Tableof Contents

 

 

 

**UNITED STATES SECURITIES ANDEXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 
| **x**                                                 | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF  1934**            |
|-------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------|
| ** **                                            | ** ** | ** **                                                                                                   |
| **FOR THE  QUARTERLY PERIOD ENDED DECEMBER 31, 2008** |
|                                                  |       |                                                                                                         |   |   |
| **o**                                                 | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND  EXCHANGE ACT OF 1934** |

 

**FOR THE TRANSITION PERIOD FROM                        TO                         .**

 

**Commission File No. 001-31298**

 

**LANNETT COMPANY, INC.**

 (Exact Name ofRegistrant 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 ofprincipal executive offices and telephone number)

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Exchange Act during the past 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.
| ** ** | **Yes  ****x** | ** ** | **No  ****o** | ** ** |
|------------|--------------------------|------------|-------------------------|------------|

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller reporting company. See the definitions of “largeaccelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2of 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 markwhether the registrant is a shell company (as defined in Rule 12B-12 ofthe Exchange Act).
| ** ** | **Yes  ****o** | ** ** | **No  ****x** | ** ** |
|------------|--------------------------|------------|-------------------------|------------|

 

Indicate the number of sharesoutstanding of each class of the registrant’s common Stock, as of the latestpractical date.

 
| **Class**                                 | ** ** | **Outstanding as of February 9, 2009** |
|-------------------------------------------|------------|-----------------------------------------------------------------|
| Common stock, par value  $0.001 per share |       | 24,505,971  shares                                              |

 

 

 

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**Tableof Contents**

 
| ** **                                                                                    | ** **  | ** ** | ** **                                                                                                                   | ** ** | **Page No.** |
|-----------------------------------------------------------------------------------------------|-------------|------------|------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|
| **PART I.  FINANCIAL INFORMATION**                                                       |        |       |
| ** **                                                                                    |        |       |                                                                                                                         |       |              |
| ** **                                                                                    | **ITEM 1.** | ** ** | **FINANCIAL STATEMENTS**                                                                                                     |       |              |
| ** **                                                                                    | ** **  | ** ** | ** **                                                                                                                   |       |              |
|                                                                                          |        |       | Consolidated Balance Sheets  as of December 31, 2008 (unaudited) and June 30, 2008                                 |       | 1                 |
|                                                                                          |        |       |                                                                                                                         |       |              |
|                                                                                          |        |       | Consolidated Statements of Operations  (unaudited)  for the three and six months ended December 31, 2008 and 2007       |       | 2                 |
|                                                                                          |        |       |                                                                                                                         |       |              |
|                                                                                          |        |       | Consolidated Statement of  Changes in Shareholders’ Equity (unaudited)  for the six months ended December 31, 2008 |       | 3                 |
|                                                                                          |        |       |                                                                                                                         |       |              |
|                                                                                          |        |       | Consolidated Statements of Cash Flows  (unaudited)  for the six months ended December 31, 2008 and 2007                 |       | 4                 |
|                                                                                          |        |       |                                                                                                                         |       |              |
|                                                                                          |        |       | Notes to  Consolidated Financial Statements (unaudited)                                                                      |       | 5                 |
|                                                                                          |        |       |                                                                                                                         |       |              |
| ** **                                                                                    | **ITEM 2.** | ** ** | **MANAGEMENT’S  DISCUSSION AND ANALYSIS OFFINANCIAL  CONDITION AND RESULTS OF OPERATIONS**                              |       | 29                |
| ** **                                                                                    |        |       | ** **                                                                                                                   |       |              |
| ** **                                                                                    | **ITEM 3.** | ** ** | **QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**                                                              |       | 42                |
| ** **                                                                                    |        |       |                                                                                                                         |       |              |
| ** **                                                                                    | **ITEM 4.** | ** ** | **CONTROLS AND  PROCEDURES**                                                                                                 |       | 42                |
| ** **                                                                                    | ** **  | ** ** | ** **                                                                                                                   |       |              |
| **PART II.  OTHER INFORMATION**                                                          |        |       |
| ** **                                                                                    |        |       |                                                                                                                         |       |              |
| ** **                                                                                    | **ITEM 1.** | ** ** | **LEGAL PROCEEDINGS**                                                                                                        |       | 43                |
| ** **                                                                                    | ** **  | ** ** | ** **                                                                                                                   |       |              |
| ** **                                                                                    | **ITEM 6.** | ** ** | **EXHIBITS**                                                                                                                 |       | 43                |
| ** **                                                                                    | ** **  | ** ** | ** **                                                                                                                   |       |              |
| **CERTIFICATION OF  PRESIDENT & CHIEF EXECUTIVE OFFICER**                            |
| ** **                                                                                    |        |       |                                                                                                                         |       |              |
| **CERTIFICATION OF VICE PRESIDENT  OF FINANCE, TREASURER & CHIEF FINANCIAL OFFICER** |
| ** **                                                                                    |        |       |                                                                                                                         |       |              |
| **CERTIFICATION  PURSUANT TO SECTION 906 OF SARBANES OXLEY ACT OF 2002**                 |

 

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# **PART I.  FINANCIAL INFORMATION**

#  

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

 

