Table of Contents

 

 

 

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**x****                QUARTERLY REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF1934**

 

**FOR THEQUARTERLY PERIOD ENDED MARCH 31, 2010**

** **

**o****                   TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGEACT OF 1934**

 

**FOR THETRANSITION PERIOD FROM              TO            .**

 

**Commission File No. 001-31298**

 

**LANNETT COMPANY, INC.**

(Exact Name of Registrant asSpecified 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 principalexecutive offices and telephone number)

 

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the ExchangeAct during the past 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. **Yes****x**** No ****o**

 

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

 

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

 

Indicateby check mark whether the registrant has submitted electronically and posted onits corporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 ofthis chapter) during the preceding 12 months (or for such shorter period thatthe registrant was required to submit and post such files). Yes  o No o

 

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

 

Indicate the number of shares outstanding of each class of theregistrant’s common stock, as of the latest practical date.

 

| **Class**                                | ** ** | **Outstanding as of May 12, 2010** |
|------------------------------------------|------------|-------------------------------------------------------------|
| Common stock, par value $0.001 per share |       | 25,212,203 shares                                           |

 

 

 

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Tableof Contents

 

**Table of Contents**

 
| ** **                                                                    | ** **                                                                                                                  | **Page No.** |
|-------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------------------------------------|-------------------|
|                                                                          |                                                                                                                        |              |
| **PART I.  FINANCIAL INFORMATION**                                       |                                                                                                                        |
|                                                                          |                                                                                                                        |              |
| **ITEM 1.**                                                                   | **FINANCIAL STATEMENTS**                                                                                                    |              |
|                                                                          |                                                                                                                        |              |
|                                                                          | Consolidated  Balance Sheets   as of March 31, 2010 (unaudited) and June 30, 2009                                 | 1                 |
|                                                                          |                                                                                                                        |              |
|                                                                          | Consolidated  Statements of Operations (unaudited)  for the three and nine months ended March 31, 2010 and 2009        | 2                 |
|                                                                          |                                                                                                                        |              |
|                                                                          | Consolidated Statement of Changes in Shareholders’  Equity (unaudited)   for the nine months ended March 31, 2010 | 3                 |
|                                                                          |                                                                                                                        |              |
|                                                                          | Consolidated Statements of Cash Flows (unaudited)   for the nine months ended March 31, 2010 and 2009                  | 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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Table of Contents

 

**PART I.  FINANCIAL INFORMATION**

 

**ITEM 1. FINANCIAL STATEMENTS**

 

**LANNETTCOMPANY, INC. AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                              | ** ** | **(Unaudited)**         | ** **  | ** **             | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|-------------|------------------------|------------|
| ** **                                                                                                                              | ** ** | **March 31, 2010** | ** **  | **June 30, 2009** | ** ** |
| **ASSETS**                                                                                                                              |       |                    |        |                   |       |
| Current  Assets                                                                                                                         |       |                    |        |                   |       |
| Cash  and cash equivalents                                                                                                              |       | $                       | 18,724,120  |                   | $          | 25,832,456 |   |
| Investment  securities - available for sale                                                                                             |       | 735,866                 |        | 347,921                |       |
| Trade  accounts receivable (net of allowance of $130,291 and $132,000, respectively)                                                    |       | 36,351,222              |        | 29,945,748             |       |
| Inventories,  net                                                                                                                       |       | 19,224,205              |        | 16,195,361             |       |
| Interest  receivable                                                                                                                    |       | 10,373                  |        | 90,425                 |       |
| Prepaid  taxes                                                                                                                          |       | 777,254                 |        | —                 |       |
| Deferred  tax assets                                                                                                                    |       | 4,402,216               |        | 4,296,929              |       |
| Other  current assets                                                                                                                   |       | 2,325,475               |        | 602,335                |       |
| **Total Current Assets**                                                                                                                |       | 82,550,731              |        | 77,311,175             |       |
|                                                                                                                                    |       |                    |        |                   |       |
| Property,  plant and equipment                                                                                                          |       | 47,455,902              |        | 41,431,158             |       |
| Less  accumulated depreciation                                                                                                          |       | (20,587,319             | )           | (18,533,773            | )          |
|                                                                                                                                    |       | 26,868,583              |        | 22,897,385             |       |
|                                                                                                                                    |       |                    |        |                   |       |
| Construction  in progress                                                                                                               |       | 3,289,394               |        | 591,685                |       |
| Investment  securities - available for sale                                                                                             |       | 397,164                 |        | 801,748                |       |
| Intangible  assets (product rights) - net of accumulated amortization                                                                   |       | 8,243,652               |        | 9,118,710              |       |
| Deferred  tax assets                                                                                                                    |       | 12,346,852              |        | 13,757,545             |       |
| Other  assets                                                                                                                           |       | 156,913                 |        | 98,873                 |       |
| **Total Assets**                                                                                                                        |       | $                       | 133,853,289 |                   | $          | 124,577,121 |   |
|                                                                                                                                    |       |                    |        |                   |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                           |       |                    |        |                   |       |
| **LIABILITIES**                                                                                                                         |       |                    |        |                   |       |
| Current  Liabilities                                                                                                                    |       |                    |        |                   |       |
| Accounts  payable                                                                                                                       |       | $                       | 17,744,719  |                   | $          | 16,805,468 |   |
| Accrued  expenses                                                                                                                       |       | 2,664,225               |        | 1,842,434              |       |
| Accrued  payroll and payroll related                                                                                                    |       | 3,978,104               |        | 5,150,104              |       |
| Income  taxes payable                                                                                                                   |       | —                  |        | 711,073                |       |
| Current  portion of long-term debt                                                                                                      |       | 4,862,141               |        | 435,386                |       |
| Rebates,  chargebacks and returns payable                                                                                               |       | 15,488,545              |        | 13,734,540             |       |
| **Total Current Liabilities**                                                                                                           |       | 44,737,734              |        | 38,679,005             |       |
|                                                                                                                                    |       |                    |        |                   |       |
| Long-term  debt, less current portion                                                                                                   |       | 3,025,377               |        | 7,703,382              |       |
| Unearned  grant funds                                                                                                                   |       | 500,000                 |        | 500,000                |       |
| Other  long-term liabilities                                                                                                            |       | 8,972                   |        | 47,111                 |       |
| **Total Liabilities**                                                                                                                   |       | 48,272,083              |        | 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, 24,865,931 and 24,517,696 shares, respectively |       | 24,866                  |        | 24,518                 |       |
| Additional  paid in capital                                                                                                             |       | 79,302,749              |        | 76,250,309             |       |
| Retained  earnings                                                                                                                      |       | 6,748,381               |        | 1,743,565              |       |
| Noncontrolling  interest                                                                                                                |       | 124,878                 |        | 93,654                 |       |
| Accumulated  other comprehensive (loss) income                                                                                          |       | (7,572                  | )           | 24,751                 |       |
|                                                                                                                                    |       | 86,193,302              |        | 78,136,797             |       |
| Less:  Treasury stock at cost - 101,309 and 82,228 shares, respectively                                                                 |       | (612,096                | )           | (489,174               | )          |
| **TOTAL SHAREHOLDERS’ EQUITY**                                                                                                     |       | 85,581,206              |        | 77,647,623             |       |
|                                                                                                                                    |       |                    |        |                   |       |
| **TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                     |       | $                       | 133,853,289 |                   | $          | 124,577,121 |   |

 

Theaccompanying notes to the consolidated financial statements are an integralpart of these statements.

 

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**LANNETT COMPANY, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)**

 
| ** **                                                    | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|---------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                    | ** ** | **March  31,**    | ** ** | **March 31,**    | ** ** |
| ** **                                                    | ** ** | **2010**               | ** ** | **2009**              | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                    | ** ** | ** **             | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net  sales                                                    |       | $                      | 31,266,224 |                  | $          | 28,761,316 |   | $ | 91,417,926 |   | $ | 83,553,341 |   |
| Cost  of sales                                                |       | 20,190,460             |       | 16,564,244            |       | 59,095,559 |   | 50,396,809 |   |
| Amortization  of intangible assets                            |       | 448,667                |       | 446,167               |       | 1,346,000 |   | 1,338,500 |   |
| Product  royalties                                            |       | 229,827                |       | 143,877               |       | 967,889 |   | 186,874 |   |
|                                                          |       |                   |       |                  |       |   |   |   |   |
| Gross  profit                                                 |       | 10,397,270             |       | 11,607,028            |       | 30,008,478 |   | 31,631,158 |   |
|                                                          |       |                   |       |                  |       |   |   |   |   |
| Research  and development expenses                            |       | 3,352,173              |       | 1,981,338             |       | 9,110,126 |   | 5,685,168 |   |
| Selling,  general, and administrative expenses                |       | 4,392,593              |       | 7,491,583             |       | 12,205,145 |   | 19,116,199 |   |
| Gain  on sale of assets                                       |       | (19,394                | )          | (38,472               | )          | (19,629 | ) | (60,481 | ) |
|                                                          |       |                   |       |                  |       |   |   |   |   |
| Operating  income                                             |       | 2,671,898              |       | 2,172,579             |       | 8,712,836 |   | 6,890,272 |   |
|                                                          |       |                   |       |                  |       |   |   |   |   |
| Other  income (expense):                                      |       |                   |       |                  |       |   |   |   |   |
| Foreign  currency gain                                        |       | 2,050                  |       | —                |       | 2,758 |   | — |   |
| Interest  income                                              |       | 5,168                  |       | 77,954                |       | 49,451 |   | 215,604 |   |
| Interest  expense                                             |       | (49,528                | )          | (75,417               | )          | (204,032 | ) | (259,057 | ) |
|                                                          |       | (42,310                | )          | 2,537                 |       | (151,823 | ) | (43,453 | ) |
|                                                          |       |                   |       |                  |       |   |   |   |   |
| Income  before income tax expense                             |       | 2,629,588              |       | 2,175,116             |       | 8,561,013 |   | 6,846,819 |   |
| Income  tax expense                                           |       | 527,327                |       | 851,310               |       | 3,524,973 |   | 2,696,733 |   |
| Consolidated  net income                                      |       | 2,102,261              |       | 1,323,806             |       | 5,036,040 |   | 4,150,086 |   |
| Less  net income from noncontrolling interest                 |       | (9,407                 | )          | (9,324                | )          | (31,224 | ) | (36,377 | ) |
|                                                          |       |                   |       |                  |       |   |   |   |   |
| Net  income attributable to Lannett Company, Inc.        |       | $                      | 2,092,854  |                  | $          | 1,314,482 |   | $ | 5,004,816 |   | $ | 4,113,709 |   |
|                                                          |       |                   |       |                  |       |   |   |   |   |
| Basic  income per common share - Lannett Company, Inc.   |       | $                      | 0.08       |                  | $          | 0.05 |   | $ | 0.20 |   | $ | 0.17 |   |
| Diluted  income per common share - Lannett Company, Inc. |       | $                      | 0.08       |                  | $          | 0.05 |   | $ | 0.20 |   | $ | 0.17 |   |
|                                                          |       |                   |       |                  |       |   |   |   |   |
| Basic  weighted average number of shares                      |       | 24,849,745             |       | 24,502,629            |       | 24,697,669 |   | 24,424,187 |   |
| Diluted  weighted average number of shares                    |       | 25,286,331             |       | 24,756,041            |       | 25,171,750 |   | 24,524,822 |   |

 

Theaccompanying notes to the consolidated financial statements are an integralpart of these statements.

