Table of Contents

 

 

 

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**x****      QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934**

** **

**FOR THEQUARTERLY PERIOD ENDED MARCH 31, 2009**

 

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

** **

**FOR THETRANSITION PERIOD FROM                   TO                   .**

 

**Commission File No. 001-31298**

 

**LANNETT COMPANY, INC.**

(Exact Name of Registrant as Specified in its Charter)

 

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

 

**9000 State Road**

**Philadelphia, PA 19136**

**(215) 333-9000**

(Address of principal executive offices and telephonenumber)

 

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

 

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 of thischapter) during the preceding 12 months (or for such shorter period that theregistrant was required to submit and post such files). **Yes****o****  No****o**

 

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

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

 

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

 

Indicate the number of shares outstanding of eachclass of the registrant’s common Stock, as of the latest practical date.

 

| **Class**                                | ** ** | **Outstanding as of May 8, 2009** |
|------------------------------------------|------------|------------------------------------------------------------|
| Common stock, par value $0.001 per share |       | 24,514,696 shares                                          |

 

 

 

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Table of Contents

 

**Tableof Contents**

 
| ** **                                                                    | ** **                                                                                                                 | **Page No.** |
|-------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------------------------------------|-------------------|
|                                                                          |                                                                                                                       | ** **        |
| **PART I. FINANCIAL INFORMATION**                                        |                                                                                                                       |              |
| ** **                                                                    |                                                                                                                       |              |   |
| **ITEM  1.**                                                                  | **FINANCIAL STATEMENTS**                                                                                                   |              |   |
| ** **                                                                    | ** **                                                                                                                 |              |   |
|                                                                          | Consolidated Balance Sheets as of  March 31, 2009 (unaudited) and June 30, 2008                                  |              | 1 |
|                                                                          |                                                                                                                       |              |   |
|                                                                          | Consolidated Statements of  Operations (unaudited) for the three and nine months ended March 31,  2009 and 2008       |              | 2 |
|                                                                          |                                                                                                                       |              |   |
|                                                                          | Consolidated Statement of  Changes in Shareholders’ Equity (unaudited) for the nine months ended  March 31, 2009 |              | 3 |
|                                                                          |                                                                                                                       |              |   |
|                                                                          | Consolidated Statements of  Cash Flows (unaudited) for the nine months ended March 31, 2009 and 2008                  |              | 4 |
|                                                                          |                                                                                                                       |              |   |
|                                                                          | Notes to Consolidated Financial Statements (unaudited)                                                                     |              | 5 |
|                                                                          |                                                                                                                       |              |   |
| **ITEM  2.**                                                                  | **MANAGEMENT’S DISCUSSION AND ANALYSIS  OFFINANCIAL CONDITION AND RESULTS OF  OPERATIONS**                            |              | 30 |
|                                                                          | ** **                                                                                                                 |              |   |
| **ITEM 3.**                                                                   | **QUANTITATIVE  AND QUALITATIVE DISCLOSURESABOUT  MARKET RISK**                                                            |              | 43 |
|                                                                          | ** **                                                                                                                 |              |   |
| **ITEM 4.**                                                                   | **CONTROLS AND  PROCEDURES**                                                                                               |              | 43 |
| ** **                                                                    | ** **                                                                                                                 |              |   |
| **PART II.  OTHER INFORMATION**                                          |                                                                                                                       |              |
| ** **                                                                    |                                                                                                                       |              |
| **ITEM 1.**                                                                   | **LEGAL PROCEEDINGS**                                                                                                      |              | 44 |
| ** **                                                                    | ** **                                                                                                                 |              |   |
| **ITEM 4.**                                                                   | **SUBMISSION  OF MATTERS TO A VOTE OF SECURITY HOLDERS**                                                                   |              | 45 |
| ** **                                                                    | ** **                                                                                                                 |              |   |
| **ITEM  6.**                                                                  | **EXHIBITS**                                                                                                               |              | 45 |
| ** **                                                                    | ** **                                                                                                                 |              |   |
| **CERTIFICATION  OF PRESIDENT & CHIEF EXECUTIVE OFFICER**            |                                                                                                                       |              |
| ** **                                                                    |                                                                                                                       |              |
| **CERTIFICATION  OF INTERIM CHIEF FINANCIAL OFFICER**                         |                                                                                                                       |              |
| ** **                                                                    |                                                                                                                       |              |
| **CERTIFICATION  PURSUANT TO SECTION 906 OF SARBANES OXLEY ACT OF 2002** |                                                                                                                       |              |

 

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# **PARTI.  FINANCIAL INFORMATION**

 

## ***ITEM1.  FINANCIAL STATEMENTS***

 

**LANNETT COMPANY, INC. AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                              | ** ** | **(UNAUDITED)**              | ** **  | ** **                  | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|-------------|-----------------------------|------------|
| ** **                                                                                                                              | ** ** | **March 31, 2009** | ** **  | **June 30, 2008** | ** ** |
| **ASSETS**                                                                                                                              |       |                         |        |                        |       |
| Current Assets                                                                                                                          |       |                         |        |                        |       |
| Cash and cash  equivalents                                                                                                              |       | $                            | 15,435,756  |                        | $          | 6,256,712 |   |
| Short term  investments                                                                                                                 |       | —                       |        | 354,155                     |       |
| Trade accounts  receivable (net of allowance of $178,958 and $207,151, respectively)                                                    |       | 29,215,192                   |        | 34,114,982                  |       |
| Inventories, net                                                                                                                        |       | 16,031,235                   |        | 11,617,258                  |       |
| Interest  receivable                                                                                                                    |       | 129,459                      |        | 51,781                      |       |
| Prepaid taxes                                                                                                                           |       | 1,156,472                    |        | 1,598,937                   |       |
| Deferred tax  assets                                                                                                                    |       | 4,150,938                    |        | 6,997,935                   |       |
| Other current  assets                                                                                                                   |       | 985,517                      |        | 591,415                     |       |
| **Total  Current Assets**                                                                                                               |       | 67,104,569                   |        | 61,583,175                  |       |
|                                                                                                                                    |       |                         |        |                        |       |
| Property, plant  and equipment                                                                                                          |       | 40,551,276                   |        | 39,996,008                  |       |
| Less accumulated  depreciation                                                                                                          |       | (17,761,680                  | )           | (15,261,905                 | )          |
|                                                                                                                                    |       | 22,789,596                   |        | 24,734,103                  |       |
|                                                                                                                                    |       |                         |        |                        |       |
| Construction in  progress                                                                                                               |       | 482,340                      |        | 458,046                     |       |
| Investment  securities - available for sale                                                                                             |       | 1,486,772                    |        | 2,145,980                   |       |
| Intangible  assets - net of accumulated amortization                                                                                    |       | 9,577,063                    |        | 10,361,835                  |       |
| Deferred tax  assets                                                                                                                    |       | 13,997,628                   |        | 14,200,771                  |       |
| Other assets                                                                                                                            |       | 168,269                      |        | 195,354                     |       |
| **Total  Assets**                                                                                                                       |       | $                            | 115,606,237 |                        | $          | 113,679,264 |   |
|                                                                                                                                    |       |                         |        |                        |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                          |       |                         |        |                        |       |
| **LIABILITIES**                                                                                                                         |       |                         |        |                        |       |
| Current  Liabilities                                                                                                                    |       |                         |        |                        |       |
| Accounts payable                                                                                                                        |       | $                            | 16,109,987  |                        | $          | 13,085,772 |   |
| Accrued expenses                                                                                                                        |       | 4,447,679                    |        | 2,451,783                   |       |
| Deferred revenue                                                                                                                        |       | 19,329                       |        | 982,668                     |       |
| Current portion  of long-term debt                                                                                                      |       | 503,469                      |        | 791,912                     |       |
| Rebates,  chargebacks and returns payable                                                                                               |       | 11,172,174                   |        | 18,326,417                  |       |
| **Total  Current Liabilities**                                                                                                          |       | 32,252,638                   |        | 35,638,552                  |       |
|                                                                                                                                    |       |                         |        |                        |       |
| Long-term debt,  less current portion                                                                                                   |       | 7,886,439                    |        | 8,186,922                   |       |
| Unearned grant  funds                                                                                                                   |       | 500,000                      |        | 500,000                     |       |
| Other long-term  liabilities                                                                                                            |       | 47,862                       |        | 32,001                      |       |
| **Total  Liabilities**                                                                                                                  |       | 40,686,939                   |        | 44,357,475                  |       |
| ** **                                                                                                                              |       |                         |        |                        |       |
| Commitments and  contingencies, See notes 10 and 11                                                                                     |       |                         |        |                        |       |
| Minority  interest in Cody LCI Realty, LLC, net of taxes                                                                                |       | 86,685                       |        | 50,309                      |       |
|                                                                                                                                    |       |                         |        |                        |       |
| **SHAREHOLDERS’  EQUITY**                                                                                                          |       |                         |        |                        |       |
| Common stock -  authorized 50,000,000 shares, par value $0.001; issued and outstanding,  24,506,471 and 24,283,963 shares, respectively |       | 24,506                       |        | 24,284                      |       |
| Additional paid  in capital                                                                                                             |       | 75,951,216                   |        | 74,497,100                  |       |
| Accumulated  deficit                                                                                                                    |       | (676,971                     | )           | (4,790,680                  | )          |
| Accumulated  other comprehensive income                                                                                                 |       | 23,036                       |        | 9,722                       |       |
|                                                                                                                                    |       | 75,321,787                   |        | 69,740,426                  |       |
| Less: Treasury  stock at cost - 82,228 and 74,970 shares, respectively                                                                  |       | (489,174                     | )           | (468,946                    | )          |
| **TOTAL  SHAREHOLDERS’ EQUITY**                                                                                                    |       | 74,832,613                   |        | 69,271,480                  |       |
|                                                                                                                                    |       |                         |        |                        |       |
| **TOTAL  LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                    |       | $                            | 115,606,237 |                        | $          | 113,679,264 |   |

 

The accompanyingnotes to consolidated financial statements are an integral part of thesestatements.

 

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**LANNETT COMPANY, INC. ANDSUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                                               | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|--------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                               | ** ** | **March  31,**         | ** ** | **March 31,**              | ** ** |
| ** **                                                               | ** ** | **2009**                         | ** ** | **2008**                        | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                                               | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                                                                |       | $                                | 28,761,316 |                            | $          | 16,579,512 |   | $ | 83,553,341 |   | $ | 51,654,484 |   |
| Cost of sales                                                            |       | 16,564,244                       |       | 12,276,526                      |       | 50,396,809 |   | 36,688,446 |   |
| Amortization of  intangible assets                                       |       | 446,167                          |       | 446,166                         |       | 1,338,500 |   | 1,338,498 |   |
| Product  royalties                                                       |       | 143,877                          |       | (40,674                         | )          | 186,874 |   | 196,672 |   |
|                                                                     |       |                             |       |                            |       |   |   |   |   |
| Gross profit                                                             |       | 11,607,028                       |       | 3,897,494                       |       | 31,631,158 |   | 13,430,868 |   |
|                                                                     |       |                             |       |                            |       |   |   |   |   |
| Research and  development expenses                                       |       | 1,981,338                        |       | 1,516,904                       |       | 5,685,168 |   | 3,715,334 |   |
| Selling,  general, and administrative expenses                           |       | 7,491,583                        |       | 4,222,103                       |       | 19,116,199 |   | 12,457,030 |   |
| Gain on sale of  assets                                                  |       | 38,472                           |       | —                          |       | 60,481 |   | — |   |
|                                                                     |       |                             |       |                            |       |   |   |   |   |
| Operating income  (loss)                                                 |       | 2,172,579                        |       | (1,841,513                      | )          | 6,890,272 |   | (2,741,496 | ) |
|                                                                     |       |                             |       |                            |       |   |   |   |   |
| Other income  (expense):                                                 |       |                             |       |                            |       |   |   |   |   |
| Interest income                                                          |       | 77,954                           |       | 45,239                          |       | 215,604 |   | 170,967 |   |
| Interest expense                                                         |       | (75,417                          | )          | (75,025                         | )          | (259,057 | ) | (291,146 | ) |
|                                                                     |       | 2,537                            |       | (29,786                         | )          | (43,453 | ) | (120,179 | ) |
|                                                                     |       |                             |       |                            |       |   |   |   |   |
| Income (loss)  before income tax expense (benefit) and minority interest |       | 2,175,116                        |       | (1,871,299                      | )          | 6,846,819 |   | (2,861,675 | ) |
|                                                                     |       |                             |       |                            |       |   |   |   |   |
| Income tax  expense (benefit)                                            |       | 851,310                          |       | (615,454                        | )          | 2,696,733 |   | (821,122 | ) |
| Minority  interest in Cody LCI Realty, LLC, net of taxes                 |       | (9,324                           | )          | —                          |       | (36,377 | ) | — |   |
|                                                                     |       |                             |       |                            |       |   |   |   |   |
| Net income  (loss)                                                       |       | $                                | 1,314,482  |                            | $          | (1,255,845 | ) | $ | 4,113,709 |   | $ | (2,040,553 | ) |
|                                                                     |       |                             |       |                            |       |   |   |   |   |
| Basic income  (loss) per common share                                    |       | $                                | 0.05       |                            | $          | (0.05 | ) | $ | 0.17 |   | $ | (0.08 | ) |
| Diluted income  (loss) per common share                                  |       | $                                | 0.05       |                            | $          | (0.05 | ) | $ | 0.17 |   | $ | (0.08 | ) |
|                                                                     |       |                             |       |                            |       |   |   |   |   |
| Basic weighted average  number of shares                                 |       | 24,502,629                       |       | 24,268,449                      |       | 24,424,187 |   | 24,208,830 |   |
| Diluted weighted  average number of shares                               |       | 24,756,041                       |       | 24,268,449                      |       | 24,524,822 |   | 24,208,830 |   |

 

The accompanyingnotes to consolidated financial statements are an integral part of thesestatements.

 

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**LANNETTCOMPANY, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENT OF CHANGES INSHAREHOLDERS’ EQUITY**

(UNAUDITED)

 
| ** **                                                            | ** ** | **Common  Stock** | ** ** | **Additional** | ** ** | ** **  | ** ** | ** **      | ** ** | **Accum.  Other** | ** ** | ** **       | ** ** |
|-----------------------------------------------------------------------|------------|-------------------|------------|----------------|------------|-------------|------------|-----------------|------------|-------------------|------------|------------------|------------|
| ** **                                                            | ** ** | **Shares**        | ** ** | ** **     | ** ** | **Paid-in** | ** ** | **Accumulated** | ** ** | **Treasury**      | ** ** | **Other  Comp.** | ** ** | **Shareholders’** | ** ** |
| ** **                                                            | ** ** | **Issued**        | ** ** | **Amount**     | ** ** | **Capital** | ** ** | **Deficit**     | ** ** | **Stock**         | ** ** | **Income**       | ** ** | **Equity** | ** ** |
| ** **                                                            | ** ** | ** **        | ** ** | ** **     | ** ** | ** **  | ** ** | ** **      | ** ** | ** **        | ** ** | ** **       | ** ** | ** ** | ** ** |
| **Balance,  June  30, 2008**                                     |       | 24,283,963        |       | $              | 24,284     |        | $          | 74,497,100      |       | $                 | (4,790,680 | )                | $          | (468,946 | ) | $ | 9,722 |   | $ | 69,271,480 |   |
|                                                                  |       |              |       |           |       |        |       |            |       |              |       |             |       |   |   |
| Exercise of stock  options                                            |       | 7,800             |       | 8              |       | 33,714      |       | —          |       | —            |       | —           |       | 33,722 |   |
|                                                                  |       |              |       |           |       |        |       |            |       |              |       |             |       |   |   |
| Shares issued in  connection with employee stock purchase plan        |       | 41,106            |       | 41             |       | 82,054      |       | —          |       | —            |       | —           |       | 82,095 |   |
| Share based  compensation                                             |       |              |       |           |       |        |       |            |       |              |       |             |       |   |   |
| Restricted stock                                                      |       | —            |       | —         |       | 129,021     |       | —          |       | —            |       | —           |       | 129,021 |   |
| Stock options                                                         |       | —            |       | —         |       | 731,286     |       | —          |       | —            |       | —           |       | 731,286 |   |
| Employee stock  purchase plan                                         |       | —            |       | —         |       | 70,315      |       | —          |       | —            |       | —           |       | 70,315 |   |
| Shares issued in  connection with restricted stock grant              |       | 68,602            |       | 68             |       | 101,331     |       | —          |       | —            |       | —           |       | 101,399 |   |
| Shares issued for  contingent consideration for Cody Labs Acquisition |       | 105,000           |       | 105            |       | 430,395     |       | —          |       | —            |       | —           |       | 430,500 |   |
| Stock options  repurchased                                            |       | —            |       | —         |       | (124,000    | )          | —          |       | —            |       | —           |       | (124,000 | ) |
| Purchase of treasury  stock                                           |       | —            |       | —         |       | —      |       | —          |       | (20,228           | )          | —           |       | (20,228 | ) |
| Other  comprehensive income, net of income tax                        |       | —            |       | —         |       | —      |       | —          |       | —            |       | 13,314           |       | 13,314 |   |
| Net income                                                            |       | —            |       | —         |       | —      |       | 4,113,709       |       | —            |       | —           |       | 4,113,709 |   |
|                                                                  |       |              |       |           |       |        |       |            |       |              |       |             |       |   |   |
| **Balance,  March 31, 2009**                                     |       | 24,506,471        |       | $              | 24,506     |        | $          | 75,951,216      |       | $                 | (676,971   | )                | $          | (489,174 | ) | $ | 23,036 |   | $ | 74,832,613 |   |