**LANNETT COMPANY, INC. AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

 
| ** **                                                                                                                              | ** ** | **(UNAUDITED)**                 | ** **  | ** **                  | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|-------------|-----------------------------|------------|
| ** **                                                                                                                              | ** ** | **December 31, 2008** | ** **  | **June 30, 2008** | ** ** |
| **ASSETS**                                                                                                                              |       |                            |        |                        |       |
| Current Assets                                                                                                                          |       |                            |        |                        |       |
| Cash                                                                                                                                    |       | $                               | 12,455,596  |                        | $          | 6,256,712 |   |
| Short term  investments                                                                                                                 |       | 304,036                         |        | 354,155                     |       |
| Trade accounts  receivable (net of allowance of $225,000 and $207,151, respectively)                                                    |       | 26,584,613                      |        | 34,114,982                  |       |
| Inventories, net                                                                                                                        |       | 13,962,528                      |        | 11,617,258                  |       |
| Interest  receivable                                                                                                                    |       | 83,475                          |        | 51,781                      |       |
| Prepaid taxes                                                                                                                           |       | 1,937,607                       |        | 1,598,937                   |       |
| Deferred tax  assets                                                                                                                    |       | 4,253,225                       |        | 6,997,935                   |       |
| Other current  assets                                                                                                                   |       | 1,054,590                       |        | 591,415                     |       |
| **Total  Current Assets**                                                                                                               |       | 60,635,670                      |        | 61,583,175                  |       |
| ** **                                                                                                                              |       |                            |        |                        |       |
| Property, plant  and equipment                                                                                                          |       | 40,375,207                      |        | 39,996,008                  |       |
| Less accumulated  depreciation                                                                                                          |       | (16,926,017                     | )           | (15,261,905                 | )          |
|                                                                                                                                    |       | 23,449,190                      |        | 24,734,103                  |       |
|                                                                                                                                    |       |                            |        |                        |       |
| Construction in  progress                                                                                                               |       | 493,609                         |        | 458,046                     |       |
| Investment  securities - available for sale                                                                                             |       | 2,307,793                       |        | 2,145,980                   |       |
| Intangible  assets - net of accumulated amortization                                                                                    |       | 10,032,916                      |        | 10,361,835                  |       |
| Deferred tax  assets                                                                                                                    |       | 17,131,202                      |        | 17,380,115                  |       |
| Other assets                                                                                                                            |       | 177,298                         |        | 195,354                     |       |
| **Total  Assets**                                                                                                                       |       | $                               | 114,227,678 |                        | $          | 116,858,608 |   |
| ** **                                                                                                                              |       |                            |        |                        |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                          |       |                            |        |                        |       |
| **LIABILITIES**                                                                                                                         |       |                            |        |                        |       |
| Current  Liabilities                                                                                                                    |       |                            |        |                        |       |
| Accounts payable                                                                                                                        |       | $                               | 12,585,222  |                        | $          | 13,085,772 |   |
| Accrued expenses                                                                                                                        |       | 3,164,324                       |        | 2,451,783                   |       |
| Deferred revenue                                                                                                                        |       | 643,535                         |        | 982,668                     |       |
| Current portion  of long-term debt                                                                                                      |       | 638,037                         |        | 791,912                     |       |
| Rebates,  chargebacks and returns payable                                                                                               |       | 12,004,030                      |        | 18,326,417                  |       |
| **Total  Current Liabilities**                                                                                                          |       | 29,035,148                      |        | 35,638,552                  |       |
| ** **                                                                                                                              |       |                            |        |                        |       |
| Long-term debt,  less current portion                                                                                                   |       | 8,044,853                       |        | 8,186,922                   |       |
| Deferred tax  liabilities                                                                                                               |       | 3,286,239                       |        | 3,179,344                   |       |
| Unearned grant  funds                                                                                                                   |       | 500,000                         |        | 500,000                     |       |
| Other long-term  liabilities                                                                                                            |       | 49,075                          |        | 32,001                      |       |
| **Total  Liabilities**                                                                                                                  |       | 40,915,315                      |        | 47,536,819                  |       |
| ** **                                                                                                                              |       |                            |        |                        |       |
| Commitments and  contingencies, See notes 10 and 11                                                                                     |       |                            |        |                        |       |
| Minority  interest in Cody LCI Realty, LLC, net of taxes                                                                                |       | 77,361                          |        | 50,309                      |       |
|                                                                                                                                    |       |                            |        |                        |       |
| **SHAREHOLDERS’  EQUITY**                                                                                                          |       |                            |        |                        |       |
| Common stock -  authorized 50,000,000 shares, par value $0.001; issued and outstanding,  24,486,032 and 24,283,963 shares, respectively |       | 24,486                          |        | 24,284                      |       |
| Additional paid  in capital                                                                                                             |       | 75,642,020                      |        | 74,497,100                  |       |
| Accumulated  deficit                                                                                                                    |       | (1,991,453                      | )           | (4,790,680                  | )          |
| Accumulated  other comprehensive income                                                                                                 |       | 49,123                          |        | 9,722                       |       |
|                                                                                                                                    |       | 73,724,176                      |        | 69,740,426                  |       |
| Less: Treasury  stock at cost - 82,228 and 74,970 shares, respectively                                                                  |       | (489,174                        | )           | (468,946                    | )          |
| **TOTAL  SHAREHOLDERS’ EQUITY**                                                                                                    |       | 73,235,002                      |        | 69,271,480                  |       |
| ** **                                                                                                                              |       |                            |        |                        |       |
| **TOTAL  LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                    |       | $                               | 114,227,678 |                        | $          | 116,858,608 |   |

 

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

 

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**LANNETT COMPANY, INC. ANDSUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                                               | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|--------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                               | ** ** | **December 31,**            | ** ** | **December 31,**          | ** ** |
| ** **                                                               | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                                               | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                                                                |       | $                                | 29,224,372 |                           | $          | 17,534,942 |   | $ | 54,792,025 |   | $ | 35,074,972 |   |
| Cost of sales                                                            |       | 17,712,370                       |       | 12,619,384                     |       | 33,832,565 |   | 24,411,920 |   |
| Amortization of  intangible assets                                       |       | 446,167                          |       | 446,166                        |       | 892,333 |   | 892,332 |   |
| Product  royalties                                                       |       | 42,997                           |       | 41,776                         |       | 42,997 |   | 237,346 |   |
|                                                                     |       |                             |       |                           |       |   |   |   |   |
| Gross profit                                                             |       | 11,022,838                       |       | 4,427,616                      |       | 20,024,130 |   | 9,533,374 |   |
|                                                                     |       |                             |       |                           |       |   |   |   |   |
| Research and  development expenses                                       |       | 1,840,717                        |       | 946,282                        |       | 3,703,830 |   | 2,198,430 |   |
| Selling, general,  and administrative expenses                           |       | 6,675,472                        |       | 4,255,217                      |       | 11,624,616 |   | 8,234,927 |   |
| Gain on sale of  assets                                                  |       | 26,940                           |       | —                         |       | 22,009 |   | — |   |
|                                                                     |       |                             |       |                           |       |   |   |   |   |
| Operating income  (loss)                                                 |       | 2,533,589                        |       | (773,883                       | )          | 4,717,693 |   | (899,983 | ) |
|                                                                     |       |                             |       |                           |       |   |   |   |   |
| Other  income(expense):                                                  |       |                             |       |                           |       |   |   |   |   |
| Interest income                                                          |       | 91,883                           |       | 48,686                         |       | 137,650 |   | 105,808 |   |
| Interest expense                                                         |       | (117,431                         | )          | (92,333                        | )          | (183,640 | ) | (196,201 | ) |
|                                                                     |       | (25,548                          | )          | (43,647                        | )          | (45,990 | ) | (90,393 | ) |
|                                                                     |       |                             |       |                           |       |   |   |   |   |
| Income (loss)  before income tax expense (benefit) and minority interest |       | 2,508,041                        |       | (817,530                       | )          | 4,671,703 |   | (990,376 | ) |
|                                                                     |       |                             |       |                           |       |   |   |   |   |
| Income tax  expense (benefit)                                            |       | 925,433                          |       | (159,983                       | )          | 1,845,423 |   | (205,668 | ) |
| Minority  interest in Cody LCI Realty, LLC, net of taxes                 |       | (9,546                           | )          | —                         |       | (27,053 | ) | — |   |
|                                                                     |       |                             |       |                           |       |   |   |   |   |
| Net income  (loss)                                                       |       | $                                | 1,573,062  |                           | $          | (657,547 | ) | $ | 2,799,227 |   | $ | (784,708 | ) |
|                                                                     |       |                             |       |                           |       |   |   |   |   |
| Basic income  (loss) per common share                                    |       | $                                | 0.06       |                           | $          | (0.03 | ) | $ | 0.11 |   | $ | (0.03 | ) |
| Diluted income  (loss) per common share                                  |       | $                                | 0.06       |                           | $          | (0.03 | ) | $ | 0.11 |   | $ | (0.03 | ) |
|                                                                     |       |                             |       |                           |       |   |   |   |   |
| Basic weighted  average number of shares                                 |       | 24,468,149                       |       | 24,183,044                     |       | 24,385,818 |   | 24,179,344 |   |
| Diluted weighted  average number of shares                               |       | 24,546,787                       |       | 24,183,044                     |       | 24,510,726 |   | 24,179,344 |   |

 

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

 

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**LANNETT COMPANY, INC. ANDSUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CHANGES INSHAREHOLDERS’ EQUITY**

(UNAUDITED)

 
| ** **                                                            | ** ** | **Common Stock** | ** ** | **Additional** | ** ** | ** **  | ** ** | ** **      | ** ** | **Accum.**   | ** ** | ** **           | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------|------------|----------------|------------|-------------|------------|-----------------|------------|--------------|------------|----------------------|------------|
| ** **                                                            | ** ** | **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 |   |
| ** **                                                            |       |                  |       |           |       |        |       |            |       |         |       |                 |       |   |   |
| Shares issued in  connection with employee stock purchase plan        |       | 28,467                |       | 29             |       | 57,895      |       | —          |       | —       |       | —               |       | 57,924 |   |
| Share based  compensation                                             |       |                  |       |           |       |        |       |            |       |         |       |                 |       |   |   |
| Restricted stock                                                      |       | —                |       | —         |       | 86,014      |       | —          |       | —       |       | —               |       | 86,014 |   |
| Stock options                                                         |       | —                |       | —         |       | 437,993     |       | —          |       | —       |       | —               |       | 437,993 |   |
| Employee stock  purchase plan                                         |       | —                |       | —         |       | 31,292      |       | —          |       | —       |       | —               |       | 31,292 |   |
| 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 |   |
| Purchase of  treasury stock                                           |       | —                |       | —         |       | —      |       | —          |       | (20,228      | )          | —               |       | (20,228 | ) |
| Other  comprehensive income, net of income tax                        |       | —                |       | —         |       | —      |       | —          |       | —       |       | 39,401               |       | 39,401 |   |
| Net income                                                            |       | —                |       | —         |       | —      |       | 2,799,227       |       | —       |       | —               |       | 2,799,227 |   |
|                                                                  |       |                  |       |           |       |        |       |            |       |         |       |                 |       |   |   |
| **Balance,  December 31, 2008**                                  |       | 24,486,032            |       | $              | 24,486     |        | $          | 75,642,020      |       | $            | (1,991,453 | )                    | $          | (489,174 | ) | $ | 49,123 |   | $ | 73,235,002 |   |