 

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**LANNETT COMPANY, INC. ANDSUBSIDIARIES**

**CONSOLIDATEDSTATEMENT 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 (Loss)** | ** ** | **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          |       | 124            |       | 558,600     |       | —       |       | —       |       | —             |       | —            |       | 558,724 |   |
| Shares issued in  connection with employee stock purchase plan |       | 27,410           |       | 27             |       | 137,963     |       | —       |       | —       |       | —             |       | —            |       | 137,990 |   |
| Share based  compensation                                      |       |             |       |           |       |        |       |         |       |         |       |               |       |              |       |   |   |
| Restricted stock                                               |       | —           |       | —         |       | 349,238     |       | —       |       | —       |       | —             |       | —            |       | 349,238 |   |
| Stock options                                                  |       | —           |       | —         |       | 850,607     |       | —       |       | —       |       | —             |       | —            |       | 850,607 |   |
| Employee stock purchase  plan                                  |       | —           |       | —         |       | 43,516      |       | —       |       | —       |       | —             |       | —            |       | 43,516 |   |
| Shares issued in  connection with restricted stock grant       |       | 197,225          |       | 197            |       | 1,048,765   |       | —       |       | —       |       | —             |       | —            |       | 1,048,962 |   |
| Tax benefit on stock  options exercised                        |       |             |       |           |       | 63,751      |       |         |       |         |       |               |       |              |       | 63,751 |   |
| Purchase of treasury  stock                                    |       | —           |       | —         |       | —      |       | —       |       | (122,922     | )          | —             |       | —            |       | (122,922 | ) |
| Income from  noncontrolling interest                           |       | —           |       | —         |       | —      |       | —       |       | —       |       | 31,224             |       | —            |       | 31,224 |   |
| Other comprehensive  loss, net of income tax                   |       | —           |       | —         |       | —      |       | —       |       | —       |       | —             |       | (32,323           | )          | (32,323 | ) |
| Net income - Lannett  Company, Inc.                       |       | —           |       | —         |       | —      |       | 5,004,816    |       | —       |       | —             |       | —            |       | 5,004,816 |   |
|                                                           |       |             |       |           |       |        |       |         |       |         |       |               |       |              |       |   |   |
| **Balance,  March 31, 2010**                              |       | 24,865,931       |       | $              | 24,866     |        | $          | 79,302,749   |       | $            | 6,748,381  |               | $          | (612,096          | )          | $ | 124,878 |   | $ | (7,572 | ) | $ | 85,581,206 |   |

 

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

 

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**LANNETTCOMPANY, INC. AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

(UNAUDITED)

 
| ** **                                                                         | ** ** | **For the nine months ended March 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                         | ** ** | **2010**                                     | ** ** | **2009** | ** ** |
|                                                                               |       |                                         |       |   |   |
| OPERATING  ACTIVITIES:                                                             |       |                                         |       |   |   |
| Net  income - Lannett Company, Inc.                                           |       | $                                            | 5,004,816  |   | $ | 4,113,709 |   |
| Adjustments  to reconcile net income to net cash provided by operating activities: |       |                                         |       |   |   |
| Depreciation  and amortization                                                     |       | 3,485,136                                    |       | 3,868,662 |   |
| Deferred  tax expense                                                              |       | 1,312,062                                    |       | 2,890,589 |   |
| Stock  compensation expense                                                        |       | 1,533,611                                    |       | 1,032,021 |   |
| Other  noncash (income) expenses                                                   |       | (11,054                                      | )          | 15,859 |   |
| Gain  on sale of assets                                                            |       | (19,629                                      | )          | (60,481 | ) |
| Income  from noncontrolling interest                                               |       | 31,224                                       |       | 36,377 |   |
| Changes  in assets and liabilities which provided (used) cash:                     |       |                                         |       |   |   |
| Trade  accounts receivable                                                         |       | (6,817,060                                   | )          | (4,607,629 | ) |
| Inventories                                                                        |       | (3,028,844                                   | )          | (4,413,977 | ) |
| Prepaid  and income taxes payable                                                  |       | (1,488,327                                   | )          | 442,465 |   |
| Prepaid  expenses and other assets                                                 |       | (1,728,213                                   | )          | (444,695 | ) |
| Accounts  payable                                                                  |       | 939,251                                      |       | 3,024,215 |   |
| Accrued  expenses                                                                  |       | 821,791                                      |       | (168,843 | ) |
| Rebates,  chargebacks and returns payable                                          |       | 2,165,591                                    |       | 2,353,176 |   |
| Accrued  payroll and payroll related                                               |       | (413,288                                     | )          | 2,040,739 |   |
| Deferred  revenue                                                                  |       | —                                       |       | (963,339 | ) |
| Net  cash provided by operating activities                                         |       | 1,787,067                                    |       | 9,158,848 |   |
|                                                                               |       |                                         |       |   |   |
| INVESTING  ACTIVITIES:                                                             |       |                                         |       |   |   |
| Purchases  of property, plant and equipment (including construction in progress)   |       | (8,788,906                                   | )          | (583,762 | ) |
| Proceeds  from sale of property, plant and equipment                               |       | 29,550                                       |       | 1,500 |   |
| Purchase  of intangible asset (product rights)                                     |       | (500,000                                     | )          | — |   |
| Proceeds  from sale of investment securities - available for sale                  |       | —                                       |       | 7,075,041 |   |
| Purchase  of investment securities - available for sale                            |       | —                                       |       | (5,979,246 | ) |
| Net  cash (used in) provided by investing activities                               |       | (9,259,356                                   | )          | 513,533 |   |
|                                                                               |       |                                         |       |   |   |
| FINANCING  ACTIVITIES:                                                             |       |                                         |       |   |   |
| Repayments  of debt                                                                |       | (251,250                                     | )          | (588,926 | ) |
| Proceeds  from issuance of stock                                                   |       | 696,714                                      |       | 115,817 |   |
| Tax  benefit on stock options exercised                                            |       | 63,751                                       |       | — |   |
| Purchase  of treasury stock                                                        |       | (122,922                                     | )          | (20,228 | ) |
| Net  cash provided by (used in) financing activities                               |       | 386,293                                      |       | (493,337 | ) |
|                                                                               |       |                                         |       |   |   |
| Effect  of foreign currency rates on cash and cash equivalents                     |       | (22,340                                      | )          | — |   |
|                                                                               |       |                                         |       |   |   |
| NET  (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS                              |       | (7,108,336                                   | )          | 9,179,044 |   |
|                                                                               |       |                                         |       |   |   |
| CASH  AND CASH EQUIVALENTS, BEGINNING OF PERIOD                                    |       | 25,832,456                                   |       | 6,256,712 |   |
|                                                                               |       |                                         |       |   |   |
| CASH  AND CASH EQUIVALENTS, END OF PERIOD                                          |       | $                                            | 18,724,120 |   | $ | 15,435,756 |   |
|                                                                               |       |                                         |       |   |   |
| SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION -                                |       |                                         |       |   |   |
| Interest  paid                                                                     |       | $                                            | 136,802    |   | $ | 149,640 |   |
| Income  taxes paid                                                                 |       | $                                            | 3,637,565  |   | $ | 250,000 |   |
| Lannett  stock issued - contingent consideration - Cody Labs acquistion            |       | $                                            | —     |   | $ | 581,175 |   |

 

 The accompanying notes to the consolidatedfinancial statements are an integral part of these statements.

 

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** **

**LANNETT COMPANY, INC. AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED 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 ninemonths ended March 31, 2010 are not necessarily indicative of the resultsthat may be expected for the fiscal year ending June 30, 2010. You shouldread these unaudited financial statements in combination with the other Notesin this section; “Management’s Discussion and Analysis of Financial Conditionand Results of Operations” appearing in Item 2; and the Financial Statements,including the Notes to the Financial Statements, included in our Annual Reporton Form 10-K for the fiscal year ended June 30, 2009.

 

**Note 2.  Summary of SignificantAccounting Policies**

 

LannettCompany, Inc., a Delaware corporation, and subsidiaries (the “Company” or“Lannett”), develop, manufacture, package, market, and distribute activepharmaceutical ingredients as well as pharmaceutical products sold undergeneric chemical names.  The Companymanufactures solid oral dosage forms, including tablets and capsules, topicaland oral solutions, and is pursuing partnerships and research contracts for thedevelopment and production of other dosage forms, including ophthalmic, nasaland injectable products.

 

***Use of Estimates —***The preparation of financialstatements in conformity with accounting principles generally accepted in theUnited States of America requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the reporting period.  Actual results could differ from thoseestimates.  As applicable to theseconsolidated financial statements, the most significant estimates andassumptions relate to sales reserves and allowances, income taxes, 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 local currency is thefunctional currency of its newly created foreign subsidiary. Assets andliabilities of the foreign subsidiary are translated into U.S. dollars at theperiod-end currency exchange rate and revenues and expenses are translated atan average currency exchange rate for the period. The resulting translationadjustment is recorded in a separate component of shareholders’ equity andchanges to such are included in comprehensive income. Exchange adjustmentsresulting from transactions denominated in foreign currencies are recognized inthe consolidated statements of operations.

 

***Reclassifications*** - Certainprior year amounts have been reclassified to conform to the current yearfinancial statement presentation.

 

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***Revenue Recognition*** - The Companyrecognizes revenue when its products are shipped.  At this point, titleand risk of loss have transferred to the customer and provisions for estimates,including rebates, promotional adjustments, price adjustments, returns,chargebacks, and other potential adjustments are reasonably determinable. Accruals for these provisions are presented in the consolidated financialstatements as rebates, chargebacks and returns payable and reductions to netsales. 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 generally requireadditional accruals as they are the primary recipient of chargebacks andrebates. 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 customer sales. The only variable is customer mix, and this assumption is based on historicaldata and sales expectations.

 

***Chargebacks***— The provision forchargebacks is the most significant and complex estimate used in therecognition of revenue.  The Companysells its products directly to wholesale distributors, generic distributors,retail pharmacy chains, and mail-order pharmacies.  The Company also sells its productsindirectly to independent pharmacies, managed care organizations, hospitals,nursing homes, and group purchasing organizations, collectively referred to as“indirect customers.”  Lannett entersinto agreements with its indirect customers to establish pricing for certainproducts.  The indirect customers thenindependently select a wholesaler from which to actually purchase the productsat these agreed-upon prices.  Lannettwill provide credit to the wholesaler for the difference between theagreed-upon price with the indirect customer and the wholesaler’s invoice priceif the price sold to the indirect customer is lower than the direct price tothe wholesaler.  This credit is called achargeback.  The provision forchargebacks is based on expected sell-through levels by the Company’s wholesalecustomers to the indirect customers and estimated wholesaler inventorylevels.  As sales to the large wholesalecustomers, such as Cardinal Health, AmerisourceBergen, and McKesson increase,the reserve for chargebacks will also generally increase.  However, the size of the increase depends onthe product mix and the amount of those sales that end up at indirect customerswith which the Company has specific chargeback agreements.  The Company continually monitors the reservefor chargebacks and makes adjustments when management believes that expectedchargebacks on actual sales may differ from actual chargeback reserves.

 

***Rebates***— Rebates are offered to theCompany’s key chain drug store, distributor and wholesaler customers to promotecustomer loyalty and increase product sales. These rebate programs provide customers with rebate credits uponattainment of pre-established volumes or attainment of net sales milestones fora specified period.  Other promotionalprograms are incentive programs offered to the customers.  At the time of shipment, the Companyestimates reserves for rebates and other promotional credit programs based onthe specific terms in each agreement. The reserve for rebates increases as sales to certain wholesale andretail customers increase.  However,since these rebate programs are not identical for all customers, the size ofthe reserve will depend on the mix of customers that are eligible to receiverebates.

 

***Returns —*** Consistent with industrypractice, the Company has a product returns policy that allows customers toreturn product within a specified period prior to and subsequent to theproduct’s lot expiration 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 historical experience, changes to businesspractices, and credit terms.  While suchexperience has allowed for reasonable estimations in the past, history may notalways be an accurate indicator of future returns.  The Company continually monitors theprovisions for returns and makes adjustments when management believes that 

 

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actualproduct returns may differ from established reserves.  Generally, the reserve for returns increasesas net sales increase.  The reserve forreturns is included in the rebates, chargebacks and returns payable account onthe 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 their inventoriesat 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 becomes available.  Other adjustments are included in therebates, chargebacks and returns payable account on the balance sheet.

 

The following tables identify the reserves for each major category ofrevenue allowance and a summary of the activity for the nine months ended March 31,2010 and 2009:

 
| **For the  nine months ended March 31, 2010**                                          | ** ** | ** **      | ** ** | ** **  | ** ** | ** **  | ** ** | ** ** | ** ** | ** **  | ** ** |
|---------------------------------------------------------------------------------------------|------------|-----------------|------------|-------------|------------|-------------|------------|------------|------------|-------------|------------|
| **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                      |       | (5,218,835      | )          | (2,537,746  | )          | (3,112,587  | )          | —     |       | (10,869,168 | )          |
| 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 |       | 35,900,162      |       | 12,529,499  |       | 3,803,056   |       | 880,860    |       | 53,113,577  |       |
| Actual  credits issued related to sales recorded in Fiscal 2010                             |       | (30,081,997     | )          | (9,527,547  | )          | —      |       | (880,860   | )          | (40,490,404 | )          |
| Reserve  Balance as of March 31, 2010                                                  |       | $               | 6,689,132  |        | $          | 3,001,952   |       | $          | 5,797,461  |        | $          | — |   | $ | 15,488,545 |   |
|                                                                                        |       |            |       |        |       |        |       |       |       |        |       |
| **For the nine months ended March 31, 2009**             | ** ** | ** **      | ** ** | ** **  | ** ** | ** **  | ** ** | ** ** | ** ** | ** **  | ** ** |
| **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                      |       | (3,930,992      | )          | (632,314    | )          | (12,246,259 | )          | —     |       | (16,809,565 | )          |
| 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 |       | 24,342,932      |       | 8,498,516   |       | 3,441,427   |       | 208,649    |       | 36,491,524  |       |
| Actual  credits issued related to sales recorded in Fiscal 2009                             |       | (19,914,114     | )          | (6,754,177  | )          | —      |       | (167,911   | )          | (26,836,202 | )          |
| Reserve  Balance as of March 31, 2009                                                  |       | $               | 4,547,233  |        | $          | 1,744,339   |       | $          | 4,839,864  |        | $          | 40,738 |   | $ | 11,172,174 |   |

 

The total reserve for chargebacks, rebates, returns and otheradjustments increased from $13,734,540 at June 30, 2009 to $15,488,545 at March 31,2010.   As of March 31, 2010 approximately $10,129,000 ofthe 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 of 

 

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approximately $416,000 of Multivitamin returns reserve on theconsolidated balance sheet at March 31, 2010. The increase in reserves wasdue to an increase in the rebates reserve as a result of the timing of creditsbeing processed by the customers and by the Company, an increase in chargebackreserves due primarily to an increase in inventory levels at wholesalerdistribution centers, and an increase in the return reserves due to an increasein overall sales.