 

**The accompanying notes toconsolidated financial statements are an integral part of these statements.**

 

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** **

**LANNETTCOMPANY, INC. AND SUBSIDIARIES**

### **CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

(UNAUDITED)

 
| ** **                                                                                | ** ** | **For the nine months ended March 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                                | ** ** | **2009**                                     | ** ** | **2008** | ** ** |
|                                                                                      |       |                                         |       |   |   |
| OPERATING  ACTIVITIES:                                                                    |       |                                         |       |   |   |
| Net income  (loss)                                                                        |       | $                                            | 4,113,709  |   | $ | (2,040,553 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by operating activities: |       |                                         |       |   |   |
| Depreciation and  amortization                                                            |       | 3,868,662                                    |       | 3,745,611 |   |
| Deferred tax  expense                                                                     |       | 2,890,589                                    |       | (821,183 | ) |
| Stock  compensation expense                                                               |       | 930,622                                      |       | 768,922 |   |
| Restricted stock  grant                                                                   |       | 101,399                                      |       | 300,090 |   |
| Other noncash  expenses                                                                   |       | 15,859                                       |       | 11,418 |   |
| Gain on sale of  assets                                                                   |       | (60,481                                      | )          | — |   |
| Minority  interest in Cody LCI Realty LLC, net of taxes                                   |       | 36,377                                       |       | — |   |
| Changes in  assets and liabilities which provided (used) cash:                            |       |                                         |       |   |   |
| Trade accounts  receivable                                                                |       | (4,607,629                                   | )          | 989,194 |   |
| Inventories                                                                               |       | (4,413,977                                   | )          | 2,500,069 |   |
| Prepaid taxes                                                                             |       | 442,465                                      |       | — |   |
| Prepaid expenses  and other assets                                                        |       | (444,695                                     | )          | (41,362 | ) |
| Accounts payable                                                                          |       | 3,024,215                                    |       | (959,458 | ) |
| Accrued expenses                                                                          |       | 4,225,072                                    |       | (1,021,108 | ) |
| Deferred revenue                                                                          |       | (963,339                                     | )          | (460,804 | ) |
| Net cash  provided by operating activities                                                |       | 9,158,848                                    |       | 2,970,836 |   |
|                                                                                      |       |                                         |       |   |   |
| INVESTING  ACTIVITIES:                                                                    |       |                                         |       |   |   |
| Purchases of  property, plant and equipment (including construction in progress)          |       | (583,762                                     | )          | (2,052,276 | ) |
| Proceeds from  sale of fixed assets                                                       |       | 1,500                                        |       | — |   |
| Proceeds from  sale of investment securities - available for sale                         |       | 7,075,041                                    |       | 1,520,198 |   |
| Purchase of  investment securities - available for sale                                   |       | (5,979,246                                   | )          | (600,605 | ) |
| Net cash  provided by (used in) investing activities                                      |       | 513,533                                      |       | (1,132,683 | ) |
|                                                                                      |       |                                         |       |   |   |
| FINANCING  ACTIVITIES:                                                                    |       |                                         |       |   |   |
| Repayments of  debt                                                                       |       | (588,926                                     | )          | (443,214 | ) |
| Proceeds from  issuance of stock                                                          |       | 115,817                                      |       | 86,115 |   |
| Purchase of  treasury stock                                                               |       | (20,228                                      | )          | (74,376 | ) |
| Net cash used in  financing activities                                                    |       | (493,337                                     | )          | (431,475 | ) |
|                                                                                      |       |                                         |       |   |   |
| NET INCREASE IN  CASH AND CASH EQUIVALENTS                                                |       | 9,179,044                                    |       | 1,406,678 |   |
|                                                                                      |       |                                         |       |   |   |
| CASH AND CASH  EQUIVLAENTS, BEGINNING OF PERIOD                                           |       | 6,256,712                                    |       | 5,192,341 |   |
|                                                                                      |       |                                         |       |   |   |
| CASH AND CASH  EQUIVALENTS, END OF PERIOD                                                 |       | $                                            | 15,435,756 |   | $ | 6,599,019 |   |
|                                                                                      |       |                                         |       |   |   |
| SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION -                                       |       |                                         |       |   |   |
|                                                                                      |       |                                         |       |   |   |
| Interest paid                                                                             |       | $                                            | 149,640    |   | $ | 97,114 |   |
| Income taxes  paid                                                                        |       | $                                            | 250,000    |   | $ | — |   |
| Lannett stock  issued - acquisition of Cody Labs’ DEA license                        |       | $                                            | 581,175    |   | $ | — |   |

 

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

 

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**LANNETT COMPANY, INC.  AND SUBSIDIARIES**

 

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

 

**Note 1.  Interim FinancialInformation**

 

The accompanying unaudited financial statements have been prepared inaccordance with U.S. generally accepted accounting principles for presentationof interim financial statements and with the instructions to Form 10-Q andArticle 10 of Regulation S-X. Accordingly, the unaudited financialstatements do not include all the information and footnotes necessary for acomprehensive presentation of the financial position, results of operations,and cash flows for the periods presented. In the opinion of management, theunaudited financial statements include all the normal recurring adjustmentsthat are necessary for a fair presentation of the financial position, resultsof operations, and cash flows for the periods presented.  Operating results for the three and ninemonth periods ended March 31, 2009 are not necessarily indicative of theresults that may be expected for the fiscal year ending June 30, 2009. Youshould read these unaudited financial statements in combination with the otherNotes in this section; “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” appearing in Item 2; and the FinancialStatements, including the Notes to the Financial Statements, included in ourAnnual Report on Form 10-K for the fiscal year ended June 30, 2008.

 

**Note2.  Summary of Significant AccountingPolicies**

 

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

 

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

 

***Principles of Consolidation***- Theconsolidated financial statements include the accounts of the operating parentcompany, Lannett Company, Inc., and its wholly owned subsidiaries, LannettHoldings, Inc. and Cody Laboratories, Inc. (“Cody”).  Cody includes the consolidation of Cody LCIRealty, LLC, a variable interest entity.  See Note 16 regarding theconsolidation of this variable interest entity. All intercompany accounts and transactions have been eliminated.

 

***Reclassifications*** - The June 30,2008 Consolidated Balance Sheet, the Consolidated Statements of Operations forthe three and nine months ended March 31, 2008 and the ConsolidatedStatement of Cash Flows for the nine months ended March 31, 2008 have beenreclassified to conform to the current year presentation.

 

***Revenue Recognition*** - The Company recognizesrevenue when its products are shipped.  At this point, title and risk ofloss have transferred to the customer and provisions for estimates, includingrebates, promotional adjustments, price adjustments, returns, chargebacks, andother potential adjustments are reasonably

 

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determinable.  Accrualsfor these provisions are presented in the consolidated financial statements asrebates, chargebacks and returns payable and reductions to net sales. Thechange in the reserves for various sales adjustments may not be proportionallyequal to the change in sales because of changes in both the product and thecustomer mix. Increased sales to wholesalers will generally require additionalaccruals as they are the primary recipient of chargebacks and rebates.Incentives offered to secure sales vary from product to product. Provisions forestimated rebates and promotional credits are estimated based upon contractualterms.  Provisions for other customer credits, such as price adjustments,returns, and chargebacks, require management to make subjective judgments oncustomer mix. Unlike branded innovator drug companies, Lannett does not useinformation about product levels in distribution channels from third-partysources, such as IMS and NDC Health, in estimating future returns and othercredits. Lannett calculates a chargeback/rebate rate based on contractual termswith its customers and applies this rate to customer sales.  The onlyvariable is customer mix, and this assumption is based on historical data andsales expectations.

 

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

*** ***

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

*** ***

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

 

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***Other Adjustments —*** Otheradjustments consist primarily of price adjustments, also known as “shelf stockadjustments,” which are credits issued to reflect decreases in the selling pricesof the Company’s products that customers have remaining in their inventories atthe 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 and otherfactors and evaluates the reserve as additional information becomesavailable.  Other adjustments areincluded in the rebates, chargebacks and returns payable account on the balancesheet.

 

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

 

**Forthe 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 |   |

 

**For the nine months ended March 31,2008**

 
| **Reserve Category**                                                                       | ** ** | **Chargebacks** | ** **      | **Rebates** | ** ** | **Returns**     | ** ** | **Other** | ** **      | **Total**   | ** ** |
|--------------------------------------------------------------------------------------------|------------|-----------------|-----------------|-------------|------------|-----------------|------------|-----------|-----------------|-------------|------------|
|                                                                                       |       |            |            |        |       |            |       |      |            |        |       |
| Reserve Balance  as of June 30, 2007                                                  |       | $               |  4,649,478 |        | $          |  871,339   |       | $         |  113,313   |        | $          |  52,234 |   | $ |  5,686,364 |   |
| Actual credits  issued related to sales recorded in prior fiscal years                     |       | (4,429,923      | )               | (1,741,804  | )          | (146,917        | )          | —    |            | (6,318,644  | )          |
| Reserves or  (reversals) charged during Fiscal 2008 related to sales in prior fiscal years |       | —          |            | 870,465     |       | 50,000          |       | (50,000   | )               | 870,465     |       |
| Reserves charged  to net sales during Fiscal 2008 related to sales recorded in Fiscal 2008 |       | 17,985,506      |            | 6,240,517   |       | 2,200,267       |       | 473,423   |            | 26,899,713  |       |
| Actual credits  issued related to sales recorded in Fiscal 2008                            |       | (14,721,493     | )               | (4,988,844  | )          | (805,702        | )          | (473,552  | )               | (20,989,591 | )          |
| Reserve Balance  as of March 31, 2008                                                 |       | $               |  3,483,568 |        | $          |  1,251,673 |       | $         |  1,410,961 |        | $          |  2,105 |   | $ |  6,148,307 |   |

 

The total reserve for chargebacks, rebates, returns and otheradjustments decreased from $18,326,417 at June 30, 2008 to $11,172,174 at March 31,2009. The significant decrease in the returns reserve balance wasprimarily the result of credits issued during the first nine months of Fiscal2009 related to the returns of the Prenatal Multivitamin product shipped inFiscal 2008.  It is our expectation that all of the product will bereturned based on our inability to have the product specified as a brandequivalent, and information from our customers regarding their intentions toreturn the product.  As of March 31, 2009 approximately$9,507,000 of the return reserve was applied to accounts receivable forcustomers who had returned the Prenatal Multivitamin product by that date, leavinga balance of approximately $1,038,000 of Multivitamin returns reserve on thebooks at March 31, 2009.

 

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The increase in chargeback reserves between June 30, 2008 and March 31,2009 was due primarily to an increase in inventory levels at wholesalerdistribution centers.

 

TheCompany ships its products to the warehouses of its wholesale and retail chaincustomers.  When the Company and a customer enter into an agreement forthe supply of a product, the customer will generally continue to purchase theproduct, stock its warehouse(s), and resell the product to its owncustomers.  The Company’s customer will reorder the product as itswarehouse is depleted.  The Company generally has no minimum size ordersfor its customers.  Additionally, most warehousing customers prefer not tostock excess inventory levels due to the additional carrying costs andinefficiencies created by holding excess inventory.  As such, the Company’scustomers continually reorder the Company’s products.  It is common forthe Company’s customers to order the same products on a monthly basis. For generic pharmaceutical manufacturers, it is critical to ensure thatcustomers’ warehouses are adequately stocked with its products.  This isimportant due to the fact that several generic competitors compete for theconsumer demand for a given product.  Availability of inventory ensuresthat a manufacturer’s product is considered.  Otherwise, retailprescriptions would be filled with competitors’ products.  For 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 affecta generic drug market.  If the historical data the Company uses and theassumptions management makes to calculate its estimates of future returns,chargebacks, and other credits do not accurately approximate future activity,its net sales, gross profit, net income and earnings per share couldchange.  However, management believes that these estimates are reasonablebased upon historical experience and current conditions.

 

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

 

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

 

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***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. There is no market for this type of financial liability.

 

***Investment Securities*** - The Company’s investmentsecurities consist of marketable debt securities, primarily in U.S. governmentand agency obligations.  All of the Company’s marketable debt securitiesare classified as available-for-sale and recorded at fair value, based onquoted market prices.  Unrealized holding gains and losses are recorded,net of any tax effect, as a separate component of accumulated othercomprehensive income.  No gains or losses on marketable debt securitiesare realized until they are sold or a decline in fair value is determined to beother-than-temporary.  In accordance with Financial Accounting StandardsBoard (“FASB”) Staff Position Nos. FAS 115-1 and FAS 124-1 “The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments” (“FSP115-1”), the Company reviews its marketable securities and determines whetherthe investments are other-than-temporarily impaired. If the investments aredeemed to be other-than-temporarily impaired, the investments are written downto their then current fair market value with a new cost basis being established.There were no securities determined by management to be other-than-temporarilyimpaired during the nine months ended March 31, 2009, or the fiscal yearended June 30, 2008.

 

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

 

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

 

***Intangible Assets***— In March 2004,****the Company entered into an agreement with Jerome StevensPharmaceuticals, Inc. (JSP) for the exclusive marketing and distributionrights in the United States to the current line of JSP products in exchange forfour million (4,000,000) shares of the Company’s common stock.  As a result of the JSP agreement, the Companyrecorded an intangible asset of $67,040,000 for the exclusive marketing anddistribution rights obtained from JSP. The intangible asset was recorded based upon the fair value of the fourmillion (4,000,000) shares at the time of issuance to JSP.  During the quarter ended March 31, 2005,the Company recorded a non-cash impairment loss of approximately $46,093,000 inaccordance with SFAS 144, *Accounting for Impairmentor Disposal of Long-lived Assets* to reduce the carrying value of theintangible asset to its fair value of approximately $16,062,000 as of the dateof the impairment.  As of March 31,2009 and June 30, 2008, management concluded the carrying value of theintangible asset was less than its fair value and, therefore, no furtherimpairment was required.

 

TheCompany will incur annual amortization expense of approximately $1,785,000 forthe intangible asset over the remaining term of the contract.  For each nine month period ended March 31,2009 and 2008, the Company incurred amortization expense of approximately$1,338,000.

 

Futureannual amortization expense of the JSP intangible asset consists ofapproximately the following:

 
| **Fiscal Year Ending June 30,** | ** ** | **Annual Amortization Expense** | ** **      |
|--------------------------------------|------------|---------------------------------|-----------------|
| 2009                                 |       | $                               | 447,000         |   |
| 2010                                 |       | 1,785,000                       |            |
| 2011                                 |       | 1,785,000                       |            |
| 2012                                 |       | 1,785,000                       |            |
| 2013                                 |       | 1,785,000                       |            |
| Thereafter                           |       | 1,337,000                       |            |
|                                 |       | $                               |  8,924,000 |   |

 

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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 of Lannett stock to the former owners of CodyLabs, which was completed in October 2008. Therefore, the Company has recorded an intangible asset related to theacquisition of a drug import license in the original amount of $581,175 to theIntangible Asset account and has recorded a corresponding Deferred TaxLiability in the amount of approximately $150,700 due to the non-deductibilityof the amortization for tax purposes. The Company has assigned a 15 year life to this intangible asset basedon average life cycles of Lannett products.

 

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

 

InFiscal 2008, the Company obtained FDA approval to use the proprietaryrights.  Accordingly, the Company hascapitalized this purchased product right as an indefinite lived intangibleasset.