 

**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 six months ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2008**                                                                | ** ** | **2007** | ** ** |
| ** **                                                                                 | ** ** | ** **                                                              | ** ** | ** ** | ** ** |
| OPERATING  ACTIVITIES:                                                                     |       |                                                                    |       |   |   |
| Net income  (loss)                                                                         |       | $                                                                       | 2,799,227  |   | $ | (784,708 | ) |
| Adjustments to  reconcile net loss to net cash provided by (used in) operating activities: |       |                                                                    |       |   |   |
| Depreciation and  amortization                                                             |       | 2,577,146                                                               |       | 2,765,232 |   |
| Deferred tax  expense                                                                      |       | 2,923,575                                                               |       | (205,669 | ) |
| Stock  compensation expense                                                                |       | 555,299                                                                 |       | 483,643 |   |
| Restricted stock  grant                                                                    |       | 101,399                                                                 |       | — |   |
| Other noncash  expenses                                                                    |       | 17,074                                                                  |       | 7,575 |   |
| Gain on sale of  fixed assets                                                              |       | (240                                                                    | )          | — |   |
| (Gain) loss on  sale of securities                                                         |       | (21,770                                                                 | )          | 9,150 |   |
| Minority  interest in Cody LCI Realty LLC, net of taxes                                    |       | 27,052                                                                  |       | — |   |
| Changes in  assets and liabilities which provided (used) cash:                             |       |                                                                    |       |   |   |
| Trade accounts  receivable                                                                 |       | (1,096,522                                                              | )          | (1,918,792 | ) |
| Inventories                                                                                |       | (2,345,270                                                              | )          | 2,524,308 |   |
| Prepaid taxes                                                                              |       | (338,670                                                                | )          | — |   |
| Prepaid expenses  and other assets                                                         |       | (476,813                                                                | )          | (327,856 | ) |
| Accounts payable                                                                           |       | (500,550                                                                | )          | (3,924,555 | ) |
| Accrued expenses                                                                           |       | 3,017,045                                                               |       | (938,276 | ) |
| Deferred revenue                                                                           |       | (339,133                                                                | )          | (448,633 | ) |
| Net cash  provided by (used in) operating activities                                       |       | 6,898,849                                                               |       | (2,758,581 | ) |
|                                                                                       |       |                                                                    |       |   |   |
| INVESTING  ACTIVITIES:                                                                     |       |                                                                    |       |   |   |
| Purchases of  property, plant and equipment (including construction in progress)           |       | (418,962                                                                | )          | (1,245,243 | ) |
| Proceeds from  sale of fixed assets                                                        |       | 1,500                                                                   |       | — |   |
| Proceeds from  sale of investment securities - available for sale                          |       | 5,525,349                                                               |       | 1,392,456 |   |
| Purchase of  investment securities - available for sale                                    |       | (5,549,604                                                              | )          | (366,030 | ) |
| Net cash used in  investing activities                                                     |       | (441,717                                                                | )          | (218,817 | ) |
|                                                                                       |       |                                                                    |       |   |   |
| FINANCING  ACTIVITIES:                                                                     |       |                                                                    |       |   |   |
| Repayments of  debt                                                                        |       | (295,944                                                                | )          | (283,997 | ) |
| Proceeds from  issuance of stock                                                           |       | 57,924                                                                  |       | 54,823 |   |
| Purchase of  treasury stock                                                                |       | (20,228                                                                 | )          | — |   |
| Net cash used in  financing activities                                                     |       | (258,248                                                                | )          | (229,174 | ) |
|                                                                                       |       |                                                                    |       |   |   |
| NET INCREASE  (DECREASE) IN CASH                                                           |       | 6,198,884                                                               |       | (3,206,572 | ) |
|                                                                                       |       |                                                                    |       |   |   |
| CASH, BEGINNING  OF PERIOD                                                                 |       | 6,256,712                                                               |       | 5,192,341 |   |
|                                                                                       |       |                                                                    |       |   |   |
| CASH, END OF  PERIOD                                                                       |       | $                                                                       | 12,455,596 |   | $ | 1,985,769 |   |
|                                                                                       |       |                                                                    |       |   |   |
| SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION -                                        |       |                                                                    |       |   |   |
|                                                                                       |       |                                                                    |       |   |   |
| Interest paid                                                                              |       | $                                                                       | 137,866    |   | $ | 131,099 |   |
| 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 six monthperiods ended December 31, 2008 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.

 

**Note 2.  Summary of Significant Accounting Policies**

 

Lannett Company, Inc.,a Delaware corporation, and subsidiaries (the “Company” or “Lannett”), develop,manufacture, package, market, and distribute active pharmaceutical ingredientsas well as pharmaceutical 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***- The consolidated financial statementsinclude the accounts of the operating parent company, Lannett Company, Inc.,and its wholly owned subsidiaries, Lannett Holdings, Inc. and CodyLaboratories, Inc. (“Cody”).  Codyincludes the consolidation of Cody LCI Realty, LLC, a variable interestentity,.  See Note 16 regarding the consolidation of this variableinterest entity.  All intercompanyaccounts and transactions have been eliminated.

 

***Reclassifications*** - The June 30, 2008 ConsolidatedBalance Sheet, the Consolidated Statements of Operations for the three and sixmonths ended December 31, 2007 and the Consolidated Statement of CashFlows for the six months ended December 31, 2007 have been reclassified toconform 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 and chargebacks payable and reductions to net sales. The change in thereserves for various sales adjustments may not be proportionally equal to thechange in sales because of changes in both the product and the customer mix.Increased sales to wholesalers will generally require additional accruals asthey are the primary recipient of chargebacks and rebates. Incentives offeredto secure sales vary from product to product. Provisions for estimated rebatesand promotional credits are estimated based upon contractual terms. Provisions for other customer credits, such as price adjustments, returns, andchargebacks, require management to make subjective judgments on customer mix.Unlike branded innovator drug companies, Lannett does not use information aboutproduct levels in distribution channels from third-party sources, such as IMSand NDC Health, in estimating future returns and other credits. Lannettcalculates a chargeback/rebate rate based on contractual terms with itscustomers and applies this rate to customer sales.  The only variable iscustomer mix, and this assumption is based on historical data and salesexpectations.

 

***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 and chargebacks payable account on thebalance sheet.

 

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***Other Adjustments —*** Other adjustments consist primarily of priceadjustments, also known as “shelf stock adjustments,” which are credits issuedto reflect decreases in the selling prices of the Company’s products thatcustomers have remaining in their inventories at the time of the pricereduction.  Decreases in selling pricesare discretionary decisions made by management to reflect competitive marketconditions.  Amounts recorded forestimated shelf stock adjustments are based upon specified terms with directcustomers, estimated declines in market prices, and estimates of inventory heldby customers.  The Company regularlymonitors these and other factors and evaluates the reserve as additionalinformation becomes available.  Otheradjustments are included in the rebates and chargebacks payable account on thebalance sheet.