 

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, theCompany’s customers continually reorder the Company’s products.  It iscommon for the Company’s customers to order the same products on a monthlybasis.  For generic pharmaceutical manufacturers, it is critical to ensurethat customers’ warehouses are adequately stocked with its products.  Thisis important 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 thisreason, the Company periodically offers incentives to its customers to purchaseits products.  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 threemonths.  The Company records this revenue, net of any discounts offeredand accepted by its customers at the time of shipment.  The Company’sproducts have either 24 months or 36 months of shelf-life at the time ofmanufacture.  The Company monitors its customers’ purchasing trends toattempt to identify any significant lapses in purchasing activity.  If theCompany observes a lack of recent activity, inquiries will be made to suchcustomer regarding the success of the customer’s resale efforts.  TheCompany attempts to minimize any potential return (or shelf life issues) bymaintaining an active dialogue with 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 affect ageneric 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 convertible to cash.

 

***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 

 

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Company’sexpectations and the provisions established, the Company cannot guarantee thatit will continue to experience the same credit loss rates that it has in thepast.

 

***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*** - TheCompany’s investment securities consist of marketable debt securities,primarily in U.S. government and agency obligations.  All of the Company’smarketable debt securities are classified as available-for-sale and recorded atfair value, based on quoted market prices.  Unrealized holding gains andlosses are recorded, net of any tax effect, as a separate component ofaccumulated other comprehensive (loss) income.  No gains or losses onmarketable debt securities are realized until they are sold or a decline infair value is determined to be other-than-temporary.  The Company reviewsits marketable securities and determines whether the investments areother-than-temporarily impaired. If the investments are deemed to beother-than-temporarily impaired, the investments are written down to their thencurrent fair market value with a new cost basis being established. There wereno securities determined by management to be other-than-temporarily impairedduring the nine months ended March 31, 2010 or the fiscal year ended June 30,2009.

 

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

 

***Research and Development***— Research anddevelopment expenses 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 March 31,2010 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.

 

OnApril 10, 2007, the Company entered into a Stock Purchase Agreement toacquire Cody by purchasing all of the remaining shares of common stock of Cody.The consideration for the April 10, 2007 acquisition was approximately$4,438,000, which represented the fair value of the tangible net assetsacquired. The agreement also required Lannett to issue to the sellers up to120,000 shares of unregistered common stock of the Company contingent upon thereceipt of a license from a regulatory agency. This license was subsequently received in July 2008 and triggeredthe payment of 105,000 shares (87.5% of the 120,000 shares as the Companyalready owned 12.5%) of Lannett stock to the former owners of Cody Labs, whichwas 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 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. In May 2008, the Company and Pharmeral waived their rights to anyroyalty payments on the sales of the drug by Lannett, under Lannett’s currentownership structure.  Should Lannettundergo a change in control transaction with a third party, this royalty willbe reinstated.  In Fiscal 2008, theCompany obtained FDA approval to use these proprietary rights.  Accordingly, the Company originallycapitalized these purchased product rights as an 

 

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indefinite lived intangible asset and tested this asset for impairmentat least on an annual basis.  During thefourth quarter of fiscal 2009, it was determined that this intangible asset nolonger has an indefinite life.  Noimpairment existed because the estimated fair value exceeded the carryingamount on that date. Accordingly, the $100,000 carrying amount of thisintangible asset is being amortized on a straight line basis prospectively overits 10 year remaining estimated useful life.

 

In August 2009, the Company acquired eight new ANDAs coveringthree separate product lines from another generic drug manufacturer for apurchase price of $500,000.  It isexpected that the Company will be able to produce these products by the firsthalf of Fiscal 2011.  The Company hasassigned a 15 year life to this intangible asset based on average life cyclesof Lannett products.  Amortization willbegin when the Company starts shipping these products.

 

Forthe nine months ended March 31, 2010 and 2009, the Company incurredamortization expense of approximately $1,375,000 and $1,366,000, respectively.As of March 31, 2010 and June 30, 2009, accumulated amortization totaledapproximately $8,999,000 and $7,624,000, respectively.

 

Futureannual amortization expense consists of the following as of March 31,2010:

 
| **Fiscal  Year Ending June 30,** | ** ** | **Annual Amortization  Expense** | ** ** |
|---------------------------------------|------------|----------------------------------|------------|
| 2010                                  |       | $                                | 458,354    |   |
| 2011                                  |       | 1,833,412                        |       |
| 2012                                  |       | 1,833,412                        |       |
| 2013                                  |       | 1,833,412                        |       |
| 2014                                  |       | 1,387,245                        |       |
| Thereafter                            |       | 397,817                          |       |
|                                  |       | $                                | 7,743,652  |   |

 

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 Companycharges advertising costs to operations as incurred.  Advertising expense for the nine months endedMarch 31, 2010 and 2009 was approximately $20,000 and $41,000,respectively.

 

***Income Taxes***- The Company uses theliability method to account for income taxes. Deferred tax assets andliabilities are determined based on the difference between the financialstatement and tax bases of assets and liabilities as measured by the enactedtax rates which will be in effect when these differences reverse.  Deferred tax expense/(benefit) is the resultof changes in deferred tax assets and liabilities.  The Company may recognize the tax benefitfrom an uncertain tax position claimed on a tax return only if it is morelikely than not that the tax position will be sustained on examination by thetaxing authorities, based on the technical merits of the position.  The tax benefits recognized in the financialstatements from such a position should be measured based on the largest benefitthat 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 reports asone operating segment.  The followingtable identifies the Company’s approximate net product sales by medicalindication for the three and nine months ended March 31, 2010 and 2009:

 

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| ** **                  | ** ** | **For the Three Months Ended  March 31,** | ** ** | **For the Nine Months Ended  March 31,** | ** ** |
|-----------------------------|------------|------------------------------------------------|------------|-----------------------------------------------|------------|
| **Medical Indication** | ** ** | **2010**                                       | ** ** | **2009**                                      | ** ** | **2010** | ** ** | **2009** | ** ** |
|                        |       |                                           |       |                                          |       |   |   |   |   |
| Migraine  Headache          |       | $                                              | 2,135,000  |                                          | $          | 2,483,000 |   | $ | 7,275,000 |   | $ | 7,230,000 |   |
| Epilepsy                    |       | 357,000                                        |       | 518,000                                       |       | 1,396,000 |   | 1,402,000 |   |
| Prescription  Vitamin       |       | 1,446,000                                      |       | 4,890,000                                     |       | 4,502,000 |   | 9,449,000 |   |
| Heart  Failure              |       | 5,070,000                                      |       | 3,938,000                                     |       | 15,212,000 |   | 15,995,000 |   |
| Thyroid  Deficiency         |       | 12,798,000                                     |       | 11,709,000                                    |       | 38,906,000 |   | 35,301,000 |   |
| Antibiotic                  |       | 1,709,000                                      |       | 1,499,000                                     |       | 4,928,000 |   | 4,471,000 |   |
| Pain  Management            |       | 3,818,000                                      |       | 1,144,000                                     |       | 8,782,000 |   | 1,791,000 |   |
| Other                       |       | 3,933,000                                      |       | 2,580,000                                     |       | 10,417,000 |   | 7,914,000 |   |
|                        |       |                                           |       |                                          |       |   |   |   |   |
| Total                       |       | $                                              | 31,266,000 |                                          | $          | 28,761,000 |   | $ | 91,418,000 |   | $ | 83,553,000 |   |

 

***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%, 8%, 5% and5%, respectively of net sales for the nine months ended March 31,2010.  Those same products accounted for42%, 19%, 9%, 1% and 11% respectively, of net sales for the nine months ended March 31,2009.  For the three months ended March 31,2010 and 2009, the same five products accounted for 41%, 16%, 7%, 5% and 5%,and 41%, 14%, 9%, 2% and 17%, respectively, of net sales.

 

Fiveof the Company’s customers accounted for 26%, 11%, 9%, 8% and 6%, respectively,of net sales for the nine months ended March 31, 2010, and 29%, 6%, 5%, 8%and 8%, respectively, of net sales for the nine months ended March 31,2009.  For the three months ended March 31,2010 and 2009, five customers accounted for 27%, 11%, 11%, 8% and 7%, and 29%,7%, 8%, 8% and 9%, respectively, of net sales. At March 31, 2010, these five customers accounted for 74% 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 Company recognizescompensation cost for share-based compensation issued to or purchased byemployees, net of estimated forfeitures, under share-based compensation plansusing a fair value method.

 

AtMarch 31, 2010, the Company had three stock-based employee compensationplans (the “Old Plan,” the “2003 Plan,” and the Long-term Incentive Plan, or“LTIP”).

 

Duringthe nine months ended March 31, 2009, the Company awarded 30,000 shares ofrestricted stock under the LTIP which vested immediately.  Stock compensation expense of zero and $101,400was recognized during the three and nine months ended March 31, 2009,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 $129,021 and was recognized during thethree and nine months ended March 31, 2010 and 2009, respectively, relatedto the 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 of $130,129 and $220,217was recognized during the three and nine months ended March 31, 2010,respectively, related to the vesting of these shares of restricted stock.

 

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Duringthe three months ended March 31, 2010, the Company awarded 45,000 sharesof restricted stock under the LTIP which vested immediately.  Stockcompensation expense of $290,250 was recognized during the three months ended March 31,2010 related 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 nine months ended March 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                          |       | 66.6                         | %          | 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 |       | $                            | 3.99       |                             | $          | 4.00                         |       | $                                | 1.44       |   | $ | 1.41 |   |
|                                              |            |                              |            |                                  |            |                              |            |                                  |            |  |  |  |  |

 

Zerooptions were issued under the LTIP during the three months ended March 31,2010 and 2009, respectively. Approximately 528,000 and 147,000 options were issued under the LTIPduring the nine months ended March 31, 2010 and 2009, respectively.  There were 122,350 and 7,800 shares underoptions that were exercised in the nine months ended March 31, 2010 and2009, respectively.  At March 31,2010, there were 2,102,981 options outstanding. Of those, 1,039,050 were options issued under the LTIP, 854,698 wereissued under the 2003 Plan, and 209,233 under the Old Plan.  There are no further shares authorized to beissued under the Old Plan.  1,125,000shares were authorized to be issued under the 2003 Plan, with 48,740 sharesunder options having already been exercised under that plan.  2,500,000 shares were authorized to be issuedunder the LTIP, with 92,100 shares under options having already been exercisedunder 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 unvestedawards are expected to be forfeited during the vesting period. This assumptionis based on our historical forfeiture rate. Periodically, management willassess whether it is necessary to adjust the estimated rate to reflect changesin actual forfeitures or changes in expectations. For example, adjustments maybe needed 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  March 31,** | ** ** | **Nine Months Ended********March 31,** | ** ** |
|-------------------------------|------------|----------------------------------------|------------|---------------------------------------------|------------|
| ** **                    | ** ** | **2010**                               | ** ** | **2009**                                    | ** ** | **2010** | ** ** | **2009** | ** ** |
|                          |       |                                   |       |                                        |       |   |   |   |   |
| Share based compensation      |       |                                   |       |                                        |       |   |   |   |   |
| Stock options                 |       | $                                      | 320,013    |                                        | $          | 293,293 |   | $ | 850,607 |   | $ | 731,286 |   |
| Employee stock purchase plan  |       | 10,440                                 |       | 39,023                                      |       | 43,516 |   | 70,315 |   |
| Restricted stock              |       | 463,386                                |       | 43,007                                      |       | 639,488 |   | 230,420 |   |
| Tax benefit at statutory rate |       | 22,934                                 |       | 22,180                                      |       | 56,677 |   | 66,541 |   |
|                               |            |                                        |            |                                             |            |  |  |  |  |  |  |  |  |

 

Duringthe third quarter of Fiscal Year 2009 as part of the former CFO’s resignation,the Company repurchased all of his 185,000 outstanding stock options.  Therefore, the Company recorded asincremental stock compensation expense, the previously unrecognizedcompensation cost totaling approximately $83,000 related to options for whichthe requisite service period had not been rendered as of the repurchasedate.  See Note 11 for additionalinformation.

