exchange for a credit to be applied to futurepurchases.  The Company’s policy requiresthat the customer obtain pre-approval from the Company for any qualifyingreturn.  The Company estimates itsprovision for returns based on 

 

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historical experience,changes to business practices, and credit terms.  While such experience has allowed forreasonable estimations in the past, history may not always be an accurateindicator of future returns.  The Companycontinually monitors the provisions for returns and makes adjustments whenmanagement believes that actual product returns may differ from establishedreserves.  Generally, the reserve forreturns increases as net sales increase. The reserve for returns is included in the rebates, chargebacks andreturns payable account on the balance sheet.

 

***Other Adjustments —*** Otheradjustments consist primarily of price adjustments, also known as “shelf stockadjustments,” which are credits issued to reflect decreases in the sellingprices of the Company’s products that customers have remaining in theirinventories at the time of the price reduction. Decreases in selling prices are discretionary decisions made bymanagement to reflect competitive market conditions.  Amounts recorded for estimated shelf stockadjustments are based upon specified terms with direct customers, estimateddeclines in market prices, and estimates of inventory held by customers.  The Company regularly monitors these andother factors and evaluates the reserve as additional information becomesavailable.  Other adjustments areincluded in the rebates, chargebacks and returns payable account on the balancesheet.

 

The following tables identify the reserves for each major category ofrevenue allowance and a summary of the activity for the six months ended December 31,2009 and 2008:

 

**For thesix months ended December 31, 2009**

 
| **Reserve  Category**                                                                      | ** ** | **Chargebacks** | ** ** | **Rebates** | ** ** | **Returns** | ** ** | **Other** | ** ** | **Total**   | ** ** |
|--------------------------------------------------------------------------------------------|------------|-----------------|------------|-------------|------------|-------------|------------|-----------|------------|-------------|------------|
|                                                                                       |       |            |       |        |       |        |       |      |       |        |       |
| Reserve Balance as of  June 30, 2009                                                  |       | $               | 6,089,802  |        | $          | 2,537,746   |       | $         | 5,106,992  |        | $          | — |   | $ | 13,734,540 |   |
| Actual credits issued  related to sales recorded in prior fiscal years                     |       | (5,045,921      | )          | (2,455,912  | )          | (2,336,002  | )          | —    |       | (9,837,835  | )          |
| Reserves or (reversals)  charged during Fiscal 2010 related to sales in prior fiscal years |       | —          |       | —      |       | —      |       | —    |       | —      |       |
| Reserves charged to net  sales during Fiscal 2010 related to sales recorded in Fiscal 2010 |       | 22,373,840      |       | 9,050,542   |       | 2,649,924   |       | 608,323   |       | 34,682,629  |       |
| Actual credits issued  related to sales recorded in Fiscal 2010                            |       | (17,840,184     | )          | (5,847,204  | )          | —      |       | (608,323  | )          | (24,295,711 | )          |
| Reserve Balance as of  December 31, 2009                                              |       | $               | 5,577,537  |        | $          | 3,285,172   |       | $         | 5,420,914  |        | $          | — |   | $ | 14,283,623 |   |

 

**For thesix months ended December 31, 2008**

 
| **Reserve  Category**                                                                      | ** ** | **Chargebacks** | ** ** | **Rebates** | ** ** | **Returns** | ** ** | **Other** | ** ** | **Total**   | ** ** |
|--------------------------------------------------------------------------------------------|------------|-----------------|------------|-------------|------------|-------------|------------|-----------|------------|-------------|------------|
|                                                                                       |       |            |       |        |       |        |       |      |       |        |       |
| Reserve Balance as of  June 30, 2008                                                  |       | $               | 4,049,407  |        | $          | 632,314     |       | $         | 13,642,589 |        | $          | 2,107 |   | $ | 18,326,417 |   |
| Actual credits issued  related to sales recorded in prior fiscal years                     |       | (3,635,348      | )          | (428,739    | )          | (10,428,254 | )          | —    |       | (14,492,341 | )          |
| Reserves or (reversals)  charged during Fiscal 2009 related to sales in prior fiscal years |       | —          |       | —      |       | 2,107       |       | (2,107    | )          | —      |       |
| Reserves charged to net  sales during Fiscal 2009 related to sales recorded in Fiscal 2009 |       | 16,588,951      |       | 5,662,865   |       | 2,146,732   |       | 140,828   |       | 24,539,376  |       |
| Actual credits issued  related to sales recorded in Fiscal 2009                            |       | (12,105,256     | )          | (4,138,238  | )          | —      |       | (125,928  | )          | (16,369,422 | )          |
| Reserve Balance as of  December 31, 2008                                              |       | $               | 4,897,754  |        | $          | 1,728,202   |       | $         | 5,363,174  |        | $          | 14,900 |   | $ | 12,004,030 |   |

 

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The total reserve for chargebacks, rebates, returns and otheradjustments increased from $13,734,540 at June 30, 2009 to $14,283,623 at December 31,2009.   As of December 31, 2009 approximately $10,058,000of the original $10,545,000 return reserve recorded in Fiscal 2008 for PrenatalMultivitamin was applied to accounts receivable for customers who had returnedthe Prenatal Multivitamin product by that date, leaving a balance ofapproximately $487,000 of Multivitamin returns reserve on the consolidatedbalance sheet at December 31, 2009. The increase in reserves was due to anincrease in the rebates reserve as a result of the timing of credits beingprocessed by the customers and by the Company, and partially offset by adecrease in chargeback reserves due primarily to a decrease in inventory levelsat wholesaler distribution centers.

 

The Company ships its products to the warehouses of its wholesale andretail chain customers.  When the Company and a customer enter into anagreement for the supply of a product, the customer will generally continue topurchase the product, stock its warehouse(s), and resell the product toits own customers.  The Company’s customer will reorder the product as itswarehouse is depleted.  The Company generally has no minimum size ordersfor its customers.  Additionally, most warehousing customers prefer not tostock excess inventory levels due to the additional carrying costs andinefficiencies created by holding excess inventory.  As such, the Company’scustomers continually reorder the Company’s products.  It is common forthe Company’s customers to order the same products on a monthly basis. For generic pharmaceutical manufacturers, it is critical to ensure thatcustomers’ warehouses are adequately stocked with its products.  This isimportant due to the fact that several generic competitors compete for theconsumer demand for a given product.  Availability of inventory ensuresthat a manufacturer’s product is considered.  Otherwise, retailprescriptions would be filled with competitors’ products.  For this reason,the Company periodically offers incentives to its customers to purchase itsproducts.  These incentives are generally up-front discounts off itsstandard prices at the beginning of a generic campaign launch for anewly-approved or newly-introduced product, or when a customer purchases aLannett product for the first time.  Customers generally inform theCompany that such purchases represent an estimate of expected resale for aperiod of time.  This period of time is generally up to three months. The Company records this revenue, net of any discounts offered and accepted byits customers at the time of shipment.  The Company’s products have either24 months or 36 months of shelf-life at the time of manufacture.  TheCompany monitors its customers’ purchasing trends to attempt to identify anysignificant lapses in purchasing activity.  If the Company observes a lackof recent activity, inquiries will be made to such customer regarding thesuccess of the customer’s resale efforts.  The Company attempts to minimizeany potential return (or shelf life issues) by maintaining an active dialoguewith the customers.

 

Theproducts that the Company sells are generic versions of brand nameddrugs.  The consumer markets for such drugs are well-established marketswith many years of historically-confirmed consumer demand.  Such consumerdemand may be affected by several factors, including alternative treatments andcosts, etc.  However, the effects of changes in such consumer demand forthe Company’s products, like generic products manufactured by other genericcompanies, are gradual in nature.  Any overall decrease in consumer demandfor generic products generally occurs over an extended period of time. This is because there are thousands of doctors, prescribers, third-partypayers, institutional formularies and other buyers of drugs that must changeprescribing habits and medicinal practices before such a decrease would affecta generic drug market.  If the historical data the Company uses and theassumptions management makes to calculate its estimates of future returns,chargebacks, and other credits do not accurately approximate future activity,its net sales, gross profit, net income and earnings per share couldchange.  However, management believes that these estimates are reasonablebased upon historical experience and current conditions.

 

***Cash and cash equivalents —***The Company considers allhighly liquid securities purchased with original maturities of 90 days or lessto be cash equivalents.  Cash equivalentsare stated at cost, which approximates fair value, and consist of certificatesof deposit that are readily converted to cash.

 

***Accounts Receivable*** - The Company performsongoing credit evaluations of its customers and adjusts credit limits basedupon payment history and the customer’s current credit worthiness, asdetermined by a review of current credit information. The Company continuouslymonitors collections and payments from its customers and 

 

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maintainsa provision for estimated credit losses based upon historical experience andany specific customer collection issues that have been identified. While suchcredit losses have historically been within both the Company’s expectations andthe provisions established, the Company cannot guarantee that it will continueto experience the same credit loss rates that it has in the past.

 

***Fair Value of FinancialInstruments*** - The Company’s financial instruments consistprimarily of cash and cash equivalents, accounts receivable, accounts payable,accrued expenses and debt obligations. The carrying values of these assets andliabilities approximate fair value based upon the short-term nature of theseinstruments.  The Company has estimatedthat the fair value of long-term debt associated with the 20 year mortgage onits land and building in Cody, Wyoming approximates the discounted amount offuture payments to the mortgage-holder.

 

***Investment Securities*** - The Company’s investmentsecurities consist of marketable debt securities, primarily in U.S. governmentand agency obligations.  All of the Company’s marketable debt securitiesare classified as available-for-sale and recorded at fair value, based onquoted market prices.  Unrealized holding gains and losses are recorded,net of any tax effect, as a separate component of accumulated othercomprehensive income.  No gains or losses on marketable debt securitiesare realized until they are sold or a decline in fair value is determined to beother-than-temporary.  The Company reviews its marketable securities anddetermines whether the investments are other-than-temporarily impaired. If theinvestments are deemed to be other-than-temporarily impaired, the investmentsare written down to their then current fair market value with a new cost basisbeing established. There were no securities determined by management to beother-than-temporarily impaired during the six months ended December 31,2009 or the fiscal year ended June 30, 2009.

 

***Shipping and Handling Costs*** — The cost of shipping products to customers is recognized at the time the products are shipped, and is included in cost of sales.

 

***Research and Development***— Research and developmentexpenses are charged to operations as incurred.

 

***Intangible Assets***— In March 2004,****the Company entered into an agreement with Jerome StevensPharmaceuticals, Inc. (JSP) for the exclusive marketing and distributionrights in the United States to the current line of JSP products in exchange forfour million (4,000,000) shares of the Company’s common stock.  As a result of the JSP agreement, the Companyrecorded an intangible asset for the exclusive marketing and distributionrights obtained from JSP.  As of December 31,2009 and June 30, 2009, management concluded the carrying value of theintangible asset was less than its fair value and, therefore, no impairment wasrequired.  The Company will incur annualamortization expense of approximately $1,785,000 for the JSP intangible assetover the remaining term of the agreement.

 

On April 10, 2007, the Company entered into a Stock PurchaseAgreement to acquire Cody by purchasing all of the remaining shares of commonstock of Cody. The consideration for the April 10, 2007 acquisition wasapproximately $4,438,000, which represented the fair value of the tangible netassets acquired. The agreement also required Lannett to issue to the sellers upto 120,000 shares of unregistered common stock of the Company contingent uponthe receipt of a license from a regulatory agency.  This license was subsequently received in July 2008and triggered the payment of 105,000 shares (87.5% of the 120,000 shares as theCompany already owned 12.5%) of Lannett stock to the former owners of CodyLabs, which was completed in October 2008. Therefore, the Company recorded an intangible asset related to theacquisition of a drug import license in the original amount of $581,175 andrecorded a corresponding deferred tax liability of approximately $150,700 dueto the non-deductibility of the amortization for tax purposes.  The Company has assigned a 15 year life tothis intangible asset based on average life cycles of Lannett products.

 

In January 2005, Lannett Holdings, Inc.entered into an agreement in which the Company purchased for $100,000 andfuture royalty payments the proprietary rights to manufacture and distribute aproduct for which Pharmeral, Inc. owned the ANDA.  In May 2008, the Company and Pharmeralwaived their rights to any royalty payments on the sales of the drug byLannett, under Lannett’s current ownership structure.  Should Lannett undergo a change in control 

 

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transaction with a third party, this royalty will bereinstated.  In Fiscal 2008, the Companyobtained FDA approval to use these proprietary rights.  Accordingly, the Company originallycapitalized these purchased product rights as an indefinite lived intangibleasset and tested this asset for impairment at least on an annual basis.  During the fourth quarter of fiscal 2009, itwas determined that this intangible asset no longer has an indefinitelife.  No impairment existed because theestimated fair value exceeded the carrying amount on that date. Accordingly,the $100,000 carrying amount of this intangible asset is being amortized on astraight line basis prospectively over its 10 year remaining estimated usefullife.

 

InAugust 2009, the Company acquired eight new ANDAs covering three separateproduct lines from another generic drug manufacturer for a purchase price of$500,000.  It is expected that theCompany will be able to produce these products by the third quarter of thisfiscal year.  The Company has assigned a15 year life to this intangible asset based on average life cycles of Lannettproducts.  Amortization will begin whenthe Company starts shipping these products.

 

Forthe six months ended December 31, 2009 and 2008, the Company incurredamortization expense of approximately $917,000 and $892,000, respectively. Asof December 31, 2009 and June 30, 2009, accumulated amortizationtotaled approximately $8,541,000 and $7,624,000, respectively.

 

Futureannual amortization expense consists of the following as of December 31,2009:

 
| **Fiscal  Year Ending June 30,** | ** ** | **Annual Amortization  Expense** | ** ** |
|---------------------------------------|------------|----------------------------------|------------|
| 2010                                  |       | $                                | 916,706    |   |
| 2011                                  |       | 1,833,412                        |       |
| 2012                                  |       | 1,833,412                        |       |
| 2013                                  |       | 1,833,412                        |       |
| 2014                                  |       | 1,387,245                        |       |
| Thereafter                            |       | 397,817                          |       |
|                                  |       | $                                | 8,202,004  |   |

 

Theamounts above do not include the ANDA’s purchased in August 2009 for$500,000 as amortization will begin when the Company starts shipping theseproducts.

 

***Advertising Costs*** - The Company chargesadvertising costs to operations as incurred. Advertising expense for the six months ended December 31, 2009 and2008 was approximately $11,000 and $31,000, respectively.