 

The following tables identify the reserves for each major category ofrevenue allowance and a summary of the activity for the six months ended December 31,2008 and 2007:

 

**For the six months ended December 31,2008**

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

 

**For thesix months ended December 31, 2007**

 
| **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                     |       | (4,010,074      | )          | (1,700,473  | )          | (146,916    | )          | —    |       | (5,857,463  | )          |
| 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 |       | 14,619,361      |       | 4,729,061   |       | 1,108,662   |       | 110,000   |       | 20,567,084  |       |
| Actual credits  issued related to sales recorded in Fiscal 2008                            |       | (11,294,160     | )          | (3,244,688  | )          | (97,147     | )          | (110,129  | )          | (14,746,124 | )          |
| Reserve Balance  as of December 31, 2007                                              |       | $               | 3,964,605  |        | $          | 1,525,704   |       | $         | 1,027,912  |        | $          | 2,105 |   | $ | 6,520,326 |   |

 

The total reserve for chargebacks, rebates, returns and otheradjustments decreased from $18,326,417 at June 30, 2008 to $12,004,030 at December 31,2008.  The increase in chargeback reserves between June 30, 2008 and December 31,2008 was due primarily to an increase in inventory levels at wholesalerdistribution centers. The significant decrease in the returns reserve balancewas primarily the result of credits issued during the first half of Fiscal 2009related to the returns of the Prenatal Multivitamin product shipped in Fiscal2008.  It is our expectation that all of the product will be returnedbased on our inability to have the product specified as a brand equivalent, andinformation from our customers regarding their intentions to return the product.  Asof December 31, 2008 approximately $8,627,000 of the return reserve wasapplied to accounts receivable for customers who 

 

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had returned the Prenatal Multivitamin product by that date, leaving abalance of approximately $1,900,000 of Multivitamin returns reserve on thebooks at December 31, 2008.

 

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 the Companythat such purchases represent an estimate of expected resale for a period oftime.  This period of time is generally up to three months.  TheCompany records this revenue, net of any discounts offered and accepted by itscustomers at the time of shipment.  The Company’s products have either 24months or 36 months of shelf-life at the time of manufacture.  The Companymonitors its customers’ purchasing trends to attempt to identify anysignificant lapses in purchasing activity.  If the Company observes a lackof recent activity, inquiries will be made to such customer regarding thesuccess of the customer’s resale efforts.  The Company attempts tominimize any potential return (or shelf life issues) by maintaining an activedialogue 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.

 

***Accounts Receivable*** - The Company performs ongoing credit evaluations of its customers andadjusts credit limits based upon payment history and the customer’s currentcredit worthiness, as determined by a review of current credit information. TheCompany continuously monitors collections and payments from its customers andmaintains a provision for estimated credit losses based upon historicalexperience and any specific customer collection issues that have beenidentified. While such credit losses have historically been within both the Company’sexpectations and the provisions established, the Company cannot guarantee thatit will continue to experience the same credit loss rates that it has in thepast.

 

***Fair Value of FinancialInstruments*** - TheCompany’s financial instruments consist primarily of cash and cash equivalents,accounts receivable, accounts payable, accrued expenses and debt obligations.The carrying values of these assets and liabilities approximate fair valuebased upon the short-term nature of these instruments.  The Company has estimated that the fair valueof long-term debt associated with the 20 year mortgage on its land and 

 

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building in Cody, Wyomingapproximates the discounted amount of future payments to themortgage-holder.  There is no market forthis 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 periodically reviews its marketable securities anddetermines whether the investments are other-than-temporarily impaired. If theinvestments are deemed to be other-than-temporarily impaired, the investmentsare written down to their then current fair market value with a new cost basisbeing established. There were no securities determined by management to beother-than-temporarily impaired during the six months ended December 31,2008, or the fiscal year ended 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 Companyentered into an agreement with Jerome Stevens Pharmaceuticals, Inc. (JSP)for the exclusive marketing and distribution rights in the United States to thecurrent line of JSP products in exchange for four million (4,000,000) shares ofthe Company’s common stock.  As a resultof the JSP agreement, the Company recorded an intangible asset of $67,040,000for the exclusive marketing and distribution rights obtained from JSP.  The intangible asset was recorded based uponthe fair value of the four million (4,000,000) shares at the time of issuanceto JSP.   During the quarter ended March 31,2005, the Company recorded a non-cash impairment loss of approximately$46,093,000 in accordance 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 June 30,and December 31, 2008, management concluded the intangible asset wascorrectly stated at fair value and, therefore, no further impairment wasrequired.

 

TheCompany will incur annual amortization expense of approximately $1,785,000 forthe intangible asset over the remaining term of the contract.   For each six month period ended December 31,2008 and 2007, the Company incurred amortization expense of approximately$892,000.

 

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

 
| **Fiscal Year Ending June 30,** | ** ** | **Annual Amortization Expense** | ** ** |
|-----------------------------------------------------|------------|-------------------------------------------|------------|
| 2009                                                |       | $                                         | 893,000    |   |
| 2010                                                |       | 1,785,000                                 |       |
| 2011                                                |       | 1,785,000                                 |       |
| 2012                                                |       | 1,785,000                                 |       |
| 2013                                                |       | 1,785,000                                 |       |
| Thereafter                                          |       | 1,337,000                                 |       |
|                                                |       | $                                         | 9,370,000  |   |

 

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 

 

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contingentupon the receipt of a license from a regulatory agency.  This license was subsequently received in July 2008and triggered the payment of 105,000 shares of Lannett stock to the formerowners of Cody Labs, which was completed in October 2008.  Therefore, the Company has recorded anintangible asset related to the acquisition of a drug import license in theoriginal amount of $581,200 to the Intangible Asset account and has recorded acorresponding Deferred Tax Liability in the amount of approximately $150,700due to the non-deductibility of the amortization for tax purposes.  The Company has assigned a 15 year life tothis intangible asset based on average life cycles of Lannett products.

 

InJanuary 2005, Lannett Holdings, Inc. entered into an agreement inwhich the Company purchased for $100,000 and future royalty payments theproprietary rights to manufacture and distribute a product for which Pharmeral, Inc.owned the ANDA.  In Fiscal 2008, theCompany obtained FDA approval to use the proprietary rights.  Accordingly, the Company has capitalized thispurchased product right as an indefinite lived intangible asset.

 

***Advertising Costs*** - The Company chargesadvertising costs to operations as incurred. Advertising expense for the six months ended December 31, 2008 and2007 was approximately $31,000 and $4,000, respectively.

 

***Income Taxes*** - The Company uses the liability methodspecified by Statement of Financial Accounting Standards 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***—******TheCompany reports segment information in accordance with Statement of FinancialAccounting Standard No. 131, *Disclosures about Segmentsof an Enterprise and Related Information*(FAS 131*)*.  The Companyoperates one business segment - generic pharmaceuticals; accordingly theCompany has one reporting segment.  Inaccordance with FAS 131, the Company aggregates its financial information forall products and reports as one operating segment.  The following table identifies the Company’sapproximate net product sales by medical indication for the three and sixmonths ended December 31, 2008 and 2007:

 
| ** **                  | ** ** | **For the Three Months Ended  December 31,** | ** ** | **For the Six Months Ended  December 31,** | ** ** |
|-----------------------------|------------|-----------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| **Medical Indication** | ** ** | **2008**                                                              | ** ** | **2007**                                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
|                        |       |                                                                  |       |                                                                |       |   |   |   |   |
| Migraine  Headache          |       | $                                                                     | 2,429,000  |                                                                | $          | 2,794,000 |   | $ | 4,748,000 |   | $ | 5,442,000 |   |
| Epilepsy                    |       | 204,000                                                               |       | 848,000                                                             |       | 884,000 |   | 1,972,000 |   |
| Pre Natal  Vitamin          |       | 4,559,000                                                             |       | —                                                              |       | 4,559,000 |   | — |   |
| Heart Failure               |       | 5,709,000                                                             |       | 1,070,000                                                           |       | 12,057,000 |   | 2,159,000 |   |
| Thyroid  Deficiency         |       | 12,202,000                                                            |       | 9,593,000                                                           |       | 23,668,000 |   | 18,685,000 |   |
| Antibiotic                  |       | 1,524,000                                                             |       | 581,000                                                             |       | 3,020,000 |   | 1,556,000 |   |
| Antibacterial               |       | 9,000                                                                 |       | 1,798,000                                                           |       | 1,194,000 |   | 3,529,000 |   |
| Other                       |       | 2,588,000                                                             |       | 851,000                                                             |       | 4,662,000 |   | 1,732,000 |   |
|                        |       |                                                                  |       |                                                                |       |   |   |   |   |
| Total                       |       | $                                                                     | 29,224,000 |                                                                | $          | 17,535,000 |   | $ | 54,792,000 |   | $ | 35,075,000 |   |