 

***Advertising Costs*** - The Company chargesadvertising costs to operations as incurred. Advertising expense for the nine months ended March 31, 2009 and2008 was approximately $41,000 and $5,000, respectively.

 

***Income Taxes*** - The Company uses the liability methodspecified by Statement of Financial Accounting Standards (“SFAS”) No. 109,*Accounting for Income Taxes (“FAS 109”).*  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.

 

***Segment Information***—******The Company reports segmentinformation in accordance with Statement of Financial Accounting Standard No. 131,*Disclosures about Segments of an Enterprise andRelated Information*(“FAS 131”*)*.  The Company operates one business segment -generic pharmaceuticals; accordingly the Company has one reportingsegment.  In accordance with FAS 131, 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, 2009 and 2008:

 
| ** **                  | ** ** | **For the Three Months Ended  March 31,** | ** ** | **For the Nine Months Ended   March 31,** | ** ** |
|-----------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|
| **Medical Indication** | ** ** | **2009**                                       | ** ** | **2008**                                       | ** ** | **2009** | ** ** | **2008** | ** ** |
|                        |       |                                           |       |                                           |       |   |   |   |   |
| Migraine  Headache          |       | $                                              | 2,483,000  |                                           | $          | 2,373,000 |   | $ | 7,230,000 |   | $ | 7,815,000 |   |
| Epilepsy                    |       | 518,000                                        |       | 816,000                                        |       | 1,402,000 |   | 2,787,000 |   |
| Pre Natal  Vitamin          |       | 4,890,000                                      |       | —                                         |       | 9,449,000 |   | — |   |
| Heart Failure               |       | 3,938,000                                      |       | 1,004,000                                      |       | 15,995,000 |   | 3,164,000 |   |
| Thyroid  Deficiency         |       | 11,710,000                                     |       | 9,288,000                                      |       | 35,378,000 |   | 27,974,000 |   |
| Antibiotic                  |       | 1,493,000                                      |       | 846,000                                        |       | 4,514,000 |   | 2,402,000 |   |
| Antibacterial               |       | 9,000                                          |       | 1,447,000                                      |       | 1,202,000 |   | 4,976,000 |   |
| Other                       |       | 3,720,000                                      |       | 806,000                                        |       | 8,383,000 |   | 2,536,000 |   |
|                        |       |                                           |       |                                           |       |   |   |   |   |
| Total                       |       | $                                              | 28,761,000 |                                           | $          | 16,580,000 |   | $ | 83,553,000 |   | $ | 51,654,000 |   |

 

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***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 42%, 11%, 19%, 9%and 3%, respectively of net sales for the nine months ended March 31,2009.  Those same products accounted for54%, 0%, 6%, 15% and 4% respectively, of net sales for the nine months ended March 31,2008.  For the three months ended March 31,2009 and 2008, the same five products accounted for 41%, 17%, 14%, 9% and 3%,and 56%, 0%, 6%, 14%, and 4%, respectively, of net sales.

 

DuringLannett’s third quarter of 2009, the brand version of the Prenatal vitamin wasremoved from the marketplace.  It isexpected that, due to the lack of selling activities by the branded drugcompany, Lannett will experience a decline in sales for its generic product.  Additionally, the Company entered into asettlement agreement with this brand drug company related to the outstandinglitigation between the two companies. Pursuant to the settlement, the Company will receive a license to sellthe generic version of the drug and will become an authorized genericprovider.  Lannett will cease offeringits prenatal product if and when the brand is restored to the marketplace.

 

Fourof the Company’s customers accounted for 45%, 19%, 17%, and 12%, respectively,of net sales for the nine months ended March 31, 2009, and 31%, 8%, 5%,and 7%, respectively, of net sales for the nine months ended March 31,2008.  For the three months ended March 31,2009 and 2008, these customers accounted for 32%, 11%, 11%, and 9%, and 29%, 6%,4%, and 10%, respectively, of net sales. At March 31, 2009, these four customers accounted for 62% of theCompany’s accounts receivable balances. At June 30, 2008, these four customers accounted for 55% of theCompany’s accounts receivable balances.

 

***Share-based Compensation -***The Companyfollows the guidance in FASB SFAS No. 123 (R), “*Share-BasedPayment*” (“FAS 123(R)”).  This standard is a revision of SFAS No. 123,“*Accounting for Stock-Based Compensation*”and supersedes Accounting Principles Board Opinion (“APB”) No. 25, “*Accounting for Stock Issued to Employees*.”   FAS123(R) addresses the accounting for share-based compensation in which wereceive employee services in exchange for our equity instruments.  Underthe standard, we recognize compensation cost for share-based compensationissued to or purchased by employees, net of estimated forfeitures, undershare-based compensation plans using a fair value method.

 

AtMarch 31, 2009, the Company had three stock-based employee compensationplans (the “Old Plan,” the “2003 Plan,” and the Long-term Incentive Plan, or “LTIP”).  During the nine months ended March 31,2009, the Company awarded 30,000 shares of restricted stock under the LTIPwhich vested immediately.  Stockcompensation expense of zero and $ 101,399 was recognized during the three andnine months ended March 31, 2009, related to these shares of restrictedstock.

 

TheCompany is required to record compensation expense for all awards granted afterthe date of adoption of FAS 123(R) and for the unvested portion ofpreviously granted awards that remained outstanding as of the beginning of theperiod of adoption.  The Company measures the fair value of share-basedcompensation cost for options using the Black-Scholes option pricing model. The following table presents the weighted average assumptions used to estimatefair values of the stock options granted and the estimated forfeiture ratesduring the nine months ended March 31:

 
| ** **                                    | ** ** | **Incentive Stock  Options** | ** ** | **Non-qualified  Stock Options** | ** ** | **Incentive Stock  Options** | ** ** | **Non-qualified  Stock Options** | ** ** |
|-----------------------------------------------|------------|------------------------------|------------|----------------------------------|------------|------------------------------|------------|----------------------------------|------------|
| ** **                                    | ** ** | **FY 2009**                  | ** ** | **FY 2009**                      | ** ** | **FY 2008**                  | ** ** | **FY 2008**                      | ** ** |
| Risk-free  interest rate                      |       | 2.6                          | %          | 2.5                              | %          | 4.2                          | %          | 4.2                              | %          |
| Expected  volatility                          |       | 59.4                         | %          | 59.4                             | %          | 56.0                         | %          | 56.0                             | %          |
| 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 |       | $1.44                        |       | $1.41                            |       | $2.11                        |       | $2.11                            |       |

 

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Nooptions were issued under the LTIP during the three months ended March 31,2009 and 2008, respectively. Approximately 147,000 and 548,000 options were issued under the LTIPduring the nine months ended March 31, 2009 and 2008, respectively.  There were 7,800 and zero shares under optionthat were exercised in the nine months ended March 31, 2009 and 2008,respectively.  At March 31, 2009,there were 1,522,581 options outstanding. Of those, 605,900 were options issued under the LTIP, 705,448 wereissued under the 2003 Plan, and 211,233 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 12,090 shares underoption having already been exercised under that plan.  2,500,000 shares were authorized to be issuedunder the LTIP, with 3,400 shares under option having already been exercisedunder that plan.

 

Expectedvolatility is based on the historical volatility of the price of our commonshares over the historical period equal to the expected term of theoption.  We use historical information toestimate expected term within the valuation model.  The expected term ofawards 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 abusiness restructuring that is not expected to recur.  The forfeiture rate is 5% at March 31,2009 and 2008. As the Company continues to grow, this rate is likely to changeto match such changes in turnover and hiring rates. Under the provisions of FAS123R, 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.

 

Thefollowing table presents all share-based compensation costs recognized in ourstatements of operations as part of selling, general and administrativeexpenses:

 
| ** **                                           | ** ** | **Three Months Ended  March 31,** | ** ** | **Nine Months Ended  March 31,** | ** ** |
|------------------------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                                           | ** ** | **2009**                               | ** ** | **2008**                              | ** ** | **2009** | ** ** | **2008** | ** ** |
|                                                 |       |                                   |       |                                  |       |   |   |   |   |
| Method used to  account for share-based compensation |       | Fair Value                             |       | Fair Value                            |       | Fair Value |   | Fair Value |   |
| Share based  compensation                            |       |                                   |       |                                  |       |   |   |   |   |
| Stock options                                        |       | $293,293                               |       | $236,876                              |       | $731,286 |   | $656,626 |   |
| Employee stock  purchase plan                        |       | 39,023                                 |       | 5,522                                 |       | 70,315 |   | 20,389 |   |
| Restricted stock                                     |       | 43,007                                 |       | 42,889                                |       | 230,420 |   | 91,905 |   |

 

Aspart of the former CFO’s resignation, the Company repurchased all of his185,000 outstanding stock options. Therefore, the Company recorded, asincremental stock compensation expense, the previously unrecognized compensationcost totaling approximately $83,000 related to options for which the requisiteservice period had not been rendered as of the repurchase date.  See Note 11 for additional information.

 

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

 
| ** **                         | ** ** | **Awards** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Aggregate  Intrinsic  Value** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** |
|------------------------------------|------------|------------|------------|----------------------------------------|------------|---------------------------------|------------|-----------------------------------------------------|------------|
| Options vested                     |       | 981,670    |       | $                                      | 9.56       |                            | $          | 307,865                                             |       | 5.7 |   |
| Options expected  to vest          |       | 513,865    |       | $                                      | 4.08       |                            |       | 798,376                                             |       | 8.6 |   |
| Total vested and  expected to vest |       | 1,495,535  |       | $                                      | 7.68       |                            | $          | 1,106,241                                           |       | 6.7 |   |

 

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

 
| ** **                        | ** ** | **Awards** | ** ** | **Weighted  Average  Grant Date  Fair Value  per share** | ** ** |   |   |   |   |
|-----------------------------------|------------|------------|------------|----------------------------------------------------------|------------|--------|--------|--------|--------|
| Nonvested at  July 1, 2008   |       | 124,800    |       | $                                                        | 502,944    |   |   |   |   |   |
| Granted                           |       | 30,000     |       | 101,399                                                  |       |   |   |   |   |
| Vested                            |       | (68,602    | )          | (256,966                                                 | )          |   |   |   |   |
| Forfeited                         |       | (9,000     | )          | (36,270                                                  | )          |   |   |   |   |
| Nonvested at  March 31, 2009 |       | 77,198     |       | $                                                        | 311,107    |   |   |   |   |   |

 

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Asummary of award activity under the Plans as of March 31, 2009 and 2008,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, 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 |   |

 
| ** **                                             | ** ** | **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, 2007                      |       | 501,349                     |       | $                              | 7.48       |   |   |   |   |   | 617,982 |   | $ | 11.00 |   |   |   |   |   |
| Granted                                                |       | 462,918                     |       | $                              | 4.03       |   |   |   |   |   | 85,082 |   | $ | 4.03 |   |   |   |   |   |
| Exercised                                              |       | —                      |       | —                         |       |   |   |   |   | — |   | — |   |   |   |   |   |
| Forfeited or  expired                                  |       | (6,900                      | )          | $                              | 5.67       |   |   |   |   |   | — |   | — |   |   |   |   |   |
| Outstanding at  March 31, 2008                    |       | 957,367                     |       | $                              | 5.83       |   | $ | 3,280 |   | 8.2 |   | 703,064 |   | $ | 10.16 |   | — |   | 6.8 |   |
|                                                   |       |                        |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Outstanding at  March 31, 2008 and not yet vested |       | 626,638                     |       | $                              | 4.57       |   | — |   | 9.2 |   | 183,651 |   | $ | 5.05 |   | — |   | 8.9 |   |
|                                                   |       |                        |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Exercisable at  March 31, 2008                    |       | 330,729                     |       | $                              | 8.21       |   | $ | 3,280 |   | 6.3 |   | 519,413 |   | $ | 11.96 |   | — |   | 6.0 |   |

 

Optionswith a fair value of $762,511 vested during the nine months ended March 31,2009.  As of March 31, 2009,there was $1,212,930 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 1.34years. As of March 31, 2008, there was approximately $1,556,000 oftotal unrecognized compensation cost related to nonvested share-based compensationawards granted under the Plans. 

 

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

 

***Earnings (Loss) per CommonShare***— SFAS No. 128,*Earningsper Share,* (“FAS 128”) requires a dual presentation of basic anddiluted earnings per share on the face of the Company’s consolidated statementof 

 

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operations and areconciliation of the computation of basic earnings per share to dilutedearnings per share.  Basic earnings pershare excludes the dilutive impact of common stock equivalents and is computedby dividing net income by the weighted-average number of shares of common stockoutstanding for the period.  Dilutedearnings per share include the effect of potential dilution from the exerciseof outstanding common stock equivalents into common stock using the treasurystock method; such items would not be considered for diluted loss per share dueto their antidilutive effects.  Earningsper share amounts for all periods presented have been calculated in accordancewith the requirements of FAS 128.  Areconciliation of the Company’s basic and diluted income (loss) per sharefollows:

 
| ** **                                                        | ** ** | **Three  Months Ended March 31,** | ** ** | **Nine  Months Ended March 31,** | ** ** |
|-------------------------------------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                                                        | ** ** | **2009**                               | ** ** | **2008**                              | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                                        | ** ** | **Net  Income**                        | ** ** | **Shares**                            | ** ** | **Net Loss** | ** ** | **Shares** | ** ** | **Net  Income** | ** ** | **Shares** | ** ** | **Net Loss** | ** ** | **Shares** | ** ** |
| ** **                                                        | ** ** | **(Numerator)**                        | ** ** | **(Denominator)**                     | ** ** | **(Numerator)** | ** ** | **(Denominator)** | ** ** | **(Numerator)** | ** ** | **(Denominator)** | ** ** | **(Numerator)** | ** ** | **(Denominator)** | ** ** |
|                                                              |       |                                   |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic income  (loss) per share factors                            |       | $                                      | 1,314,482  |                                  | 24,502,629 |   | $ | (1,255,845 | ) | 24,268,449 |   | $ | 4,113,709 |   | 24,424,187 |   | $ | (2,040,553 | ) | 24,208,830 |   |
| Effect of potentially dilutive option and restricted  stock plans |       | —                                 |       | 253,412                               |       | — |   | — |   | — |   | 100,635 |   | — |   | — |   |
| Diluted income  (loss) per share factors                          |       | $                                      | 1,314,482  |                                  | 24,756,041 |   | $ | (1,255,845 | ) | 24,268,449 |   | $ | 4,113,709 |   | 24,524,822 |   | $ | (2,040,553 | ) | 24,208,830 |   |
|                                                              |       |                                   |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic income  (loss) per share                                    |       | $                                      | 0.05       |                                  |       |   | $ | (0.05 | ) |   |   | $ | 0.17 |   |   |   | $ | (0.08 | ) |   |   |
| Diluted income  (loss) per share                                  |       | $                                      | 0.05       |                                  |       |   | $ | (0.05 | ) |   |   | $ | 0.17 |   |   |   | $ | (0.08 | ) |   |   |

 

The number of anti-dilutive shares that have been excluded in thecomputation of diluted income (loss) per share for the three and nine monthsended March 31, 2009 were 865,642 and 1,470,779, respectively. The numberof anti-dilutive shares that have been excluded in the computation of dilutedincome (loss) per share for the three and nine months ended March 31, 2008were 1,915,231. 

 

**Note 3.  New Accounting Standards**

 

In September 2006, theFASB issued SFAS No. 157, “Fair Value Measurements” (“FAS 157”). This Statement defines fair value, establishes a framework for measuring fairvalue in generally accepted accounting principles (GAAP), and expandsdisclosures about fair value measurements. This Statement applies under otheraccounting pronouncements that require or permit fair value measurements, theBoard having previously concluded in those accounting pronouncements that fairvalue is the relevant measurement attribute. Accordingly, this Statement doesnot require any new fair value measurements. However, for some entities, theapplication of this Statement will change current practice. In February, 2008,the FASB issued FASB Staff Position 157-1, *Application of FASBStatement No. 157 to FASB Statement 13 and Other Accounting PronouncementsThat Address Fair value Measurements for Purposes of Lease Classification andMeasurement under Statement 13* (“FSP FAS 157-1”) and FASB StaffPosition 157-2, Effective Date of FASB Statement No. 157 (“FSP FAS 157-2”). FSP FAS 157-1 amends FAS 157 to remove certain leasing transactions from itsscope.  FSP FAS 157-2 defers the effective date of FAS 157 for allnon-financial assets and non-financial liabilities, except for items that arerecognized or disclosed at fair value in the financial statements on arecurring basis.  We adopted the guidance of FAS 157 as it applies to ourfinancial instruments on July 1, 2008. The adoption of FAS 157 did not have a material impact on the company’sfinancial statements. Marketable securities represent the only item recorded onthe Company’s balance sheets at fair value. Marketable securities are allclassified as available-for-sale and values are derived

 

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solely from level 1 inputs.In October 2008, the FASB issued FASB Staff Position No. FAS 157-3,Determining the Fair Value of a Financial Asset When the Market for That AssetIs Not Active (“FSP FAS 157-3”).  FSP FAS 157-3 clarifies the applicationof FAS 157 in a market that is not active and provides an example to illustratekey considerations in determining the fair value of a financial asset when themarket for that financial asset is not active.  FSP FAS 157-3 waseffective upon issuance, including for prior periods for which financial statementshave not been issued.  FSP FAS 157-3 did not impact our financialreporting as we do not hold any such assets.