 

***Income Taxes***- The Company uses the liability method to account for income taxes.Deferred tax assets and liabilities are determined based on the differencebetween the financial statement and tax bases of assets and liabilities asmeasured by the enacted tax rates which will be in effect when thesedifferences reverse.  Deferred taxexpense/(benefit) is the result of changes in deferred tax assets andliabilities.  The Company may recognizethe tax benefit from an uncertain tax position claimed on a tax return only ifit is more likely than not that the tax position will be sustained onexamination by the taxing authorities, based on the technical merits of theposition.  The tax benefits recognized inthe financial statements from such a position should be measured based on thelargest benefit that has a greater than 50% likelihood of being realized upon ultimatesettlement. The authoritative standards issued by the FASB also provideguidance on de-recognition, classification, interest and penalties on incometaxes, accounting in interim periods and requires increased disclosures.

 

***Segment Information***- The Companyoperates one business segment - generic pharmaceuticals; accordingly theCompany has one reporting segment.  TheCompany aggregates its financial information for all products and 

 

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reportsas one operating segment.  The followingtable identifies the Company’s approximate net product sales by medicalindication for the three and six months ended December 31, 2009 and 2008:

 
| ** **              | ** ** | **For the Three Months Ended  December 31,** | ** ** | **For the Six Months Ended  December 31,** | ** ** |
|-------------------------|------------|---------------------------------------------------|------------|-------------------------------------------------|------------|
| **Medical  Indication** | ** ** | **2009**                                          | ** ** | **2008**                                        | ** ** | **2009** | ** ** | **2008** | ** ** |
|                    |       |                                              |       |                                            |       |   |   |   |   |
| Migraine Headache       |       | $                                                 | 2,476,000  |                                            | $          | 2,429,000 |   | $ | 5,139,000 |   | $ | 4,748,000 |   |
| Epilepsy                |       | 428,000                                           |       | 204,000                                         |       | 1,039,000 |   | 884,000 |   |
| Prescription Vitamin    |       | 1,567,000                                         |       | 4,559,000                                       |       | 3,056,000 |   | 4,559,000 |   |
| Heart Failure           |       | 5,289,000                                         |       | 5,709,000                                       |       | 10,142,000 |   | 12,057,000 |   |
| Thyroid Deficiency      |       | 13,085,000                                        |       | 12,203,000                                      |       | 26,109,000 |   | 23,668,000 |   |
| Antibiotic              |       | 1,558,000                                         |       | 1,524,000                                       |       | 3,219,000 |   | 3,020,000 |   |
| Pain Management         |       | 944,000                                           |       | 285,000                                         |       | 3,824,000 |   | 562,000 |   |
| Other                   |       | 3,370,000                                         |       | 2,311,000                                       |       | 7,624,000 |   | 5,294,000 |   |
|                    |       |                                              |       |                                            |       |   |   |   |   |
| Total                   |       | $                                                 | 28,717,000 |                                            | $          | 29,224,000 |   | $ | 60,152,000 |   | $ | 54,792,000 |   |

 

***Concentration of Market and Credit Risk*** - Five of theCompany’s products, defined as generics containing the same active ingredientor combination of ingredients, accounted for approximately 43%, 17%, 9%, 5% and5%, respectively of net sales for the six months ended December 31,2009.  Those same products accounted for43%, 22%, 9%, 1% and 8% respectively, of net sales for the six months ended December 31,2008.  For the three months ended December 31,2009 and 2008, the same five products accounted for 46%, 18%, 9%, 5% and 3%,and 42%, 20%, 8%, 16% and 2%, respectively, of net sales.

 

Fiveof the Company’s customers accounted for 26%, 11%, 8%, 8% and 6%, respectively,of net sales for the six months ended December 31, 2009, and 30%, 5%, 8%,5% and 8%, respectively, of net sales for the six months ended December 31,2008.  For the three months ended December 31,2009 and 2008, five customers accounted for 27%, 10%, 9%, 8% and 6%, and 34%,8%, 9%, 8% and 12%, respectively, of net sales. At December 31, 2009, these five customers accounted for 71% of theCompany’s accounts receivable balances. At June 30, 2009, these five customers accounted for 69% of theCompany’s accounts receivable balances.

 

***Share-based Compensation -***The Companyrecognizes compensation cost for share-based compensation issued to orpurchased by employees, net of estimated forfeitures, under share-basedcompensation plans using a fair value method.

 

AtDecember 31, 2009, the Company had three stock-based employee compensationplans (the “Old Plan,” the “2003 Plan,” and the Long-term Incentive Plan, or “LTIP”).

 

Duringthe six months ended December 31, 2008, the Company awarded 30,000 sharesof restricted stock under the LTIP which vested immediately.  Stock compensation expense of zero and$101,400 was recognized during the three and six months ended December 31,2008, related to these shares of restricted stock.

 

Duringthe fiscal year ended June 30, 2008, the Company awarded 209,264 shares ofrestricted stock under the LTIP of which, 74,464 of these shares vested 100% onJanuary 1, 2008.  The remaindervests in equal portions on September 18, 2008, 2009 and 2010.  Stockcompensation expense of $43,007 and $86,014 and was recognized during the threeand six months ended December 31, 2009 and 2008, respectively, related tothe vesting of these shares of restricted stock.

 

Duringthe three months ended December 31, 2009, the Company awarded 237,500shares of restricted stock under the LTIP which vest in equal portions on October 29,2010, 2011 and 2012.  Stock compensation expense 

 

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of$90,089 was recognized during the three months ended December 31, 2009related to the vesting of these shares of restricted stock.

 

TheCompany measures the fair value of share-based compensation cost for optionsusing the Black-Scholes option pricing model. The following table presents the weighted average assumptions used toestimate fair values of the stock options granted and the estimated forfeiturerates during the six months ended December 31:

 
| ** **                                    | ** ** | **Incentive Stock  Options** | ** ** | **Non-qualified  Stock Options** | ** ** | **Incentive Stock  Options** | ** ** | **Non-qualified  Stock Options** | ** ** |
|-----------------------------------------------|------------|------------------------------|------------|----------------------------------|------------|------------------------------|------------|----------------------------------|------------|
| ** **                                    | ** ** | **FY 2010**                  | ** ** | **FY 2010**                      | ** ** | **FY 2009**                  | ** ** | **FY 2009**                      | ** ** |
| Risk-free  interest rate                      |       | 2.4                          | %          | 2.4                              | %          | 2.6                          | %          | 2.5                              | %          |
| Expected  volatility                          |       | 66.5                         | %          | 66.8                             | %          | 59.4                         | %          | 59.4                             | %          |
| Expected  dividend yield                      |       | 0.0                          | %          | 0.0                              | %          | 0.0                          | %          | 0.0                              | %          |
| Forfeiture  rate                              |       | 5.0                          | %          | 5.0                              | %          | 5.0                          | %          | 5.0                              | %          |
| Expected  term                                |       | 5.0 years                    |       | 5.0 years                        |       | 5.0 years                    |       | 5.0 years                        |       |
| Weighted  average fair value at date of grant |       | $                            | 4.02       |                             | $          | 4.00                         |       | $                                | 1.44       |   | $ | 1.41 |   |
|                                               |            |                              |            |                                  |            |                              |            |                                  |            |  |  |  |  |

 

Approximately528,000 and 47,000 options were issued under the LTIP during the three monthsended December 31, 2009 and 2008, respectively.  Approximately 528,000 and 147,000 optionswere issued under the LTIP during the six months ended December 31, 2009and 2008, respectively.  There were122,350 and zero shares under options that were exercised in the six monthsended December 31, 2009 and 2008, respectively.  At December 31, 2009, there were2,079,481 options outstanding.  Of those,1,039,050 were options issued under the LTIP, 829,198 were issued under the2003 Plan, and 211,233 under the Old Plan. There are no further shares authorized to be issued under the OldPlan.  1,125,000 shares were authorizedto be issued under the 2003 Plan, with 48,740 shares under options havingalready been exercised under that plan. 2,500,000 shares were authorized to be issued under the LTIP, with92,100 shares under options having already been exercised under that plan.

 

Expectedvolatility is based on the historical volatility of the price of our commonshares since the date we commenced trading on the NYSE-Amex, April 2002,or a historical period equal to the expected term of the option, whichever isshorter.  We use historical informationto estimate expected term within the valuation model.  The expected termof awards represents the period of time that options granted are expected to beoutstanding.  The risk-free rate for periods within the expected life ofthe option is based on the U.S. Treasury yield curve in effect at the time ofgrant.  Compensation cost is recognized using the straight-line methodover the vesting or service period and is net of estimated forfeitures.

 

Theforfeiture rate assumption is the estimated annual rate at which unvested awardsare expected to be forfeited during the vesting period. This assumption isbased on our historical forfeiture rate. Periodically, management will assesswhether it is necessary to adjust the estimated rate to reflect changes inactual forfeitures or changes in expectations. For example, adjustments may beneeded if forfeitures were affected by turnover that resulted from a businessrestructuring that is not expected to recur. The Company will incur additional expense if the actual forfeiture rateis lower than originally estimated. A recovery of prior expense will berecorded if the actual rate is higher than originally estimated.

 

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Thefollowing table presents all share-based compensation costs recognized in ourstatements of operations, substantially all of which is reflected in theselling, general and administrative expense line:

 
| ** **                     | ** ** | **Three  Months Ended  December 31,** | ** ** | **Six  Months Ended********December 31,** | ** ** |
|--------------------------------|------------|---------------------------------------|------------|-------------------------------------------|------------|
| ** **                     | ** ** | **2009**                              | ** ** | **2008**                                  | ** ** | **2009** | ** ** | **2008** | ** ** |
|                           |       |                                  |       |                                      |       |   |   |   |   |
| Share  based compensation      |       |                                  |       |                                      |       |   |   |   |   |
| Stock  options                 |       | $                                     | 297,725    |                                      | $          | 219,193 |   | $ | 530,593 |   | $ | 437,992 |   |
| Employee  stock purchase plan  |       | 11,636                                |       | 4,701                                     |       | 33,076 |   | 31,292 |   |
| Restricted  stock              |       | 133,096                               |       | 43,007                                    |       | 176,103 |   | 187,414 |   |
| Tax  benefit at statutory rate |       | 21,797                                |       | 22,180                                    |       | 33,743 |   | 44,361 |   |
|                                |            |                                       |            |                                           |            |  |  |  |  |  |  |  |  |

 

Optionsoutstanding that have vested and are expected to vest as of December 31, 2009 areas follows:

 
| ** **                        | ** ** | **Awards** | ** ** | **Weighted -  Average  Exercise  Price** | ** ** | **Aggregate  Intrinsic  Value** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** |
|-----------------------------------|------------|------------|------------|------------------------------------------|------------|---------------------------------|------------|-----------------------------------------------------|------------|
| Options vested                    |       | 1,138,781  |       | $                                        | 8.85       |                            | $          | 709,364                                             |       | 5.4 |   |
| Options expected to vest          |       | 893,665    |       | $                                        | 6.03       |                            | $          | 575,352                                             |       | 9.3 |   |
| Total vested and expected to vest |       | 2,032,446  |       | $                                        | 7.61       |                            | $          | 1,284,716                                           |       | 7.1 |   |

 

Asummary of nonvested restricted stock award activity as of December 31, 2009and changes during the six months then ended, is presented below:

 
| ** **                     | ** ** | **Awards** | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** |
|--------------------------------|------------|------------|------------|-----------------------------------------------|------------|
| Nonvested at July 1, 2009      |       | 77,198     |       | $                                             | 311,108    |   |
| Granted                        |       | 354,225    |       | 2,406,963                                     |       |
| Vested                         |       | (142,225   | )          | (861,478                                      | )          |
| Forfeited                      |       | (9,300     | )          | (37,479                                       | )          |
| Nonvested at December 31, 2009 |       | 279,898    |       | $                                             | 1,819,114  |   |

 

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Asummary of award activity under the Plans as of December 31, 2009 and 2008, andchanges during the six months then ended, is presented below:

 
|                                                 |       | **Incentive  Stock Options** |       | **Nonqualified  Stock Options** |       |
|------------------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **                                           | ** ** | ** **                   | ** ** | ** **                      | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                                           | ** ** | ** **                   | ** ** | **Weighted-**                   | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | **Weighted-** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                           | ** ** | ** **                   | ** ** | **Average**                     | ** ** | **Aggregate** | ** ** | **Remaining** | ** ** | ** ** | ** ** | **Average** | ** ** | **Aggregate** | ** ** | **Remaining** | ** ** |
| ** **                                           | ** ** | ** **                   | ** ** | **Exercise**                    | ** ** | **Intrinsic** | ** ** | **Contractual** | ** ** | ** ** | ** ** | **Exercise** | ** ** | **Intrinsic** | ** ** | **Contractual** | ** ** |
| ** **                                           | ** ** | **Awards**                   | ** ** | **Price**                       | ** ** | **Value** | ** ** | **Life** | ** ** | **Awards** | ** ** | **Price** | ** ** | **Value** | ** ** | **Life** | ** ** |
|                                                 |       |                         |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Outstanding at July 1,  2009                         |       | 958,909                      |       | $                               | 5.60       |   |   |   |   |   | 626,772 |   | $ | 10.52 |   |   |   |   |   |
| Granted                                              |       | 477,142                      |       | $                               | 7.04       |   |   |   |   |   | 152,658 |   | $ | 6.99 |   |   |   |   |   |
| Exercised                                            |       | (108,546                     | )          | $                               | 4.47       |   |   |   |   |   | (13,804 | ) | $ | 4.97 |   |   |   |   |   |
| Forfeited, expired or  repurchased                   |       | (13,650                      | )          | $                               | 5.82       |   |   |   |   |   | — |   | $ | — |   |   |   |   |   |
| Outstanding at December  31, 2009                    |       | 1,313,855                    |       | $                               | 6.21       |   | $ | 1,042,689 |   | 7.9 |   | 765,626 |   | $ | 9.91 |   | $ | 272,308 |   | 5.9 |   |
|                                                 |       |                         |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Outstanding at December  31, 2009 and not yet vested |       | 744,482                      |       | $                               | 5.99       |   | $ | 498,048 |   | 9.3 |   | 196,218 |   | $ | 6.20 |   | $ | 107,585 |   | 9.5 |   |
| Exercisable at December  31, 2009                    |       | 569,373                      |       | $                               | 6.50       |   | $ | 544,641 |   | 6.1 |   | 569,408 |   | $ | 11.19 |   | $ | 164,723 |   | 4.7 |   |

 
| ** **                                           | ** ** | **Incentive Stock Options** | ** ** | **Nonqualified Stock Options** | ** ** |
|------------------------------------------------------|------------|-----------------------------|------------|--------------------------------|------------|
| ** **                                           | ** ** | ** **                  | ** ** | ** **                     | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                                           | ** ** | ** **                  | ** ** | **Weighted-**                  | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | **Weighted-** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                           | ** ** | ** **                  | ** ** | **Average**                    | ** ** | **Aggregate** | ** ** | **Remaining** | ** ** | ** ** | ** ** | **Average** | ** ** | **Aggregate** | ** ** | **Remaining** | ** ** |
| ** **                                           | ** ** | ** **                  | ** ** | **Exercise**                   | ** ** | **Intrinsic** | ** ** | **Contractual** | ** ** | ** ** | ** ** | **Exercise** | ** ** | **Intrinsic** | ** ** | **Contractual** | ** ** |
| ** **                                           | ** ** | **Awards**                  | ** ** | **Price**                      | ** ** | **Value** | ** ** | **Life** | ** ** | **Awards** | ** ** | **Price** | ** ** | **Value** | ** ** | **Life** | ** ** |
|                                                 |       |                        |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Outstanding at July 1,  2008                         |       | 991,267                     |       | $                              | 5.76       |   |   |   |   |   | 703,064 |   | $ | 10.16 |   |   |   |   |   |
| Granted                                              |       | 109,002                     |       | $                              | 2.79       |   |   |   |   |   | 37,998 |   | $ | 2.80 |   |   |   |   |   |
| Exercised                                            |       | —                      |       | —                         |       |   |   |   |   | — |   | — |   |   |   |   |   |
| Forfeited or expired                                 |       | (94,150                     | )          | $                              | 4.81       |   |   |   |   |   | (25,000 | ) | $ | 5.02 |   |   |   |   |   |
| Outstanding at December  31, 2008                    |       | 1,006,119                   |       | $                              | 5.53       |   | $ | 680,495 |   | 7.7 |   | 716,062 |   | $ | 9.95 |   | 176,895 |   | 6.1 |   |
|                                                 |       |                        |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Outstanding at December  31, 2008 and not yet vested |       | 478,663                     |       | $                              | 4.04       |   | 519,552 |   | 8.9 |   | 136,448 |   | $ | 4.38 |   | 137,385 |   | 8.7 |   |
| Exercisable at December  31, 2008                    |       | 527,456                     |       | $                              | 6.89       |   | $ | 160,943 |   | 6.6 |   | 579,614 |   | $ | 11.26 |   | 39,510 |   | 5.6 |   |

 

Optionswith a fair value of $652,505 vested during the six months ended December 31,2009.  As of December 31, 2009, there was$4,391,788 of total unrecognized compensation cost related to nonvestedshare-based compensation awards granted under the Plans.  That cost is expected to be recognized over aweighted average period of 1.84 years. The Company issues new shares when stock options are exercised.