 

***Concentration of Market and Credit Risk*** - Six of theCompany’s products, defined as generics containing the same active ingredientor combination of ingredients, accounted for approximately 43%, 22%, 8%, 9%, 1%and 2%, respectively of net sales for the six months ended December 31,2008.  Those same products accounted for53%, 6%, 0%, 8%, 8% and 6%, respectively, of net sales for the six months endedDecember 31, 2007.  For the threemonths ended December 31, 2008 and 2007, the same six products accountedfor 42%, 20%, 16%, 8%, 2%, and 1%, and 55%, 6%, 0%, 8%, 8%, and 3%,respectively, of net sales.

 

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Fourof the Company’s customers accounted for 42%, 17%, 11%, and 13%, respectively,of net sales for the six months ended December 31, 2008, and 33%, 10%, 6%,and 6%, respectively, of net sales for the six months ended December 31,2007.  For the three months ended December 31,2008 and 2007, these customers accounted for 34%, 12%, 9%, and 8%, and 35%, 8%,5%, and 7%, respectively, of net sales. At December 31, 2008, these four customers accounted for 60% 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 Financial Accounting Standards Board (FASB) Statementof Financial Accounting Standards (SFAS) No. 123 (R), “*Share-Based Payment*” (SFAS 123(R)).  This standard is arevision of SFAS 123, “*Accounting for Stock-BasedCompensation*” and supersedes Accounting Principles Board Opinion (“APB”)No. 25, “*Accounting for Stock Issued to Employees*.”  SFAS 123(R) addresses the accounting for share-based compensation in whichwe receive employee services in exchange for our equity instruments. Under the 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.

 

AtDecember 31, 2008, the Company had three stock-based employee compensationplans (the “Old Plan,” the “2003 Plan,” and the Long-term Incentive Plan, or “LTIP”).  During the six months ended December 31,2008, the Company awarded 30,000 shares of restricted stock under the LTIPwhich vested immediately.  Stockcompensation expense of $ 101,400 was recognized during the three and sixmonths ended December 31, 2008, related to these shares of restrictedstock.

 

TheCompany is required to record compensation expense for all awards granted afterthe date of adoption of SFAS 123(R) and for the unvested portion ofpreviously granted awards that remained outstanding as of the beginning of theperiod of adoption.  The Company measures share-based compensation costfor options using the Black-Scholes option pricing model.  The followingtable presents the weighted average assumptions used to estimate fair values ofthe stock options granted and the estimated forfeiture rates during the sixmonths ended December 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 |   |
|                                               |            |                                   |            |                                       |            |                                   |            |                                       |            |  |  |  |  |

 

Approximately47,000 and zero options were issued under the LTIP during the three monthsended December 31, 2008 and 2007, respectively.  Approximately 147,000 and 548,000 optionswere issued under the LTIP during the six months ended December 31, 2008and 2007, respectively.  There were noshares under option that were exercised in the six months ended December 31,2008 or 2007.  At December 31, 2008,there were 1,722,181 options outstanding. Of those, 683,900 were options issued under the LTIP, 827,048 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 7,690 sharesunder option having already been exercised under that plan.  2,500,000 shares were authorized to be issuedunder the LTIP, with no shares under option having yet been exercised underthat plan.

 

Expectedvolatility is based on the historical volatility of the price of our commonshares over a historical period equal to the expected term of the option.  We use historical information to estimateexpected term within the valuation model.  The expected term of awardsrepresents 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 

 

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yieldcurve in effect at the time of grant.  Compensation cost is recognizedusing a straight-line method over the vesting or service period and is net ofestimated 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 December 31,2008 and 2007. 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  December 31,** | ** ** | **Six Months Ended  December 31,** | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                           | ** ** | **2008**                                            | ** ** | **2007**                                          | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                 |       |                                                |       |                                              |       |   |   |   |   |
| Method used to  account for share-based compensation |       | Fair Value                                          |       | Fair Value                                        |       | Fair Value |   | Fair Value |   |
| Share based  compensation                            |       |                                                |       |                                              |       |   |   |   |   |
| Stock options                                        |       | $                                                   | 219,193    |                                              | 248,176    |   | 437,993 |   | $ | 419,760 |   |
| Employee stock  purchase plan                        |       | $                                                   | 4,701      |                                              | 5,098      |   | 31,292 |   | $ | 14,867 |   |
| Restricted stock                                     |       | $                                                   | 43,007     |                                              | 42,889     |   | 187,413 |   | $ | 49,016 |   |
| Tax benefit at  statutory rate                       |       | $                                                   | 22,180     |                                              | 27,032     |   | 44,361 |   | $ | 54,064 |   |

 

Optionsoutstanding that have vested and are expected to vest as of December 31,2008 are as follows:

 
| ** **                         | ** ** | **Awards** | ** ** | **Weighted -Average  Exercise  Price** | ** ** | **Aggregate  Intrinsic  Value** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** |
|------------------------------------|------------|------------|------------|---------------------------------------------|------------|---------------------------------|------------|-----------------------------------------------------|------------|
| Options vested                     |       | 1,107,070  |       | $                                           | 9.18       |                            | $          | 200,453                                             |       | 6.1 |   |
| Options expected  to vest          |       | 584,355    |       | $                                           | 4.11       |                            | $          | 656,937                                             |       | 8.8 |   |
| Total vested and  expected to vest |       | 1,691,425  |       | $                                           | 7.43       |                            | $          | 857,390                                             |       | 7.0 |   |

 

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Asummary of nonvested restricted stock award activity as of December 31,2008 and changes during the six 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     |       | $                                                                       | 101,400    |   |
| Vested                               |       | (68,602    | )          | $                                                                       | (269,056   | ) |
| Forfeited                            |       | (9,000     | )          | $                                                                       | (36,270    | ) |
| Nonvested at  December 31, 2008 |       | 77,198     |       | $                                                                       | 311,108    |   |

 

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Asummary of award activity under the Plans as of December 31, 2008 and2007, and changes during the six months then ended, is presented below:

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

 
| ** **                                           | ** ** | **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  December 31, 2007               |       | 957,367                               |       | $                                        | 5.83       |   | $ | 4,680 |   | 8.5 |   | 703,064 |   | $ | 10.16 |   |   |   | 7.0 |   |
|                                                 |       |                                  |       |                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Outstanding at  Decmeber 31, 2007 and not yet vested |       | 647,919                               |       | $                                        | 4.65       |   |   |   | 9.4 |   | 207,726 |   | $ | 5.28 |   |   |   | 9.0 |   |
| Exercisable at  December 31, 2007               |       | 309,448                               |       | $                                        | 8.29       |   | $ | 4,680 |   | 6.5 |   | 495,338 |   | $ | 12.20 |   |   |   | 6.2 |   |

 

Optionswith a fair value of approximately $726,000 vested during the three monthsended December 31, 2008.  Asof December 31, 2008, there was approximately $1,466,000 of totalunrecognized compensation cost related to nonvested share-based compensationawards granted under the Plans.  That cost is expected to be recognizedover a weighted average period of 1.4 years. As of December 31,2007, there was approximately $2,260,000 of total unrecognized compensationcost related to nonvested share-based compensation awards granted under thePlans.