 

Optionsoutstanding that have vested and are expected to vest as of March 31, 2010are as follows:

 
| ** **                        | ** ** | **Awards** | ** ** | **Weighted -   Average  Exercise  Price** | ** ** | **Aggregate  Intrinsic  Value** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** |
|-----------------------------------|------------|------------|------------|-------------------------------------------|------------|---------------------------------|------------|-----------------------------------------------------|------------|
| Options vested                    |       | 1,136,781  |       | $                                         | 8.86       |                            | $          | 107,932                                             |       | 5.1 |   |
| Options expected to vest          |       | 917,890    |       | $                                         | 6.03       |                            | $          | 156,441                                             |       | 9.1 |   |
| Total vested and expected to vest |       | 2,054,671  |       | $                                         | 7.60       |                            | $          | 264,373                                             |       | 6.9 |   |

 

Asummary of nonvested restricted stock award activity as of March 31, 2010and changes during the nine months then ended, is presented below:

 
| ** **                       | ** ** | **Awards** | ** ** | **Weighted  Average Grant  Date Fair Value** | ** ** |
|----------------------------------|------------|------------|------------|----------------------------------------------|------------|
| Nonvested at July 1, 2009   |       | 77,198     |       | $                                            | 311,108    |   |
| Granted                          |       | 399,225    |       | 2,697,213                                    |       |
| Vested                           |       | (197,225   | )          | (1,192,028                                   | )          |
| Forfeited                        |       | (9,300     | )          | (37,479                                      | )          |
| Nonvested at March 31, 2010 |       | 269,898    |       | $                                            | 1,778,814  |   |

 

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Asummary of award activity under the Plans as of March 31, 2010 and 2009,and changes during the nine 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                                                |       | 502,642                     |       | $                              | 6.98       |   |   |   |   |   | 152,658 |   | $ | 6.99 |   |   |   |   |   |
| Exercised                                              |       | (108,546                    | )          | $                              | 4.47       |   |   |   |   |   | (13,804 | ) | $ | 4.97 |   |   |   |   |   |
| Forfeited,  expired or repurchased                     |       | (15,650                     | )          | $                              | 5.17       |   |   |   |   |   | — |   | $ | — |   |   |   |   |   |
| Outstanding  at March 31, 2010                    |       | 1,337,355                   |       | $                              | 6.21       |   | $ | 214,484 |   | 7.7 |   | 765,626 |   | $ | 9.91 |   | $ | 58,121 |   | 5.7 |   |
|                                                   |       |                        |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Outstanding  at March 31, 2010 and not yet vested |       | 769,982                     |       | $                              | 5.98       |   | $ | 129,399 |   | 9.1 |   | 196,218 |   | $ | 6.20 |   | $ | 35,275 |   | 9.2 |   |
| Exercisable  at March 31, 2010                    |       | 567,373                     |       | $                              | 6.52       |   | $ | 85,085 |   | 5.8 |   | 569,408 |   | $ | 11.19 |   | $ | 22,846 |   | 4.5 |   |

 
| ** **                                             | ** ** | **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                                              |       | (7,800                      | )          | $                              | 4.32       |   |   |   |   |   | — |   | — |   |   |   |   |   |
| Forfeited,  expired or repurchased                     |       | (196,660                    | )          | $                              | 5.02       |   |   |   |   |   | (114,290 | ) | $ | 5.75 |   |   |   |   |   |
| Outstanding  at March 31, 2009                    |       | 895,809                     |       | $                              | 5.58       |   | $ | 924,868 |   | 7.5 |   | 626,772 |   | $ | 10.52 |   | 223,393 |   | 5.8 |   |
|                                                   |       |                        |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Outstanding  at March 31, 2009 and not yet vested |       | 420,018                     |       | $                              | 4.03       |   | 661,780 |   | 8.7 |   | 120,893 |   | $ | 4.23 |   | 178,616 |   | 8.5 |   |
| Exercisable  at March 31, 2009                    |       | 475,791                     |       | $                              | 6.94       |   | $ | 263,088 |   | 6.4 |   | 505,879 |   | $ | 12.02 |   | 44,777 |   | 5.1 |   |

 

Optionswith a fair value of $652,505 vested during the nine months ended March 31,2010.  As of March 31, 2010,there was $4,151,892 of total unrecognized compensation cost related tononvested share-based compensation awards granted under the Plans.  Thatcost is expected to be recognized over a weighted average period of 1.8years.  The Company issues new shareswhen stock options are exercised.

 

***Unearned Grant Funds*** — The Companyrecords all grant funds received as a liability until the Company fulfills allthe 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

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theexercise of outstanding common stock equivalents into common stock using thetreasury stock method.  A reconciliationof the Company’s basic and diluted income per share follows:

 
| ** **                                                        | ** ** | **Three Months Ended  March 31,** | ** ** | **Nine Months Ended  March 31,** | ** ** |
|-------------------------------------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                                                        | ** ** | **2010**                               | ** ** | **2009**                              | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                        | ** ** | **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                                 |       | $                                      | 2,092,854  |                                  | 24,849,745 |   | $ | 1,314,482 |   | 24,502,629 |   | $ | 5,004,816 |   | 24,697,669 |   | $ | 4,113,709 |   | 24,424,187 |   |
|                                                              |       |                                   |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Effect of potentially  dilutive option and restricted stock plans |       | —                                 |       | 436,586                               |       | — |   | 253,412 |   | — |   | 474,081 |   | — |   | 100,635 |   |
|                                                              |       |                                   |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Diluted earnings per  share factors                               |       | $                                      | 2,092,854  |                                  | 25,286,331 |   | $ | 1,314,482 |   | 24,756,041 |   | $ | 5,004,816 |   | 25,171,750 |   | $ | 4,113,709 |   | 24,524,822 |   |
|                                                              |       |                                   |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic earnings per share                                          |       | $                                      | 0.08       |                                  |       |   | $ | 0.05 |   |   |   | $ | 0.20 |   |   |   | $ | 0.17 |   |   |   |
| Diluted earnings per  share                                       |       | $                                      | 0.08       |                                  |       |   | $ | 0.05 |   |   |   | $ | 0.20 |   |   |   | $ | 0.17 |   |   |   |

 

Thenumber of anti-dilutive shares that have been excluded in the computation ofdiluted earnings per share for the three and nine months ended March 31,2010 were 1,406,344 and 1,315,984, respectively. The number of anti-dilutiveshares that have been excluded in the computation of diluted earnings per sharefor the three and nine months ended March 31, 2009 were 865,642 and1,470,779, respectively.

 

**Note 3.  New Accounting Standards**

 

InDecember 2007, the FASB issued authoritative guidance which significantlychanges the accounting for business combinations in a number of areas includingthe treatment of contingent consideration, contingencies, acquisition costs,in-process research and development and restructuring costs. In addition, underthe guidance, changes in deferred tax asset valuation allowances and acquiredincome tax uncertainties in a business combination after the measurement periodwill impact income tax expense. In April 2009, updated guidance was issuedto address application issues regarding the accounting and disclosureprovisions for contingencies. The authoritative guidance applies prospectivelyto business combinations for which the acquisition date is on or after thebeginning of the fiscal year beginning July 1, 2009.  Earlyapplication is not permitted. The effect of this authoritative guidance on ourconsolidated financial statements will depend on the nature and terms of anybusiness combinations that occur after the effective date.

 

InDecember 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 theconsolidated entity that should be reported as equity in the consolidatedfinancial statements and establishes a single method of accounting for changesin a parent’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 noncontrollinginterests as a component 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.

 

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InApril 2008, the FASB issued authoritative guidance which amends the factorsthat should be considered in developing renewal or extension assumptions usedto determine the useful life of a recognized intangible asset. The guidance isintended to improve the consistency between the useful life of a recognizedintangible asset and the period of expected cash flows used to measure the fairvalue of the asset. We adopted this authoritative guidance effective July 1,2009.  The adoption of this guidance didnot have a significant impact on our consolidated financial statements.

 

InJune 2009, the FASB issued authoritative guidance for determining whetheran entity is a variable interest entity and modifies the methods allowed fordetermining the primary beneficiary of a variable interest entity. Thisguidance requires an enterprise to perform an analysis to determine whether theenterprise’s variable interest or interests give it a controlling financialinterest in a variable interest entity. It also requires ongoing reassessmentsof whether an enterprise is the primary beneficiary of a variable interestentity.  The authoritative guidance iseffective for the annual reporting period that begins after November 15,2009. We do not expect the adoption of this authoritative guidance to have asignificant impact on our consolidated financial statements.

 

InJanuary 2010, the FASB issued authoritative guidance which requiresreporting entities to make new disclosures about recurring or nonrecurringfair-value measurements including significant transfers into and out of Level 1and Level 2 fair-value measurements and information on purchases, sales,issuances, and settlements on a gross basis in the reconciliation of Level 3fair- value measurements. ASU 2010-6 is effective for annual reporting periodsbeginning after December 15, 2009, except for Level 3 reconciliationdisclosures which are effective for annual periods beginning after December 15,2010. We do not anticipate that this update will have a material impact on ourconsolidated financial statements.

 

**Note 4.  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.

 

Inventories consist of the following:

 
| ** **         | ** ** | **March 31, 2010** | ** ** | **June 30, 2009** | ** ** |
|--------------------|------------|-------------------------|------------|------------------------|------------|
|               |       |                    |       |                   |       |
| Raw materials      |       | $                       | 5,751,616  |                   | $          | 5,755,982 |   |
| Work-in-process    |       | 2,155,116               |       | 2,846,600              |       |
| Finished goods     |       | 10,376,718              |       | 6,664,193              |       |
| Packaging supplies |       | 940,753                 |       | 928,586                |       |
|               |       | $                       | 19,224,205 |                   | $          | 16,195,361 |   |

 

The preceding amounts are net of inventory reserves of $2,409,378 and$2,744,305 at March 31, 2010 and June 30, 2009, respectively.

 

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**Note 5.  Property, Plant andEquipment**

 

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 March 31, 2010 and 2009 wasapproximately $714,000 and $836,000, respectively. Depreciation expense for thenine months ended March 31, 2010 and 2009 was approximately $2,110,000 and$2,503,000, respectively.

 

Property, plant and equipment consist of the following:

 
| ** **                 | ** ** | ** **       | ** ** | **March 31,** | ** ** | **June 30,** | ** ** |
|----------------------------|------------|------------------|------------|--------------------|------------|-------------------|------------|
| ** **                 | ** ** | **Useful Lives** | ** ** | **2010**           | ** ** | **2009**          | ** ** |
| Land                       |       | —           |       | $                  | 1,418,314  |              | $          | 918,314 |   |
| Building  and improvements |       | 10  - 39 years   |       | 21,040,027         |       | 17,048,351        |       |
| Machinery  and equipment   |       | 5  - 10 years    |       | 24,099,278         |       | 22,573,324        |       |
| Furniture  and fixtures    |       | 5  - 7 years     |       | 898,283            |       | 891,169           |       |
|                       |       |             |       | $                  | 47,455,902 |              | $          | 41,431,158 |   |
| Accumulated  depreciation  |       |             |       | (20,587,319        | )          | (18,533,773       | )          |
|                       |       |             |       | $                  | 26,868,583 |              | $          | 22,897,385 |   |

 

**Note 6.  Investment Securities -Available-for-Sale**

 

OnJuly 1, 2008, the Company adopted the authoritative guidance whichclarifies the definition of fair value, establishes a framework for measuringfair value, and expands the disclosures on fair value measurements. Fair valueis defined as the exchange price that would be received for an asset or paid totransfer a liability (an exit price) in the principal or most advantageousmarket for the asset or liability in an orderly transaction between marketparticipants on the measurement date. The authoritative guidance alsoestablishes a fair value hierarchy which requires an entity to maximize the useof observable inputs and minimize the use of unobservable inputs when measuringfair value. Three levels of inputs were established that may be used to measurefair value:

 

Level 1— Quoted prices in active markets for identical assets or liabilities.  The Company does not have any Level 1available-for-sale securities as of March 31, 2010 or June 30, 2009.

 

Level 2— Observable inputs other than Level 1 prices, such as quoted prices forsimilar assets or liabilities; quoted prices for identical or similarinstruments in markets that are not active; or model-derived valuations whoseinputs are observable or whose significant value drivers are observable. TheCompany’s Level 2 assets and liabilities primarily include debt securitieswith quoted prices that are traded less frequently than exchange-tradedinstruments, corporate bonds, U.S. government and agency securities and certainmortgage-backed and asset-backed securities whose values are determined usingpricing models with inputs that are observable in the market or can be derivedprincipally from or corroborated by observable market data.  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 by little or no market activity andthat are financial instruments whose values are determined using pricingmodels, discounted cash flow methodologies, or similar techniques, as well asinstruments for which the determination of fair value requires significantjudgment or estimation. The Company does not have any Level 3available-for-sale securities as of March 31, 2010 or June 30, 2009.

 

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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 amortized cost, gross unrealized gains and losses, and fair valueof the Company’s available-for-sale securities are summarized as follows:

 

March 31,2010

Available-for-Sale

 
| ** **              | ** ** | **Amortized Cost** | ** ** | **Gross Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
|-------------------------|------------|-------------------------|------------|----------------------------------|------------|-------------------------------|------------|---------------------|------------|
|                    |       |                    |       |                             |       |                          |       |                |       |
| U.S.  Government Agency |       | $                       | 928,910    |                             | $          | 21,551                        |       | $                   | —     |   | $ | 950,461 |   |
| Corporate  Bonds        |       | 179,507                 |       | 3,062                            |       | —                        |       | 182,569             |       |
|                    |       | $                       | 1,108,417  |                             | $          | 24,613                        |       | $                   | —     |   | $ | 1,133,030 |   |

 

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 |   |

 

The amortized cost and fair value of the Company’s currentavailable-for-sale securities by contractual maturity at March 31, 2010and June 30, 2009 are summarized as follows:

 
| ** **                              | ** ** | **March 31, 2010** | ** ** | **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    |                   | $          | 735,866 |   | $ | 338,159 |   | $ | 347,921 |   |
| Due after one year  through five years  |       | 388,179                 |       | 397,164                |       | 770,258 |   | 801,748 |   |
| Due after five years  through ten years |       | —                  |       | —                 |       | — |   | — |   |
| Due after ten years                     |       | —                  |       | —                 |       | — |   | — |   |
|                                    |       |                    |       |                   |       |   |   |   |   |
| Total  available-for-sale securities    |       | 1,108,417               |       | 1,133,030              |       | 1,108,417 |   | 1,149,669 |   |
| Less current portion                    |       | 720,238                 |       | 735,866                |       | 338,159 |   | 347,921 |   |
|                                    |       |                    |       |                   |       |   |   |   |   |
| Long term  available-for-sale securites |       | $                       | 388,179    |                   | $          | 397,164 |   | $ | 770,258 |   | $ | 801,748 |   |

 

TheCompany uses the specific identification method to determine the cost ofsecurities sold. For the nine months ended March 31, 2010, the Company hadno realized gains or losses, whereas for the nine months ended March 31,2009, the Company had realized gains of $60,242.