 

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***UnearnedGrant Funds*** —The Company records all grant funds received as a liability until the Companyfulfills all the requirements of the grant funding program.

 

***Earnings per Common Share***— A dualpresentation of basic and diluted earnings per share is required on the face ofthe Company’s consolidated statement of operations as well as a reconciliationof the computation of basic earnings per share to diluted earnings pershare.  Basic earnings per share excludesthe dilutive impact of common stock equivalents and is computed by dividing netincome by the weighted-average number of shares of common stock outstanding forthe period.  Diluted earnings per shareinclude the effect of potential dilution from the exercise of outstandingcommon stock equivalents into common stock using the treasury stockmethod.  A reconciliation of the Company’sbasic and diluted income per share follows:

 
| ** **                                                        | ** ** | **Three  Months Ended December 31,** | ** ** | **Six  Months Ended December 31,** | ** ** |
|-------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                        | ** ** | **2009**                             | ** ** | **2008**                           | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                                        | ** ** | **Net  Income**                      | ** ** | **Shares**                         | ** ** | **Net  Income** | ** ** | **Shares** | ** ** | **Net  Income** | ** ** | **Shares** | ** ** | **Net  Income** | ** ** | **Shares** | ** ** |
| ** **                                                        | ** ** | **(Numerator)**                      | ** ** | **(Denominator)**                  | ** ** | **(Numerator)** | ** ** | **(Denominator)** | ** ** | **(Numerator)** | ** ** | **(Denominator)** | ** ** | **(Numerator)** | ** ** | **(Denominator)** | ** ** |
|                                                              |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic  earnings per share factors                                 |       | $                                    | 54,592     |                               | 24,713,006 |   | $ | 1,573,062 |   | 24,468,149 |   | $ | 2,911,962 |   | 24,623,284 |   | $ | 2,799,227 |   | 24,385,818 |   |
|                                                              |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Effect  of potentially dilutive option and restricted stock plans |       | —                               |       | 494,758                            |       | — |   | 78,638 |   | — |   | 529,171 |   | — |   | 124,908 |   |
|                                                              |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Diluted  earnings per share factors                               |       | $                                    | 54,592     |                               | 25,207,764 |   | $ | 1,573,062 |   | 24,546,787 |   | $ | 2,911,962 |   | 25,152,455 |   | $ | 2,799,227 |   | 24,510,726 |   |
|                                                              |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic  earnings per share                                         |       | $                                    | 0.00       |                               |       |   | $ | 0.06 |   |   |   | $ | 0.12 |   |   |   | $ | 0.11 |   |   |   |
| Diluted  earnings per share                                       |       | $                                    | 0.00       |                               |       |   | $ | 0.06 |   |   |   | $ | 0.12 |   |   |   | $ | 0.11 |   |   |   |

 

The number of anti-dilutive shares that have been excluded in thecomputation of diluted earnings per share for the three and six months ended December31, 2009 were 1,319,244 and 623,523, respectively. The number of anti-dilutiveshares that have been excluded in the computation of diluted earnings per sharefor the three and six months ended December 31, 2008 were 1,797,379 and1,650,379, respectively.

 

**Note 3.  New Accounting Standards**

 

In June 2009, theFinancial Accounting Standards Board (“FASB”) issued the FASB AccountingStandards Codification (“the Codification”), which establishes the Codificationas the source of authoritative accounting guidance to be applied in thepreparation of financial statements in conformity with generally acceptedaccounting principles (“GAAP”).  TheCodification, which changes the referencing of financial standards, becameeffective for interim and annual periods ending on or after September 15,2009.  The Codification is now the singleofficial source of authoritative U.S. GAAP (other than guidance issued by theSecurities and Exchange Commission), superseding existing FASB, AmericanInstitute of Certified Public Accountants, Emerging Issues Task Force andrelated literature.  Only one level ofauthoritative U.S. GAAP now exists.  Allother literature is considered non-authoritative.  The Codification does not change U.S.GAAP.    We adopted the Codificationduring the first quarter of fiscal year 2010.

 

In December 2007, theFASB issued authoritative guidance which significantly changes the accountingfor business combinations in a number of areas including the treatment ofcontingent consideration, contingencies, acquisition costs, in-process researchand development and restructuring costs. In addition, under the guidance,changes in deferred tax asset valuation allowances and acquired income taxuncertainties in a business 

 

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combination after themeasurement period will impact income tax expense. In April 2009, updatedguidance was issued to address application issues regarding the accounting anddisclosure provisions for contingencies. The authoritative guidance appliesprospectively to business combinations for which the acquisition date is on orafter the beginning of the fiscal year beginning July 1, 2009.  Early application is not permitted. The effectof this authoritative guidance on our consolidated financial statements willdepend on the nature and terms of any business combinations that occur afterthe effective date.

 

In December 2007, the FASB issued authoritative guidance to establishaccounting and reporting standards for the noncontrolling (minority) interestin a subsidiary and for the deconsolidation of a subsidiary. It clarifies thata noncontrolling interest in a subsidiary is an ownership interest in the consolidatedentity that should be reported as equity in the consolidated financialstatements and establishes a single method of accounting for changes in aparent’s ownership interest in a subsidiary that do not result indeconsolidation. We adopted this authoritative guidance effective July 1, 2009.As a result of the adoption, the Company presents noncontrolling interests as acomponent of equity on its consolidated balance sheets.  Minority interest expense is now shown belownet income under the heading “net income from noncontrolling interest”.  Prior year financial statements have beenreclassified to reflect the adoption of this guidance.  The adoption of this guidance did not haveany other significant impact on our consolidated financial statements.

 

In April 2008, the FASBissued authoritative guidance which amends the factors that should beconsidered in developing renewal or extension assumptions used to determine theuseful life of a recognized intangible asset. The guidance is intended to improvethe consistency between the useful life of a recognized intangible asset andthe period of expected cash flows used to measure the fair value of the asset.We adopted this authoritative guidance effective July 1, 2009.  The adoption of this guidance did not have asignificant impact on our consolidated financial statements.

 

In June 2009, the FASBissued authoritative guidance for determining whether an entity is a variableinterest entity and modifies the methods allowed for determining the primarybeneficiary of a variable interest entity. This guidance requires an enterpriseto perform an analysis to determine whether the enterprise’s variable interestor interests give it a controlling financial interest in a variable interestentity. It also requires ongoing reassessments of whether an enterprise is theprimary beneficiary of a variable interest entity.  The authoritative guidance is effective forthe annual reporting period that begins after November 15, 2009. We do notexpect the adoption of this authoritative guidance to have a significant impacton our consolidated financial statements.

 

**Note4.  Inventories**

 

TheCompany values its inventory at the lower of cost (determined by the first-in,first-out method) or market, regularly reviews inventory quantities on hand,and records a provision for excess and obsolete inventory based primarily onestimated forecasts of product demand.   The Company’s estimates of future product demand may fluctuate, in whichcase estimated required reserves for excess and obsolete inventory may increaseor decrease.   If the Company’s inventoryis determined to be overvalued, the Company recognizes such costs in cost ofgoods sold at the time of such determination. Likewise, if inventory isdetermined to be undervalued, the Company may have recognized excess cost ofgoods sold in previous periods and would recognize such additional operatingincome at the time of sale.

 

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Inventoriesconsist of the following:

 
| ** **          | ** ** | **December 31, 2009** | ** ** | **June 30, 2009** | ** ** |
|---------------------|------------|-----------------------|------------|-------------------|------------|
|                |       |                  |       |              |       |
| Raw  materials      |       | $                     | 6,397,103  |              | $          | 5,755,982 |   |
| Work-in-process     |       | 1,892,640             |       | 2,846,600         |       |
| Finished  goods     |       | 9,518,344             |       | 6,664,193         |       |
| Packaging  supplies |       | 967,764               |       | 928,586           |       |
|                |       | $                     | 18,775,851 |              | $          | 16,195,361 |   |

 

The preceding amounts are net of inventory reserves of $2,982,834 and$2,744,305 at December 31, 2009 and June 30, 2009, respectively.

 

**Note5.  Property, Plant and Equipment**

 

Property, plant and equipment are stated at cost.  Depreciation is provided for by thestraight-line method for financial reporting purposes over the estimated usefullives of the assets.  Depreciationexpense for the three months ended December 31, 2009 and 2008 was approximately$688,000 and $830,000, respectively. Depreciation expense for the six monthsended December 31, 2009 and 2008 was approximately $1,396,000 and $1,667,000,respectively.

 

Property, plant and equipment consist of the following:

 
| ** **                 | ** ** | ** **       | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
|----------------------------|------------|------------------|------------|------------------|------------|--------------|------------|
| ** **                 | ** ** | **Useful Lives** | ** ** | **2009**         | ** ** | **2009**     | ** ** |
| Land                       |       | —           |       | $                | 1,418,314  |         | $          | 918,314 |   |
| Building  and improvements |       | 10  - 39 years   |       | 20,968,960       |       | 17,048,351   |       |
| Machinery  and equipment   |       | 5  - 10 years    |       | 23,637,495       |       | 22,573,324   |       |
| Furniture  and fixtures    |       | 5  - 7 years     |       | 898,126          |       | 891,169      |       |
|                       |       |             |       | $                | 46,922,895 |         | $          | 41,431,158 |   |
| Accumulated  depreciation  |       |             |       | (19,920,946      | )          | (18,533,773  | )          |
|                       |       |             |       | $                | 27,001,949 |         | $          | 22,897,385 |   |

 

**Note6.  Investment Securities -Available-for-Sale**

 

On July1, 2008, the Company adopted the authoritative guidance which clarifies thedefinition of fair value, establishes a framework for measuring fair value, andexpands the disclosures on fair value measurements. Fair value is defined asthe exchange price that would be received for an asset or paid to transfer aliability (an exit price) in the principal or most advantageous market for theasset or liability in an orderly transaction between market participants on themeasurement date. The authoritative guidance also establishes a fair valuehierarchy which requires an entity to maximize the use of observable inputs andminimize the use of unobservable inputs when measuring fair value. Three levelsof inputs were established that may be used to measure fair value:

 

Level 1 — Quoted prices in active markets foridentical assets or liabilities.  TheCompany does not have any Level 1 available-for-sale securities as of December 31,2009 or June 30, 2009.

 

Level 2 — Observable inputs other than Level 1 prices,such as quoted prices for similar assets or liabilities; 

 

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quotedprices for identical or similar instruments in markets that are not active; ormodel-derived valuations whose inputs are observable or whose significant valuedrivers are observable. The Company’s Level 2 assets and liabilities primarilyinclude debt securities with quoted prices that are traded less frequently thanexchange-traded instruments, corporate bonds, U.S. government and agencysecurities and certain mortgage-backed and asset-backed securities whose valuesare determined using pricing models with inputs that are observable in themarket or can be derived principally from or corroborated by observable marketdata.  The fair value of the Company’savailable-for-sale securities in the table below are derived solely from Level2 inputs.

 

Level 3 — Unobservable inputs that are supported bylittle or no market activity and that are financial instruments whose valuesare determined using pricing models, discounted cash flow methodologies, orsimilar techniques, as well as instruments for which the determination of fairvalue requires significant judgment or estimation. The Company does not haveany Level 3 available-for-sale securities as of December 31, 2009 or June 30,2009.

 

Ifthe inputs used to measure the financial assets and liabilities fall withinmore than one level described above, the categorization is based on the lowestlevel input that is significant to the fair value measurement of theinstrument.