 

***UnearnedGrant Funds*** — The Company records all grant fundsreceived as a liability until the Company fulfills all the requirements of thegrant funding program.

 

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***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 operations and a reconciliation of the computation of basic earnings pershare to diluted earnings per share. Basic earnings per share excludes the dilutive impact of common stockequivalents and is computed by dividing net income by the weighted-averagenumber of shares of common stock outstanding for the period.  Diluted earnings per share include the effectof potential dilution from the exercise of outstanding common stock equivalentsinto common stock using the treasury stock method; such items would not beconsidered for diluted loss per share due to their antidilutive effects.  Earnings per share amounts for all periodspresented have been calculated in accordance with the requirements of FAS128.  A reconciliation of the Company’sbasic and diluted income (loss) per share follows:

 
| ** **                                                        | ** ** | **Three Months Ended December 31,** | ** ** | **Six Months Ended December 31,** | ** ** |
|-------------------------------------------------------------------|------------|---------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                                        | ** ** | **2008**                                                | ** ** | **2007**                                              | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                                        | ** ** | **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                            |       | $                                                       | 1,573,062  |                                                  | 24,468,149 |   | $ | (657,547 | ) | 24,183,044 |   | $ | 2,799,227 |   | 24,385,818 |   | $ | (784,708 | ) | 24,179,344 |   |
| Effect of  potentially dilutive option and restricted stock plans |       | —                                                  |       | 78,638                                                |       | — |   | — |   | — |   | 124,908 |   | — |   | — |   |
| Diluted income  (loss) per share factors                          |       | $                                                       | 1,573,062  |                                                  | 24,546,787 |   | $ | (657,547 | ) | 24,183,044 |   | $ | 2,799,227 |   | 24,510,726 |   | $ | (784,708 | ) | 24,179,344 |   |
|                                                              |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic income  (loss) per share                                    |       | $                                                       | 0.06       |                                                  |       |   | $ | (0.03 | ) |   |   | $ | 0.11 |   |   |   | $ | (0.03 | ) |   |   |
| Diluted income  (loss) per share                                  |       | $                                                       | 0.06       |                                                  |       |   | $ | (0.03 | ) |   |   | $ | 0.11 |   |   |   | $ | (0.03 | ) |   |   |

 

The number of anti-dilutive shares that have been excluded in thecomputation of diluted income (loss) per share for the three and six monthsended December 31, 2008 were 1,797,379 and 1,650,379, respectively. Thenumber of anti-dilutive shares that have been excluded in the computation ofdiluted income (loss) per share for the three and six months ended December 31,2007 were 1,869,695.

 

**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 No. 157 forall non-financial assets and non-financial liabilities, except for items thatare recognized 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 solely from level 1inputs. In October 2008, the FASB issued FASB Staff Position No. FAS157-3, Determining 

 

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the Fair Value of aFinancial Asset When the Market for That Asset Is Not Active (“FSP FAS 157-3”). FSP FAS 157-3 clarifies the application of FAS 157 in a market that is notactive and provides an example to illustrate key considerations in determiningthe fair value of a financial asset when the market for that financial asset isnot active.  FSP FAS 157-3 was effective upon issuance, including forprior periods for which financial statements have not been issued.  FSPFAS 157-3 did not impact our financial reporting as we do not hold any suchassets.

 

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 is effective for our fiscal year beginning July 1, 2008.EITF 07-3 requires non-refundable advance payments for future research anddevelopment activities to be capitalized until the goods have been delivered orrelated services have been performed. As the guidance in EITF 07-03 isconsistent with our existing policy, EITF 07-03 did not have any impact onour financial statements 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” (“SFAS 141(R)”).SFAS 141(R) will significantly change the accounting for businesscombinations in a number of areas including the treatment of contingentconsideration, contingencies, acquisition costs, in-process research anddevelopment and restructuring costs. In addition, under SFAS 141(R),changes in deferred tax asset valuation allowances and acquired income taxuncertainties in a business combination after the measurement period willimpact income tax expense. SFAS 141(R) applies 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 SFAS 141(R) on our consolidated financialstatements will depend on the nature and terms of any business combinationsthat occur after its effective date.

 

In December 2007, theFASB issued SFAS No. 160, “Noncontrolling Interests in ConsolidatedFinancial Statements” (“SFAS 160”). SFAS 160 amends AccountingResearch Bulletin No. 51 to establish accounting and reporting standardsfor the noncontrolling (minority) interest in a subsidiary and for thedeconsolidation of a subsidiary. It clarifies that a noncontrolling interest ina subsidiary is an ownership interest in the consolidated 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. SFAS 160 is effectivefor our fiscal year beginning July 1, 2009. We are currently evaluatingthe impact the adoption of SFAS 160 will have on our consolidatedfinancial statements.

 

In March 2008, the FASBissued SFAS No. 161, “Disclosures about Derivative Instruments and HedgingActivities” (“SFAS 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, 

 

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2009 and for all interimperiods within that fiscal year.  Early adoption is encouraged.  Wedo not expect the adoption of SFAS 161 to have a significant impact on ourconsolidated financial statements as we do not currently have any derivativeswithin the scope of SFAS 161.

 

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 SFAS 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.

 

**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 such costs in cost of goods sold at thetime of such determination.

 

Inventoriesconsist of the following:

 
| ** **          | ** ** | **December 31, 2008** | ** ** | **June 30, 2008** | ** ** |
|---------------------|------------|---------------------------------|------------|-----------------------------|------------|
|                |       |                            |       |                        |       |
| Raw materials       |       | $                               | 4,666,911  |                        | $          | 3,530,951 |   |
| Work-in-process     |       | 3,032,800                       |       | 1,034,360                   |       |
| Finished goods      |       | 5,630,146                       |       | 6,767,718                   |       |
| Packaging  supplies |       | 632,671                         |       | 284,229                     |       |
|                |       | $                               | 13,962,528 |                        | $          | 11,617,258 |   |

 

The preceding amounts are net of inventory reserves of $2,194,272 and$1,642,668 at December 31, 2008 and June 30, 2008, respectively.

 

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**Note5.  Property, Plant and Equipment**

** **

Property, plant and equipment are stated at cost.  Depreciation expense for financial reportingpurposes is provided for by the straight-line method over the estimated usefullives of the assets.  Depreciationexpense for the three months ended December 31, 2008 and 2007 wasapproximately $833,000 and $986,000, respectively. Depreciation expense for thesix months ended December 31, 2008 and 2007 was approximately $1,667,000and $1,873,000, respectively.  Property,plant and equipment consist of the following:

 
| ** **                 | ** ** | ** **            | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
|----------------------------|------------|-----------------------|------------|-----------------------|------------|-------------------|------------|
| ** **                 | ** ** | **Useful Lives** | ** ** | **2008**              | ** ** | **2008**          | ** ** |
| Land                       |       | —                |       | $                     | 918,314    |              | $          | 918,314 |   |
| Building and  improvements |       | 10 - 39 years         |       | 16,901,780            |       | 16,806,057        |       |
| Machinery and  equipment   |       | 5 - 10 years          |       | 21,717,851            |       | 21,434,375        |       |
| Furniture and  fixtures    |       | 5 - 7 years           |       | 837,262               |       | 837,262           |       |
|                       |       |                  |       | $                     | 40,375,207 |              | $          | 39,996,008 |   |
|                       |       |                  |       | (16,926,017           | )          | (15,261,905       | )          |
|                       |       |                  |       | $                     | 23,449,190 |              | $          | 24,734,103 |   |

 

As of December 31,2008, substantially all of the Company’s property, plant and equipment werepledged as collateral for the Company’s loans. See Note 9.