 

In February 2007, theFASB issued SFAS No. 159, The Fair Value Option for Financial Assets andFinancial Liabilities—including an amendment of FASB Statement No. 115 (“FAS 159”),which allows companies to choose, at specific election dates, to measureeligible financial assets and liabilities at fair value that are not otherwiserequired to be measured at fair value. If a company elects the fair valueoption for an eligible item, changes in that item’s fair value in subsequentreporting periods must be recognized in current earnings.  FAS 159 iseffective for our fiscal year beginning July 1, 2008. The adoption ofFAS 159 did not have any impact on our consolidated financialstatements as we have not elected to apply the fair value option to any of ourfinancial assets and liabilities.

 

In June 2007, theEmerging Issues Task Force (“EITF”) reached a final consensus on EITF Issue No. 07-3,“Accounting for Nonrefundable Advance Payments for Goods or Services to Be Usedin Future Research and Development Activities” (“EITF 07-3”). EITF 07-3 iseffective for our fiscal year beginning July 1, 2008. EITF 07-3requires non-refundable advance payments for future research and developmentactivities to be capitalized until the goods have been delivered or relatedservices have been performed. As the guidance in EITF 07-03 is consistentwith our existing policy, EITF 07-03 did not have any impact on our financialstatements or related disclosures.

 

In November 2007, theEITF reached a final consensus on EITF Issue No. 07-1, “Accounting forCollaborative Arrangements Related to the Development and Commercialization ofIntellectual Property” (“EITF 07-1”). EITF 07-1 will be effective forour fiscal year beginning July 1, 2009 and interim periods within thatfiscal year. Adoption is on a retrospective basis to all prior periodspresented for all collaborative arrangements existing as of the effective date.We are currently evaluating the impact of adopting EITF 07-1 on ourconsolidated financial statements.

 

In December 2007, theFASB issued SFAS No. 141(R), “Business Combinations” (“FAS 141(R)”).FAS 141(R) will significantly change the accounting for business combinationsin a number of areas including the treatment of contingent consideration,contingencies, acquisition costs, in-process research and development andrestructuring costs. In addition, under FAS 141(R), changes in deferredtax asset valuation allowances and acquired income tax uncertainties in abusiness combination after the measurement period will impact income taxexpense. In April 2009, FAS 141(R) was amended by FASB Staff PositionFAS 141R-1, “Accounting for Assets Acquired and Liabilities Assumed in aBusiness Combination That Arise from Contingencies,” (“FSP FAS 141(R)-1”) toaddress application issues regarding the accounting and disclosure provisionsfor contingencies. FSP FAS 141(R) amends FAS 141R by replacing theguidance on the initial recognition and measurement of assets and liabilitiesarising from contingencies acquired or assumed in a business combination. FSPFAS 141(R)-1 also amends FAS 141R’s subsequent accounting guidance forcontingent assets and liabilities recognized at the acquisition date and amendsthe disclosure requirements for contingencies. FAS 141(R) and FSP FAS 141(R)-1 apply prospectively to businesscombinations for which the acquisition date is on or after the beginning of thefiscal year beginning July 1, 2009.  Early application is notpermitted. The effect of these standards on our consolidated financialstatements will depend on the nature and terms of any business combinationsthat occur after their effective date.

 

In December 2007, theFASB issued SFAS No. 160, “Noncontrolling Interests in ConsolidatedFinancial Statements” (“FAS 160”). FAS 160 amends Accounting ResearchBulletin No. 51 to establish accounting and reporting standards for thenoncontrolling (minority) interest in a subsidiary and for the deconsolidationof a subsidiary. It clarifies that a noncontrolling interest in a subsidiary isan ownership interest in the consolidated

 

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entity that should bereported as equity in the consolidated financial statements and establishes asingle method of accounting for changes in a parent’s ownership interest in asubsidiary that do not result in deconsolidation. FAS 160 is effective forour fiscal year beginning July 1, 2009. We are currently evaluating theimpact the adoption of FAS 160 will have on our consolidated financialstatements.

 

In March 2008, the FASBissued SFAS No. 161, “Disclosures about Derivative Instruments and HedgingActivities” (“FAS 161”).  The new standard is intended to help investorsbetter understand how derivative instruments and hedging activities affect anentity’s financial position, financial performance and cash flows throughenhanced disclosure requirements.  The new standard is effective for ourfiscal year beginning July 1, 2009 and for all interim periods within thatfiscal year.  Early adoption is encouraged.  We do not expect theadoption of FAS 161 to have a significant impact on our consolidated financialstatements as we do not currently have any derivatives within the scope of FAS161.

 

In April 2008, the FASBissued FASB Staff Position No. FAS 142-3, “Determination of the UsefulLife of Intangible Assets” (“FSP FAS 142-3”).  FSP FAS 142-3 amends thefactors that should be considered in developing renewal or extensionassumptions used to determine the useful life of a recognized intangible assetunder FASB Statement No. 142, “Goodwill and Other Intangible Assets”. TheFSP is intended to improve the consistency between the useful life of arecognized intangible asset under Statement 142 and the period of expected cashflows used to measure the fair value of the asset under FAS 141(R) andother U.S. generally accepted accounting principles.  The new standard iseffective for our financial statements issued for fiscal years and interimperiods beginning July 1, 2009.  We are currently evaluating theimpact of FSP FAS 142-3.

 

InApril 2009, the FASB issued FASB Staff Position (FSP) FAS 115-2 and FAS124-2, “Recognition and Presentation of Other-Than-Temporary Impairments,” tomake the guidance on other-than-temporary impairments of debt securities moreoperational and improve the financial statement disclosures related toother-than-temporary impairments for debt and equity securities. The FSPclarifies the interaction of the factors that should be considered whendetermining whether a debt security is other-than-temporarily impaired.

 

Toevaluate whether a debt security is other-than-temporarily impaired, an entitymust first determine whether the fair value of the debt security is less thanits amortized cost basis at the balance sheet date. If the fair value is lessthan the amortized cost basis, then the entity must assess whether it intendsto sell the security and whether it is more likely than not that it will berequired to sell the debt security before recovery of its amortized cost basis.If an entity determines that it will sell a debt security or that it morelikely than not will be required to sell a debt security before recovery of itsamortized cost basis, then it must recognize the difference between the fairvalue and the amortized cost basis of the debt security in earnings. Otherwise,the other-than-temporary impairment must be separated into two components: theamount related to the credit loss and the amount related to all other factors.The amount related to the credit loss must be recognized in earnings, while theother component must be recognized in other comprehensive income, net of tax.The portion of other-than-temporary impairment recognized in earnings woulddecrease the amortized cost basis of the debt security, and subsequentrecoveries in the fair value of the debt security would not result in awrite-up of the amortized cost basis.

 

FSPFAS 115-2 and FAS 124-2 are effective for interim and annual periods endingafter June 15, 2009, with early adoption permitted for periods endingafter March 15, 2009. If an entity adopts either FSP FAS 157-4 or FSP FAS107-1 and APB 28-1 for periods ending after March 15, 2009, then it mustadopt this FSP at the same time. The Company intends to adopt FSP FAS 115-2 andFAS 124-2 effective June 30, 2009.

 

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**Note4.  Inventories**

 

The Company values its inventory at the lower of cost (determined bythe first-in, first-out method) or market, regularly reviews inventoryquantities on hand, and records a provision for excess and obsolete inventorybased primarily on estimated forecasts of product demand and productionrequirements.  The Company’s estimates offuture product demand may fluctuate, in which case estimated required reservesfor excess and obsolete inventory may increase or decrease.  If the Company’s inventory is determined tobe overvalued, the Company recognizes the amount of the inventory write-down incost of goods sold at the time of such determination.

 

Inventories consistof the following: 

 
| ** **          | ** ** | **March 31, 2009** | ** **       | **June 30, 2008** | ** ** |
|---------------------|------------|-------------------------|------------------|------------------------|------------|
|                |       |                    |             |                   |       |
| Raw materials       |       | $                       | 5,306,828        |                   | $          | 3,530,951 |   |
| Work-in-process     |       | 2,742,986               |             | 1,034,360              |       |
| Finished goods      |       | 7,328,825               |             | 6,767,718              |       |
| Packaging  supplies |       | 652,596                 |             | 284,229                |       |
|                |       | $                       |  16,031,235 |                   | $          | 11,617,258 |   |

 

The preceding amounts are net of inventory reserves of $2,384,644 and$1,642,668 at March 31, 2009 and June 30, 2008, respectively.

 

**Note 5.  Property, Plant andEquipment**

** **

Property, plant and equipment are stated atcost.  Depreciation expense for financialreporting purposes is provided for by the straight-line method over theestimated useful lives of the assets. Depreciation expense for the three months ended March 31, 2009 and2008 was approximately $836,000 and $768,000, respectively. Depreciation expensefor the nine months ended March 31, 2009 and 2008 was approximately$2,503,000 and $2,641,000, respectively. Property, plant and equipment consist of the following:

 
| ** **                 | ** ** | ** **       | ** ** | **March 31,** | ** **       | **June 30,** | ** ** |
|----------------------------|------------|------------------|------------|--------------------|------------------|-------------------|------------|
| ** **                 | ** ** | **Useful Lives** | ** ** | **2009**           | ** **       | **2008**          | ** ** |
| Land                       |       | —           |       | $                  | 918,314          |              | $          | 918,314 |   |
| Building and  improvements |       | 10 - 39 years    |       | 16,944,908         |             | 16,806,057        |       |
| Machinery and  equipment   |       | 5 - 10 years     |       | 21,813,099         |             | 21,434,375        |       |
| Furniture and  fixtures    |       | 5 - 7 years      |       | 874,955            |             | 837,262           |       |
|                       |       |             |       | $                  |  40,551,276 |              | $          | 39,996,008 |   |
| Accumulated  depreciation  |       |             |       | (17,761,680        | )                | (15,261,905       | )          |
|                       |       |             |       | $                  |  22,789,596 |              | $          | 24,734,103 |   |

 

As of March 31,2009, substantially all of the Company’s property, plant and equipment werepledged as collateral for the Company’s loans. See Note 9. 

 

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

 

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

 
| **March 31, 2009  Available-for-Sale** |
|---------------------------------------------|
| ** **                                  | ** ** | **Amortized Cost** | ** ** | **Gross Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
|                                        |   |   |   |   |   |   |   |   |   |
| U.S. Government  Agency                     |   | $ | 928,910 |   | $ | 40,600 |   |   |   | $ | 969,510 |   |
| Asset-Backed  Securities                    |   | 190,038 |   | 2,157 |   | (10,694 | ) | 181,501 |   |
| Corporate Bonds                             |   | 329,431 |   | 6,330 |   |   |   | 335,761 |   |
|                                        |   | $ |  1,448,379 |   | $ | 49,087 |   | $ | (10,694 | ) | $ | 1,486,772 |   |
|                                             |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| **June 30,  2008  Available-for-Sale** |
|---------------------------------------------|
| ** **                                  | ** ** | **Amortized Cost** | ** ** | **Gross Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
|                                        |   |   |   |   |   |   |   |   |   |
| U.S. Government  Agency                     |   | $ | 2,036,039 |   | $ | 48,059 |   | $ | (9,854 | ) | $ | 2,074,244 |   |
| Asset-Backed  Securities                    |   | 447,893 |   | 1,013 |   | (23,015 | ) | 425,891 |   |
|                                        |   | $ | 2,483,932 |   | $ | 49,072 |   | $ | (32,869 | ) | $ | 2,500,135 |   |

 

The amortized costand fair value of the Company’s current available-for-sale securities bycontractual maturity at March 31, 2009 and June 30, 2008 aresummarized as follows: 

 
| ** **                              | ** ** | **March 31, 2009** | ** ** | **June 30, 2008** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                              | ** ** | **Available for Sale**  | ** ** | **Available for Sale** | ** ** |
| ** **                              | ** ** | **Amortized**           | ** ** | **Fair**               | ** ** | **Amortized** | ** ** | **Fair** | ** ** |
| ** **                              | ** ** | **Cost**                | ** ** | **Value**              | ** ** | **Cost** | ** ** | **Value** | ** ** |
| Due in one year  or less                |       | $                       | —     |                   | $          | — |   | $ | 343,638 |   | $ | 354,155 |   |
| Due after one  year through five years  |       | 1,258,340               |       | 1,305,270              |       | 1,692,401 |   | 1,720,089 |   |
| Due after five  years through ten years |       | 94,827                  |       | 96,985                 |       | 121,608 |   | 121,769 |   |
| Due after ten  years                    |       | 95,212                  |       | 84,517                 |       | 326,285 |   | 304,122 |   |
|                                    |       |                    |       |                   |       |   |   |   |   |
| Total  available-for-sale securities    |       | 1,448,379               |       | 1,486,772              |       | 2,483,932 |   | 2,500,135 |   |
| Less current  portion                   |       | —                  |       | —                 |       | 343,638 |   | 354,155 |   |
|                                    |       |                    |       |                   |       |   |   |   |   |
| Long term  available-for-sale securites |       | $                       | 1,448,379  |                   | $          | 1,486,772 |   | $ | 2,140,294 |   | $ | 2,145,980 |   |

 

TheCompany uses the specific identification method to determine the cost ofsecurities sold. For nine months ended March 31, 2009, the Company hadrealized gains of $60,242, whereas for the nine months ended March 31,2008, the Company had realized losses of $7,239.

 

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Therewere no securities held from a single issuer that represented more than 10% ofshareholders’ equity.

 

Thetable below indicates the length of time individual securities have been in acontinuous unrealized loss position as of March 31, 2009:

 

March 31,2009

 
| ** **                                    | ** ** | **Number**     | ** ** | **Less than 12 months** | ** ** | **12 months or longer** | ** ** | **Total** | ** ** |
|-----------------------------------------------|------------|----------------|------------|-------------------------|------------|-------------------------|------------|-----------|------------|
| **Description of**                            | ** ** | **of**         | ** ** | **Fair**                | ** ** | **Unrealized**          | ** ** | **Fair**  | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| **Securities**                                | ** ** | **Securities** | ** ** | **Value**               | ** ** | **Loss**                | ** ** | **Value** | ** ** | **Loss** | ** ** | **Value** | ** ** | **Loss** | ** ** |
|                                          |       |           |       |                    |       |                    |       |      |       |   |   |   |   |   |   |
| U.S. Government  Agency                       |       | —         |       | $                       | —     |                    | $          | —    |       | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Corporate Bonds                               |       | —         |       | —                  |       | —                  |       | —    |       | — |   | — |   | — |   |
| Asset-Backed  Securities                      |       | 3              |       | —                  |       | —                  |       | 84,517    |       | (10,694 | ) | 84,517 |   | (10,694 | ) |
| Total tempory  impaired investment securities |       | 3              |       | $                       | —     |                    | $          | —    |       | $ | 84,517 |   | $ | (10,694 | ) | $ | 84,517 |   | $ | (10,694 | ) |

 

Theinvestment securities shown above currently have fair values less thanamortized cost and therefore contain unrealized losses. The Company hasevaluated these securities and has determined that the decline in value is notrelated to any company or industry specific event. At March 31, 2009,there were 3 out of 19 investment securities with unrealized losses. TheCompany anticipates full recovery of amortized costs with respect to thesesecurities at maturity or sooner in the event of a more favorable marketinterest rate environment.

 

Noneof the Company’s investment securities was pledged as collateral for borrowingsas of March 31, 2009.