 

The amortizedcost, gross unrealized gains and losses, and fair value of the Company’savailable-for-sale securities are summarized as follows:

 

December 31, 2009

Available-for-Sale

 
| ** **              | ** ** | **Amortized Cost** | ** ** | **Gross Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
|-------------------------|------------|--------------------|------------|-----------------------------|------------|-------------------------------|------------|----------------|------------|
|                    |       |               |       |                        |       |                          |       |           |       |
| U.S.  Government Agency |       | $                  | 928,910    |                        | $          | 28,209                        |       | $              | —     |   | $ | 957,119 |   |
| Corporate  Bonds        |       | 179,507            |       | 1,956                       |       | —                        |       | 181,463        |       |
|                    |       | $                  | 1,108,417  |                        | $          | 30,165                        |       | $              | —     |   | $ | 1,138,582 |   |

 

June 30, 2009

Available-for-Sale

 
| ** **              | ** ** | **Amortized Cost** | ** ** | **Gross Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
|-------------------------|------------|--------------------|------------|-----------------------------|------------|-------------------------------|------------|----------------|------------|
|                    |       |               |       |                        |       |                          |       |           |       |
| U.S.  Government Agency |       | $                  | 928,910    |                        | $          | 40,352                        |       | $              | —     |   | $ | 969,262 |   |
| Corporate  Bonds        |       | 179,507            |       | 900                         |       | —                        |       | 180,407        |       |
|                    |       | $                  | 1,108,417  |                        | $          | 41,252                        |       | $              | —     |   | $ | 1,149,669 |   |

 

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The amortized costand fair value of the Company’s current available-for-sale securities bycontractual maturity at December 31, 2009 and June 30, 2009 are summarized asfollows:

 
| ** **                              | ** ** | **December 31, 2009**  | ** ** | **June 30, 2009**      | ** ** |
|-----------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                              | ** ** | **Available for Sale** | ** ** | **Available for Sale** | ** ** |
| ** **                              | ** ** | **Amortized**          | ** ** | **Fair**               | ** ** | **Amortized** | ** ** | **Fair** | ** ** |
| ** **                              | ** ** | **Cost**               | ** ** | **Value**              | ** ** | **Cost** | ** ** | **Value** | ** ** |
| Due  in one year or less                |       | $                      | 720,238    |                   | $          | 741,869 |   | $ | 338,159 |   | $ | 347,921 |   |
| Due  after one year through five years  |       | 388,179                |       | 396,713                |       | 770,258 |   | 801,748 |   |
| Due  after five years through ten years |       | —                 |       | —                 |       | — |   | — |   |
| Due  after ten years                    |       | —                 |       | —                 |       | — |   | — |   |
|                                    |       |                   |       |                   |       |   |   |   |   |
| Total  available-for-sale securities    |       | 1,108,417              |       | 1,138,582              |       | 1,108,417 |   | 1,149,669 |   |
| Less  current portion                   |       | 720,238                |       | 741,869                |       | 338,159 |   | 347,921 |   |
|                                    |       |                   |       |                   |       |   |   |   |   |
| Long  term available-for-sale securites |       | $                      | 388,179    |                   | $          | 396,713 |   | $ | 770,258 |   | $ | 801,748 |   |

 

TheCompany uses the specific identification method to determine the cost ofsecurities sold. For the six months ended December 31, 2009, the Company had norealized gains or losses, whereas for the six months ended December 31, 2008,the Company had realized gains of $21,770.

 

Asof December 31, 2009 and June 30, 2009, there were no securities held from asingle issuer that represented more than 10% of shareholders’ equity.  As of December 31, 2009, there were noindividual securities in a continuous unrealized loss position.

 

**Note7. Bank Line of Credit**

** **

The Company has a $3,000,000 line of credit fromWachovia Bank, N.A. (“Wachovia”) that bears interest at the prime interest rateless 0.25% (3.00% at December 31 and June 30, 2009, respectively). As of December31 and June 30, 2009, the Company had $3,000,000 of availability under thisline of credit.  The line of credit is collateralizedby substantially all of the Company’s assets.  The agreement contains covenants with respectto working capital, net worth and certain ratios, as well as othercovenants.  As of December 31, 2009, theCompany was in compliance with all financial covenants under the agreement.

 

Theexisting line of credit, which was scheduled to expire on November 30, 2009,was renewed and extended during the first quarter of Fiscal 2010 to November 30,2010.   As part of the renewal agreement,the Company is no longer required to maintain any minimum deposit balances withWachovia, and the availability fee on the unused balance of the line of creditwas reduced to 0.375%

 

**Note8.  Unearned Grant Funds**

 

InJuly 2004, the Company received $500,000 of grant funding from the Commonwealthof Pennsylvania, acting through the Department of Community and EconomicDevelopment.  The grant funding programrequires the Company to use the funds for machinery and equipment located attheir Pennsylvania locations, hire an additional 100 full-time employees by June30, 2006, operate its Pennsylvania locations a minimum of five years and meetcertain matching investment requirements.  If the Company fails to comply with any of therequirements above, the Company would be liable to repay the full amount of thegrant funding ($500,000).  The Companyhas recorded the unearned grant funds as a liability until the Company complieswith all of the requirements of the grant funding program.  As of December 31, 2009, the Company has hadpreliminary 

 

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discussionswith the Commonwealth of Pennsylvania to determine whether it will be requiredto repay any of the funds provided under the grant funding program.  Based on information available at December 31,2009, the Company has recorded the grant funding as a long-term liability underthe caption of Unearned Grant Funds.

 

**Note9.  Long-Term Debt**

 

Long-term debtconsists of the following:

 
| ** **                                                            | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
|-----------------------------------------------------------------------|------------|------------------|------------|--------------|------------|
| ** **                                                            | ** ** | **2009**         | ** ** | **2009**     | ** ** |
| PIDC Regional Center, LP III loan                                     |       | $                | 4,500,000  |         | $          | 4,500,000 |   |
| Pennsylvania Industrial Development Authority loan                    |       | 965,280          |       | 1,002,607    |       |
| Pennsylvania Department of Community &  Economic Development loan |       | 131,480          |       | 182,831      |       |
| Tax-exempt bond loan (PAID)                                           |       | 680,000          |       | 680,000      |       |
| Equipment loan                                                        |       | —           |       | 80,130       |       |
| First National Bank of Cody mortgage                                  |       | 1,668,684        |       | 1,693,200    |       |
|                                                                  |       |             |       |         |       |
| Total debt                                                            |       | 7,945,444        |       | 8,138,768    |       |
| Less current portion                                                  |       | 359,971          |       | 435,386      |       |
|                                                                  |       |             |       |         |       |
| Long term debt                                                        |       | $                | 7,585,473  |         | $          | 7,703,382 |   |

 

Current Portion of Long TermDebt 

 
| ** **                                                            | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
|-----------------------------------------------------------------------|------------|------------------|------------|--------------|------------|
| ** **                                                            | ** ** | **2009**         | ** ** | **2009**     | ** ** |
| PIDC Regional Center, LP III loan                                     |       | $                | —     |         | $          | — |   |
| Pennsylvania Industrial Development Authority loan                    |       | 76,058           |       | 75,017       |       |
| Pennsylvania Department of Community &  Economic Development loan |       | 104,814          |       | 103,100      |       |
| Tax-exempt bond loan (PAID)                                           |       | 125,000          |       | 125,000      |       |
| Equipment loan                                                        |       | —           |       | 80,130       |       |
| First National Bank of Cody mortgage                                  |       | 54,099           |       | 52,139       |       |
|                                                                  |       |             |       |         |       |
| Total current portion of long term debt                               |       | $                | 359,971    |         | $          | 435,386 |   |

 

The Company financed $4,500,000 through the Philadelphia IndustrialDevelopment Corporation (PIDC). The Company pays a bi-annual interest paymentat a rate equal to two and one-half percent per annum.  The outstanding principal balance is due andpayable on January 1, 2011.

 

The Company financed $1,250,000 through the Pennsylvania IndustrialDevelopment Authority (PIDA).  TheCompany is required to make equal payments each month for 180 months starting February1, 2006 with interest of two and three-quarter percent per annum.

 

An additional $500,000 was financed through the Pennsylvania Departmentof Community and Economic Development Machinery and Equipment Loan Fund.  The Company is required to make equal paymentsfor 60 months starting May 1, 2006 with interest of two and three quarterpercent per annum.

 

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In April 1999, the Company entered into a loan agreement (the “Agreement”)with a governmental authority, the Philadelphia Authority for IndustrialDevelopment (the “Authority” or “PAID”), to finance future construction andgrowth projects of the Company. The Authority issued $3,700,000 in tax-exemptvariable rate demand and fixed rate revenue bonds to provide the funds tofinance such growth projects pursuant to a trust indenture (“the TrustIndenture”).  A portion of the Company’sproceeds from the bonds was used to pay for bond issuance costs ofapproximately $170,000.  The TrustIndenture requires that the Company repay the Authority loan throughinstallment payments beginning in May 2003 and continuing through May 2014, theyear the bonds mature. The bonds bear interest at the floating variable ratedetermined by the organization responsible for selling the bonds (the “remarketingagent”).  The interest rate fluctuates ona weekly basis.  The effective interestrate at December 31, 2009 and June 30, 2009 was 0.47% and 0.62%, respectively.

 

TheCompany entered into agreements (the “2003 Loan Financing”) with Wachovia tofinance the purchase of the Torresdale Avenue facility, the renovation andsetup of the building, and other anticipated capital expenditures.  The Company, as part of the 2003 LoanFinancing agreement, is required to make equal payments of principal andinterest.  The only portion of the loanthat remained outstanding at June 30, 2009 was the Equipment Loan, which had anoutstanding balance of $80,130 at June 30, 2009.  This loan was fully repaid as of December 31,2009.

 

Theexisting line of credit, which was scheduled to expire on November 30, 2009,was renewed and extended during the first quarter of Fiscal 2010 to November 30,2010.   As part of the renewal agreement,the Company is no longer required to maintain any minimum deposit balances withWachovia, and the availability fee on the unused balance of the line of creditwas reduced to 0.375%

 

The Company has executed Security Agreements with Wachovia, PIDA and PIDCin which the Company has agreed to pledge substantially all of its assets tocollateralize the amounts due.

 

Aspart of the Cody acquisition, the Company became primary beneficiary to avariable interest entity (“VIE”) called Cody LCI Realty, LLC.  See Note 16, Consolidation of VariableInterest Entity for additional description.  The VIE owns land and a building which isbeing leased to Cody.  A mortgage loanwith First National Bank of Cody has been consolidated in the Company’sfinancial statements, along with the related land and building.  Principal and interest payments of $14,782, ata fixed interest rate of 7.5%, are being made on a monthly basis through June 2026. The mortgage loan is collateralized bythe land and building.

 

Long-termdebt amounts due, for the twelve month periods ended December 31 are asfollows:

 
| **Twelve**        | ** ** | **Amounts Payable** | ** ** |
|-------------------|------------|---------------------|------------|
| **Month Periods** | ** ** | **to Institutions** | ** ** |
|              |       |                |       |
| 2010              |       | $                   | 359,971    |   |
| 2011              |       | 4,793,268           |       |
| 2012              |       | 275,071             |       |
| 2013              |       | 287,222             |       |
| 2014              |       | 259,749             |       |
| Thereafter        |       | 1,970,163           |       |
|              |       |                |       |
|              |       | $                   | 7,945,444  |   |

 

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**Note10.  Contingencies**

** **

On March 17, 2009, theCompany and KV Pharmaceuticals, DrugTech Corp., and Ther-Rx Corp (collectively “KV”)settled their outstanding litigation. Pursuant to the settlement, the Company received a license from KV andbecame an authorized generic provider regarding its Prenatal vitamin product.  During the terms of the license, the Companywill pay KV a royalty on all future sales of its Prenatal vitamin product.  Lannett will cease offering its Prenatalvitamin product if and when the brand is restored to the marketplace.

 

**Note11.   Commitments**

** **

***Leases***

 

**In June 2006, Lannett signed a lease agreement on a 66,000square foot facility located on seven acres in Philadelphia.  The Company purchased this building in October2009 for approximately $3.8 million plus the cost of fit out.  A significant portion of the purchase priceand fit out costs are expected to be financed through a series of loans with abank and a Pennsylvania state run development agency by the third quarter ofFiscal 2010.  This new facility isinitially going to be used for warehouse space with the expectation of makingthis facility the Company’s headquarters and possibly additional manufacturingspace.  The other Philadelphia locationswill continue to be utilized for manufacturing, packaging, and research.**

** **

**Lannett’s subsidiary, Cody leases a 73,000 square footfacility in Cody, Wyoming.  This locationhouses Cody’s manufacturing and production facilities. Cody leases the facilityfrom Cody LCI Realty, LLC, a Wyoming limited liability company which is 50%owned by Lannett.   See Note 16.**

** **

**Rental and lease expense for the three months ended December31, 2009 and 2008 was approximately $23,000 and $115,000, respectively.  Rental and lease expense for the six monthsended December 31, 2009 and 2008 was approximately $105,000 and $225,000,respectively.**

** **

***Employment Agreements***

 

TheCompany has entered into employment agreements with Arthur P. Bedrosian,President and Chief Executive Officer, Keith R. Ruck, Vice President of Financeand Chief Financial Officer, Kevin Smith, Vice President of Sales andMarketing, William Schreck, Senior Vice President and General Manager, ErnestSabo, Vice President of Regulatory Affairs and Chief Compliance Officer, andStephen Kovary, Vice President of Operations.  Each of the agreements provide for an annualbase salary and eligibility to receive a bonus.  The bonus amounts of these executives aredetermined by the Board of Directors.  Additionally, these executives are eligible toreceive stock options and restricted stock awards, which are granted at thediscretion of the Board of Directors, and in accordance with the Company’spolicies regarding stock option and restricted stock grants.  Under the agreements, these executiveemployees may be terminated at any time with or without cause, or by reason ofdeath or disability.  In certaintermination situations, the Company is liable to pay severance compensation tothese executives of between 18 months and three years.

 

Duringthe third quarter of Fiscal Year 2009, the Company’s former Vice President ofFinance, Treasurer, Secretary and Chief Financial Officer resigned.  As part of his separation agreement, theCompany is obligated to pay to him approximately $670,000 to settle anyoutstanding obligations from his employment agreement, including any salary,bonus, vacation, stock options and medical benefits.  Of this amount, $300,440 was paid in Fiscal2009 with $165,000 designated for the payment of pro rated bonus, and $11,440was designated for the payment of accrued but unused paid time off.  As part of the settlement, $124,000 was designatedas the portion of the settlement related to the repurchase of his outstandingstock options. The Company therefore charged this amount to Additional Paid inCapital, as it represents the fair value of the options repurchased on therepurchase date.  Additional payments 

 

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totalingapproximately $369,000 for severance and benefits will be paid in Fiscal 2010and Fiscal 2011 pursuant to the separation agreement.

 

**Note12.  Comprehensive Income**

 

The Company’sother comprehensive income is comprised of unrealized gains (losses) oninvestment securities classified as available-for-sale as well as foreigncurrency translation adjustments.  Thecomponents of comprehensive income and related taxes consisted of thefollowing:

 
| ** **                                   | ** ** | **For the Three Months Ended  December 31,** | ** ** | **For the Six Months Ended  December 31,** | ** ** |
|----------------------------------------------|------------|----------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                   | ** ** | **2009**                                     | ** ** | **2008**                                   | ** ** | **2009** | ** ** | **2008** | ** ** |
|                                         |       |                                         |       |                                       |       |   |   |   |   |
| Net Income                                   |       | $                                            | 54,592     |                                       | $          | 1,573,062 |   | $ | 2,911,962 |   | $ | 2,799,227 |   |
| Foreign currency translation adjustments     |       | 10,899                                       |       | —                                     |       | 10,899 |   | — |   |
| Unrealized Holding (Loss) Gain on Securities |       | (7,336                                       | )          | 57,876                                     |       | (11,087 | ) | 65,669 |   |
| Tax effect                                   |       | 2,935                                        |       | (23,150                                    | )          | 4,435 |   | (26,268 | ) |
|                                         |       |                                         |       |                                       |       |   |   |   |   |
| Total Other Comprehensive Income             |       | 6,498                                        |       | 34,726                                     |       | 4,247 |   | 39,401 |   |
|                                         |       |                                         |       |                                       |       |   |   |   |   |
| Total Comprehensive Income                   |       | $                                            | 61,090     |                                       | $          | 1,607,788 |   | $ | 2,916,209 |   | $ | 2,838,628 |   |

 

**Note 13.   Employee Benefit Plan**

 

TheCompany has a defined contribution 401k plan (the “Plan”) covering substantiallyall employees.  Pursuant to the Planprovisions, the Company is required to make matching contributions equal to 50%of each employee’s contribution, but not to exceed 4% of the employee’scompensation for the Plan year.  Contributions to the Plan during the threemonths ended December 31, 2009 and 2008 were $62,000 and $75,000,respectively.  For the six months ended December31, 2009 and 2008, contributions to the Plan were $215,000 and $163,000,respectively.