 

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Asof March 31, 2010 and June 30, 2009, there were no securities heldfrom a single issuer that represented more than 10% of shareholders’equity.  As of March 31, 2010, therewere no individual securities in a continuous unrealized loss position.

 

**Note 7. Bank Line of Credit**

 

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% and 3.00% at March 31,2010 and June 30, 2009, respectively). As of March 31, 2010 and June 30,2009, the Company had $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. As of March 31, 2010, the Company was in compliance with allfinancial 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 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%.

 

**Note 8.  Unearned Grant Funds**

 

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 therequirements of the grant funding program. As of March 31, 2010, the Company has had preliminary discussionswith the Commonwealth of Pennsylvania to determine whether it will berequired to repay any of the funds provided under the grant fundingprogram.  Based on information available at March 31, 2010, theCompany has recorded the grant funding as a long-term liability under thecaption of Unearned Grant Funds.

 

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**Note 9.  Long-Term Debt**

 

Long-term debt consists of the following:

 
| ** **                                                                 | ** ** | **March 31,** | ** ** | **June 30,** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------|------------|-------------------|------------|
| ** **                                                                 | ** ** | **2010**           | ** ** | **2009**          | ** ** |
| PIDC  Regional Center, LP III loan                                         |       | $                  | 4,500,000  |              | $          | 4,500,000 |   |
| Pennsylvania  Industrial Development Authority loan                        |       | 946,425            |       | 1,002,607         |       |
| Pennsylvania  Department of Community & Economic Development loan |       | 105,538            |       | 182,831           |       |
| Tax-exempt  bond loan (PAID)                                               |       | 680,000            |       | 680,000           |       |
| Equipment  loan                                                            |       | —             |       | 80,130            |       |
| First  National Bank of Cody mortgage                                      |       | 1,655,555          |       | 1,693,200         |       |
|                                                                       |       |               |       |              |       |
| Total  debt                                                                |       | 7,887,518          |       | 8,138,768         |       |
| Less  current portion                                                      |       | 4,862,141          |       | 435,386           |       |
|                                                                       |       |               |       |              |       |
| Long  term debt                                                            |       | $                  | 3,025,377  |              | $          | 7,703,382 |   |
|                                                                       |       |               |       |              |       |
| ** **                                                                 | ** ** | **March 31,** | ** ** | **June 30,** | ** ** |
| **Current Portion of Long Term Debt**             | ** ** | **2010**           | ** ** | **2009**          | ** ** |
| PIDC  Regional Center, LP III loan                                         |       | $                  | 4,500,000  |              | $          | — |   |
| Pennsylvania  Industrial Development Authority loan                        |       | 76,554             |       | 75,017            |       |
| Pennsylvania  Department of Community & Economic Development loan |       | 105,516            |       | 103,100           |       |
| Tax-exempt  bond loan (PAID)                                               |       | 125,000            |       | 125,000           |       |
| Equipment  loan                                                            |       | —             |       | 80,130            |       |
| First  National Bank of Cody mortgage                                      |       | 55,071             |       | 52,139            |       |
|                                                                       |       |               |       |              |       |
| Total  current portion of long term debt                                   |       | $                  | 4,862,141  |              | $          | 435,386 |   |

 

In December 2005, the Company financed $4,500,000 through thePhiladelphia Industrial Development Corporation (PIDC). The Company pays abi-annual interest payment at a rate equal to two and one-half percent perannum.  The outstanding principal balance is due and payable on January 1,2011.  The Company intends to refinancethis loan during the fourth quarter of fiscal 2010.

 

The Company financed $1,250,000 through the Pennsylvania IndustrialDevelopment Authority (PIDA).  The Company is required to make equalpayments each month for 180 months starting February 1, 2006 with interestof 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 payments for 60 months starting May 1,2006 with interest of two and three quarter percent per annum.

 

In April 1999, the Company entered into a loan agreement (the“Agreement”) with a governmental authority, the Philadelphia Authority forIndustrial Development (the “Authority” or “PAID”), to finance futureconstruction and growth projects of the Company. The Authority issued$3,700,000 in tax-exempt variable rate demand and fixed rate revenue bonds toprovide the funds to finance such growth projects pursuant to a trust indenture(“the 

 

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Trust Indenture”).  A portion of the Company’s proceeds from thebonds was used to pay for bond issuance costs of approximately $170,000. The Trust Indenture requires that the Company repay the Authority loan throughinstallment payments beginning in May 2003 and continuing through May 2014,the year the bonds mature. The bonds bear interest at the floating variable ratedetermined by the organization responsible for selling the bonds (the“remarketing agent”).  The interest rate fluctuates on a weeklybasis.  The effective interest rate at March 31, 2010 and June 30,2009 was 0.50% 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.  TheCompany, as part of the 2003 Loan Financing agreement, is required to makeequal payments of principal and interest.  The only portion of the loanthat remained outstanding at June 30, 2009 was the Equipment Loan, whichhad an outstanding balance of $80,130 at June 30, 2009.  This loanwas fully repaid as of March 31, 2010.

 

The Company has executed Security Agreements with Wachovia, PIDA andPIDC in which the Company has agreed to pledge substantially all of its assetsto collateralize the amounts due.

 

Aspart of the Cody acquisition, the Company became primary beneficiary to avariable interest entity (“VIE”) called Cody LCI Realty, LLC.  See Note16, Consolidation of Variable Interest Entity for additional description. The VIE owns land and a building which is being leased to Cody.  A mortgageloan with First National Bank of Cody has been consolidated in the Company’sfinancial statements, along with the related land and building.  Principaland interest payments of $14,782, at a fixed interest rate of 7.5%, are beingmade on a monthly basis through June 2026.  The mortgage loan iscollateralized by the land and building.

 

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

 
| **Twelve**         | ** ** | **Amounts Payable** | ** ** |
|--------------------|------------|---------------------|------------|
| **Month  Periods** | ** ** | **to Institutions** | ** ** |
|               |       |                |       |
| 2011               |       | $                   | 4,862,141  |   |
| 2012               |       | 268,093             |       |
| 2013               |       | 275,305             |       |
| 2014               |       | 290,459             |       |
| 2015               |       | 240,161             |       |
| Thereafter         |       | 1,951,359           |       |
|               |       |                |       |
|               |       | $                   | 7,887,518  |   |

 

**Note 10.  Contingencies**

 

OnMarch 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.

 

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**Note 11.   Commitments**

 

***Leases***

 

InJune 2006, Lannett signed a lease agreement on a 66,000 square footfacility located on seven acres in Philadelphia.  The Company purchased this building in October 2009for 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.  Construction is expected to be completedduring the fourth quarter of Fiscal 2010. The financing will be competed shortly thereafter.  This new facility is initially going to beused for warehouse space with the expectation of making this facility theCompany’s headquarters and possibly additional manufacturing space.  The other Philadelphia locations willcontinue to be utilized for manufacturing, packaging, and research.

 

Lannett’ssubsidiary, Cody leases a 73,000 square foot facility in Cody, Wyoming.  This location houses Cody’s manufacturing andproduction facilities. Cody leases the facility from Cody LCI Realty, LLC, aWyoming limited liability company which is 50% owned by Lannett.   See Note 16.

 

Rentaland lease expense for the three months ended March 31, 2010 and 2009 wasapproximately $30,000 and $110,000, respectively.  Rental and lease expense for the nine monthsended March 31, 2010 and 2009 was approximately $134,000 and $335,000,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, Ernest Sabo,Vice President of Regulatory Affairs and Chief Compliance Officer, and StephenKovary, Vice President of Operations.  Each of the agreements provide foran annual base salary and eligibility to receive a bonus.  The bonusamounts of these executives are determined by the Board of Directors. Additionally, these executives are eligible to receive stock options andrestricted stock awards, which are granted at the discretion of the Board ofDirectors, and in accordance with the Company’s policies regarding stock optionand restricted stock grants.  Under theagreements, these executive employees may be terminated at any time with orwithout cause, or by reason of death 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 wasdesignated as the portion of the settlement related to the repurchase of hisoutstanding stock options. The Company therefore charged this amount toAdditional Paid in Capital, as it represents the fair value of the optionsrepurchased on the repurchase date. Additional payments totaling approximately $369,000 for severance andbenefits will be paid in Fiscal 2011 pursuant to the separation agreement.

 

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**Note 12.  Comprehensive Income**

 

The Company’s other comprehensive (loss) income is comprised ofunrealized gains (losses) on investment securities classified asavailable-for-sale as well as foreign currency translation adjustments.  The components of comprehensive income andrelated taxes consisted of the following:

 
| ** **                                    | ** ** | **For the Three Months Ended  March 31,** | ** ** | **For the Nine Months Ended  March 31,** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                    | ** ** | **2010**                                       | ** ** | **2009**                                      | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                          |       |                                           |       |                                          |       |   |   |   |   |
| Net  Income                                   |       | $                                              | 2,092,854  |                                          | $          | 1,314,482 |   | $ | 5,004,816 |   | $ | 4,113,709 |   |
| Foreign  currency translation adjustments     |       | (33,239                                        | )          | —                                        |       | (22,340 | ) | — |   |
| Unrealized  holding (loss) gain on securities |       | (5,552                                         | )          | (43,479                                       | )          | (16,639 | ) | 22,190 |   |
| Tax  effect                                   |       | 2,221                                          |       | 17,392                                        |       | 6,656 |   | (8,876 | ) |
|                                          |       |                                           |       |                                          |       |   |   |   |   |
| Total  Other Comprehensive (Loss) Income      |       | (36,570                                        | )          | (26,087                                       | )          | (32,323 | ) | 13,314 |   |
|                                          |       |                                           |       |                                          |       |   |   |   |   |
| Total  Comprehensive Income                   |       | $                                              | 2,056,284  |                                          | $          | 1,288,395 |   | $ | 4,972,493 |   | $ | 4,127,023 |   |

 

**Note 13.   Employee Benefit Plan**

 

TheCompany has a defined contribution 401k plan (the “Plan”) coveringsubstantially all employees.  Pursuant to the Plan provisions, the Companyis required to make matching contributions equal to 50% of each employee’scontribution, but not to exceed 4% of the employee’s compensation for the Planyear.  Contributions to the Plan during the three months ended March 31,2010 and 2009 were $88,000 and $86,000, respectively.  For the nine months ended March 31, 2010and 2009, contributions to the Plan were $303,000 and $249,000, respectively.

 

**Note 14.   Employee Stock Purchase Plan**

 

InFebruary 2003, the Company’s shareholders approved an Employee StockPurchase Plan (“ESPP”).  Employees eligible to participate in the ESPP maypurchase shares of the Company’s stock at 85% of the lower of the fair marketvalue of the common stock on the first day of the calendar quarter, or the lastday 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 implementedon April 1, 2003 and is qualified under Section 423 of the InternalRevenue Code.  The Board of Directors authorized an aggregate total of1,125,000 shares of the Company’s common stock for issuance under theESPP.  As of March 31, 2010, 203,001 shares have been issued underthe ESPP.  Compensation expense of $10,440 and $39,023 has been recognizedfor the three months ended March 31, 2010 and 2009, respectively, relatingto the ESPP. Compensation expense of $43,516 and $70,315 has been recognizedfor the nine months ended March 31, 2010 and 2009, respectively, relatingto 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.

 

Theprovision for federal, state and local income taxes for the three months ended March 31,2010 and 2009 was tax expense of approximately $527,000 and $851,000,respectively, with effective tax rates of 20% and 39%, respectively. Theprovision for federal, state and local income taxes for the nine months ended March 31,2010 and 2009 was tax expense of approximately $3,525,000 and $2,697,000,respectively, with effective tax rates of 41% and 39%, respectively.  The effective tax rate for the three monthsended March 31, 2010 was lower compared to the three months ended March 31,2009 due primarily to the settlement reached with the IRS related to its review of the federal income tax return forFiscal 2008.  As a result of thesettlement, the Company recorded a refund receivable totaling approximately$418,000.  The Company also reduced itsliability for unrecognized tax benefits by approximately $216,000 as aresult of the IRS settlement.  Theeffective tax rate for the nine months ended March 31, 2010 includes theimpact of 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 approximately 8% for the nine months ended March 31, 2010.  The increase in effective tax rate related tothis change in Pennsylvania tax law was essentially offset by the impact of theIRS settlement agreement described above.  The Company expects its overall effective tax rate will be approximately40% to 42% for the full year ended June 30, 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 March 31, 2010 and June 30, 2009, the Company reported totalunrecognized benefits of $82,044 and $297,663, respectively.  As a result of the positions taken during theperiod, the Company has not recorded any interest and penalties for the periodended March 31, 2010 in the statement of operations and no cumulativeinterest and penalties have been recorded either in the Company’s statement offinancial position as of March 31, 2010 and June 30, 2009. TheCompany will recognize interest accrued on unrecognized tax benefits ininterest expense and any related penalties in operating expenses.  The Company does not believe that the totalunrecognized tax benefits will significantly increase or decrease in the nexttwelve months.

 

The Company files income tax returns in theUnited States federal jurisdiction, Pennsylvania, New Jersey andCalifornia.  The Company’s tax returns for Fiscal 2005 and prior generallyare no longer subject to review as such years generally are closed. The IRS hascompleted its review of the federal income tax return for Fiscal 2008.  Asdescribed above, the Company recorded a refund receivable totalingapproximately $418,000 and reduced its liability for unrecognizedtax benefits by approximately $216,000 as a result of the settlement agreementreached with the IRS.  The Company believes that an unfavorableresolution for open tax years would not be material to the financial positionof the Company.