 

**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:

 

December 31, 2008

Available-for-Sale

 
| ** **               | ** ** | ** **              | ** ** | **Gross**                        | ** ** | ** **             | ** ** |
|--------------------------|------------|-------------------------|------------|----------------------------------|------------|------------------------|------------|
| ** **               | ** ** | **Amortized Cost** | ** ** | **Gross Unrealized  Gains** | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
| U.S. Government  Agency  |       | $                       | 2,024,653  |                             | $          | 93,882                 |       | $ | — |   | $ | 2,118,535 |   |
| Corporate Bonds          |       | 149,924                 |       | 5,954                            |       | —                 |       | 155,878 |   |
| Asset-Backed  Securities |       | 355,380                 |       | 3,050                            |       | (21,014                | )          | 337,416 |   |
|                     |       | $                       | 2,529,957  |                             | $          | 102,886                |       | $ | (21,014 | ) | $ | 2,611,829 |   |

** **

June 30, 2008

Available-for-Sale

 
| ** **               | ** ** | ** **              | ** ** | **Gross**                        | ** ** | ** **             | ** ** |
|--------------------------|------------|-------------------------|------------|----------------------------------|------------|------------------------|------------|
| ** **               | ** ** | **Amortized Cost** | ** ** | **Gross Unrealized  Gains** | ** ** | **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 |   |

 

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The amortized costand fair value of the Company’s current available-for-sale securities by contractualmaturity at December 31, and June 30, 2008 are summarized as follows:

 
| ** **                                | ** ** | **December 31, 2008**  | ** ** | **June 30, 2008**      | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                | ** ** | **Available for Sale** | ** ** | **Available for Sale** | ** ** |
| ** **                                | ** ** | **Amortized**                    | ** ** | **Fair**                         | ** ** | **Amortized** | ** ** | **Fair** | ** ** |
| ** **                                | ** ** | **Cost**                         | ** ** | **Value**                        | ** ** | **Cost** | ** ** | **Value** | ** ** |
| Due in one year  or less                  |       | $                                | 293,902    |                             | $          | 304,036 |   | $ | 343,638 |   | $ | 354,155 |   |
| Due after one  year through five years    |       | 1,880,675                        |       | 1,970,377                        |       | 1,692,401 |   | 1,720,089 |   |
| Due after five  years through ten years   |       | 104,478                          |       | 105,789                          |       | 121,608 |   | 121,769 |   |
| Due after ten  years                      |       | 250,902                          |       | 231,627                          |       | 326,285 |   | 304,122 |   |
|                                      |       |                             |       |                             |       |   |   |   |   |
| Total  available-for-sale securities      |       | 2,529,957                        |       | 2,611,829                        |       | 2,483,932 |   | 2,500,135 |   |
| Less current  portion                     |       | 293,902                          |       | 304,036                          |       | 343,638 |   | 354,155 |   |
|                                      |       |                             |       |                             |       |   |   |   |   |
| Long term  available-for-sales securities |       | $                                | 2,236,055  |                             | $          | 2,307,793 |   | $ | 2,140,294 |   | $ | 2,145,980 |   |

 

TheCompany uses the specific identification method to determine the cost ofsecurities sold. For six months ended December 31, 2008 the Company hadrealized gains of $21,770 whereas for the six months ended December 31,2007, the Company had realized losses of $9,150.

 

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 December 31, 2008:

 

December 31, 2008

 
| ** **                                    | ** ** | **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                       |       | 0              |       | $                                      | —     |                                   | $          | —    |       | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Corporate Bonds                               |       | 0              |       | —                                 |       | —                                 |       | —    |       | — |   | — |   | — |   |
| Asset-Backed  Securities                      |       | 4              |       | —                                 |       | —                                 |       | 131,996   |       | (21,014 | ) | 131,996 |   | (21,014 | ) |
| Total tempory  impaired investment securities |       | 4              |       | $                                      | —     |                                   | $          | —    |       | $ | 131,996 |   | $ | (21,014 | ) | $ | 131,996 |   | $ | (21,014 | ) |

 

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 December 31, 2008,there were approximately 4 out of 29 

 

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investmentsecurities with unrealized losses. The Company anticipates full recovery ofamortized costs with respect to these securities at maturity or sooner in theevent of a more favorable market interest rate environment.

 

Noneof the Company’s investment securities was pledged as collateral for borrowingsas of December 31, 2008.

 

**Note7. Bank Line of Credit**

** **

TheCompany has a $3,000,000 line of credit from Wachovia Bank, N.A. (now a subsidiaryof Wells Fargo & Co. as of December 31, 2008) that bears interestat the prime interest rate less 0.25% (3.75% at December 31, 2008). TheCompany currently has $2,830,079 available under this line of credit.  The Company entered into a letter of creditin the amount of $520,000 of which $169,921 is outstanding as of December 31,2008.  The line of credit was renewed andextended to November 30, 2009.    The line of credit iscollateralized by substantially all of the Company’s assets.  Theagreement contains covenants with respect to working capital, net worth andcertain ratios, as well as other covenants.  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 December 31, 2008, the Company was in compliance withall financial 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.

 

**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 December 31, 2008,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 funding program.  Based on information availableat December 31, 2008, the Company has recorded the grant funding as along-term liability under the caption of Unearned Grant Funds.

 

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**Note9.  Long-Term Debt**

 

Long-term debtconsists of the following:

 
| ** **                                                                 | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
|----------------------------------------------------------------------------|------------|-----------------------|------------|-------------------|------------|
| ** **                                                                 | ** ** | **2008**              | ** ** | **2008**          | ** ** |
| PIDC Regional  Center, LP III loan                                         |       | $                     | 4,500,000  |              | $          | 4,500,000 |   |
| Pennsylvania  Industrial Development Authority loan                        |       | 1,039,422             |       | 1,075,732         |       |
| Pennsylvania  Department of Community & Economic Development loan |       | 233,515               |       | 283,475           |       |
| Tax-exempt bond  loan (PAID)                                               |       | 795,000               |       | 795,000           |       |
| Equipment loan                                                             |       | 240,390               |       | 400,653           |       |
| SBA loan                                                                   |       | 157,411               |       | 183,750           |       |
| First National  Bank of Cody                                               |       | 1,717,152             |       | 1,740,224         |       |
|                                                                       |       |                  |       |              |       |
| Total debt                                                                 |       | 8,682,890             |       | 8,978,834         |       |
| Less current  portion                                                      |       | 638,037               |       | 791,912           |       |
|                                                                       |       |                  |       |              |       |
| Long term debt                                                             |       | $                     | 8,044,853  |              | $          | 8,186,922 |   |

 
| ** **                                                                 | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
|----------------------------------------------------------------------------|------------|-----------------------|------------|-------------------|------------|
| ** **                                                                 | ** ** | **2008**              | ** ** | **2008**          | ** ** |
| Current Portion  of Long Term Debt                                         |       |                  |       |              |       |
| PIDC Regional  Center, LP III loan                                         |       | $                     | —     |              | $          | — |   |
| Pennsylvania Industrial  Development Authority loan                        |       | 74,051                |       | 73,132            |       |
| Pennsylvania  Department of Community & Economic Development loan |       | 101,810               |       | 100,614           |       |
| Tax-exempt bond  loan (PAID)                                               |       | 115,000               |       | 115,000           |       |
| Equipment loan                                                             |       | 240,390               |       | 400,653           |       |
| SBA loan                                                                   |       | 56,450                |       | 54,025            |       |
| First National  Bank of Cody                                               |       | 50,336                |       | 48,488            |       |
|                                                                       |       |                  |       |              |       |
| Total current  portion of long term debt                                   |       | $                     | 638,037    |              | $          | 791,912 |   |

 

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 

 

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and growth projects of the Company. The Authority issued $3,700,000 intax-exempt variable rate demand and fixed rate revenue bonds to provide thefunds to finance such growth projects pursuant to a trust indenture (“the TrustIndenture”).  A portion of the Company’s proceeds from the bonds was usedto pay for bond issuance costs of approximately $170,000.  The TrustIndenture requires that the Company repay the Authority loan throughinstallment payments beginning in May 2003 and continuing through May 2014,the year the bonds mature. The bonds bear interest at the floating variablerate determined by the organization responsible for selling the bonds (the “remarketingagent”).  The interest rate fluctuates on a weekly basis.  Theeffective interest rate at December 31, 2008 was 2.20%.