 

**Note7. Bank Line of Credit**

** **

TheCompany has a $3,000,000 line of credit from Wachovia Bank, N.A. (now asubsidiary of Wells Fargo & Co.) that bears interest at the primeinterest rate less 0.25% (3.00% at March 31, 2009). The line of credit wasrenewed and extended to November 30, 2009.    The line ofcredit is collateralized by substantially all of the Company’s assets. The agreement contains covenants with respect to working capital, net worth andcertain ratios, as well as other covenants.  At June 30, 2008, theCompany was not in compliance with one of these covenants, but received awaiver from its lending institution with respect to that covenant as of June 30,2008.  As of March 31, 2009, the Company was in compliance with allfinancial covenants under the agreement.

 

TheCompany is required to maintain and comply with a debt service coverage ratioof not less than 2 to 1 (to be measured quarterly).  Debt service coverageis defined as the ratio of earnings before interest, taxes, depreciation andamortization (EBITDA) to the sum of interest expenses plus scheduled currentmaturities of long-term debt and current capitalized lease obligations. The terms of the waiver received as of June 30, 2008 require the Companyto at all times maintain deposit balances in excess of $3,500,000 with the Bankfor the balance of the arrangement.  Additionally, the Company shall nowpay to the Bank an availability fee equal to 0.50% per annum calculated daily,on the available but unused balance of the line of credit instead of theprevious 0.25% per annum rate.

 

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**Note8.  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, 2009, theCompany has had preliminary discussions with the Commonwealth  ofPennsylvania to determine whether it will be required to repay any of the fundsprovided under the grant funding program.  Based on information availableat March 31, 2009, the Company has recorded the grant funding as along-term liability under the caption of Unearned Grant Funds.

 

**Note9.  Long-Term Debt**

 

Long-term debtconsists of the following:

 
| ** **                                                                 | ** ** | **March 31,** | ** ** | **June 30,** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------|------------|-------------------|------------|
| ** **                                                                 | ** ** | **2009**           | ** ** | **2008**          | ** ** |
| PIDC Regional  Center, LP III loan                                         |       | $                  | 4,500,000  |              | $          | 4,500,000 |   |
| Pennsylvania  Industrial Development Authority loan                        |       | 1,021,077          |       | 1,075,732         |       |
| Pennsylvania  Department of Community & Economic Development loan |       | 208,275            |       | 283,475           |       |
| Tax-exempt bond  loan (PAID)                                               |       | 795,000            |       | 795,000           |       |
| Equipment loan                                                             |       | 160,260            |       | 400,653           |       |
| SBA loan                                                                   |       | —             |       | 183,750           |       |
| First National  Bank of Cody                                               |       | 1,705,296          |       | 1,740,224         |       |
|                                                                       |       |               |       |              |       |
| Total debt                                                                 |       | 8,389,908          |       | 8,978,834         |       |
| Less current  portion                                                      |       | 503,469            |       | 791,912           |       |
|                                                                       |       |               |       |              |       |
| Long term debt                                                             |       | $                  | 7,886,439  |              | $          | 8,186,922 |   |

 
| ** **                                                                 | ** ** | **March 31,** | ** ** | **June 30,** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------|------------|-------------------|------------|
| ** **                                                                 | ** ** | **2009**           | ** ** | **2008**          | ** ** |
| Current Portion  of Long Term Debt                                         |       |               |       |              |       |
| PIDC Regional  Center, LP III loan                                         |       | $                  | —     |              | $          | — |   |
| Pennsylvania  Industrial Development Authority loan                        |       | 74,549             |       | 73,132            |       |
| Pennsylvania  Department of Community & Economic Development loan |       | 102,451            |       | 100,614           |       |
| Tax-exempt bond  loan (PAID)                                               |       | 115,000            |       | 115,000           |       |
| Equipment loan                                                             |       | 160,260            |       | 400,653           |       |
| SBA loan                                                                   |       | —             |       | 54,025            |       |
| First National  Bank of Cody                                               |       | 51,209             |       | 48,488            |       |
|                                                                       |       |               |       |              |       |
| Total current  portion of long term debt                                   |       | $                  | 503,469    |              | $          | 791,912 |   |

 

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The Company financed $4,500,000 through the Philadelphia IndustrialDevelopment Corporation (PIDC). The Company is required to pay a bi-annualinterest payment at a rate equal to two and one-half percent per annum. The outstanding principal balance is due and payable on January 1, 2011.

 

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 for IndustrialDevelopment (the “Authority” or “PAID”), to finance future construction andgrowth projects of the Company. The Authority issued $3,700,000 in tax-exemptvariable rate demand and fixed rate revenue bonds to provide the funds tofinance such growth projects pursuant to a trust indenture (“the Trust Indenture”). A portion of the Company’s proceeds from the bonds was used to pay for bondissuance costs of approximately $170,000.  The Trust Indenture requiresthat the Company repay the Authority loan through installment paymentsbeginning in May 2003 and continuing through May 2014, the year thebonds mature. The bonds bear interest at the floating variable rate determinedby the organization responsible for selling the bonds (the “remarketing agent”). The interest rate fluctuates on a weekly basis.  The effective interestrate at March 31, 2009 was 0.62%.

 

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 remains outstanding at March 31, 2009 was the Equipment Loan whichconsists of a term loan with a term of five years and had an outstandingbalance of $160,260 at March 31, 2009.  The terms of the Equipmentloan require that the Company meet certain financial covenants and reportingstandards, including the attainment of specific financial liquidity and networth ratios.  As of June 30, 2008, the Company was not in compliancewith one of these covenants, but received a waiver from its lending institutionwith respect to that covenant as of June 30, 2008.  As of March 31,2009, the Company was in compliance with all financial covenants under theagreement.

 

TheCompany is required to maintain and comply with a debt service coverage ratioof not less than 2 to 1 (to be measured quarterly).  Debt service coverageis defined as the ratio of earnings before interest, taxes, depreciation andamortization (EBITDA) to the sum of interest expenses plus scheduled currentmaturities of long-term debt and current capitalized lease obligations. The terms of the waiver received as of June 30, 2008 require the Companyto at all times maintain deposit balances in excess of $3,500,000 with the Bankfor the balance of the arrangement.  Additionally, the Company shall nowpay to the Bank an availability fee equal to 0.50% per annum calculated daily,on the available but unused balance of the line of credit instead of theprevious 0.25% per annum rate.

 

The financing facilities under the 2003 Loan Financing, of which onlythe Equipment Loan is left, bear interest at a variable rate equal to the LIBORrate plus 150 basis points.  The LIBOR rate is the rate per annum, basedon a 30-day interest period, quoted two business days prior to the first day ofsuch interest period for the offering by leading banks in the London interbankmarket of dollar deposits.  As of March 31, 2009, the interest ratefor the 2003 Loan Financing (of which only the Equipment loan remains) was1.98%.

 

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.

 

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Includedin the acquisition of Cody was a loan from the Small Business Administration (“SBA”). The loan required fixed monthly payments, and had an effective interest rate of8.75%, through July 31, 2012.  This loan was paid off in the thirdquarter of fiscal 2009.

 

Alsoas part 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.  Amortgage loan with First National Bank of Cody has been consolidated in theCompany’s financial statements, along with the related land and building. The mortgage has 18 years remaining.  Principal and interest payments of$14,782, at a fixed interest rate of 7.5%, are being made on a monthly basisthrough June 2026.  The mortgage loan is collateralized by the landand building.

 

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

 
| **Twelve Month** | ** ** | **Amounts Payable** | ** ** |
|------------------|------------|---------------------|------------|
| **Periods**      | ** ** | **to Institutions** | ** ** |
|             |       |                |       |
| 2010             |       | $                   | 503,469    |   |
| 2011             |       | 4,862,066           |       |
| 2012             |       | 268,217             |       |
| 2013             |       | 275,438             |       |
| 2014             |       | 290,680             |       |
| Thereafter       |       | 2,190,038           |       |
|             |       | $                   | 8,389,908  |   |
|                  |            |                     |            |  |  |

 

**Note10.  Contingencies**

 

In early June 2008, theCompany filed a declaratory judgment suit in the Federal District Courtof Delaware (Civil Action No. 08-338 (JJF)) against KVPharmaceuticals, DrugTech Corp., and Ther-Rx Corp (collectively “KV”). The complaint sought declaratory judgment for non-infringement andinvalidity of certain patents owned by KV.  The complaint further soughtdeclaratory judgment of anti-trust violations and federal and state unfaircompetition violations for actions taken by KV in securing and enforcing thesepatents.  After the complaint was filed, KV countered with amotion for a Temporary Restraining Order (“TRO”) to prevent the Company fromlaunching its Multivitamin with Mineral Capsules (“MMCs”), due to allegedpatent and trademark infringement issues.  The TRO was heard and,ultimately, resulted in a conclusion by the court that the Company’s productlabel on the MMCs should be modified.  KV also countered with claimsof infringement by the Company of KV’s patents seeking the Company’s profitsfor sales of MMCs or other monetary relief, preliminary and permanentinjunctive relief, attorney’s fees and a finding of willful infringement.On March 17, 2009 the Company and KV settled the litigation.  In light of the withdrawal of KV’s innovatorprenatal product, and the resulting anticipated decline in sales and decliningmarket for written prescription, the Company decided it was pointless tocontinue the litigation and entered into the settlement arrangement withKV.  Pursuant to the settlement, theCompany will receive a license from KV and will become an authorized genericprovider.  During the terms of thelicense, the Company will pay KV a royalty on all future sales of its Prenatalvitamin product.  Lannett will ceaseoffering its Prenatal vitamin product if and when the brand is restored to themarketplace.

 

In or about July 2008,Albion International and Albion, Inc. filed suit in the United StatesDistrict Court, District of Utah (Case No. 2:08cv00515) against Lannettasserting claims for patent and trademark infringement, as well as unfaircompetition, arising out of Lannett’s use of product that it purchased fromAlbion and used as an

 

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ingredient in itsMMC.  Lannett filed a motion to dismiss the complaint on the basis that itpurchased the product from Albion and, as such, was authorized to use theproduct in its MMC.  The Court granted the motion and dismissed thecomplaint but gave Albion leave to file an amended complaint.  On January 20,2009, Albion filed an amended complaint.   Lannett filed ananswer to the complaint and counterclaim, asserting, among otherthings, that Albion tortuously interfered with Lannett’scontracts.  Subsequent to the filing of the answer andcounterclaim, Lannett and Albion reached an agreement inprincipal to settle the case.  Under terms of the settlement, the partieswould each dismiss their claims against each other and providereleases.  Lannett is in the process of negotiating the language of awritten settlement agreement.

 

**Note11.   Commitments**

 

***Leases***

 

**In June 2006, Lannett signed a lease agreement on a66,000 square foot facility located on seven acres in Philadelphia.  An additional agreement which gives theCompany the option to buy the facility was also signed.  This facility is initially going to be usedfor warehouse space with the expectation of making this facility the Company’sheadquarters in addition to manufacturing and warehousing.  The other Philadelphia locations willcontinue to be utilized as manufacturing, packaging, and as a researchlaboratory.**

** **

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

** **

**Rental and lease expense for the three months ended March 31,2009 and 2008 was approximately $110,000 and $109,000, respectively.  Rental and lease expense for the nine monthsended March 31, 2009 and 2008 was approximately $335,000 and $339,000,respectively**.

 

***Contractual Obligations***

 

Thefollowing table represents annual debt, lease and contractual purchaseobligations as of March 31, 2009:

 
| ** **               | ** ** | **Total**   | ** **  | **Less than 1  year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **More than 5  years** | ** ** |
|--------------------------|------------|-------------|-------------|-----------------------|------------|---------------|------------|---------------|------------|------------------------|------------|
|                     |       |        |        |                  |       |          |       |          |       |                   |       |
| Long-Term Debt           |       | $           | 8,389,908   |                  | $          | 503,469       |       | $             | 5,130,283  |                   | $          | 566,118 |   | $ | 2,190,038 |   |
| Operating Leases         |       | 1,159,342   |        | 475,317               |       | 679,011       |       | 5,014         |       | —                 |       |
| Purchase  Obligations    |       | 110,833,125 |        | 20,322,500            |       | 43,510,625    |       | 47,000,000    |       | —                 |       |
| Interest on  Obligations |       | 1,865,991   |        | 221,960               |       | 569,154       |       | 276,650       |       | 798,227                |       |
| Total                    |       | $           | 122,248,366 |                  | $          | 21,523,246    |       | $             | 49,889,073 |                   | $          | 47,847,782 |   | $ | 2,988,265 |   |

 

The purchase obligations above are due primarily to the agreement withJerome Stevens Pharmaceuticals, Inc. If the minimum purchase requirement is not met, Jerome Stevens has theright to terminate the contract within 60 days of Lannett’s failure to meet therequirement.  If Jerome Stevensterminates the contract, Lannett does not pay any fee, but could lose itsexclusive distribution rights in the United States.  If Lannett’s management believes that it isnot in the Company’s best interest to fulfill the minimum purchaserequirements, it can also terminate the contract without

 

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any penalty.  If either partywere to terminate the purchase agreement, there would be a significant impacton the operating cash flows of the Company from the termination.

 

***Employment Agreements***

 

TheCompany has entered into employment agreements with Arthur P. Bedrosian,President and Chief Executive Officer, Kevin Smith, Vice President of Sales andMarketing, and William Schreck, Vice President of Logistics, (the “NamedExecutives”).  Each of the agreements provide for an annual base salaryand eligibility to receive a bonus.  The salary and bonus amounts of theNamed Executives are determined by the Board of Directors.  Additionally,the Named Executives are eligible to receive stock options and restrictedshares, which are granted at the discretion of the Board of Directors, and inaccordance with the Company’s policies regarding stock option grants.  Under the agreements, the Named Executiveemployees may be terminated at any time with or without cause, or by reason ofdeath or disability.  In certaintermination situations, the Company is liable to pay severance compensation tothe Named Executive of between one year and three years.

 

Duringthe third quarter of Fiscal Year 2009, the Company’s Vice President of Finance,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.  This liability is expected to be paid duringthe fourth quarter of Fiscal Year 2009. As part of the settlement, $124,000 was designated as the portion of thesettlement related to the repurchase of his outstanding 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.

 

**Note12.  Other Comprehensive Income (Loss)**

 

The Company’sother comprehensive income (loss) is comprised of unrealized gains oninvestment securities classified as available-for-sale.  The components of comprehensive income (loss)and related taxes consisted of the following as of March 31, 2009 and2008:

 
| ** **                                    | ** ** | **For the Three Months Ended  March 31,** | ** ** | **For the Nine Months Ended  March 31,** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                    | ** ** | **2009**                                       | ** ** | **2008**                                      | ** ** | **2009** | ** ** | **2008** | ** ** |
|                                          |       |                                           |       |                                          |       |   |   |   |   |
| Other  Comprehensive Income (Loss):           |       |                                           |       |                                          |       |   |   |   |   |
| Net Income  (Loss)                            |       | $                                              | 1,314,482  |                                          | $          | (1,255,845 | ) | $ | 4,113,709 |   | $ | (2,040,553 | ) |
| Unrealized  Holding (Loss) Gain on Securities |       | (43,479                                        | )          | 71,315                                        |       | 22,190 |   | 101,715 |   |
| Add: Tax savings  at statutory rate           |       | 17,392                                         |       | (28,526                                       | )          | (8,876 | ) | (40,686 | ) |
|                                          |       |                                           |       |                                          |       |   |   |   |   |
| Total Other  Comprehensive (Loss) Income      |       | (26,087                                        | )          | 42,789                                        |       | 13,314 |   | 61,029 |   |
|                                          |       |                                           |       |                                          |       |   |   |   |   |
| Total  Comprehensive Income (Loss)            |       | $                                              | 1,288,395  |                                          | $          | (1,213,056 | ) | $ | 4,127,023 |   | $ | (1,979,524 | ) |

 

**Note13.   Employee Benefit Plan**

 

TheCompany has a defined contribution 401k plan (the “Plan”) covering substantiallyall employees.  Pursuant to the Plan provisions, the Company is requiredto make matching contributions equal to 50% of each employee’s contribution,but not to exceed 4% of the employee’s compensation for the Plan year. Contributions to the Plan during the three months ended March 31, 2009 and2008 were $86,000 and $88,000, respectively. For the nine months ended March 31, 2009 and 2008 the contributionsto the Plan were $249,000 and $265,000, respectively.

 

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**Note14.   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, 2009, 167,366 shares have been issued underthe ESPP.  Compensation expense of $39,023 and $5,522 has been recognizedfor the three months ended March 31, 2009 and 2008, respectively, relatingto the ESPP. Compensation expense of $70,315 and $20,389 has been recognizedfor the nine months ended March 31, 2009 and 2008, respectively, relatingto the ESPP.