 

**Note 14.   Employee Stock Purchase Plan**

 

InFebruary 2003, the Company’s shareholders approved an Employee Stock PurchasePlan (“ESPP”).  Employees eligible toparticipate in the ESPP may purchase shares of the Company’s stock at 85% ofthe lower of the fair market value of the common stock on the first day of thecalendar quarter, or the last day of the calendar quarter.  Under the ESPP, employees can authorize theCompany to withhold up to 10% of their compensation during any quarterlyoffering period, subject to certain limitations.  The ESPP was implemented on April 1, 2003 andis qualified under Section 423 of the Internal Revenue Code.  The Board of Directors authorized an aggregatetotal of 1,125,000 shares of the Company’s common stock for issuance under theESPP.  As of December 31, 2009, 191,224shares have been issued under the ESPP.  Compensation expense of $11,636 and $4,701 hasbeen recognized for the three months ended December 31, 2009 and 2008,respectively, relating to the ESPP. Compensation expense of $33,076 and $31,292has been recognized for the six months ended December 31, 2009 and 2008,respectively, relating to the ESPP.

 

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**Note 15.  Income Taxes**

 

TheCompany uses the liability method to account for income taxes.  Deferred tax assets and liabilities aredetermined based on the difference between the financial statement and taxbases of assets and liabilities as measured by the enacted tax rates which willbe in effect when these differences reverse. Deferred tax expense/(benefit) is the result of changes in deferred taxassets and liabilities.

 

The provision forfederal, state and local income taxes for the three months ended December 31,2009 and 2008 was tax expense of approximately $1,170,000 and $925,000,respectively, with effective tax rates of 95% and 37%, respectively. Theprovision for federal, state and local income taxes for the six months ended December31, 2009 and 2008 was tax expense of approximately $2,998,000 and $1,845,000,respectively, with effective tax rates of 51% and 40%, respectively.  The effective tax rate for the three and sixmonths ended December 31, 2009 was a higher effective tax rate compared to thethree and six months ended December 31, 2008 due primarily to a change inPennsylvania tax law which lowered the Company’s apportionment factor withinthis state.  The impact of this changecaused the Company to reduce its deferred tax assets by approximately $650,000,and therefore increased the effective tax rate by 11% for the six months ended December31, 2009.  The Company expects itsoverall effective tax rate will be approximately 45% for the full year ended June30, 2010.

 

TheCompany may recognize the tax benefit from an uncertain tax position claimed ona tax return only if it is more likely than not that the tax position will besustained on examination by the taxing authorities, based on the technicalmerits of the position.  The tax benefitsrecognized in the financial statements from such a position should be measuredbased on the largest benefit that has a greater than 50% likelihood of beingrealized upon ultimate settlement. The authoritative standards issued by theFASB also provide guidance on de-recognition, classification, interest andpenalties on income taxes, accounting in interim periods and requires increaseddisclosures.

 

Asof December 31, 2009 and June 30, 2009, the Company reported total unrecognizedbenefits of $297,663, all of which would affect the Company’s effective taxrate if recognized.  As a result of thepositions taken during the period, the Company has not recorded any interestand penalties for the period ended December 31, 2009 in the statement ofoperations and no cumulative interest and penalties have been recorded eitherin the Company’s statement of financial position as of December 31, 2009 and June30, 2009. The Company will recognize interest accrued on unrecognized taxbenefits in interest expense and any related penalties in operatingexpenses.  The Company does not believethat the total unrecognized tax benefits will significantly increase ordecrease in the next twelve months.

 

The Company files income tax returns in theUnited States federal jurisdiction, Pennsylvania, New Jersey and California.  The Company’s tax returns for Fiscal 2005 andprior generally are no longer subject to review as such years generally areclosed. The Company is currently undergoing a review of its federal income taxreturn for Fiscal 2008 by the IRS.  TheCompany believes that an unfavorable resolution for open tax years would not bematerial to the financial position of the Company.

 

**Note 16.Consolidation of Variable Interest Entity**

 

Lannettconsolidates any Variable Interest Entity (“VIE”) of which it is the primarybeneficiary. The liabilities recognized as a result of consolidating a VIE donot represent additional claims on our general assets; rather, they representclaims against the specific assets of the consolidated VIE. Conversely, assetsrecognized as a result of consolidating a VIE do not represent additionalassets that could be used to satisfy claims against our general assets.Reflected in the December 31, 2009 and June 30, 2009 balance sheets areconsolidated VIE assets of approximately $1.9 million and $1.9 million, whichare comprised mainly of land and building. VIE liabilities consist of amortgage on that property in the amount of approximately $1.7 and $1.7 millionat December 31, 2009 and June 30, 2009, respectively.

 

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CodyLCI Realty LLC (“Realty”) is the only VIE that is consolidated.  Realty had been consolidated by Cody prior toits acquisition by Lannett.  Realty is a50/50 joint venture with a former shareholder of Cody.  Its purpose was to acquire the facility usedby Cody.  Until the acquisition of Cody inApril 2007, Lannett had not consolidated the VIE because Cody Labs had been theprimary beneficiary of the VIE.  Therisks associated with our interests in this VIE is limited to a decline in thevalue of the land and building as compared to the balance of the mortgage noteon that property, up to Lannett’s 50% share of the venture.  Realty owns the land and building, and Codyleases the building and property from Realty for $20,000 per month effective October2009.  All intercompany rent expense iseliminated upon consolidation with Cody.

 

TheCompany is not involved in any other VIE.

 

**Note17.  Related Party Transactions**

 

TheCompany had sales of approximately $428,000 and $384,000 during the six monthsended December 31, 2009 and 2008, respectively, to a generic distributor,Auburn Pharmaceutical Company.  Sales toAuburn Pharmaceutical Company for the three months ended December 31, 2009 and2008 were $215,000 and $217,000, respectively. Jeffrey Farber (the “related party”), who is a current board member andthe son of the Chairman of the Board of Directors and principal shareholder ofthe Company, is the owner of Auburn Pharmaceutical Company.  Accounts receivable includes amounts due fromthe related party of approximately $83,000 and $125,000 at December 31, 2009and June 30, 2009, respectively.  In theCompany’s opinion, the terms of these transactions were not more favorable tothe related party than would have been to a non-related party.

 

In January 2005, Lannett Holdings, Inc. entered into anagreement in which the Company purchased for $100,000 and future royaltypayments the proprietary rights to manufacture and distribute a product forwhich Pharmeral, Inc. owned the ANDA.  InFiscal 2008, the Company obtained FDA approval to use the proprietaryrights.  Accordingly, the Companyoriginally capitalized these rights as an indefinite lived intangible asset andtested this asset for impairment at least on an annual basis.  During the fourth quarter of Fiscal 2009, itwas determined that this intangible asset no longer has an indefinitelife.  No impairment existed because theestimated fair value exceeded the carrying amount on that date. Accordingly,the $100,000 carrying amount of this intangible asset is being amortized on astraight line basis prospectively over its 10 year remaining estimated usefullife.

 

Arthur Bedrosian, President and Chief Executive Officer,currently owns 100% of Pharmeral, Inc. This transaction was approved by the Board of Directors of the Companyand in their opinion the terms were not more favorable to the related partythan they would have been to a non-related party. In May 2008, Mr. Bedrosianand Pharmeral waived their rights to any royalty payments on the sales of thedrug by Lannett under Lannett’s current ownership structure.  Should Lannett undergo a change in controltransaction with a third party, this royalty would be reinstated.

 

ProvellPharmaceuticals, LLC (“Provell”) is a joint venture to distributepharmaceutical products through mail order outlets.  In exchange for access to Lannett’s drugproviders, Lannett initially received a 33% ownership interest in thisventure.  Lannett’s ownership interestsubsequently decreased to 25% due to the additional issuance of shares byProvell in which Lannett did not participate. The investment is valued at zero, due to losses incurred to date byProvell.  During June 2009, the Companyterminated its participation in this joint venture. In connection with thetermination agreement, the Company is required to pay Provell ten percent ofnet sales of certain products for a period of up to twenty four months.

 

Accountsreceivable includes amounts due from Provell of zero and approximately $55,000at December 31, 2009 and June 30, 2009, respectively. The Company recognizedrevenues from Provell of approximately $311,000 and $386,000, respectively,during the three and six months ended December 31, 2008.

 

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**Note 18.  Material Contract withSupplier**

 

JeromeStevens Pharmaceuticals agreement:

 

TheCompany’s primary finished product inventory supplier is Jerome StevensPharmaceuticals, Inc. (“JSP”), in Bohemia, New York.  Purchases of finished goods inventory fromJSP accounted for approximately 76% and 71% of the Company’s inventorypurchases during the three and six month periods ended December 31, 2009 and65% and 69% during the three and six month periods ended December 31, 2008,respectively.   On March 23, 2004,****the Company entered into an agreement with JSP for theexclusive distribution rights in the United States to the current line of JSPproducts, in exchange for four million (4,000,000) shares of the Company’scommon stock.  The JSP products coveredunder the agreement included Butalbital, Aspirin, Caffeine with CodeinePhosphate capsules, Digoxin tablets and Levothyroxine Sodium tablets, soldgenerically and under the brand name Unithroid®.  The term of the agreement is ten years,beginning on March 23, 2004 and continuing through March 22, 2014.  Both Lannett and JSP have the right toterminate the contract if one of the parties does not cure a material breach ofthe contract within thirty (30) days of notice from the non-breaching party.

 

Duringthe term of the agreement, the Company is required to use commerciallyreasonable efforts to purchase minimum dollar quantities of JSP’s productsbeing distributed by the Company.  Theminimum quantity to be purchased in the first year of the agreement is $15million.  Thereafter, the minimumquantity to be purchased increases by $1 million per year up to $24 million forthe last year of the ten-year contract. The Company has met the minimum purchase requirement for the first fiveyears of the contract, but there is no guarantee that the Company will be ableto continue to do so in the future. If the Company does not meet the minimumpurchase requirements, JSP’s sole remedy is to terminate the agreement.

 

Underthe agreement, JSP is entitled to nominate one person to serve on the Company’sBoard of Directors (the “Board”) provided, however, that the Board shall havethe right to reasonably approve any such nominee in order to fulfill itsfiduciary duty by ascertaining that such person is suitable for membership onthe board of a publicly traded corporation. Suitability is determined by, butnot limited to, the requirements of the Securities and Exchange Commission, theAmerican Stock Exchange, and other applicable laws, including theSarbanes-Oxley Act of 2002.  As of December31, 2009, JSP has not exercised the nomination provision of the agreement.

 

TheCompany’s financial condition, as well as its liquidity resources, are verydependent on an uninterrupted supply of product from Jerome Stevens.  Should there be an interruption in the supplyof product from Jerome Stevens for any reason, this event would have a materialimpact to the financial condition of Lannett.

 

**Note 19.  Subsequent Events**

 

In May2009, the FASB issued authoritative guidance which defines the period after thebalance sheet date during which a reporting entity’s management should evaluateevents or transactions that may occur for potential recognition or disclosurein the financial statements.  The Companyadopted this authoritative guidance effective with its financial statements asof and for the year ended June 30, 2009. In preparing these financialstatements, the Company has evaluated events and transactions for potentialrecognition or disclosure through February 11, 2010, the date the financialstatements were issued.

 

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**ITEM 2.*       *MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.**

 

***Introduction***

 

The following informationshould be read in conjunction with the consolidated financial statements andnotes in Part I, Item 1 of this Quarterly Report and with Management’sDiscussion and Analysis of Financial Condition and Results of Operationscontained in the Company’s Annual Report on Form 10-K for the fiscal yearended June 30, 2009.

 

ThisReport on Form 10-Q and certain information incorporated herein byreference contain forward-looking statements which are not historical factsmade pursuant to the “safe harbor” provisions of the Private Securities LitigationReform Act of 1995. Forward-looking statements are not promises or guaranteesand investors are cautioned that all forward-looking statements involve risksand uncertainties, including but not limited to the impact of competitiveproducts and pricing, product demand and market acceptance, new productdevelopment, the regulatory environment, including without limitation, relianceon key strategic alliances, availability of raw materials, fluctuations inoperating results and other risks detailed from time to time in the Company’sfilings with the Securities and Exchange Commission. These statements are basedon management’s current expectations and are naturally subject to uncertaintyand changes in circumstances. We caution you not to place undue reliance uponany such forward-looking statements which speak only as of the date made.Lannett is under no obligation to, and expressly disclaims any such obligationto, update or alter its forward-looking statements, whether as a result of newinformation, future events or otherwise.

 

***Critical Accounting Policies***

 

Thediscussion and analysis of our financial condition and results of operationsare based upon our consolidated financial statements, which have been preparedin accordance with accounting principles generally accepted in the UnitedStates of America. The preparation of these financial statements requires us tomake estimates and judgments that affect the reported amount of assets andliabilities, revenues and expenses, and related disclosure of contingent assetsand liabilities at the date of our financial statements. Actual results maydiffer from these estimates under different assumptions or conditions.

 

Critical accounting policies are defined as those that are reflectiveof significant judgments and uncertainties, and potentially result inmaterially different results under different assumptions and conditions.  We believe that our critical accountingpolicies include those described below.

 

***Consolidation of Variable Interest Entity*** — The Companyconsolidates any Variable Interest Entity (“VIE”) of which we are the primarybeneficiary. The liabilities recognized as a result of consolidating a VIE donot represent additional claims on our general assets; rather, they representclaims against the specific assets of the consolidated VIE. Conversely, assetsrecognized as a result of consolidating a VIE do not represent additionalassets that could be used to satisfy claims against our general assets.  Reflected in the December 31, 2009 and June 30,2009 balance sheets are consolidated VIE assets of approximately $1.9 millionand $1.9 million, respectively, which is comprised mainly of land and abuilding. VIE liabilities consist of a mortgage on that property in the amountof approximately $1.7 and $1.7 million at December 31, 2009 and June 30,2009, respectively. This VIE was initially consolidated by Cody, as Cody hasbeen the primary beneficiary.  Cody has then been consolidated withinLannett’s financial statements since its acquisition in April 2007.