 

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**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 March 31, 2010 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 March 31, 2010 and June 30, 2009, respectively.

 

CodyLCI Realty LLC (“Realty”) is the only VIE that is consolidated.  Realtyhad been consolidated by Cody prior to its acquisition by Lannett.  Realtyis a 50/50 joint venture with a former shareholder of Cody.  Its purposewas to acquire the facility used by Cody.  Until the acquisition ofCody in April 2007, Lannett had not consolidated the VIE because CodyLabs had been the primary beneficiary of the VIE.  The risks associatedwith our interests in this VIE is limited to a decline in the value of the landand building as compared to the balance of the mortgage note on that property,up to Lannett’s 50% share of the venture.  Realty owns the land andbuilding, and Cody leases the building and property from Realty for $20,000 permonth effective October 2009.  All intercompany rent expense iseliminated upon consolidation with Cody.

 

TheCompany is not involved in any other VIE.

 

**Note 17.  Related PartyTransactions**

 

The Company had sales of approximately $625,000 and $522,000 during thenine months ended March 31, 2010 and 2009, respectively, to a genericdistributor, Auburn Pharmaceutical Company (“Auburn“).  Sales to Auburn for the three months ended March 31,2010 and 2009 were $201,000 and $138,000, respectively.  Jeffrey Farber (the “related party”), who is acurrent board member and the son of the Chairman of the Board of Directors andprincipal shareholder of the Company, is the owner of Auburn.  Accounts receivable includes amounts due fromthe related party of approximately $139,000 and $125,000 at March 31, 2010and June 30, 2009, respectively.  Inthe Company’s opinion, the terms of these transactions were not more favorableto the 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. (“Pharmeral”) owned the ANDA.  In Fiscal 2008, the Company obtained FDAapproval to use the proprietary rights. Accordingly, the Company originally capitalized these rights as anindefinite lived intangible asset and tested this asset for impairment at leaston an annual basis.  During the fourthquarter of Fiscal 2009, it was determined that this intangible asset no longerhas an indefinite life.  No impairmentexisted because the estimated fair value exceeded the carrying amount on thatdate. Accordingly, the $100,000 carrying amount of this intangible asset isbeing amortized on a straight line basis prospectively over its 10 yearremaining estimated useful life.

 

Arthur Bedrosian, President and Chief Executive Officer, currently owns100% of Pharmeral.  This transaction wasapproved by the Board of Directors of the Company and in their opinion theterms were not more favorable to the related party than they would have been toa non-related party. In May 2008, Mr. Bedrosian and Pharmeral waivedtheir rights to any royalty payments on the sales of the drug by Lannett underLannett’s current ownership structure. Should Lannett undergo a change in control transaction with a thirdparty, this royalty would be reinstated.

 

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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, theCompany terminated its participation in this joint venture. In connection withthe termination agreement, the Company is required to pay Provell ten percentof net 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 March 31, 2010 and June 30, 2009, respectively. The Companyrecognized revenues from Provell of approximately $349,000 and $735,000,respectively, during the three and nine months ended March 31, 2009.

 

**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 73% and 77% of the Company’s inventorypurchases during the three and nine month periods ended March 31, 2010 and70% and 69% during the three and nine month periods ended March 31, 2009,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 theright to terminate the contract if one of the parties does not cure a materialbreach of the contract within thirty (30) days of notice from the non-breachingparty.

 

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 sixyears 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 March 31,2010, 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 JSP.  Should there be an interruption in the supplyof product from JSP for any reason, this event would have a material impact tothe financial condition of Lannett.

 

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**ITEM 2.          MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONAND RESULTS OF OPERATIONS.**

 

***Introduction***

 

Thefollowing information should be read in conjunction with the consolidatedfinancial statements and notes in Part I, Item 1 of this Quarterly Reportand with Management’s Discussion and Analysis of Financial Condition andResults of Operations contained in the Company’s Annual Report on Form 10-Kfor the fiscal year ended 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 March 31, 2010 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 March 31, 2010 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.

 

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***Revenue Recognition*** — The Companyrecognizes revenue when its products are shipped.  At this point, title andrisk of loss have transferred to the customer and provisions for rebates,promotional adjustments, price adjustments, returns, chargebacks, and otherpotential adjustments are reasonably determinable.  Accruals for theseprovisions are presented in the consolidated financial statements as rebates,chargebacks and returns payable and as reductions to net sales. The change inthe reserves for various sales adjustments may not be proportionally equal tothe 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 estimated rebatesand promotional credits are estimated based upon contractual terms. Provisions for other customer credits, such as price adjustments, returns, andchargebacks, require management to make subjective judgments on customer mix.Unlike branded innovator drug companies, Lannett does not use information aboutproduct levels in distribution channels from third-party sources, such as IMSand Wolters Kluwer, in estimating future returns and other credits. Lannettcalculates 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.  The chargeback/rebate reserve is reviewed on a monthly basisby management using several ratios and calculated metrics.  As we continueto obtain additional information about our historical experience forchargebacks, rebates and returns, we also update our estimates of the requiredreserves.

 

***Chargebacks***— The provision forchargebacks is the most significant and complex estimate used in therecognition of revenue.  The Company sells its products directly towholesale distributors, generic distributors, retail pharmacy chains, andmail-order pharmacies.  The Company also sells its products indirectly toindependent pharmacies, managed care organizations, hospitals, nursing homes,and group purchasing organizations, collectively referred to as “indirectcustomers.”  Lannett enters into agreements with its indirect customers toestablish pricing for certain products.  The indirect customers thenindependently select a wholesaler from which to actually purchase the productsat these agreed-upon prices.  Lannett will provide credit to thewholesaler for the difference between the agreed-upon price with the indirectcustomer and the wholesaler’s invoice price if the price sold to the indirectcustomer is lower than the direct price to the wholesaler.  This credit iscalled a chargeback.  The provision for chargebacks is based on expectedsell-through levels by the Company’s wholesale customers to the indirectcustomers and estimated wholesaler inventory levels.  As sales by theCompany to the large wholesale customers, such as Cardinal Health,AmerisourceBergen, and McKesson, increase, the reserve for chargebacks willalso generally increase.  However, the size of the increase depends on theexpected mix of product sales to the indirect customers. The Companycontinually monitors the reserve for chargebacks and makes adjustments when managementbelieves that expected chargebacks on actual sales may differ from the amountsthat were assumed in the establishment of the chargeback reserves.

 

***Rebates***— Rebates are offered to theCompany’s key chain drug store and wholesaler customers to promote customerloyalty and increase product sales.  These rebate programs providecustomers with rebate credits upon attainment of pre-established volumes orattainment of net sales milestones for a specified period.  Otherpromotional programs are incentive programs offered to the customers.  Atthe time of shipment, the Company estimates reserves for rebates and otherpromotional credit programs based on the specific terms in eachagreement.  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 with industrypractice, 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

 

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cause management to believe that future product returns may differ fromthose returns assumed in the establishment of reserves.  Generally, thereserve for returns increases as sales increase and decrease when credits areissued or payments are made for actual returns received.  The reserve forreturns is included in the rebates, chargebacks and returns payable account onthe balance sheet.

 

***Other Adjustments —*** Other adjustments consistprimarily of price adjustments, also known as “shelf stock adjustments,” whichare credits issued to reflect decreases in the selling prices of the Company’sproducts that customers have remaining in their inventories at the time of aprice reduction.  Decreases in selling prices are discretionary decisionsmade by management to reflect competitive market conditions.  Amountsrecorded for estimated shelf stock adjustments are based upon specified termswith direct 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.

 

Thefollowing tables identify the reserves for each major category of revenueallowance and a summary of the activity for the nine months ended March 31,2010 and 2009:

 
| **For the  nine months ended March 31, 2010  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                      |       | (5,218,835      | )          | (2,537,746  | )          | (3,112,587  | )          | —    |       | (10,869,168 | )          |
| 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 |       | 35,900,162      |       | 12,529,499  |       | 3,803,056   |       | 880,860   |       | 53,113,577  |       |
| Actual  credits issued related to sales recorded in Fiscal 2010                             |       | (30,081,997     | )          | (9,527,547  | )          | —      |       | (880,860  | )          | (40,490,404 | )          |
| Reserve  Balance as of March 31, 2010                                                  |       | $               | 6,689,132  |        | $          | 3,001,952   |       | $         | 5,797,461  |        | $          | — |   | $ | 15,488,545 |   |

 
| **For the  nine months ended March 31, 2009  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                      |       | (3,930,992      | )          | (632,314    | )          | (12,246,259 | )          | —    |       | (16,809,565 | )          |
| 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 |       | 24,342,932      |       | 8,498,516   |       | 3,441,427   |       | 208,649   |       | 36,491,524  |       |
| Actual  credits issued related to sales recorded in Fiscal 2009                             |       | (19,914,114     | )          | (6,754,177  | )          | —      |       | (167,911  | )          | (26,836,202 | )          |
| Reserve  Balance as of March 31, 2009                                                  |       | $               | 4,547,233  |        | $          | 1,744,339   |       | $         | 4,839,864  |        | $          | 40,738 |   | $ | 11,172,174 |   |

 

The total reserve for chargebacks, rebates, returns and otheradjustments increased from $13,734,540 at June 30, 2009 to $15,488,545 at March 31,2010.   As of March 31, 2010 approximately $10,129,000 ofthe 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 $416,000 of Multivitamin returns reserve on the consolidatedbalance sheet at March 31, 2010. 

 

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The increase in reserves was due to an increase in the rebates reserve asa result of the timing of credits being processed by the customers and by theCompany, an increase in chargeback reserves due primarily to an increase ininventory levels at wholesaler distribution centers, and an increase in thereturn reserves due to an increase in overall sales.

 

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 theseestimates are reasonable based upon historical experience and currentconditions.

 

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 the pricingof other generic companies.  The Companyhas improved its computer systems in order to improve the accuracy of trackingand processing chargebacks and rebates and will continue to look at ways forfurther improvements.  Improvements toautomate calculation of reserves will not only reduce the potential for humanerror, but also will result in more in-depth analysis and improved customerinteraction for resolution of open credits.

 

The rate of credits issued is monitored by the Company at least on a quarterlybasis.  The Company may change theestimate of future reserves based on the amount of credits processed, or therate of sales made to indirect customers.  The increase of reserves to $15,488,545 at March 31, 2010 from$13,734,540 at June 30, 2009 is due to the timing of credits beingprocessed by the customers and by the Company. Approximately $10,869,000 or 79% of the reserve balance from June 30,2009 has been processed through the first nine months of Fiscal 2010.  Approximately $412,000 of that amount relatesto credits issued due to the return by customers of the Prenatal Multivitaminproduct through March 31, 2010. 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.

 

TheCompany also regularly monitors accounts receivable (“AR”) balances byreviewing both net and gross day’s sales outstanding (“DSO”).  Net DSO is calculated by dividing grossaccounts receivable less the reserve for rebates, chargebacks, returns andother adjustments by the average daily net sales for the period.  Gross DSO shows the result of the samecalculation without regard to rebates, chargebacks, returns and otheradjustments.

 

TheCompany monitors both net DSO and gross DSO as an overall check on collectionsand to assess the reasonableness of the reserves. Gross DSO provides managementwith an understanding of the frequency of customer payments, and the ability toprocess customer payments and deductions. The net DSO calculation provides management with an understanding of therelationship of the AR balance net of the reserve liability 

 

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comparedto net sales after 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.

 

Thefollowing table shows the results of these calculations as of the relevantperiods:

 

| ** **          | ** ** | **3/31/10** | ** ** | **6/30/09** | ** ** | **3/31/09** | ** ** |
|---------------------|------------|-------------|------------|-------------|------------|-------------|------------|
| Net DSO (in days)   |       | 78          |       | 55          |       | 59          |       |
| Gross DSO (in days) |       | 65          |       | 53          |       | 64          |       |

 

Thelevel of net DSO at March 31, 2010 is slightly higher than the Company’sexpectation that DSO will be in the 60 to 70 day range based on 60 day paymentterms for most customers.  The increaseis due to a higher percentage of sales being shipped at the end of the quarter.

 

***Inventories****—* The Companyvalues 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 and production requirements.  The Company’s estimates of future productdemand may prove to be inaccurate, in which case it may have understated oroverstated the provision required for excess and obsolete inventory. In thefuture, if the Company’s inventory is determined to be overvalued, the Companywould be required to recognize such costs in cost of goods sold at the time ofsuch determination. Likewise, if inventory is determined to be undervalued, theCompany may have recognized excess cost of goods sold in previous periods andwould be required to recognize such additional operating income at the time ofsale.