 

**Note15.  Income Taxes**

 

TheCompany uses the liability method specified by SFAS No. 109, *Accounting for Income Taxes.* Deferred tax assets and liabilities are determined based on thedifference between the financial statement and tax bases of assets andliabilities as measured by the enacted tax rates which will be in effect whenthese differences reverse.  Deferred taxexpense/(benefit) is the result of changes in deferred tax assets andliabilities.

 

The provision forfederal, state and local income taxes for the three months ended March 31,2009 and 2008 was a tax expense of approximately $851,000 and a tax benefit ofapproximately $615,000, respectively, with effective tax rates of 39% and 33%,respectively. The provision for income taxes for the nine months ended March 31,2009 and 2008 was a tax expense of approximately $2,697,000 and a tax benefitof approximately $821,000, respectively, with effective tax rates of 39% and29%, respectively.  The effective taxrate for the three and nine month periods ended March 31, 2008 was a lowereffective tax rate compared to Fiscal 2009 due primarily to no state NOLs beingavailable for the Cody Lab losses.

 

On July 1, 2007, the Company adopted theprovisions of *FIN 48, Accounting forUncertainty in Income Taxes – an interpretation of FASB Statement No. 109*,(“FIN 48”) which provides a financial statement recognition threshold andmeasurement attribute for a tax position taken or expected to be taken in a taxreturn. Under FIN 48, the Company may recognize the tax benefit from anuncertain tax position only if it is more likely than not that the tax positionwill be sustained on examination by the taxing authorities, based on thetechnical 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. FIN 48 also provides guidance on de-recognition of income taxassets and liabilities, classification of current and deferred income taxassets and liabilities, accounting for interest and penalties associated withtax positions, and income tax disclosures.

 

The Company did not recognize any additionalcurrent or deferred income tax assets or liabilities as a result of theimplementation of FIN 48.  Additionally,the Company has not recorded any amount for unrecognized tax positions at March 31,2009.

 

The Company files tax returns in the United Statesfederal jurisdiction, Pennsylvania and New Jersey.  The Company’s tax returns for years prior to2004 generally are no longer subject to review as such years generally areclosed. The Company is not currently involved with any reviews by any taxingauthorities.  The Company believes thatan unfavorable resolution for open tax years would not be material to thefinancial position of the Company.

 

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The Company adjusted the original purchase price allocation for CodyLabs, as a result of a study and additional analysis of assets acquired.  The result of this study was to increase thedeferred tax assets by $1,255,000 and decrease the value of Cody Labs’property, plant and equipment by the same amount.  This was recorded by the Company during thethird quarter of Fiscal 2008 in accordance with SFAS No. 141, BusinessCombinations.

 

**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, 2009 and June 30, 2008 balance sheets areconsolidated VIE assets of approximately $1.9 million, which is comprisedmainly of land and building. VIE liabilities consist of a mortgage on thatproperty in the amount of approximately $1.7 and $1.8 million at March 31,2009 and June 30, 2008, respectively.

 

CodyLCI Realty LLC (“Realty”) is the only VIE that is consolidated withLannett.  Realty has been consolidated by Cody prior to its acquisition byLannett.  Realty is a 50/50 joint venture between a former shareholder ofCody Labs and Lannett.  Its purpose was to acquire the facility used byCody.  Until the acquisition of Cody in April 2007, Lannett hadnot consolidated the VIE because Cody Labs had been the primary beneficiary ofthe VIE.  The risks associated with our interests in this VIE is limitedto a decline in the value of the land and building as compared to the balanceof the mortgage note on that property, up to Lannett’s 50% share of theventure.  Realty owns the land and building, and Cody leases the buildingand property from Realty for $15,000 per month.  All intercompany rentexpense is eliminated upon consolidation with Cody.

 

TheCompany is not the primary beneficiary of any other variable interest entity.

 

**Note17.  Related Party Transactions**

 

TheCompany had sales of approximately $522,000 and $418,000 during the nine monthsended March 31, 2009 and 2008, respectively, to a distributor (the “relatedparty”) owned by Jeffrey Farber. Mr. Jeffrey Farber is a member of theBoard of Directors and acting Chairman, as well as the son of William Farber,who is the Chairman of the Board (but currently out on medical leave) andprincipal shareholder of the Company. Accounts receivable includes amounts due from the related party ofapproximately $80,000 and $87,000 at March 31, 2009 and 2008,respectively.  In management’s opinion,the terms of these transactions were not more favorable to the related partythan they would have been to a non-related party.

 

In January 2005, Lannett Holdings, Inc. enteredinto an agreement 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 Fiscal 2008, the Company obtained FDA approval to use the proprietaryrights.  Accordingly, the Company hascapitalized this purchased product right as an indefinite lived intangibleasset and will test this asset for impairment on an annual basis.  Arthur Bedrosian, President and ChiefExecutive Officer of the Company, currently owns 100% of Pharmeral, Inc.  This transaction was approved by the Board ofDirectors of the Company, and in their opinion, the terms were not morefavorable to the related party than they would have been to a non-relatedparty.  In May 2008, Mr. Bedrosianand Pharmeral waived their rights to any royalty payments on the sales of thedrug by Lannett, under Lannett’s current ownership structure.  Should Lannett undergo a major change incontrol where a third party is involved, this royalty would be reinstated.

 

As of March 31, 2009 and June 30, 2008, theCompany had approximately $19,000 and $983,000, respectively of deferredrevenue, representing payments received from Provell Pharmaceuticals, LLC (“Provell”)for inventory purchased from Lannett. The Company recognized revenue ofapproximately $349,000 and $735,000,

 

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respectively, for the three and nine months ended March 31,2009. The Company recognized revenue of approximately $12,000 and $45,000,respectively, for the three and nine months ended March 31, 2008.  Accounts receivable includes amounts due fromthe related party of approximately $109,000 and $60,000 at March 31, 2009and June 30, 2008, respectively. Provell is a joint venture to distribute pharmaceutical products throughmail order outlets.  Lannett was originally given a 33% ownership of thisventure in exchange for access to Lannett’s drug providers.  Thisownership was recently decreased to 25% due to the additional issuance ofshares by Provell in which Lannett did not participate. The investment isvalued at zero, due to losses incurred to date by Provell.  During April 2009, the Companynotified Provell that it would like to terminate its participation in thisjoint venture.

 

**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 70% and 69% of the Company’s inventorypurchases during the three and nine month periods ended March 31, 2009 and77% and 70% during the three and nine month periods ended March 31, 2008,respectively.  On March 23, 2004,****the Company entered into an agreement with JSP for theexclusive distribution rights in the United States to the current line of JSPproducts, in exchange for four million (4,000,000) shares of the Company’scommon stock.  The JSP products coveredunder the agreement included Butalbital, Aspirin, Caffeine with CodeinePhosphate capsules, Digoxin tablets and Levothyroxine Sodium tablets, soldgenerically and under the brand name Unithroid®.  The term of the agreement is ten years, beginningon March 23, 2004 and continuing through March 22, 2014.  Both Lannett and JSP have the right toterminate the contract if one of the parties does not cure a material breach ofthe contract within thirty (30) days of notice from the non-breaching party.

 

Duringthe term of the agreement, the Company is required to use commerciallyreasonable efforts to purchase minimum dollar quantities of JSP’s productsbeing distributed by the Company.  Theminimum quantity to be purchased in the first year of the agreement is $15million.  Thereafter, the minimumquantity to be purchased increases by $1 million per year up to $24 million forthe last year of the ten-year contract. The Company has met the minimum purchase requirement for the first fouryears 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 the Sarbanes-OxleyAct of 2002.  As of March 31, 2009,JSP has not exercised the nomination provision of the agreement.

 

Managementdetermined that the intangible product rights asset created by this agreementwas impaired as of March 31, 2005. See Note 2 Summary of SignificantAccounting Policies – IntangibleAssets for additional disclosure and discussion of this impairment.

 

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

 

Otheragreements:

 

InAugust 2005, the Company signed an agreement with a finished goodsprovider to purchase, at fixed prices, and distribute a certain genericpharmaceutical product in the United States. The term of the agreement was three

 

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years,beginning on August 22, 2005 and continuing through August 21,2008.  Following its expiration on August 21,2008, the agreement was not renewed. Purchases of finished goods inventoryfrom this provider accounted for approximately 2% of the Company’sinventory purchases during the nine month period ended March 31, 2009.Purchases of finished goods inventory from this provider accounted forapproximately 12% and 15% of the Company’s inventory purchases during thethree and nine month periods ended March 31, 2008.

 

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| ***ITEM 2.*** | *** *** | ***MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.*** |
|---------------|--------------|----------------------------------------------------------------------------------------------------|

*** ***

***Introduction***

 

The following informationshould be read in conjunction with the consolidated financial statements andnotes in Part I, Item 1 of this Quarterly Report and with Management’sDiscussion and Analysis of Financial Condition and Results of Operationscontained in the Company’s Annual Report on Form 10-K for the fiscal yearended June 30, 2008.

 

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 SecuritiesLitigation Reform Act of 1995. Forward-looking statements are not promises orguarantees and investors are cautioned that all forward-looking statementsinvolve risks and uncertainties, including but not limited to the impact ofcompetitive products and pricing, product demand and market acceptance, newproduct development, the regulatory environment, including without limitation,reliance on key strategic alliances, availability of raw materials,fluctuations in operating results and other risks detailed from time to time inthe Company’s filings with the Securities and Exchange Commission. Thesestatements are based on management’s current expectations and are naturallysubject to uncertainty and changes in circumstances. We caution you not toplace undue reliance upon any such forward-looking statements which speak onlyas of the date made. Lannett is under no obligation to, and expressly disclaimsany such obligation to, update or alter its forward-looking statements, whetheras a result of new information, 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, 2009 and June 30,2008 balance sheets are consolidated VIE assets of approximately $1.9 million,which is comprised mainly of land and building. VIE liabilities consist of amortgage on that property in the amount of approximately $1.7 and $1.8 millionat March 31, 2009 and June 30, 2008, respectively. This VIE wasinitially consolidated by Cody, as Cody has been the primary beneficiary. Cody has then been consolidated within Lannett’s financial statements since itsacquisition in April 2007.

 

***Revenue Recognition*** – The Company recognizesrevenue when its products are shipped.  At this point, title and risk ofloss have transferred to the customer and provisions for rebates, promotionaladjustments, price adjustments, returns, chargebacks, and other potentialadjustments are reasonably determinable.  Accruals for 

 

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these provisions arepresented in the consolidated financial statements as rebates, chargebacks andreturns payable and as reductions to net sales. The change in the reserves forvarious sales adjustments may not be proportionally equal to the change insales because of changes in both the product and the customer mix. Increasedsales to wholesalers will generally require additional accruals as they are theprimary recipient of chargebacks and rebates. Incentives offered to securesales vary from product to product. Provisions for estimated rebates andpromotional 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 its customersand applies this rate to customer sales.  The only variable is customermix, and this assumption is based on historical data and salesexpectations.  The chargeback/rebate reserve is reviewed on a monthlybasis by management using several ratios and calculated metrics.  As wecontinue to obtain additional information about our historical experience forchargebacks, rebates and returns, we also update our estimates of the requiredreserves.

 

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

 

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

 

 ***Returns–***Consistent with industry practice, the Company has a product returnspolicy that allows certain customers to return product within a specifiedperiod prior to and subsequent to the product’s lot expiration date in exchangefor a credit to be applied to future purchases.  The Company’s policyrequires that the customer obtain pre-approval from the Company for anyqualifying return.  The Company estimates its provision for returns basedon historical experience, adjusted for any changes in business practices orconditions that would cause management to believe that future product returnsmay differ from those returns assumed in the establishment of reserves. Generally, the reserve for returns increases as sales increase and decreasewhen 

 

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credits are issued or payments are made for actualreturns received.  The reserve for returns is included in the rebates,chargebacks and returns payable account on the balance sheet.

 

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

 

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

 

**For thenine 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 |   |

 

**For the nine months ended March 31, 2008**

 
| **Reserve  Category**                                                                      | ** ** | **Chargebacks** | ** ** | **Rebates** | ** ** | **Returns** | ** ** | **Other** | ** ** | **Total**   | ** ** |
|--------------------------------------------------------------------------------------------|------------|-----------------|------------|-------------|------------|-------------|------------|-----------|------------|-------------|------------|
|                                                                                       |       |            |       |        |       |        |       |      |       |        |       |
| Reserve Balance  as of June 30, 2007                                                  |       | $               | 4,649,478  |        | $          | 871,339     |       | $         | 113,313    |        | $          | 52,234 |   | $ | 5,686,364 |   |
| Actual credits  issued related to sales recorded in prior fiscal years                     |       | (4,429,923      | )          | (1,741,804  | )          | (146,917    | )          | —    |       | (6,318,644  | )          |
| Reserves or  (reversals) charged during Fiscal 2008 related to sales in prior fiscal years |       | —          |       | 870,465     |       | 50,000      |       | (50,000   | )          | 870,465     |       |
| Reserves charged  to net sales during Fiscal 2008 related to sales recorded in Fiscal 2008 |       | 17,985,506      |       | 6,240,517   |       | 2,200,267   |       | 473,423   |       | 26,899,713  |       |
| Actual credits  issued related to sales recorded in Fiscal 2008                            |       | (14,721,493     | )          | (4,988,844  | )          | (805,702    | )          | (473,552  | )          | (20,989,591 | )          |
| Reserve Balance  as of March 31, 2008                                                 |       | $               | 3,483,568  |        | $          | 1,251,673   |       | $         | 1,410,961  |        | $          | 2,105 |   | $ | 6,148,307 |   |

 

The total reserve for chargebacks, rebates, returns and otheradjustments decreased from $18,326,417 at June 30, 2008 to $11,172,174 at March 31,2009. The significant decrease in the returns reserve balance wasprimarily the result of credits issued during the first nine months of Fiscal2009 related to the returns of the Prenatal Multivitamin product shipped inFiscal 2008.  It is our expectation that all of the product will bereturned based on our inability to have the product specified as a brandequivalent, and information from our customers regarding their intentions toreturn the product.  As of March 31, 2009 approximately$9,507,000 of the return reserve was applied to accounts receivable forcustomers who had returned the Prenatal Multivitamin product by 

 

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that date, leaving a balance of approximately $1,038,000 ofMultivitamin returns reserve on the books at March 31, 2009. The increasein chargeback reserves between June 30, 2008 and March 31, 2009 wasprimarily due to an increase in inventory levels at wholesaler distributioncenters

 

Credits issued during the quarter that relate to prioryear sales are charged against the opening balance.  In aggregate, additional reserves orreversals of reserves have historically offset each other.  The table above shows the effects ofreversals 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 current conditions.

 

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

 

The rate of credits issued is monitored by the Company at least on aquarterly basis.  The Company may changethe estimate of future reserves based on the amount of credits processed, orthe rate of sales made to indirect customers.  The decrease of reserves to $11,172,174 at March 31, 2009 from$18,326,417 at June 30, 2008 is due to the timing of credits beingprocessed by the customers and by the Company. Approximately $16,810,000 or 92% of the reserve balance from June 30,2008 has been processed through the first nine months of Fiscal 2009.  Approximately $9,507,000 of that amountrelates to credits issued due to the return by customers of the PrenatalMultivitamin product through December 31, 2008.  Management estimates reserves based on salesmix.  A comparison to wholesalerinventory reports is performed quarterly, in order to justify the balance ofunclaimed chargebacks and rebates.  TheCompany has historically found a direct correlation between the calculation ofthe reserve based on sales mix, and the wholesaler inventory analysis.

 

***Accounts Receivable******–***The Company performs credit evaluations of its customers and adjusts creditlimits based upon payment history and the customer’s current credit worthiness,as determined by a review of available credit information. The Companycontinuously monitors collections and payments from its customers and maintainsa provision for estimated credit losses based upon historical experience andany specific customer collection issues that have been identified.  While such credit losses have historicallybeen within both the Company’s expectations and the provisions established, theCompany cannot guarantee that it will continue to experience the same creditloss rates that it has in the past.

 

TheCompany also regularly monitors customer Accounts Receivable (AR) balancesthrough a tool known as Days Sales Outstanding (“DSO”).  This calculation for Net DSO begins with theGross AR less the Rebates and Chargeback reserve. This net amount is thendivided by the average daily net sales for the period.  The table below shows the results of thesecalculations for the relevant periods.