 

***Revenue Recognition*** — The Company recognizesrevenue when its products are shipped.  At this point, title and risk ofloss have transferred to the customer and provisions for rebates, promotionaladjustments, price adjustments, returns, chargebacks, and other potentialadjustments are reasonably determinable.  Accruals for these provisionsare presented in the consolidated financial statements as rebates, chargebacksand returns 

 

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payable and as reductions tonet sales. The change in the reserves for various sales adjustments may not beproportionally equal to the change in sales because of changes in both theproduct and the customer mix. Increased sales to wholesalers will generallyrequire additional accruals as they are the primary recipient of chargebacksand rebates. Incentives offered to secure sales vary from product to product.Provisions for estimated rebates and promotional credits are estimated basedupon contractual terms.  Provisions for other customer credits, such asprice adjustments, returns, and chargebacks, require management to makesubjective judgments on customer mix. Unlike branded innovator drug companies,Lannett does not use information about product levels in distribution channelsfrom third-party sources, such as IMS and Wolters Kluwer, in estimating futurereturns and other credits. Lannett calculates a chargeback/rebate rate based oncontractual terms with its customers and applies this rate to customersales.  The only variable is customer mix, and this assumption is based onhistorical data and sales expectations.  The chargeback/rebate reserve isreviewed on a monthly basis by management using several ratios and calculatedmetrics.  As we continue to obtain additional information about ourhistorical experience for chargebacks, rebates and returns, we also update ourestimates of the required reserves.

 

***Chargebacks***— The provision for chargebacks is the mostsignificant and complex estimate used in the recognition of revenue.  TheCompany sells its products directly to wholesale distributors, genericdistributors, retail pharmacy chains, and mail-order pharmacies.  TheCompany also sells its products indirectly to independent pharmacies, managedcare organizations, hospitals, nursing homes, and group purchasingorganizations, collectively referred to as “indirect customers.”  Lannettenters into agreements with its indirect customers to establish pricing forcertain products.  The indirect customers then independently select awholesaler from which to actually purchase the products at these agreed-uponprices.  Lannett will provide credit to the wholesaler for the differencebetween the agreed-upon price with the indirect customer and the wholesaler’sinvoice price if the price sold to the indirect customer is lower than thedirect price to the wholesaler.  This credit is called a chargeback. The provision for chargebacks is based on expected sell-through levels by theCompany’s wholesale customers to the indirect customers and estimatedwholesaler inventory levels.  As sales by the Company to the largewholesale customers, such as Cardinal Health, AmerisourceBergen, and McKesson,increase, the reserve for chargebacks will also generally increase. However, the size of the increase depends on the expected mix of product salesto the indirect customers. The Company continually monitors the reserve forchargebacks and makes adjustments when management believes that expectedchargebacks on actual sales may differ from the amounts that were assumed inthe establishment of the chargeback reserves.

 

***Rebates***— Rebates areoffered to the Company’s key chain drug store and wholesaler customers topromote customer loyalty and increase product sales.  These rebateprograms provide customers with rebate credits upon attainment ofpre-established volumes or attainment of net sales milestones for a specifiedperiod.  Other promotional programs are incentive programs offered to thecustomers.  At the time of shipment, the Company estimates reserves forrebates and other promotional credit programs based on the specific terms ineach agreement.  The reserve for rebates increases as sales to rebate-eligiblecustomers are recognized and decreases when actual rebate payments aremade.  However, since rebate programs are not identical for all customers,the size of the reserve will depend on the mix of sales to customers that areeligible to receive rebates.

 

***Returns —***Consistent withindustry practice, the Company has a product returns policy that allows certaincustomers to return product within a specified period prior to and subsequentto the product’s lot expiration date in exchange for a credit to be applied tofuture purchases.  The Company’s policy requires that the customer obtainpre-approval from the Company for any qualifying return.  The Companyestimates its provision for returns based on historical experience, adjustedfor any changes in business practices or conditions that would cause managementto believe that future product returns may differ from those returns assumed inthe establishment of reserves.  Generally, the reserve for returnsincreases as sales increase and decrease when credits are issued or paymentsare made for actual returns received.  The reserve for returns is includedin the rebates, chargebacks and returns payable account on the balance sheet.

 

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***Other Adjustments —***Other adjustments consist primarily ofprice adjustments, also known as “shelf stock adjustments,” which are creditsissued to reflect decreases in the selling prices of the Company’s productsthat customers have remaining in their inventories at the time of a pricereduction.  Decreases in selling prices are discretionary decisions madeby management to reflect competitive market conditions.  Amounts recordedfor estimated shelf stock adjustments are based upon specified terms withdirect customers, estimated declines in market prices, and estimates ofinventory held by customers.  The Company regularly monitors these andother factors and evaluates the reserve as additional information becomesavailable.  Other adjustments are included in the rebates, chargebacks andreturns payable account on the balance sheet.  When competitors enter themarket for existing products, shelf stock adjustments may be issued to maintainprice competitiveness.

 

The following tables identify the reserves for eachmajor category of revenue allowance and a summary of the activity for the threemonths ended December 31, 2009 and 2008:

 

**Forthe six months ended December 31, 2009**

 
| **Reserve Category**                                                                        | ** ** | **Chargebacks** | ** ** | **Rebates** | ** ** | **Returns** | ** ** | **Other** | ** ** | **Total**   | ** ** |
|---------------------------------------------------------------------------------------------|------------|-----------------|------------|-------------|------------|-------------|------------|-----------|------------|-------------|------------|
| Reserve  Balance as of June 30, 2009                                                   |       | $               | 6,089,802  |        | $          | 2,537,746   |       | $         | 5,106,992  |        | $          | — |   | $ | 13,734,540 |   |
| Actual  credits issued related to sales recorded in prior fiscal years                      |       | (5,045,921      | )          | (2,455,912  | )          | (2,336,002  | )          | —    |       | (9,837,835  | )          |
| Reserves  or (reversals) charged during Fiscal 2010 related to sales in prior fiscal  years |       | —          |       | —      |       | —      |       | —    |       | —      |       |
| Reserves  charged to net sales during Fiscal 2010 related to sales recorded in Fiscal  2010 |       | 22,373,840      |       | 9,050,542   |       | 2,649,924   |       | 608,323   |       | 34,682,629  |       |
| Actual  credits issued related to sales recorded in Fiscal 2010                             |       | (17,840,184     | )          | (5,847,204  | )          | —      |       | (608,323  | )          | (24,295,711 | )          |
| Reserve  Balance as of December 31, 2009                                               |       | $               | 5,577,537  |        | $          | 3,285,172   |       | $         | 5,420,914  |        | $          | — |   | $ | 14,283,623 |   |

 

**Forthe six months ended December 31, 2008**

 
| **Reserve Category**                                                                        | ** ** | **Chargebacks** | ** ** | **Rebates** | ** ** | **Returns** | ** ** | **Other** | ** ** | **Total**   | ** ** |
|---------------------------------------------------------------------------------------------|------------|-----------------|------------|-------------|------------|-------------|------------|-----------|------------|-------------|------------|
| Reserve  Balance as of June 30, 2008                                                   |       | $               | 4,049,407  |        | $          | 632,314     |       | $         | 13,642,589 |        | $          | 2,107 |   | $ | 18,326,417 |   |
| Actual  credits issued related to sales recorded in prior fiscal years                      |       | (3,635,348      | )          | (428,739    | )          | (10,428,254 | )          | —    |       | (14,492,341 | )          |
| Reserves  or (reversals) charged during Fiscal 2009 related to sales in prior fiscal  years |       | —          |       | —      |       | 2,107       |       | (2,107    | )          | —      |       |
| Reserves  charged to net sales during Fiscal 2009 related to sales recorded in Fiscal  2009 |       | 16,588,951      |       | 5,662,865   |       | 2,146,732   |       | 140,828   |       | 24,539,376  |       |
| Actual  credits issued related to sales recorded in Fiscal 2009                             |       | (12,105,256     | )          | (4,138,238  | )          | —      |       | (125,928  | )          | (16,369,422 | )          |
| Reserve  Balance as of December 31, 2008                                               |       | $               | 4,897,754  |        | $          | 1,728,202   |       | $         | 5,363,174  |        | $          | 14,900 |   | $ | 12,004,030 |   |

 

The total reserve for chargebacks, rebates, returns and otheradjustments increased from $13,734,540 at June 30, 2009 to $14,283,623 at December 31,2009.   As of December 31, 2009 approximately $10,058,000of the original $10,545,000 return reserve recorded in Fiscal 2008 for PrenatalMultivitamin was applied to accounts receivable for customers who had returnedthe Prenatal Multivitamin product by that date, leaving a balance ofapproximately $487,000 of Multivitamin returns reserve on the consolidatedbalance sheet at December 31, 2009. The increase in reserves was due to anincrease in the rebates reserve as a result of the timing of credits beingprocessed by the customers and by the Company, and partially offset by a decreasein chargeback reserves due primarily to a decrease in inventory levels atwholesaler distribution centers.

 

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Credits issued during the quarter that relate to prior year sales arecharged against the opening balance.  Inaggregate, additional reserves or reversals of reserves have historicallyoffset each other.  The table above showsthe effects of reversals within the rebates, returns and other categories.  It is the Company’s intention that allreserves be charged to sales in the period that the sale is recognized,however, due to the nature of this estimate, it is possible that the Companymay sometimes need to increase or decrease the reserve based on prior periodsales.  If that were to occur, managementwould disclose that information at that time. If the historical data the Company uses and the assumptions managementmakes to calculate its estimates of future returns, chargebacks, and othercredits do not accurately approximate future activity, its net sales, grossprofit, net income and earnings per share could change.  However, management believes that these estimatesare reasonable based upon historical experience and current conditions.

 

The rates of reserves will vary, as well as the category under whichthe credit falls.  This variability comesabout when the Company is working with indirect customers to compete with thepricing of other generic companies.  TheCompany has improved its computer systems in order to improve the accuracy oftracking and processing chargebacks and rebates and will continue to look atways for further improvements. Improvements to automate calculation of reserves will not only reducethe potential for human error, but also will result in more in-depth analysisand improved customer interaction for resolution of open credits.

 

The rate of credits issued is monitored by the Company at least on aquarterly basis.  The Company may changethe estimate of future reserves based on the amount of credits processed, orthe rate of sales made to indirect customers.  The increase of reserves to $14,283,623 at December 31, 2009 from$13,734,540 at June 30, 2009 is due to the timing of credits beingprocessed by the customers and by the Company. Approximately $9,838,000 or 72% of the reserve balance from June 30,2009 has been processed through the first six months of Fiscal 2010.  Approximately $341,000 of that amount relatesto credits issued due to the return by customers of the Prenatal Multivitaminproduct through December 31, 2009. Management estimates reserves based on sales mix.  A comparison to wholesaler inventory reportsis performed quarterly, in order to justify the balance of unclaimedchargebacks and rebates.  The Company hashistorically found a direct correlation between the calculation of the reservebased on sales mix, and the wholesaler inventory analysis.

 

***Accounts Receivable******—*** The Company performs ongoingcredit evaluations of its customers and adjusts credit limits based uponpayment history and the customer’s current credit worthiness, as determined bya review of current credit information. The Company continuously monitorscollections and payments from its customers and maintains a provision forestimated credit losses based upon historical experience and any specificcustomer collection issues that have been identified. While such credit losseshave historically been within both the Company’s expectations and theprovisions established, the Company cannot guarantee that it will continue toexperience the same credit loss rates that it has in the past.

 

**The Company also regularlymonitors accounts receivable (“AR”) balances by reviewing both net and grossday’s sales outstanding (“DSO”).  Net DSOis calculated by dividing gross accounts receivable less the reserve forrebates, chargebacks, returns and other adjustments by the average daily netsales for the period.  Gross DSO showsthe result of the same calculation without regard to rebates, chargebacks,returns and other adjustments.**

** **

**The Company monitors both net DSOand gross DSO as an overall check on collections and to assess thereasonableness of the reserves. Gross DSO provides management with anunderstanding of the frequency of customer payments, and the ability to processcustomer payments and deductions.  Thenet DSO calculation provides management with an understanding of therelationship of the AR balance net of the reserve liability compared to net salesafter charges to the reserves during the period.  Standard payment terms offered to customersare consistent with industry practice at 60 days.   Net DSO eliminates the effect of timing ofprocessing, which is inherent in the gross DSO calculation.**

 

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**The following table shows theresults of these calculations as of the relevant periods:**

 
| ** **          | ** ** | **12/31/09** | ** ** | **6/30/09** | ** ** | **12/31/08** | ** ** |
|---------------------|------------|--------------|------------|-------------|------------|--------------|------------|
| Net DSO (in days)   |       | 64           |       | 55          |       | 54           |       |
| Gross DSO (in days) |       | 56           |       | 53          |       | 60           |       |

 

The level of net DSO at December 31, 2009is within the Company’s expectation that DSO will be in the 60 to 70 day rangebased on 60 day payment terms for most customers.  The Gross DSO is slightly below the 60 to 70day range due mainly to the timing of customer receipts.

 

***Inventories****—*The Company values its inventory at the lower of cost (determined by thefirst-in, first-out method) or market, regularly reviews inventory quantitieson hand, and records a provision for excess and obsolete inventory basedprimarily on estimated forecasts of product demand and productionrequirements.  The Company’s estimates offuture product demand may prove to be inaccurate, in which case it may haveunderstated or overstated the provision required for excess and obsoleteinventory. In the future, if the Company’s inventory is determined to beovervalued, the Company would be required to recognize such costs in cost ofgoods sold at the time of such determination. Likewise, if inventory isdetermined to be undervalued, the Company may have recognized excess cost ofgoods sold in previous periods and would be required to recognize suchadditional operating income at the time of sale.