 

***Results of Operations - Three months ended March 31,2010 compared with three months ended March 31, 2009***

 

Netsales for the three months ended March 31, 2010 (“Fiscal 2010”) increased9% to $31,266,000 from $28,761,000 for the three months ended March 31,2009 (“Fiscal 2009”). The following factors contributed to the $2,505,000increase in sales:

 
| **Medical  indication** | ** ** | **Sales volume  change %** | ** ** | **Sales price  change %** | ** ** |
|-------------------------|------------|----------------------------|------------|---------------------------|------------|
| Heart Failure           |       | 3                          | %          | 26                        | %          |
| Antibiotics             |       | 3                          | %          | 11                        | %          |
| Prescription Vitamins   |       | -67                        | %          | -9                        | %          |
| Epilepsy                |       | -24                        | %          | -9                        | %          |
| Thyroid Deficiency      |       | 6                          | %          | 3                         | %          |
| Pain Management         |       | 241                        | %          | -2                        | %          |
| Migraine Headache       |       | -14                        | %          | 0                         | %          |

 

Salesof drugs used for pain management increased by approximately $2,674,000 for thethree months ended March 31, 2010 compared to March 31, 2009. Thisincrease is due to an increased number of products offered as well as a marketwithdrawal by one of our major competitors. Sales of drugs used in the treatment of thyroid deficiency increased byapproximately $1,088,000 as a result of a continued shift away from brandeddrugs towards generic prescriptions.  Theoverall increase in sales was also affected by an increase in sales of drugsfor

 

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thetreatment of congestive heart failure by approximately $1,132,000 for the threemonths ended March 31, 2010 compared to March 31, 2009 due to anincrease in the wholesale average price. Partially offsetting these increases was a decrease in sales of ourprescription vitamins of approximately $3,444,000 due to a lack of sellingactivities by the branded drug company. Additional sales can also be attributedto new drugs used for the treatment of gallstones totaling approximately$588,000.

 

TheCompany expects to continue increasing the number of products available forsale to its customers, which will require additional FDA approvals. TheCompany’s receipt of several approvals by the FDA to offer new products hasresulted in more 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 March 31,2010 and 2009:

 
| ** **               | ** ** | **Three Months Ended March 31,** | ** ** |
|--------------------------|------------|---------------------------------------|------------|
| **Customer  Category**   | ** ** | **2010**                              | ** ** | **2009** | ** ** |
|                     |       |                                  |       |   |   |
| Wholesaler/  Distributor |       | $                                     | 14,369,000 |   | $ | 12,252,000 |   |
| Retail  Chain            |       | 15,223,000                            |       | 15,015,000 |   |
| Mail-Order  Pharmacy     |       | 1,674,000                             |       | 1,356,000 |   |
| Private  Label           |       | —                                |       | 138,000 |   |
|                     |       |                                  |       |   |   |
| Total                    |       | $                                     | 31,266,000 |   | $ | 28,761,000 |   |

 

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 third quarter increased 22% to $20,869,000 in Fiscal 2010 from$17,154,000 in Fiscal 2009.  The increasereflected the impact of the 9% increase in sales as well as additionalroyalties of approximately $86,000 primarily related to the prescriptionvitamins and our amantadine product.  Theincrease in cost of sales was more than the increase in sales due to therelative mix of the sales of the products described above.

 

Amortizationexpense primarily relates to the JSP Distribution Agreement.  For the remaining term of the JSPDistribution Agreement, the Company will incur annual amortization expense ofapproximately $1,785,000.

 

Grossprofit margins for the third quarter of Fiscal 2010 and Fiscal 2009 were 33%and 40%, respectively. Gross profit percentage decreased due to the decline insales of prescription vitamins as well as the commencement of the relatedroyalty.  While the Company iscontinuously striving to keep product costs low, there can be no guarantee thatprofit margins will not fluctuate in future periods.  Pricing pressure from competitors and costsof producing or purchasing new drugs may also fluctuate in the future. Changes in the future sales product mix mayalso occur. These changes may affect the gross profit percentage in futureperiods.

 

Researchand development (“R&D”) expenses in the third quarter increased 69% to$3,352,000 for Fiscal 2010 from $1,981,000 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 third quarterdecreased 41% to $4,393,000 in Fiscal 2010 from $7,492,000 in Fiscal 2009.  The decrease is primarily due to litigationexpenses in Fiscal 2009 related to the patent challenge with KV Pharmaceuticalsof approximately $2,530,000 for the third quarter of Fiscal 2009 which were notincurred in Fiscal 2010 as the litigation was settled in March 2009.  In the third quarter of Fiscal 

 

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2009,the Company also incurred severance costs related to the departure of theCompany’s former chief financial officer of approximately $452,000 which werenot incurred in Fiscal 2010. While the Company is focused on controlling costs,increases in personnel costs may have an ongoing and longer lasting impact onthe administrative cost structure.  Othercosts are being incurred to facilitate improvements in the Company’sinfrastructure.  These costs are expectedto be temporary investments in the future of the Company and may not continueat the same level.

 

Interestexpense in the third quarter decreased to $50,000 in Fiscal 2010 compared to$75,000 in Fiscal 2009 primarily due to lower levels of long-term debt.  Interest income in the third quarterdecreased to $5,000 in Fiscal 2010 from $78,000 in Fiscal 2009 due to lowerinterest earned on investment securities.

 

TheCompany recorded income tax expense in the third quarter of 2010 of $527,000compared to $851,000 in the third quarter of Fiscal 2009. The effective taxrate for the three months ended March 31, 2010 was 20%, compared to 39%for the three months ended March 31, 2009. The effective tax rate for the three months ended March 31, 2010was lower compared to the three months ended March 31, 2009 due primarilyto the settlement reached with the IRS related to its review of the federal income tax return for Fiscal 2008.  As a result of the settlement, the Companyrecorded a refund receivable totaling approximately $418,000.  The Company also reduced its liability for unrecognizedtax benefits by approximately $216,000 as a result of the IRS settlement.  The Company expects its overall effective taxrate will be approximately 40% to 42% for the full year ended June 30,2010.

 

TheCompany reported net income of approximately $2,093,000 in the third quarter ofFiscal 2010, or $0.08 basic and diluted earnings per share, as compared to$1,314,000 in the third quarter Fiscal 2009, or $0.05 basic and dilutedearnings per share.

 

***Results of Operations — Nine months ended March 31,2010 compared with nine months ended March 31, 2009***

 

Netsales for the nine months ended March 31, 2010 (“Fiscal 2010”) increased9% to $91,418,000 from $83,553,000 for the nine months ended March 31,2009 (“Fiscal 2009”). The following factors contributed to the $7,865,000increase in sales:

 
| **Medical  indication** | ** ** | **Sales volume  change %** | ** ** | **Sales price  change %** | ** ** |
|-------------------------|------------|----------------------------|------------|---------------------------|------------|
| Heart Failure           |       | - 7                        | %          | 2                         | %          |
| Antibiotics             |       | 10                         | %          | 0                         | %          |
| Prescription Vitamin    |       | -40                        | %          | -21                       | %          |
| Epilepsy                |       | -20                        | %          | 24                        | %          |
| Thyroid Deficiency      |       | 10                         | %          | 0                         | %          |
| Pain Management         |       | 340                        | %          | 15                        | %          |
| Migraine Headache       |       | -8                         | %          | 10                        | %          |

 

Salesof drugs used for pain management increased by approximately $6,991,000 for thenine months ended March 31, 2010 compared to March 31, 2009.  This increase is due to an increased numberof products offered as well as a market withdrawal by one of our majorcompetitors.  Sales of drugs used in thetreatment of thyroid deficiency increased by approximately $3,605,000 as aresult of a continued shift away from branded drugs 

 

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towardsgeneric prescriptions.  Partiallyoffsetting these increases was a decrease in sales of our prescription vitaminsof approximately $4,947,000 due to a lack of selling activities by the brandeddrug company. The overall increase in sales was also affected by a decrease insales of drugs for the treatment of congestive heart failure by approximately$783,000 in the first nine months of Fiscal 2010 compared to the first ninemonths of Fiscal 2009.  This decrease wasdue to a prior year product recall by several of our major competitors whichincreased our Fiscal 2009 revenues. Additional sales can also be attributed to new drugs used for thetreatment of gallstones totaling approximately $1,483,000.

 

TheCompany expects to continue increasing the number of products available forsale to its customers, which will require additional FDA approvals. TheCompany’s receipt of several approvals by the FDA to offer new products hasresulted in more 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 nine months ended March 31,2010 and 2009:

 
| ** **              | ** ** | **Nine Months Ended March 31,** | ** ** |
|-------------------------|------------|--------------------------------------|------------|
| **Customer Category**   | ** ** | **2010**                             | ** ** | **2009** | ** ** |
|                    |       |                                 |       |   |   |
| Wholesaler/ Distributor |       | $                                    | 41,710,000 |   | $ | 35,860,000 |   |
| Retail Chain            |       | 45,015,000                           |       | 43,166,000 |   |
| Mail-Order Pharmacy     |       | 4,693,000                            |       | 4,157,000 |   |
| Private Label           |       | —                               |       | 370,000 |   |
|                    |       |                                 |       |   |   |
| Total                   |       | $                                    | 91,418,000 |   | $ | 83,553,000 |   |

 

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 nine months increased 18% to $61,409,000 in Fiscal 2010from $51,922,000 in Fiscal 2009.  Theincrease reflected the impact of the 9% increase in sales as well as additionalroyalties of approximately $781,000 primarily related to the prescriptionvitamins, our amantadine product and the final payments under the Provelltermination agreement.  The increase incost of sales was more than the increase in sales due to the relative mix ofthe sales of the products described above.

 

Amortizationexpense primarily relates to the JSP Distribution Agreement.  For the remaining term of the JSPDistribution Agreement, the Company will incur annual amortization expense ofapproximately $1,785,000.

 

Grossprofit margins for the first nine months of Fiscal 2010 and Fiscal 2009 were33% and 38%, respectively. Gross profit percentage decreased due to the declinein sales of prescription vitamins as well as the commencement of the relatedroyalty.  While the Company is continuouslystriving to keep product costs low, there can be no guarantee that profitmargins will not fluctuate in future periods. Pricing pressure from competitors and costs of producing or purchasingnew drugs may also fluctuate in the future. Changes in the future sales product mix may also occur. These changes mayaffect the gross profit percentage in future periods.

 

Researchand development (“R&D”) expenses in the first nine months increased 60% to$9,110,000 for Fiscal 2010 from $5,685,000 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.

 

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Selling**,**general and administrative expenses in the first ninemonths decreased 36% to $12,205,000 in Fiscal 2010 from $19,116,000 in Fiscal2009.  The decrease is primarily due tolitigation expenses in Fiscal 2009 related to the patent challenge with KVPharmaceuticals of approximately $5,719,000 which were not incurred in Fiscal2010 as the litigation was settled in March 2009. In the third quarter ofFiscal 2009, the Company also incurred severance costs related to the departureof the Company’s former chief financial officer of approximately $452,000 whichwere not incurred in Fiscal 2010.  Whilethe Company is focused on controlling costs, increases in personnel costs mayhave an ongoing and longer lasting impact on the administrative coststructure.  Other costs are beingincurred 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.

 

Interest expense in thefirst nine months decreased to $204,000 in Fiscal 2010 compared to $259,000 inFiscal 2009 primarily due to lower levels of long-term debt.  Interest income in the first nine monthsdecreased to $49,000 in Fiscal 2010 from $216,000 in Fiscal 2009 due to lowerinterest earned on investment securities.

 

The Company recordedincome tax expense in the nine months ended March 31, 2010 totaling$3,525,000 compared to $2,697,000 in the nine months ended March 31, 2009.The effective tax rate for the nine months ended March 31, 2010 was 41%compared to 39% for the nine months ended March 31, 2009.  The effective tax rate for the nine monthsended March 31, 2010 includes the impact of a change in Pennsylvania taxlaw which lowered the Company’s apportionment factor within this state.  The impact of this change caused the Companyto reduce its deferred tax assets by approximately $650,000, and thereforeincreased the effective tax rate by approximately 8% for the nine months ended March 31,2010.  The increase in effective tax raterelated to this change in Pennsylvania tax law was essentially offset by theimpact of the settlement reached with the IRS related to its review of the federal income tax return forFiscal 2008.  As a result of thesettlement, the Company recorded arefund receivable totaling approximately $418,000 and reduced its liability forunrecognized tax benefits by approximately $216,000.  TheCompany expects its overall effective tax rate will be approximately 40% to 42%for the full year ended June 30, 2010.

 

The Company reported netincome of approximately $5,005,000 in the first nine months of Fiscal 2010, or$0.20 basic and diluted earnings per share, as compared to $4,114,000 in thefirst nine months Fiscal 2009, or $0.17 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 March 31,2010, working capital was $37,813,000, as compared to $38,632,000 at June 30,2009, a decrease of $819,000.