 

| ** **           | ** ** | **Nine months  ended  3/31/09** | ** ** | **Fiscal Year  ended  6/30/08** | ** ** | **Nine months  ended  3/31/08** | ** ** |
|----------------------|------------|---------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| Net DSO (in  days)   |       | 59                              |       | 65                              |       | 75                              |       |
| Gross DSO (in  days) |       | 64                              |       | 70                              |       | 63                              |       |

 

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The Gross DSO above shows the result of the samecalculation without regard to rebates and chargebacks. The Company monitorsboth Net DSO and Gross DSO as an overall check on collections andreasonableness of reserves.  In order tobe effective indicators, both types of DSO are evaluated on a quarterlybasis.  The Gross DSO calculationprovides management with an understanding of the frequency of customerpayments, and the ability to process customer payments and deductions.  The Net DSO calculation provides managementwith an understanding of the relationship of the A/R balance net of the reserveliability compared to net sales after reserves charged during the period.

 

TheCompany’s payment terms are consistent with the generic pharmaceutical industryat 60 days for payment from all customers, including wholesalers.  Net DSO for the third quarter of Fiscal 2009,net of rebates and chargebacks, decreased as a result of timing of return creditsbeing taken by certain customers. Management expects the DSO calculation normallevels to be 60 to 70 days.  Significantvariances greater or less than this range are reviewed and, if necessary,action is taken.

 

***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.

 

***Share-based Compensation –*** Statement ofFinancial Accounting Standards (“SFAS”) No. 123 (revised 2004), “*Share-Based Payment*,” (“FAS 123(R)”) wasadopted effective July 1, 2005. Share-based compensation cost is measured using the Black-Scholes optionpricing model.  The following tablehighlights relevant stock-option plan information for the nine months ended:

 
| ** **                                                                                   | ** ** | **March 31,  2009** | ** ** | **March 31,  2008** | ** ** |
|----------------------------------------------------------------------------------------------|------------|--------------------------|------------|--------------------------|------------|
| Share based  compensation expense                                                            |       |                     |       |                     |       |
| Stock options                                                                                |       | $                        | 731,000    |                     | $          | 657,000 |   |
| Employee stock  purchase plan                                                                |       | $                        | 70,000     |                     | $          | 20,000 |   |
| Restricted stock                                                                             |       | $                        | 230,000    |                     | $          | 92,000 |   |
| Total  unrecognized compensation cost related to non-vested share-based compensation  awards |       | $                        | 1,213,000  |                     | $          | 1,981,000 |   |
| Weighted average  period over which it is to be recognized                                   |       | 1.34 years               |       | 1.6 years                |       |

 

As part of the former CFO’sresignation, the Company repurchased all of his 185,000 outstanding stockoptions. Therefore, the Company recorded, as incremental stock compensationexpense, the previously unrecognized compensation cost totaling approximately$83,000 related to options for which the requisite service period had not beenrendered as of the repurchase date.

 

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

 

Net sales for the threemonths ended March 31, 2009 (“Fiscal 2009”) increased 73% to $28,761,000from $16,580,000 for the three months ended March 31, 2008 (“Fiscal 2008”).The increase was primarily due to sales of $4,890,000 of ourPrenatal vitamins during the third quarter of Fiscal 2009.  The increase can also be attributed toincreases in demand for Lannett’s products used for the treatment of congestiveheart failure and thyroid deficiency.  The Company looks to continue increasing the number of productsavailable for sale to our customers.  FDAapprovals are needed to continue this growth. Several recent FDA approvals have resulted in more sales of new productsin the current fiscal year compared to the prior fiscal year.  In addition to the sales of the Prenatalvitamins, the following factors contributed to the $12,181,000 increase insales:

 
| **Medical indication**    | ** ** | **Sales volume  change %** | ** ** | **Sales price  change %** | ** ** |
|---------------------------|------------|----------------------------|------------|---------------------------|------------|
| Congestive Heart  Failure |       | 189                        | %          | 36                        | %          |
| Antibiotics               |       | -8                         | %          | -89                       | %          |
| Thyroid                   |       | 28                         | %          | - 1                       | %          |
| Migraine  Headache        |       | 0                          | %          | 4                         | %          |

 

Drugsfor the treatment of congestive heart failure experienced a large increase insales price and volume as a result of the Company being one of the majorsuppliers for the generic market of this product.  This is due to several competitor recalls ofthis product.  The increase in volume indrugs used for the treatment of thyroid deficiency was mainly due to the pushof generic sales at one of our large existing retail chain customers.

 

Theincrease in product sales can be attributed primarily to three products.  Sales of drugs for the treatment ofcongestive heart failure increased by approximately $2,934,000 in the thirdquarter of Fiscal 2009 compared to the third quarter of Fiscal 2008 due to aproduct recall by several of our major competitors.  Sales of drugs used in the treatment ofthyroid deficiency increased by approximately $2,422,000.  This increase was due to an increase in salesto one large existing retail chain customer. The increase can also be contributed to the continued sales of ourprenatal vitamins discussed above.

 

DuringLannett’s third quarter of 2009, the brand version of the Prenatal vitamin wasremoved from the marketplace.  It isexpected that, due to the lack of selling activities by the branded drugcompany, Lannett will experience a decline in sales for this product.  Accordingly, the Company entered into asettlement agreement with this brand drug company related to the outstandinglitigation between the two companies. Pursuant to the settlement, the Company will receive a license to sellthe generic version of the drug and will become an authorized genericprovider.  Lannett will cease offeringits Prenatal vitaminproduct if and when the brand is restored to the marketplace.

 

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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 31,2009 and 2008:

 
| **Customer Category**    | ** ** | **2009**   | ** ** | **2008**  | ** ** |
|--------------------------|------------|------------|------------|-----------|------------|
|                     |       |       |       |      |       |
| Wholesaler/  Distributor |       | $          | 12,252,000 |      | $          | 7,152,000 |   |
| Retail Chain             |       | 15,015,000 |       | 8,465,000 |       |
| Mail-Order  Pharmacy     |       | 1,356,000  |       | 892,000   |       |
| Private Label            |       | 138,000    |       | 71,000    |       |
|                     |       |       |       |      |       |
| Total                    |       | $          | 28,761,000 |      | $          | 16,580,000 |   |

** **

**Thesales to all customer categories increased significantly as a result of anincrease in the demand for products for which the Company is the major supplierand also an increase in the number of products available for sale.**

** **

**Costof sales for the third quarter increased 35% to $17,154,000 in Fiscal 2009 from$12,682,000 in Fiscal 2008.  The increaseis due to the 73% increase in sales. Gross profit margins for the third quarter of Fiscal 2009 and Fiscal2008 were 40% and 24%, respectively. Gross profit percentage increased due tostrong profit margins on the new prenatal vitamin, increased margins for ourcongestive heart failure medication, and the overall fixed nature of someproduction costs versus the 73% increase in revenues.  While the Company is continuously striving tokeep product costs low, there can be no guarantee that profit margins will notfluctuate in future periods.  Pricingpressure from competitors and costs of producing or purchasing new drugs mayalso fluctuate in the future. C**hanges inthe future sales product mix may also occur. These changes may affect the grossprofit percentage in future periods.

** **

Amortization expense for theintangible asset for each of the three months ended March 31, 2009 and2008 was approximately $446,000.  Theamortization expense relates to the March 23, 2004 exclusive marketing anddistribution rights agreement with JSP.  For the remaining five and a fourth yearsof the contract, the Company will incur annual amortization expense of approximately$1,785,000.

 

Researchand development (“R&D”) expenses in the third quarter increased 31% to$1,981,000 for Fiscal 2009 from $1,517,000 for Fiscal 2008.  The increase is primarily due to an increasein production of drugs in development and preparation for submission to theFDA.  The Company expenses all productioncosts as R&D until the drug is approved by the FDA.  R&D expenses may fluctuate from period toperiod, based on R&D plans for submission to the FDA.

 

Selling**,**general and administrative expenses in the third quarterincreased 77% to $7,492,000 in Fiscal 2009 from $4,222,000 in Fiscal 2008.  The increase is primarily due to litigationexpenses related to the patent challenge with KV Pharmaceuticals of $2,530,000,severance costs related to the departure of the Company’s former chieffinancial officer of approximately $452,000, as well as increases in otherlegal, accounting and professional services compared to the same period inFiscal 2008. While the Company is focused on controlling costs, increases inpersonnel costs may have an ongoing and longer lasting impact on theadministrative 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.  However, as theCompany continues to invest in technology, the Company may need to investadditional funds in technology or professional services.

 

TheCompany’s interest expense was $75,000 in the third quarter of Fiscal 2009 andFiscal 2008.  Interest income in thethird quarter increased to $78,000 in Fiscal 2009 from $45,000 in Fiscal 2008due to interest earned on a higher level of investment securities.

 

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TheCompany had income tax expense in the third quarter of 2009 of $851,000compared to a benefit of $615,000 in the third quarter of Fiscal 2008 due to anet loss before income taxes in 2008. The tax rate for the three months ended March 31, 2009 is 39%,compared to 33% for the three months ended March 31, 2008.  The difference is due to the IRS’s reestablishment of theR&D tax credit during the Company’s second quarter of Fiscal 2009, no statebenefit for the Cody Lab losses and the filing of amended R&D tax creditrefund claims.

 

The Company reported netincome of approximately $1,314,000 in the third quarter of Fiscal 2009, or $0.05basic and diluted net income per share, as compared to a net loss ofapproximately $1,256,000 in the third quarter Fiscal 2008, or ($0.05) basic anddiluted loss per share.

*** ***

***Resultsof Operations - Nine months ended March 31, 2009 compared with nine monthsended March 31, 2008***

 

Net sales for the ninemonths ended March 31, 2009 (“Fiscal 2009”) increased 62% to $83,553,000from $51,654,000 for the nine months ended March 31, 2008 (“Fiscal 2008”).The increase was partly due to sales of $9,449,000 of our Prenatalvitamins during Fiscal 2009.  Theincrease can also be attributed toincreases in demand for Lannett’s productsused for the treatment of congestive heart failure, and thyroiddeficiency.  The Company looks tocontinue increasing the number of products available for sale to ourcustomers.  FDA approvals are needed tocontinue this growth.  Several recent FDAapprovals have resulted in more sales of new products in the current fiscalyear compared to the prior fiscal year. In addition to the sales of the Prenatal vitamins, the following factorscontributed to the $31,899,000 increase in sales:

 
| **Medical indication**    | ** ** | **Sales volume  change %** | ** ** | **Sales price  change %** | ** ** |
|---------------------------|------------|----------------------------|------------|---------------------------|------------|
| Congestive Heart  Failure |       | 290                        | %          | 31                        | %          |
| Antibiotics               |       | -11                        | %          | 16                        | %          |
| Thyroid                   |       | 28                         | %          | -2                        | %          |
| Migraine Headache         |       | -2                         | %          | - 6                       | %          |

 

Drugsfor the treatment of congestive heart failure experienced a large increase insales price and volume as a result of the Company being one of the majorsuppliers for the generic market of this product.  This is due to several competitor recalls ofthis product.  The increase in volume indrugs used for the treatment of thyroid deficiency was mainly due to the pushof generic sales at one of our large existing retail chain customers.

 

Theincrease in product sales can be attributed primarily to three products.  Sales of drugs for the treatment ofcongestive heart failure increased by approximately $12,831,000 for the ninemonths ended March 31, 2009 compared to March 31, 2008 due to aproduct recall by several of our major competitors.  Sales of drugs used in the treatment ofthyroid deficiency increased by approximately $7,404,000.  The main reason for this increase was due toan increase in sales to one large existing retail chain customer along with thepick up of several new customers at our existing prices.  For the nine months ended March 31,2009, the company had sales of $9,449,000 of the prenatal vitamins.

 

DuringLannett’s third quarter of 2009, the brand version of the Prenatal vitamin wasremoved from the marketplace.  It isexpected that, due to the lack of selling activities by the branded drugcompany, Lannett will experience a decline in sales for this product.  Accordingly, the Company entered into asettlement agreement with this brand drug company related to the outstandinglitigation between the two companies. Pursuant to the settlement, the Company will receive a license to sellthe generic version of the drug and will become an authorized generic provider.  Lannett will cease offering its Prenatal product if and when the brand isrestored to the marketplace.

 

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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 31,2009 and 2008:

 
| ** **               | ** ** | **Nine Months Ended March 31,** | ** ** |
|--------------------------|------------|--------------------------------------|------------|
| **Customer Category**    | ** ** | **2009**                             | ** ** | **2008** | ** ** |
|                     |       |                                 |       |   |   |
| Wholesaler/  Distributor |       | $                                    | 35,860,000 |   | $ | 22,775,000 |   |
| Retail Chain             |       | 43,166,000                           |       | 25,478,000 |   |
| Mail-Order  Pharmacy     |       | 4,157,000                            |       | 3,074,000 |   |
| Private Label            |       | 370,000                              |       | 327,000 |   |
|                     |       |                                 |       |   |   |
| Total                    |       | $                                    | 83,553,000 |   | $ | 51,654,000 |   |

 

**Thesales to all customer categories except private label increased significantlyas a result of an increase in the demand for products for which the Company isthe major supplier and also an increase in the number of products available forsale.**

** **

**Costof sales for the nine months ended March 31, 2009 increased 36% to$51,922,000 in Fiscal 2009 from $38,224,000 in Fiscal 2008.  The increase is primarily due to the 62%increase in sales.  Gross profit marginsfor the nine months ended March 31, 2009 and 2008 were 38% and 26%,respectively. Gross profit percentage increased due to strong profit margins onthe new Prenatal vitamin, an increase in the margin for congestive heartfailure medication, and the overall fixed nature of some production costsversus the 62% increase in revenues. While the Company is continuously striving to keep product costs low,there can be no guarantee that profit margins will not fluctuate in futureperiods.  Pricing pressure fromcompetitors and costs of producing or purchasing new drugs may also fluctuatein the future. C**hanges in the future salesproduct mix may also occur. These changes may affect the gross profitpercentage in future periods.

** **

Amortization expense for theintangible asset for the nine months ended March 31, 2009 and 2008 wasapproximately $1,338,000.  Theamortization expense relates to the March 23, 2004 exclusive marketing anddistribution rights agreement with JSP.  For the remaining five and a fourth yearsof the contract, the Company will incur annual amortization expense ofapproximately $1,785,000.

 

Researchand development (“R&D”) expenses for the nine months increased 53% to$5,685,000 for Fiscal 2009 from $3,715,000 for Fiscal 2008.  The increase is primarily due to an increasein production of drugs in development and preparation for submission to theFDA.  The Company expenses all productioncosts as R&D until the drug is approved by the FDA.  R&D expenses may fluctuate from period toperiod, based on R&D plans for submission to the FDA.

 

Selling**,**general and administrative expenses for the nine monthsincreased 53% to $19,116,000 in Fiscal 2009 from $12,457,000 in Fiscal2008.  The increase is primarily due tolitigation expenses related to the patent challenge with KV Pharmaceuticals ofapproximately $5,211,000, severance costs related to the departure of theCompany’s former chief financial officer of approximately $452,000, as well asincreases in other legal, accounting and professional services compared to thesame period in Fiscal 2008. 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.  However, as theCompany continues to invest in technology, the Company may need to investadditional funds in technology or professional services.

 

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TheCompany’s interest expense in the nine months ended March 31, 2009 decreased to$259,000 from $291,000 in the nine months ended March 31, 2008 primarily due tolower levels of long-term debt.  Interestincome in the nine months ended March 31, 2009 increased to $216,000 from$171,000 in the nine months ended March 31, 2008 due to interest incomereceived on a large income tax refund as well as interest earned on a higherlevel of investment securities.

 

TheCompany had income tax expense in the nine months ended March 31, 2009 of$2,697,000 compared to a benefit of $821,000 in the nine months ended March 31,2008 due to a net loss before income taxes in the 2008 fiscal period.  The tax rate for the nine months ended March 31,2009 is 39%, compared to 29% for the nine months ended March 31, 2008.  The difference is due to the IRS’s reestablishment of theR&D tax credit during the Company’s second quarter ofFiscal 2009, no state benefit for the Cody Lab losses and the filing of amendedR&D tax credit refund claims.

 

TheCompany reported netincome of approximately $4,114,000 in the first nine months of Fiscal 2009, or$0.17 basic and diluted net income per share, as compared to a net loss ofapproximately $2,041,000 in the first nine months of Fiscal 2008, or ($0.08)basic and diluted loss per share.