 

***Resultsof Operations - Three months ended December 31, 2009 compared with threemonths ended December 31, 2008***

 

Net sales for the threemonths ended December 31, 2009 (“Fiscal 2010”) decreased 2% to $28,717,000from $29,224,000 for the three months ended December 31, 2008 (“Fiscal2009”). The $507,000 decrease was primarily due to a decrease of$2,992,000 in sales of our prescription vitamins during the second quarter ofFiscal 2010 compared to the same period in Fiscal 2009.  The following factors also contributed to theoverall decrease in sales:

 
| **Medical  indication** | ** ** | **Sales volume  change %** | ** ** | **Sales price  change %** | ** ** |
|-------------------------|------------|----------------------------|------------|---------------------------|------------|
| Heart Failure           |       | -13                        | %          | 7                         | %          |
| Antibiotics             |       | 21                         | %          | -15                       | %          |
| Epilepsy                |       | -3                         | %          | 116                       | %          |
| Thyroid Deficiency      |       | 11                         | %          | - 3                       | %          |
| Pain Management         |       | 151                        | %          | 32                        | %          |
| Migraine Headache       |       | -7                         | %          | 9                         | %          |

 

Theoverall decrease in product sales can be attributed to the changes withinseveral of our product categories, but is primarily related to the decrease insales of our prescription vitamins discussed above.  In addition, sales of drugs for the treatmentof congestive heart failure decreased by approximately $420,000 in the secondquarter of Fiscal 2010 compared to the second quarter of Fiscal 2009.  This decrease was due to a prior year productrecall experienced by several of our major competitors which increased oursecond quarter of Fiscal 2009 revenues. Partially offsetting these decreaseswere increases in sales of drugs used in the treatment of thyroid deficiencywhich increased by approximately $882,000 as a result of a continued shift awayfrom branded drugs towards generic prescriptions.  Sales of drugs used for pain management alsoincreased by approximately $659,000 for the three months ended December 31,2009 compared to December 31, 2008 due to a market withdrawal by one 

 

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ofour major competitors.  Additional salescan also be attributed to new drugs used in the treatment of gallstonestotaling approximately $500,000.

 

TheCompany expects to continue increasing the number of products available forsale to its customers, which will require additional FDA approvals. The Company’sreceipt of several approvals by the FDA to offer new products has resulted inmore sales of new products in Fiscal 2010 compared to Fiscal 2009.

 

TheCompany sells its products to customers in various categories.  The table below identifies the Company’sapproximate net sales to each category for the three months ended December 31,2009 and 2008:

 
| ** **               | ** ** | **Three Months Ended December 31,** | ** ** |
|--------------------------|------------|------------------------------------------|------------|
| **Customer Category**    | ** ** | **2009**                                 | ** ** | **2008** | ** ** |
|                     |       |                                     |       |   |   |
| Wholesaler/  Distributor |       | $                                        | 12,172,000 |   | $ | 11,768,000 |   |
| Retail  Chain            |       | 15,061,000                               |       | 16,176,000 |   |
| Mail-Order  Pharmacy     |       | 1,484,000                                |       | 1,164,000 |   |
| Private  Label           |       | —                                   |       | 116,000 |   |
|                     |       |                                     |       |   |   |
| Total                    |       | $                                        | 28,717,000 |   | $ | 29,224,000 |   |

 

**Thesales to wholesaler/distributor and mail-order pharmacy customer categoriesincreased as a result of an increase in the demand for products for which theCompany is the major supplier and also an increase in the number of productsavailable for sale.**

 

**Costof sales for the second quarter increased 13% to $20,640,000 in Fiscal 2010from $18,202,000 in Fiscal 2009.  Theincrease was due primarily to a change in product mix including the increase in**drugs used in the treatment of thyroid deficiencywhich was partially offset by the decrease in our prescriptionvitamins.  Cost of sales also included anadditional $255,000 of royalties related to the prescription vitamins andamantadine products.

 

Amortization expenseprimarily relates to the JSP Distribution Agreement.  For the remaining term of the JSPDistribution Agreement,the Company will incur annual amortization expense of approximately $1,785,000.

 

Gross profit margins for the second quarter of Fiscal 2010and Fiscal 2009 were 28% and 38%, respectively. Gross profit percentagedecreased due to the decline in sales of prescription vitamins as well as thecommencement of the related royalty. While the Company is continuously striving to keep product costs low,there can be no guarantee that profit margins will not fluctuate in futureperiods.  Pricing pressure fromcompetitors and costs of producing or purchasing new drugs may also fluctuatein the future. Changes in the futuresales product mix may also occur. These changes may affect the gross profitpercentage in future periods.

 

Researchand development (“R&D”) expenses in the second quarter increased 48% to$2,730,000 for Fiscal 2010 from $1,841,000 for Fiscal 2009.  The increase is primarily due to an increasein production of drugs in development and preparation for submission to the FDAas well as increased costs for biostudies. The Company expenses all production costs as R&D until the drug isapproved by the FDA.  R&D expensesmay fluctuate from period to period, based on R&D plans for submission tothe FDA.

 

Selling**,**general and administrative expenses in the second quarterdecreased 39% to $4,049,000 in Fiscal 2010 from $6,675,000 in Fiscal 2009.  The decrease is primarily due to litigationexpenses in Fiscal 2009 related to the patent challenge with KV Pharmaceuticalsof approximately $2,393,000 for the second quarter of Fiscal 2009 which werenot incurred in Fiscal 2010 as the litigation was settled in March 2009.While the Company is focused on controlling costs, increases in personnel costsmay have an ongoing and longer lasting impact on the administrative coststructure.  Other costs are beingincurred to facilitate improvements in the Company’s 

 

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infrastructure.  These costs are expected to be temporaryinvestments in the future of the Company and may not continue at the samelevel.

 

Interestexpense in the second quarter decreased to $84,000 in Fiscal 2010 compared to$117,000 in Fiscal 2009 primarily due to lower levels of long-term debt.    Interest income in the second quarterdecreased to $21,000 in Fiscal 2010 from $92,000 in Fiscal 2009 due to lowerinterest earned on investment securities.

 

TheCompany recorded income tax expense in the second quarter of 2010 of $1,170,000compared to $925,000 in the second quarter of Fiscal 2009. The effective taxrate for the three months ended December 31, 2009 was 95%, compared to 37%for the three months ended December 31, 2008.  The effective tax rate for the three months ended December 31,2009 was higher than for the three months ended December 31, 2008 dueprimarily to a change in Pennsylvania tax law which lowered the Company’sapportionment factor within this state. The impact of this change caused the Company to reduce its deferred taxassets by approximately $650,000, and therefore increased the effective taxrate by 11% for the six months ended December 31, 2009, which in turn, hada significant impact on the second quarter of Fiscal 2010.  The Company expects its overall effective taxrate will be approximately 45% for the full year ended June 30, 2010.

 

The Company reported netincome of approximately $55,000 in the second quarter of Fiscal 2010, or $0.00basic and $0.00 diluted earnings per share, as compared to $1,573,000 in thesecond quarter Fiscal 2009, or $0.06 basic and diluted earnings per share.

 

***Resultsof Operations — Six months ended December 31, 2009 compared with sixmonths ended December 31, 2008***

 

Net sales for the sixmonths ended December 31, 2009 (“Fiscal 2010”) increased 10% to$60,152,000 from $54,792,000 for the six months ended December 31, 2008 (“Fiscal2009”). The following factors contributed to the $5,360,000 increase in sales:

 
| **Medical  indication** | ** ** | **Sales volume  change %** | ** ** | **Sales price   change %** | ** ** |
|-------------------------|------------|----------------------------|------------|----------------------------|------------|
| Heart Failure           |       | -11                        | %          | -6                         | %          |
| Antibiotics             |       | 14                         | %          | -7                         | %          |
| Epilepsy                |       | -18                        | %          | 43                         | %          |
| Thyroid Deficiency      |       | 12                         | %          | - 1                        | %          |
| Pain Management         |       | 329                        | %          | 59                         | %          |
| Migraine Headache       |       | -5                         | %          | 14                         | %          |

 

Salesof drugs used for pain management increased by approximately $3,262,000 for thesix months ended December 31, 2009 compared to December 31, 2008 dueto a market withdrawal by one of our major competitors.  Sales of drugs used in the treatment ofthyroid deficiency increased by approximately $2,441,000 as a result of acontinued shift away from branded drugs towards generic prescriptions.  Partially offsetting these increases was adecrease in sales of drugs for the treatment of congestive heart failure byapproximately $1,915,000 in the first half of Fiscal 2010 compared to the firsthalf of Fiscal 2009.  This decrease wasdue to a prior year product recall by several of our major competitors whichincreased our first half of Fiscal 2009 revenues.  The overall increase in sales was alsoaffected by a decrease in sales of our prescription vitamins of 

 

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approximately$1,503,000. Additional sales can also be attributed to new drugs used as ananesthetic and for the treatment of gallstones totaling approximately$1,100,000 and $900,000, respectively.

 

The Company expects to continue increasing thenumber of products available for sale to its customers, which will requireadditional FDA approvals. The Company’s receipt of several approvals by the FDAto offer new products has resulted in more sales of new products in Fiscal 2010compared to Fiscal 2009.

 

TheCompany sells its products to customers in various categories.  The table below identifies the Company’sapproximate net sales to each category for the six months ended December 31,2009 and 2008:

 
| ** **               | ** ** | **Six Months Ended December 31,** | ** ** |
|--------------------------|------------|----------------------------------------|------------|
| **Customer Category**    | ** ** | **2009**                               | ** ** | **2008** | ** ** |
|                     |       |                                   |       |   |   |
| Wholesaler/  Distributor |       | $                                      | 27,341,000 |   | $ | 23,608,000 |   |
| Retail  Chain            |       | 29,793,000                             |       | 28,151,000 |   |
| Mail-Order  Pharmacy     |       | 3,018,000                              |       | 2,800,000 |   |
| Private  Label           |       | —                                 |       | 233,000 |   |
|                     |       |                                   |       |   |   |
| Total                    |       | $                                      | 60,152,000 |   | $ | 54,792,000 |   |

 

**Thesales to wholesaler/distributor and retail chain customer categories increasedsignificantly as a result of an increase in the demand for products for whichthe Company is the major supplier and also an increase in the number ofproducts available for sale.**

** **

**Costof sales for the first six months increased 17% to $40,540,000 in Fiscal 2010from $34,768,000 in Fiscal 2009.  Theincrease reflected the impact of the 10% increase in sales as well as royaltiesof approximately $738,000 primarily related to the prescription vitamins ouramantadine product and the final payments under the Provell terminationagreement.  The increase in cost of saleswas more than the increase in sales due to the relative mix of the sales of thefour products described above.**

** **

Amortization expenseprimarily relates to the JSP Distribution Agreement.  For the remaining term of the JSPDistribution Agreement,the Company will incur annual amortization expense of approximately $1,785,000.

 

Gross profit margins for the first half of Fiscal 2010and Fiscal 2009 were 33% and 37%, respectively. Gross profit percentagedecreased due to the decline in sales of prescription vitamins as well as thecommencement of the related royalty. While the Company is continuously striving to keep product costs low,there can be no guarantee that profit margins will not fluctuate in futureperiods.  Pricing pressure fromcompetitors and costs of producing or purchasing new drugs may also fluctuatein the future. Changes in the futuresales product mix may also occur. These changes may affect the gross profitpercentage in future periods.

 

Researchand development (“R&D”) expenses in the first six months increased 55% to$5,758,000 for Fiscal 2010 from $3,704,000 for Fiscal 2009.  The increase is primarily due to an increasein production of drugs in development and preparation for submission to the FDAas well as increased costs for biostudies. The Company expenses all production costs as R&D until the drug isapproved by the FDA.  R&D expensesmay fluctuate from period to period, based on R&D plans for submission tothe FDA.

 

Selling**,**general and administrative expenses in the first sixmonths decreased 33% to $7,813,000 in Fiscal 2010 from $11,625,000 in Fiscal2009.  The decrease is primarily due tolitigation expenses in Fiscal 2009 related to the patent challenge with KVPharmaceuticals of approximately $3,187,000 which were not incurred in Fiscal2010 as the litigation was settled in March 2009. While the Company isfocused on controlling costs, increases in personnel costs may have an ongoingand longer lasting impact on the administrative cost structure.  Other costs 

 

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arebeing incurred to facilitate improvements in the Company’s infrastructure.  These costs are expected to be temporaryinvestments in the future of the Company and may not continue at the samelevel.

 

Interestexpense in the first six months decreased to $155,000 in Fiscal 2010 comparedto $184,000 in Fiscal 2009 primarily due to lower levels of long-termdebt.  Interest income in the first sixmonths decreased to $44,000 in Fiscal 2010 from $138,000 in Fiscal 2009 due tolower interest earned on investment securities.

 

TheCompany recorded income tax expense in the six months ended December 31,2009 totaling $2,998,000 compared to $1,845,000 in the six months ended December 31,2008. The effective tax rate for the six months ended December 31, 2009 was51%, compared to 40% for the six months ended December 31, 2008.  The effective tax rate for the six months ended December 31,2009 was higher than for the six months ended December 31, 2008 dueprimarily to a change in Pennsylvania tax law which lowered the Company’sapportionment factor within this state. The impact of this change caused the Company to reduce its deferred taxassets by approximately $650,000, and therefore increased the effective taxrate by 11% for the six months ended December 31, 2009.  The Company expects its overall effective taxrate will be approximately 45% for the full year ended June 30, 2010.

 

The Company reported netincome of approximately $2,912,000 in the first half of Fiscal 2010, or $0.12basic and diluted earnings per share, as compared to $2,799,000 in the firsthalf Fiscal 2009, or $0.11 basic and diluted earnings per share.

 

***Liquidityand Capital Resources***

 

**TheCompany has historically financed its operations with cash flow generated fromoperations, supplemented with borrowings from various government agencies andfinancial institutions.  At December 31,2009, working capital was $40,542,000, as compared to $38,632,000 at June 30,2009, an increase of $1,910,000.**

** **

**Net cashprovided by operating activities of $223,000 in the first six months of Fiscal2010 reflected net income of $2,912,000, after adjusting for non-cash items of$4,321,000, as well as cash used by changes in operating assets and liabilitiesof $7,010,000.  Significant changes inoperating assets and liabilities are comprised of:**

 

 ·               A decrease in trade accounts receivable of $685,000 primarily as aresult of the timing of cash receipts in Fiscal 2010.  The change in the accounts receivable balancefrom June 30, 2009 to December 31, 2009 includes a non-cash decreaseof approximately $341,000 related to the issuance of credits for the returns ofthe multivitamin product received by the Company through December 31,2009.

·                  An increase in inventories of $2,580,000 due to increased stockinglevels at both Lannett and Cody Labs for certain products as ofDecember 31, 2009 that are being carried in order to respond to theincreased order volume we are currently experiencing.

·                  An increase in prepaid taxes of $809,000 from income taxes payable of$711,000 related to estimated tax payments made in Fiscal 2010.

·                  A decrease in accounts payable of $2,417,000 due to the timing ofpayments at the end of the month.

·                  An increase in rebates, chargebacks and returns payable of $890,000primarily due to an increase in the rebates reserve as a result of the timingof credits being processed by the customers and by the Company partially offsetby a decrease in chargeback reserves due mainly to a decrease in inventorylevels at wholesaler distribution centers. This increase was partly offset by a non-cash decrease of approximately$341,000 related to the issuance of credits for the returns of the multivitaminproduct received by the Company through December 31, 2009.