 

Netcash provided by operating activities of $1,787,000 in the first nine months ofFiscal 2010 reflected net income of $5,005,000, after adjusting for non-cashitems of $6,331,000, as well as cash used by changes in operating assets andliabilities of $9,549,000.  Significantchanges in operating assets and liabilities are comprised of:

 
| · | An increase in trade accounts receivable of $6,817,000 primarily as a  result of increased sales in Fiscal 2010. The change in the accounts  receivable balance from June 30, 2009 to March 31, 2010 includes a  non-cash decrease of approximately $412,000 related to the issuance of  credits for the returns of the multivitamin product received by the Company  through March 31, 2010. |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| · | An increase in inventories of $3,029,000 due to increased stocking  levels at both Lannett and Cody Labs for certain products as of  March 31, 2010 that are being carried in order to respond to the  increased order volume we are currently experiencing.                                                                                                                                            |
| · | An increase in prepaid taxes of $777,000 from income taxes payable of  $711,000 related to estimated tax payments made in Fiscal 2010.                                                                                                                                                                                                                                                                       |
| · | An increase in prepaid expenses and other current assets of $1,728,000  primarily related to the                                                                                                                                                                                                                                                                                                             |

 

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|   | Company’s payment of $1,406,000 to the FDA that accompanied an initial  application for approval of a currently marketed GRASE (“Generally Recognized  As Safe and Effective”) product. The Company is currently awaiting a response  from the FDA as to whether part or all of this fee is refundable. The FDA has  three to six months from date of submission in order to determine if any  amounts are refundable. Accordingly the Company is recording this amount in  Other Current Assets. If any part of the fee is not refundable, and the  Company receives approval to market the related product, the Company expects  to record the amount as an intangible asset and amortize it over the  estimated product life. If this application is not approved, the Company has  the right to re-file an application for this specific product with no  additional fee due. |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| · | An increase in accounts payable of $939,000 due to the timing of  payments at the end of the month.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| · | An increase in rebates, chargebacks and returns payable of $2,166,000  primarily due to an  increase in the rebates reserve as a result of the timing of credits being  processed by the customers and by the Company, an increase in chargeback  reserves due primarily to an increase in inventory levels at wholesaler  distribution centers, and an increase in the return reserves due to an  increase in overall sales. This increase was partly offset by a non-cash decrease of approximately $412,000 related to the  issuance of credits for the returns of the multivitamin product received by  the Company through March 31, 2010.                                                                                                                                                                                                                                             |
| · | A decrease in accrued payroll and payroll related costs of $413,000  primarily related to the payment in the first half of Fiscal 2010 of the  Fiscal 2009 accrued incentive compensation costs totaling approximately  $4,165,000. Of this amount, approximately $759,000 was settled with the  issuance of restricted stock and is therefore excluded from the consolidated  statement of cash flows.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |

 

Net cash used ininvesting activities of $9,259,000 for the nine months ended March 31,2010 is mainly the result of purchases of property, plant and equipment of$8,789,000, primarily related to acquired land and buildings to be used as theCompany’s headquarters and additional warehouse space, as well as the purchaseof an intangible asset (product rights) for $500,000.

 

Net cash provided byfinancing activities of $386,000 for the nine months ended March 31, 2010was primarily due to proceeds from the issuance of stock of $697,000 partiallyoffset by the purchase of shares of treasury stock totaling $123,000.  The Company also made scheduled debtrepayments of $251,000.

 

Long-term debt amountsdue, for the twelve month periods ended March 31 are as follows:

 
| **Twelve**         | ** ** | **Amounts Payable** | ** ** |
|--------------------|------------|---------------------|------------|
| **Month  Periods** | ** ** | **to Institutions** | ** ** |
|               |       |                |       |
| 2011               |       | $                   | 4,862,141  |   |
| 2012               |       | 268,093             |       |
| 2013               |       | 275,305             |       |
| 2014               |       | 290,459             |       |
| 2015               |       | 240,161             |       |
| Thereafter         |       | 1,951,359           |       |
|               |       |                |       |
|               |       | $                   | 7,887,518  |   |

 

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In December 2005,the Company financed $4,500,000 through the Philadelphia Industrial DevelopmentCorporation (PIDC). The Company pays a bi-annual interest payment at a rateequal to two and one-half percent per annum.  The outstanding principalbalance is due and payable on January 1, 2011.  The Company intends to refinance this loanduring the fourth quarter of fiscal 2010.

 

The Company has a$3,000,000 line of credit from Wachovia Bank, N.A. (“Wachovia”) that bearsinterest at the prime interest rate less 0.25% (3.00% and 3.00% at March 31,2010 and June 30, 2009, respectively). As of March 31, 2010 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.

 

The existing line ofcredit which was scheduled to expire on November 30, 2009, was renewed andextended 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 ofcredit, the loan agreement and the related letter of credit require that theCompany meet certain financial covenants and reporting standards, including theattainment of standard financial liquidity and net worth ratios.  As of March 31, 2010, the Company is incompliance with all financial covenants under the agreement.

 

In July 2004, theCompany received $500,000 of grant funding from the Commonwealth ofPennsylvania, acting through the Department of Community and EconomicDevelopment.  The grant funding program requires the Company to use thefunds for machinery and equipment located at their Pennsylvania locations, hirean additional 100 full-time employees by June 30, 2006, operate itsPennsylvania locations a minimum of five years and meet certain matchinginvestment 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 Company has recorded the unearned grantfunds as a liability until the Company complies with all of the requirements ofthe grant funding program. Through March 31, 2010, the Company hashad 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 March 31, 2010, 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.

 

**Prospectsfor the Future**

 

The Company has severalgeneric products under development. These products are all orally-administered, topical and parenteralproducts designed to be generic equivalents to brand named innovatordrugs.  The Company’s developmental drugproducts are intended to treat a diverse range of indications.  As one of the oldest generic drugmanufacturers in the country, formed in 1942, Lannett currently owns severalANDAs 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.

 

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The products underdevelopment 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.

 

The Company views its April 2007acquisition of Cody Laboratories, Inc. (“Cody Labs” or “Cody”) as animportant step in becoming a vertically integrated narcotics manufacturer anddistributor by allowing it to concentrate on developing and completing itsdosage form manufacturing in order to reduce narcotic API costs. In July 2008,the DEA granted Cody Labs a license to directly import raw poppy straw forconversion into API and/or various pharmaceutical products.  Only six other companies in the U.S. havebeen granted this license to date.  Thislicense allows the Company to avoid increased costs associated with buyingnarcotic API from other manufacturers. The Company anticipates that it can use this license to become avertically integrated manufacturer of narcotic products, as well as a supplierof API to the pharmaceutical industry. The Company believes that the aging domestic population may result in ahigher demand for pain management pharmaceutical products and that it will bewell-positioned to take advantage of this increased demand.

 

Cody Labs’ manufacturingexpertise in narcotic APIs will allow Lannett to build a market with limiteddomestic competition.  The Companyanticipates that the demand for narcotics and controlled drugs will continue togrow with the “Baby Boomer” generation demographics and that it iswell-positioned to take advantage of these opportunities by concentratingadditional resources in the narcotic area. The sale of pain management productsapproximated 12% of Net Sales for the third quarter of FY 2010 and 10% of netsales year-to-date.  Additionally, theAPI and dosage form production of these products were performed at our CodyLabs operations and, due to the increased volumes of sales on these products,allowed Cody to be profitable during the Company’s third quarter of 2010.

 

In addition to theefforts of its internal product development group, Lannett has contracted withseveral outside firms for the formulation and development of several newgeneric drug products.  These outsourcedR&D products are at various stages in the development cycle — formulation,analytical method development and testing and manufacturing scale-up.  These products are orally-administered soliddosage products, topical or parenterals intended to treat a diverse range ofmedical indications.  We intend to ultimatelytransfer the formulation technology and manufacturing process for all of theseR&D products to our own commercial manufacturing sites.  The Company initiated these outsourcedR&D efforts to complement the progress of its own internal R&D efforts.

 

Occasionally, the Companywill work on developing a drug product that does not require FDA approval.  Certain prescription drugs do not requireprior FDA approval before marketing. They include, for instance, drugs listed as DESI drugs (Drug EfficacyStudy implementation) which are under evaluation by FDA, Grandfathered Drugs,and prescription multivitamin drugs. A generic manufacturer may sell productswhich are chemically equivalent to innovator drugs, under FDA rules bysimply performing and internally documenting the normal research anddevelopment involved in bringing a new product to market.  Under this scenario, a generic company canforego the time required for FDA approval.

 

More specifically,certain products, marketed prior to the Federal Food, Drug and Cosmetic Act maybe considered GRASE or Grandfathered. GRASE products are those “old drugs that do not require prior approvalfrom FDA in order to be marketed because they are generally recognized as safeand effective based on published 

 

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scientific literature.”  Similarly, Grandfathered products are thosewhich “entered the market before the passage of the 1938 act or the 1962amendments to the act.”  Under thegrandfather 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 companiescurrently producing these products.

 

The Company has enteredsupply and development agreements with certain international companies,including Wintac of India, Orion Pharma of Finland, Azad Pharma AG and SwissCaps of Switzerland, Pharma 2B (formerly Pharmaseed) of Israel and the GCGroup, as well as certain domestic companies, including Banner Pharmacaps,Cerovene, Summit Bioscience LLC and Inverness. The Company is currently in negotiations on similar agreements withother international companies, through which Lannett will market and distributeproducts manufactured by Lannett or by third parties.  Lannett intends to use its strong customerrelationships to build its market share for such products, and increase futurerevenues and income.

 

The majority of theCompany’s R&D projects are being developed in-house under Lannett’s directsupervision and with Company personnel. Hence, the Company does not believe that its outside contracts forproduct development and manufacturing supply are material in nature, nor is theCompany substantially dependent on the services rendered by such outside firms.

 

Lannett may increase itsfocus on certain specialty markets in the generic pharmaceutical industry.  Such a focus is intended to provide Lannettcustomers with increased product alternatives in categories with relatively fewmarket participants.  While there is noguarantee that Lannett has the market expertise or financial resourcesnecessary to succeed in such a market specialty, management is confident thatsuch future focus will be well received by Lannett customers and increaseshareholder value in the long run.

 

The Company plans toenhance relationships with strategic business partners, including providers ofproduct development research, raw materials, active pharmaceutical ingredientsas well as finished goods.  Managementbelieves that mutually beneficial strategic relationships in such areas,including potential financing arrangements, partnerships, joint ventures oracquisitions, could allow for potential competitive advantages in the genericpharmaceutical market.  The Company plansto continue to explore such areas for potential opportunities to enhanceshareholder value.

 

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**ITEM 3.*** ***QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

The Company has debtinstruments with variable interest rates. The Company 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% and 3.00% at March 31,2010 and June 30, 2009, respectively). As of March 31, 2010 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.  The agreementcontains covenants with respect to working capital, net worth and certainratios, as well as other covenants.  Theexisting line of credit which was to expire on November 30, 2009, wasrenewed and extended to November 30, 2010.

 

The Company invests inU.S. government agency securities and corporate bonds, all of which are exposedto interest rate fluctuations.  Theinterest earned on these investments may vary based on fluctuations in the interestrate.

 

**ITEM4.  CONTROLS AND PROCEDURES**

 

***Evaluation ofDisclosure Controls and Procedures***

 

As of the end of theperiod covered by this Form 10-Q, management performed, with theparticipation of our Chief Executive Officer and Chief Financial Officer, anevaluation of the effectiveness of our disclosure controls and procedures asdefined in Rules 13a-15(e) and 15d-15(e) of the SecuritiesExchange Act of 1934, as amended (the “Exchange Act”). Our disclosure controlsand procedures are designed to provide reasonable assurance that informationrequired to be disclosed in the reports we file or submit under the ExchangeAct is recorded, processed, summarized and reported within the time periodsspecified in the SEC’s rules and forms, and that such information isaccumulated and communicated to our management, including our Chief ExecutiveOfficer and Chief Financial Officer, to allow timely decisions regardingrequired disclosures.

 

Based upon the evaluation, the Chief Executive Officerand Chief Financial Officer concluded that the Company’s disclosure controlsand procedures were effective as of the end of the period covered by thisreport.

 

***Change in Internal Control OverFinancial Reporting***

 

There has been no change in the Company’s internalcontrol over financial reporting during the three months ended March 31, 2010that has materially affected, or is reasonably likely to materially affect, ourinternal control over financial reporting.

 

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**PART II. OTHER INFORMATION**

 

**ITEM1.  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**

 

The annual meeting of theshareholders was held on January 22, 2010. The following proposal was adopted by the margins indicated.

 

To elect seven (7) membersof the Board of Directors to serve until the next Annual Meeting ofStockholders and until their respective successors have been duly elected andqualified.

 
| **Director**         | ** ** | **Votes for** | ** ** | **Votes against** | ** ** | **Votes withheld** | ** ** |
|----------------------|------------|---------------|------------|-------------------|------------|--------------------|------------|
| William  Farber      |       | 15,925,979    |       | 0                 |       | 129,995            |       |
| Ronald  West         |       | 15,597,891    |       | 0                 |       | 458,083            |       |
| Arthur  P. Bedrosian |       | 15,921,054    |       | 0                 |       | 134,920            |       |
| Jeffrey  Farber      |       | 15,856,788    |       | 0                 |       | 199,186            |       |
| Kenneth  Sinclair    |       | 15,512,997    |       | 0                 |       | 542,977            |       |
| Albert  Wertheimer   |       | 15,601,091    |       | 0                 |       | 454,883            |       |
| Myron  Winkelman     |       | 15,583,857    |       | 0                 |       | 472,117            |       |

 

**ITEM6.  EXHIBITS**

 

(a)                           A list of the exhibits required by Item601 of Regulation S-K to be filed as a part of this Form 10-Q is shown onthe Exhibit Index filed herewith.

 

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** **

**SIGNATURE**

 

In accordance withthe requirements of the Exchange Act, the registrant caused this report to besigned on its behalf by the undersigned, thereunto duly authorized.

 
|                      |   | **LANNETT COMPANY, INC.** |
|---------------------------|--------|---------------------------|
|                      |   |                      |
| Dated: May 13,  2010 | By:    | /s/ Arthur P. Bedrosian   |
|                      |   |                      | Arthur P. Bedrosian |
|                      |   |                      | President and Chief  Executive Officer |
|                      |   |                      |
|                      |   |                      |
| Dated: May 13,  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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