 

***Liquidityand Capital Resources***

*** ***

**TheCompany has historically financed its operations by cash flow from operations.  At March 31, 2009, working capital was$34,852,000, as compared to $25,945,000 at June 30, 2008, an increase of$8,907,000.  Net cash provided byoperating activities of $9,159,000 in the first nine months of Fiscal 2009 isdue to net income of $4,114,000, adjustments for the effects of non-cash itemsof $7,783,000 and a net decrease in cash from changes in operating assets andliabilities of $2,738,000.  Significantchanges in operating assets and liabilities are comprised of:**

** **

**·**                  An increase in trade accounts receivable of $4,607,000 due primarily tothe increase in the normal receivables balance as a result of increased salesin the 2009 period, offset by the collection of approximately $10,545,000 ofreceivables outstanding at June 30, 2008 related to sales of multivitamins forwhich related reserves were accrued.  Thechange in the Accounts Receivable balance from June 30, 2008 to March 31, 2009includes a non-cash decrease of approximately $9,507,000 related to theissuance of credits for the returns of the multi vitamin product received bythe Company through March 31, 2009.

** **

**·**                  An increase in inventories of $4,414,000 due to increased stocking levelsat both Lannett and Cody Labs for several products as of March 31, 2009 thatare being carried in order to respond to the increased order volume we arecurrently experiencing.

** **

**·**                  An increase in accounts payable of $3,024,000 due to the timing ofpayments at the end of the month.

** **

**·**                  An increase in accrued expenses of $4,225,000 due to the accrual ofsignificant patent litigation expenses incurred in the second quarter of Fiscal2009 as well as an increase in accrued severance at the end of the thirdquarter related to the departure of the Company’s former chief financialofficer.

** **

**The net cash provided by investing activities of $514,000for the nine months ended March 31, 2009 was due primarily to the sale ofinvestment securities during the period.**

** **

**The net cash used in financing activities of $493,000 forthe nine months ended March 31, 2009 was due primarily to the repayment of debtduring the period.**

** **

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Thefollowing table summarizes the remaining repayments of debt, including sinkingfund requirements as of March 31, 2009 for the subsequent twelve month periods:

 
| **Twelve**        | ** ** | **Amounts Payable** | ** **      |
|-------------------|------------|---------------------|-----------------|
| **Month Periods** | ** ** | **to Institutions** | ** **      |
|              |       |                |            |
| 2010              |       | $                   | 503,469         |   |
| 2011              |       | 4,862,066           |            |
| 2012              |       | 268,217             |            |
| 2013              |       | 275,438             |            |
| 2014              |       | 290,680             |            |
| Thereafter        |       | 2,190,038           |            |
|              |       |                |            |
|              |       | $                   |  8,389,908 |   |

 

Thefollowing table represents annual debt, lease and contractual purchaseobligations as of March 31, 2009:

 
| ** **               | ** ** | **Total**   | ** **  | **Less than 1  year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **More than 5  years** | ** ** |
|--------------------------|------------|-------------|-------------|-----------------------|------------|---------------|------------|---------------|------------|------------------------|------------|
|                     |       |        |        |                  |       |          |       |          |       |                   |       |
| Long-Term Debt           |       | $           | 8,389,908   |                  | $          | 503,469       |       | $             | 5,130,283  |                   | $          | 566,118 |   | $ | 2,190,038 |   |
| Operating Leases         |       | 1,159,342   |        | 475,317               |       | 679,011       |       | 5,014         |       | —                 |       |
| Purchase  Obligations    |       | 110,833,125 |        | 20,322,500            |       | 43,510,625    |       | 47,000,000    |       | —                 |       |
| Interest on  Obligations |       | 1,865,991   |        | 221,960               |       | 569,154       |       | 276,650       |       | 798,227                |       |
| Total                    |       | $           | 122,248,366 |                  | $          | 21,523,246    |       | $             | 49,889,073 |                   | $          | 47,847,782 |   | $ | 2,988,265 |   |

 

**Purchase obligations primarilyrelate to the Company’s agreement with Jerome Stevens Pharmaceuticals, Inc.  See further description in Note 18 to theConsolidated Financial Statements.**

** **

TheCompany has a $3,000,000 line of credit from Wachovia Bank, N.A. (now asubsidiary of Wells Fargo & Co.) that bears interest at the prime interestrate less 0.25% (3.00% at March 31, 2009).  The line of credit was renewed and extended to November 30, 2009. As of March31, 2009, the Company has not borrowed under this line of credit.   Theline of credit is collateralized by substantially all of the Company’s assets.  The agreement contains covenants with respectto working capital, net worth and certain ratios, as well as other covenants.  At June 30, 2008, the Company was not incompliance with one of these covenants, but received a waiver from its lendinginstitution with respect to that covenant as of June 30, 2008.  As of March 31, 2009, the Company was incompliance with all financial covenants under the agreement.

** **

**The terms of the line of credit, the loan agreement, therelated letter of credit and the 2003 Loan Financing require that the Companymeet certain financial covenants and reporting standards, including theattainment of standard financial liquidity and net worth ratios.  As of March 31, 2009, the Company is incompliance with all financial covenants under the agreement.**

** **

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** **

InJuly 2004, the Company received $500,000 of grant funding from the Commonwealthof Pennsylvania, acting through the Department of Community and Economic Development. The grant funding program requires theCompany to use the funds for machinery and equipment located at theirPennsylvania locations, hire an additional 100 full-time employees by June 30,2006, operate its Pennsylvania locations a minimum of five years and meetcertain matching investment requirements.  If the Company fails to comply with any of therequirements above, the Company would be liable to repay the full amount of thegrant funding ($500,000).  The Companyhas recorded the unearned grant funds as a liability until the Company complieswith all of the requirements of the grant funding program. Through March 31,2009, the Company has had preliminary discussions with the Commonwealth ofPennsylvania to determine whether it will be required to repay any of the fundsprovided under the grant fund. Based on information available at March 31,2009, the Company has recorded the grant funding as a long-term liability underthe caption of Unearned Grant Funds. Except as set forth in this report, the Company is not aware of anytrends, events or uncertainties that have or are reasonably likely to have amaterial adverse impact on the Company’s short-term or long-term liquidity orfinancial condition.

*** ***

**Prospects for the Future**

** **

The Company has several generic products under development.  These products are all orally-administered,topical and parenteral products designed to be generic equivalents to brandnamed innovator drugs.  The Company’sdevelopmental drug products are intended to treat a diverse range ofindications.  As the oldest generic drugmanufacturer in the country, formed in 1942, Lannett currently owns severalANDAs for products which it does not manufacture and market.  These ANDAs are simply 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 tointroduce one of these products into the consumer marketplace, it must reviewthe ANDA and related documentation to ensure that the approved productspecifications, formulation and other factors meet current FDA requirements forthe marketing of that drug.  The Companywould then redevelop the product and submit it to the FDA for supplementalapproval.  The FDA’s approval process forANDA supplements is similar to that of a new ANDA.   Generally, in these situations, the Companymust file a supplement to the FDA for the applicable ANDA, informing the FDA ofany significant changes in the manufacturing process, the formulation, or theraw material supplier of the previously-approved ANDA.

 

A majority of the products in development represent either previouslyapproved ANDAs that the Company is planning to reintroduce (ANDA supplements),or new formulations (new ANDAs).  Theproducts under development are at various stages in the developmentcycle—formulation, scale-up, and/or clinical testing.  Depending on the complexity of the activeingredient’s chemical characteristics, the cost of the raw material, theFDA-mandated requirement of bioequivalence studies, the cost of such studiesand other developmental factors, the cost to develop a new generic productvaries and can range from $100,000 to $1 million.  Some of Lannett’s developmental products willrequire bioequivalence studies, while others will not—depending on the FDA’sOrange Book classification.  Since theCompany has no control over the FDA review process, management is unable toanticipate whether or when it will be able to begin producing and shippingadditional products.

 

In addition to the efforts of its internal product development group,Lannett has contracted with several outside firms for the formulation anddevelopment of several new generic drug products.  These outsourced R&D products are atvarious stages in the development cycle — formulation, analytical methoddevelopment and testing and manufacturing scale-up.  These products are orally-administered soliddosage products intended to treat a diverse range of medical indications.  It is the Company’s intention to ultimatelytransfer the formulation technology and manufacturing process for all of theseR&D products to the Company’s own commercial manufacturing sites.  The Company initiated these outsourced R&Defforts to complement the progress of its own internal R&D efforts.

 

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Occasionally, the Company will work on developing a drug product thatdoes not require FDA approval.  Certainprescription drugs do not require prior FDA approval before marketing such asdrugs listed as DESI drugs (Drug Efficacy Study implementation) which are underevaluation by FDA, Grandfathered Drugs, and prescription multivitamin drugs. Ageneric manufacturer may sell products which are chemically equivalent toinnovator drugs, under FDA rules by simply performing and internally documentingthe normal research and development involved in bringing a new product tomarket.  Under this scenario, a genericcompany can forego the time required for FDA ANDA approval.

 

More specifically, certain products, marketed prior to the FederalFood, Drug, and Cosmetic Act (FFDCA) may be considered GRASE or Grandfathered.  GRASE products are those “old drugs that donot require prior approval from FDA in order to be marketed because they aregenerally recognized as safe and effective based on published scientificliterature.”  Similarly, Grandfatheredproducts are those which “entered the market before the passage of the 1938 actor the 1962 amendments to the act.”  Under the grandfather clause, such a productis exempted from the “effectiveness requirements [of the act] if itscomposition and labeling have not changed since 1962 and if, on the day beforethe 1962 amendments became effective, it was (1) used or sold commercially inthe United States, (2) not a new drug as defined by the act at that time, and (3)not covered by an effective application.”

 

The Company signed supply and/or development agreements with AzadPharma AG, of Switzerland, Wintac Limited of India, Cerovene, Inc. of theUnited States, Swiss Caps AG of Switzerland and Banner Pharmacaps of the UnitedStates, and is in negotiations with companies in Israel and China for similarnew product initiatives, in which Lannett will market and distribute productsmanufactured 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 the Company’s R&D projects are being developedin-house under Lannett’s direct supervision and with Company personnel.  Hence, the Company does not believe that itsoutside contracts for product development and manufacturing supply are materialin nature, nor is the Company substantially dependent on the services renderedby such outside firms.  Since the Companyhas no control over the FDA review process, management is unable to anticipatewhether or when it will be able to begin producing and shipping such additionalproducts.

 

Lannett may increase its focus on certain specialty markets in thegeneric pharmaceutical industry.  Such afocus is intended to provide Lannett customers with increased productalternatives in categories with relatively few market participants.  While there is no guarantee that Lannett hasthe market expertise or financial resources necessary to succeed in such amarket specialty, management is confident that such future focus will be wellreceived by Lannett customers and increase shareholder value in the long run.

 

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

 

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** **

**ITEM 3.*** ***QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

**The Company has debt instrumentswith variable interest rates.  The EquipmentLoan, amounting to $160,260 at March 31, 2009, bears interest at a variablerate equal to the LIBOR rate plus 150 basis points.  In addition, the Company has a $3 millionline of credit from Wachovia Bank, N.A. (now a subsidiary of Wells Fargo &Co.)** that bearsinterest at the prime interest rate less0.25%(3.00% at March 31, 2009).  The line of credit was renewed and extended to November 30, 2009.    The line of credit is collateralized bysubstantially all of the Company’s assets. The agreement contains covenantswith respect to working capital, net worth and certain ratios, as well as othercovenants.

** **

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

 

**ITEM 4. CONTROLS AND PROCEDURES**

 

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

** **

Asof the end of the period covered by this Form 10-Q, management performed, withthe participation of our Chief Executive Officer and Interim Chief FinancialOfficer, an evaluation of the effectiveness of our disclosure controls andprocedures as defined 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 Interim Chief Financial Officer, to allow timely decisionsregarding required disclosures.

 

Based upon the evaluation,the Chief Executive Officer and Interim Chief Financial Officer concluded thatthe Company’s disclosure controls and procedures were effective as of the endof the period covered by this report.

*** ***

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

*** ***

There has been no change inthe Company’s internal control over financial reporting during the three monthsended March 31, 2009 that has materially affected, or reasonably likely tomaterially affect, our internal control over financial reporting.

 

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** **

# **PART II.  OTHER INFORMATION**

# ** **

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

 

In early June 2008, the Companyfiled a declaratory judgment suit in the Federal District Court of Delaware(Civil Action No. 08-338 (JJF)) against KV Pharmaceuticals, DrugTech Corp., andTher-Rx Corp (collectively “KV”).  Thecomplaint sought declaratory judgment for non-infringement and invalidity ofcertain patents owned by KV.  Thecomplaint further sought declaratory judgment of anti-trust violations andfederal and state unfair competition violations for actions taken by KV insecuring and enforcing these patents.  Afterthe complaint was filed, KV countered with a motion for a Temporary RestrainingOrder (“TRO”) to prevent the Company from launching its Multivitamin withMineral Capsules (“MMCs”), due to alleged patent and trademark infringementissues.  The TRO was heard and,ultimately, resulted in a conclusion by the court that the Company’s productlabel on the MMCs should be modified.  KValso countered with claims of infringement by the Company of KV’s patentsseeking the Company’s profits for sales of MMCs or other monetary relief,preliminary and permanent injunctive relief, attorney’s fees and a finding ofwillful infringement. On March 17, 2009 the Company and KV settled thelitigation.  In light of the withdrawalof KV’s innovator prenatal product, and the resulting anticipated decline insales and declining market for written prescription, the Company decided it waspointless to continue the litigation and entered into the settlementarrangement with KV.  Pursuant to thesettlement, the Company will receive a license from KV and will become anauthorized generic provider.  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.

 

In or about July 2008,Albion International and Albion, Inc. filed suit in the United States DistrictCourt, District of Utah (Case No. 2:08cv00515) against Lannett asserting claimsfor patent and trademark infringement, as well as unfair competition, arisingout of Lannett’s use of product that it purchased from Albion and used as aningredient in its MMC.  Lannett filed amotion to dismiss the complaint on the basis that it purchased the product fromAlbion and, as such, was authorized to use the product in its MMC.  The Court granted the motion and dismissed thecomplaint but gave Albion leave to file an amended complaint.  On January 20, 2009, Albion filed an amendedcomplaint.  Lannett filed an answer tothe complaint and counterclaim, asserting, among other things, that Albion tortuouslyinterfered with Lannett’s contracts.  Subsequent to the filing of the answer andcounterclaim, Lannett and Albion reached an agreement in principal to settlethe case.  Under terms of the settlement,the parties would each dismiss their claims against each other and providereleases.  Lannett is in the process ofnegotiating the language of a written settlement agreement.

 

***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.

 

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

** **

The annual meetingof shareholders was held on January 28, 2009. The following proposals were adopted by the margins indicated:

 

1.               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     |       | 22,483,800    |       | 0                 |       | 932,121            |       |
| Ronald West        |       | 22,670,475    |       | 0                 |       | 745,446            |       |
| Arthur Bedrosian   |       | 23,307,584    |       | 0                 |       | 108,337            |       |
| Jeffrey Farber     |       | 23,309,776    |       | 0                 |       | 106,145            |       |
| Kenneth Sinclair   |       | 23,147,830    |       | 0                 |       | 268,091            |       |
| Albert  Wertheimer |       | 23,271,688    |       | 0                 |       | 144,233            |       |
| Myron Winkelman    |       | 23,157,830    |       | 0                 |       | 258,091            |       |

 

## ***ITEM6.  EXHIBITS***

 

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

 

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**SIGNATURE**

 

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

 
|                     | **LANNETT COMPANY, INC.** |
|--------------------------|---------------------------|
|                     |                      |
| Dated: May 12, 2009 | By:                       | /s/ Keith R. Ruck |
|                     |                      | Keith R. Ruck |
|                     |                      | Interim Chief Financial Officer and |
|                     |                      | Corporate Controller |
|                     |                      |   |
|                     |                      |   |
| Dated: May 12, 2009 | By:                       | /s/ Arthur P. Bedrosian |
|                     |                      | Arthur P. Bedrosian |
|                     |                      | President and Chief Executive 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  Interim Chief Financial Officer Pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002                              |   | Filed Herewith |   |   |
|   |   |                                                                                                                                           |   |           |   |   |
| 32     |   | Certifications of Chief  Executive Officer and Interim Chief Financial Officer Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002 |   | Filed Herewith |   |   |

 

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