**·****                **A decrease in accrued payroll and payroll relatedcosts of $1,832,000 primarily related to the payment of the Fiscal 2009 accruedincentive compensation costs totaling approximately 

 

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$4,165,000.  Of this amount, approximately $759,000 wassettled with the issuance of restricted stock and is therefore excluded fromthe consolidated statement of cashflows.

 

**Net cash used in investing activities of $6,833,000 for thesix months ended December 31, 2009 is mainly the result of purchases ofproperty, plant and equipment of $6,343,000, primarily related to acquired landand buildings, as well as the purchase of an intangible asset (product rights)for $500,000.**

** **

**Net cash provided by financing activities of $420,000 forthe six months ended December 31, 2009 was primarily due to proceeds fromthe issuance of stock of $638,000 partially offset by the purchase of treasurystock totaling $69,000.  The Company alsomade scheduled debt repayments of $193,000.**

** **

Long-termdebt amounts due, for the twelve month periods ended December 31 are asfollows:

 
| **Twelve**        | ** ** | **Amounts Payable** | ** ** |
|-------------------|------------|---------------------|------------|
| **Month Periods** | ** ** | **to Institutions** | ** ** |
|              |       |                |       |
| 2010              |       | $                   | 359,971    |   |
| 2011              |       | 4,793,268           |       |
| 2012              |       | 275,071             |       |
| 2013              |       | 287,222             |       |
| 2014              |       | 259,749             |       |
| Thereafter        |       | 1,970,163           |       |
|              |       |                |       |
|              |       | $                   | 7,945,444  |   |

 

The Company has a $3,000,000 line of credit fromWachovia Bank, N.A. (“Wachovia”) that bears interest at the prime interest rateless 0.25% (3.00% at December 31 and June 30, 2009, respectively). Asof December 31 and June 30, 2009, the Company has $3,000,000 ofavailability under this line of credit. The line of credit is collateralized by substantially all of the Company’sassets.

 

Theexisting line of credit which was scheduled to expire on November 30,2009, was renewed and extended during the first quarter of Fiscal 2010 to November 30,2010.   As part of the renewal agreement, the Company is nolonger required to maintain any minimum deposit balances with Wachovia, and theavailability fee on the unused balance of the line of credit was reduced to0.375%.

 

**The terms of the line of credit, the loan agreement and therelated letter of credit require that the Company meet certain financialcovenants and reporting standards, including the attainment of standardfinancial liquidity and net worth ratios. As of December 31, 2009, the Company is in compliance with all financialcovenants under the agreement.**

** **

InJuly 2004, the Company received $500,000 of grant funding from theCommonwealth of Pennsylvania, acting through the Department of Community andEconomic Development.  The grant funding program requires the Company touse the funds for machinery and equipment located at their Pennsylvanialocations, hire an additional 100 full-time employees by June 30, 2006,operate its Pennsylvania locations a minimum of five years and meet certainmatching investment requirements.  If the Company fails to comply with anyof the requirements above, the Company would be liable to repay the full amountof the grant funding ($500,000).  The Company has recorded the unearnedgrant funds as a liability until the Company complies with all of the

 

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requirementsof the grant funding program. Through December 31, 2009, the Companyhas had preliminary discussions with the Commonwealth of Pennsylvania todetermine whether it will be required to repay any of the funds provided underthe grant fund. Based on information available at December 31, 2009, theCompany has recorded the grant funding as a long-term liability under thecaption of Unearned Grant Funds.  Exceptas set forth in this report, the Company is not aware of any trends, events oruncertainties that have or are reasonably likely to have a material adverseimpact on the Company’s short-term or long-term liquidity or financialcondition.

 

**Prospects for the Future**

 

TheCompany has several generic products under development.  These products are all orally-administered,topical and parenteral products designed to be generic equivalents to brandnamed innovator drugs.  The Company’sdevelopmental drug products are intended to treat a diverse range ofindications.  As one of the oldestgeneric drug manufacturers in the country, formed in 1942, Lannett currentlyowns several ANDAs for products which it does not manufacture and market.  These ANDAs are dormant on the Company’srecords.  Occasionally, the Companyreviews such ANDAs to determine if the market potential for any of these olderdrugs has recently changed, so as to make it attractive for Lannett toreconsider manufacturing and selling it. If the Company makes the determination to introduce one of theseproducts into the consumer marketplace, it must review the ANDA and relateddocumentation to ensure that the approved product specifications, formulationand other factors meet current FDA requirements for the marketing of thatdrug.  The Company would then redevelopthe product and submit it to the FDA for supplemental approval.  The FDA’s approval process for ANDAsupplements is similar to that of a new ANDA.  Generally, in these situations, the Company must file a supplement tothe FDA for the applicable ANDA, informing the FDA of any significant changesin the manufacturing process, the formulation, or the raw material supplier ofthe previously-approved ANDA.

 

Amajority of the products in development represent either previously approvedANDAs that the Company is planning to reintroduce (ANDA supplements), or newformulations (new ANDAs).  The productsunder development are at various stages in the development cycle—formulation,scale-up, and/or clinical testing. Depending on the complexity of the active ingredient’s chemicalcharacteristics, the cost of the raw material, the FDA-mandated requirement ofbioequivalence studies, the cost of such studies and other developmentalfactors, the cost to develop a new generic product varies and can range from$100,000 to $1.5 million.  Some ofLannett’s developmental products will require bioequivalence studies, whileothers will not—depending on the FDA’s Orange Book classification.  Since the Company has no control over the FDAreview process, management is unable to anticipate whether or when it will beable to begin producing and shipping additional products.

 

TheCompany views its April 2007 acquisition of Cody Laboratories, Inc. (“CodyLabs” or “Cody”) as an important step in becoming a vertically integratednarcotics manufacturer and distributor by allowing it to concentrate ondeveloping and completing its dosage form manufacturing in order to reducenarcotic API costs. In July 2008, the DEA granted Cody Labs a license todirectly import raw poppy straw for conversion into API and/or variouspharmaceutical products.  Only six othercompanies in the U.S. have been granted this license to date.  This license allows the Company to avoidincreased costs associated with buying narcotic API from othermanufacturers.  The Company anticipatesthat it can use this license to become a vertically integrated manufacturer ofnarcotic products, as well as a supplier of API to the pharmaceuticalindustry.  The Company believes that theaging domestic population may result in a higher demand for pain managementpharmaceutical products and that it will be well-positioned to take advantageof this increased demand.

 

CodyLabs’ manufacturing expertise in narcotic APIs will allow Lannett to build amarket with limited domestic competition. The Company anticipates that the demand for narcotics and controlleddrugs will continue to grow with the “Baby Boomer” generation demographics andthat it is well-positioned to take advantage of these opportunities byconcentrating additional resources in the narcotic area.

 

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Inaddition to the efforts of its internal product development group, Lannett hascontracted with several outside firms for the formulation and development ofseveral new generic drug products.  Theseoutsourced R&D products are at various stages in the development cycle —formulation, analytical method development and testing and manufacturingscale-up.  These products areorally-administered solid dosage products, topical or parenterals intended totreat a diverse range of medical indications. We intend to ultimately transfer the formulation technology andmanufacturing process for all of these R&D products to our own commercialmanufacturing sites.  The Companyinitiated these outsourced R&D efforts to complement the progress of itsown internal R&D efforts.

 

Occasionally,the Company will work on developing a drug product that does not require FDAapproval.  Certain prescription drugs donot require prior FDA approval before marketing.  They include, for instance, drugs listed asDESI drugs (Drug Efficacy Study implementation) which are under evaluation byFDA, Grandfathered Drugs, and prescription multivitamin drugs. A genericmanufacturer may sell products which are chemically equivalent to innovatordrugs, under FDA rules by simply performing and internally documenting thenormal research and development involved in bringing a new product tomarket.  Under this scenario, a genericcompany can forego the time required for FDA approval.

 

Morespecifically, certain products, marketed prior to the Federal Food, Drug andCosmetic Act may be considered GRASE or Grandfathered.  GRASE products are those “old drugs that donot require prior approval from FDA in order to be marketed because they aregenerally recognized as safe and effective based on published scientificliterature.”  Similarly, Grandfatheredproducts are those which “entered the market before the passage of the 1938 actor the 1962 amendments to the act.” Under the grandfather clause, such a product is exempted from the “effectivenessrequirements [of the act] if its composition and labeling have not changedsince 1962 and if, on the day before the 1962 amendments became effective, itwas (1) used or sold commercially in the United States, (2) not a newdrug as defined by the act at that time, and (3) not covered by aneffective application.” Recently, the FDA has increased its efforts to forcecompanies to file and seek FDA approval for these GRASE products.  Efforts have included granting marketexclusivity to approved GRASE products and issuing notices to companies currentlyproducing these products.

 

TheCompany has entered supply and development agreements with certaininternational companies, including Wintac of India, Orion Pharma of Finland,Azad Pharma AG and Swiss Caps of Switzerland, Pharma 2B (formerly Pharmaseed)of Israel, as well as certain domestic companies, including Banner Pharmacaps,Cerovene and Inverness.  The Company iscurrently in negotiations on similar agreements with other internationalcompanies, through which Lannett will market and distribute productsmanufactured by Lannett or by third parties. Lannett intends to use its strong customer relationships to build itsmarket share for such products, and increase future revenues and income.

 

Themajority of the Company’s R&D projects are being developed in-house underLannett’s direct supervision and with Company personnel.  Hence, the Company does not believe that itsoutside contracts for product development and manufacturing supply are materialin nature, nor is the Company substantially dependent on the services renderedby such outside firms.

 

Lannettmay increase its focus on certain specialty markets in the genericpharmaceutical industry.  Such a focus isintended to provide Lannett customers with increased product alternatives incategories with relatively few market participants.  While there is no guarantee that Lannett hasthe market expertise or financial resources necessary to succeed in such amarket specialty, management is confident that such future focus will be wellreceived by Lannett customers and increase shareholder value in the long run.

 

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TheCompany plans to enhance relationships with strategic business partners,including providers of product development research, raw materials, activepharmaceutical ingredients as well as finished goods.  Management believes that mutually beneficialstrategic relationships in such areas, including potential financingarrangements, partnerships, joint ventures or acquisitions, could allow forpotential competitive advantages in the generic pharmaceutical market.  The Company plans to continue to explore suchareas for potential opportunities to enhance shareholder value.

 

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| **ITEM 3.** | ** ** | **QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK** |
|-------------|------------|-----------------------------------------------------------------|

 

**The Company has debt instrumentswith variable interest rates.  TheCompany has a $3,000,000 line of credit from Wachovia Bank, N.A. (“Wachovia”)that bears interest at the prime interest rate less 0.25% (3.00% at December 31and June 30, 2009, respectively). As of December 31 and June 30,2009, the Company has $3,000,000 of availability under this line ofcredit.  The line of credit iscollateralized by substantially all of the Company’s assets.  Theagreement contains covenants with respect to working capital, net worth andcertain ratios, as well as other covenants. The existing line of credit which was to expire on November 30,2009, was renewed and extended to November 30, 2010.**

** **

TheCompany invests in U.S. treasury notes, and government asset-backed securities,all of which are exposed to interest rate fluctuations.  The interest earned on these investments mayvary based on fluctuations in the interest rate.

 

**ITEM 4. CONTROLS AND PROCEDURES**

 

***Evaluation of Disclosure Controls and Procedures***

 

Asof the end of the period covered by this Form 10-Q, management performed,with the participation of our Chief Executive Officer and Chief FinancialOfficer, an evaluation of the effectiveness of our disclosure controls andprocedures as defined in Rules 13a-15(e) and 15d-15(e) of theSecurities Exchange Act of 1934, as amended (the “Exchange Act”). Ourdisclosure controls and procedures are designed to provide reasonable assurancethat information required to be disclosed in the reports we file or submitunder the Exchange Act is recorded, processed, summarized and reported withinthe time periods specified in the SEC’s rules and forms, and that suchinformation is accumulated and communicated to our management, including ourChief Executive Officer and Chief Financial Officer, to allow timely decisionsregarding required disclosures.

 

Based upon the evaluation,the Chief Executive Officer and Chief Financial Officer concluded that theCompany’s disclosure controls and procedures were effective as of the end ofthe period covered by this report.

 

***Change in Internal ControlOver Financial Reporting***

 

There has been no change inthe Company’s internal control over financial reporting during the three monthsended December 31, 2009 that has materially affected, or is reasonablylikely to materially affect, our internal control over financial reporting.

 

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# **PART II.  OTHER INFORMATION**

#  

## ***ITEM 1.  LEGAL PROCEEDINGS***

## *** ***

On March 17, 2009,the Company and KV Pharmaceuticals, DrugTech Corp., and Ther-Rx Corp(collectively “KV”) settled their outstanding litigation.  Pursuant to the settlement, the Companyreceived a license from KV and became an authorized generic provider regardingits Prenatal vitamin product.  During theterms of the license, the Company will pay KV a royalty on all future sales ofits Prenatal vitamin product.  Lannettwill cease offering its Prenatal vitamin product if and when the brand isrestored to the marketplace.

 

***RegulatoryProceedings***

 

The Company is engaged inan industry which is subject to considerable government regulation relating tothe development, manufacturing and marketing of pharmaceutical products.  Accordingly, incidental to its business, theCompany periodically responds to inquiries or engages in administrative andjudicial proceedings involving regulatory authorities, particularly the FDA andthe Drug Enforcement Agency.

 

**ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

Nomatters have been submitted to a vote of the Company’s security holders duringthe quarter ended December 31, 2009.

 

## ***ITEM6.  EXHIBITS***

## *** ***

| (a) |   | A  list of the exhibits required by Item 601 of Regulation S-K to be filed as a  part of this Form 10-Q is shown on the Exhibit Index filed herewith. |
|-----|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

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# **SIGNATURE**

#  

In accordance with the requirements of the Exchange Act, the registrantcaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 
|                           |   | **LANNETT  COMPANY, INC.**                             |
|--------------------------------|--------|--------------------------------------------------------|
|                           |   |                                                   |
| Dated: February 11,  2010 | By:    | /s/ Arthur P. Bedrosian                                |
|                           |   | Arthur  P. Bedrosian                                   |
|                           |   | President  and Chief Executive Officer                 |
|                           |   |                                                   |
|                           |   |                                                   |
| Dated: February 11,  2010 | By:    | /s/ Keith R. Ruck                                      |
|                           |   | Keith  R. Ruck                                         |
|                           |   | Vice  President of Finance and Chief Financial Officer |

 

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**Exhibit Index**

 
| 31.1   |   | Certification of Chief  Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of  2002                              |   | Filed Herewith |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------|--------|----------------|
|   |   |                                                                                                                                   |   |           |
| 31.2   |   | Certification of Chief  Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of  2002                              |   | Filed Herewith |
|   |   |                                                                                                                                   |   |           |
| 32     |   | Certifications of Chief  Executive Officer and Chief Financial Officer Pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002 |   | Filed Herewith |

 

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