 

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 December 31, 2008 was the Equipment Loan whichconsists of a term loan with a term of five years and had an outstandingbalance of $240,390 at December 31, 2008.  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 December 31,2008, 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 2003Loan Financing bear interest at a variable rate equal to the LIBOR rate plus 150basis points.

 

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 December 31, 2008, the interestrate for the 2003 Loan Financing (of which only the Equipment loan remains) was2.94%.

 

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.

 

Includedin the acquisition of Cody was a loan from the Small Business Administration (“SBA”). The loan requires fixed monthly payments, with an effective interest rate of8.75%, through July 31, 2012.  Cody has pledged inventory, accountsreceivable and equipment as collateral.

 

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.

 

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

 
| **Twelve Month   Periods** | ** ** | **Amounts Payable    to Institutions** | ** ** |
|--------------------------------------|------------|---------------------------------------------|------------|
|                                 |       |                                        |       |
| 2009                                 |       | $                                           | 638,037    |   |
| 2010                                 |       | 4,921,501                                   |       |
| 2011                                 |       | 332,491                                     |       |
| 2012                                 |       | 275,501                                     |       |
| 2013                                 |       | 287,448                                     |       |
| Thereafter                           |       | 2,227,912                                   |       |
|                                 |       | $                                           | 8,682,890  |   |

 

**Note10.  Contingencies**

** **

In early June 2008, theCompany filed a declaratory judgment suit in the Federal DistrictCourt of 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 a motion for a Temporary Restraining Order (“TRO”) toprevent the Company from launching its Multivitamin with Mineral Capsules(“MMCs”), due to alleged patent and trademark infringement issues.  The TRO was heard and, ultimately, resulted ina conclusion by the court that the Company’s product label on the MMCs shouldbe modified.  KV also countered with claims of infringement by the Companyof KV’s patents seeking the Company’s profits for sales of MMCs or othermonetary relief, preliminary and permanent injunctive relief, attorney’s feesand a finding of willful infringement. The case is currently in itsdiscovery phase.  Recently the Court moved thetrial date.  A jury trial is now scheduled to begin on March 23,2009.  The Company believes that it has meritorious defenses withrespect to the claims asserted against it and intends to vigorously defend itsposition.

 

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 ingredient in its MMC.  Lannett filed a motion todismiss the complaint on the basis that it purchased the product from Albionand, as such, was authorized to use the product in its MMC.  TheCourt granted the motion and dismissed the complaint but gave Albion leave tofile an amended complaint.  On January 20, 2009, Albion filed anamended complaint.  Lannett’s response to the amendedcomplaint is due on March 3, 2009.  Lannett is no longerpurchasing product from Albion.  If Albion were to prevail on its claims,it may be entitled to a reasonable royalty on the Lannett product thatcontained the Albion ingredient.  The Company believes that Albion’sclaims have no merit and Lannett intends to vigorously defend the suit.

 

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**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.**

** **

In addition to the above, the Company has operatingleases, expiring in 2008, for office equipment.

 

Rental and lease expense for the three months ended December 31,2008 and 2007 was approximately $115,000 and $119,000, respectively.  Rental and lease expense for the six monthsended December 31, 2008 and 2007 was approximately $225,000 and $230,000,respectively.

 

***Contractual Obligations***

 

Thefollowing table represents annual debt, lease and contractual purchaseobligations as of December 31, 2008:

 
| ** **               | ** ** | **Total**   | ** **  | **Less than 1   year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **more than 5   years** | ** ** |
|--------------------------|------------|-------------|-------------|---------------------------------------|------------|--------------------|------------|--------------------|------------|----------------------------------------|------------|
|                     |       |        |        |                                  |       |               |       |               |       |                                   |       |
| Long-Term Debt           |       | $           | 8,682,890   |                                  | $          | 638,037            |       | $                  | 5,253,992  |                                   | $          | 562,949 |   | $ | 2,227,912 |   |
| Operating Leases         |       | 1,154,911   |        | 451,365                               |       | 696,632            |       | 6,914              |       | —                                 |       |
| Purchase  Obligations    |       | 115,717,500 |        | 19,911,250                            |       | 43,145,000         |       | 46,661,250         |       | 6,000,000                              |       |
| Interest on  Obligations |       | 1,908,200   |        | 267,184                               |       | 515,591            |       | 293,807            |       | 831,618                                |       |
| Total                    |       | $           | 127,463,501 |                                  | $          | 21,267,836         |       | $                  | 49,611,215 |                                   | $          | 47,524,920 |   | $ | 9,059,530 |   |

 

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 any penalty.  If either party were to terminate thepurchase agreement, there would be a significant impact on the operating cashflows of the Company from the termination.

 

***Employment Agreements***

 

TheCompany has entered into employment agreements with Arthur P. Bedrosian,President and Chief Executive Officer, Brian Kearns, Chief Financial Officerand Treasurer, Kevin Smith, Vice President of Sales and Marketing, and WilliamSchreck, Vice President of Logistics, (the “Named Executives”).  Each ofthe 

 

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agreementsprovide for an annual base salary and eligibility to receive a bonus.  Thesalary and bonus amounts of the Named Executives are determined by the Board ofDirectors.  Additionally, the Named Executives are eligible to receivestock options and restricted shares, which are granted at the discretion of theBoard of Directors, and in accordance with the Company’s policies regardingstock option grants.  Under theagreements, the Named Executive employees may be terminated at any time with orwithout cause, or by reason of death or disability.  In certain termination situations, theCompany is liable to pay severance compensation to the Named Executive ofbetween one year and three years.

 

**Note 12.  OtherComprehensive 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 December 31, 2008 and2007:

 
| ** **                             | ** ** | **For the Three Months Ended   December 31,** | ** ** | **For the Six Months Ended   December 31,** | ** ** |
|----------------------------------------|------------|-----------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                             | ** ** | **2008**                                                                    | ** ** | **2007**                                                                  | ** ** | **2008** | ** ** | **2007** | ** ** |
| Other  Comprehensive Income (Loss)     |       |                                                                        |       |                                                                      |       |   |   |   |   |
| Net Income  (Loss)                     |       | $                                                                           | 1,573,062  |                                                                      | $          | (657,547 | ) | $ | 2,799,227 |   | $ | (784,708 | ) |
| Unrealized Holding  Gain on Securities |       | 57,876                                                                      |       | 38,145                                                                    |       | 65,669 |   | $ | 61,543 |   |
| Add: Tax savings  at statutory rate    |       | (23,150                                                                     | )          | (14,528                                                                   | )          | (26,268 | ) | (24,617 | ) |
|                                   |       |                                                                        |       |                                                                      |       |   |   |   |   |
| Total Other  Comprehensive Income      |       | 34,726                                                                      |       | 23,617                                                                    |       | 39,401 |   | 36,926 |   |
|                                   |       |                                                                        |       |                                                                      |       |   |   |   |   |
| Total Comprehensive  Income (Loss)     |       | $                                                                           | 1,607,788  |                                                                      | $          | (633,930 | ) | $ | 2,838,628 |   | $ | (747,782 | ) |

 

**Note13.  Employee Benefit Plan**

 

TheCompany has a defined contribution 401k plan (the “Plan”) coveringsubstantially all employees.  Pursuant to the Plan provisions, the Companyis required to make matching contributions equal to 50% of each employee’scontribution, but not to exceed 4% of the employee’s compensation for the Planyear.  Contributions to the Plan during the three months ended December 31,2008 and 2007 were $75,000 and $85,000, respectively.  For the six months ended December 31,2008 and 2007 the contributions to the Plan were $163,000 and $177,000,respectively.

 

**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 December 31, 2008, 154,727 shares have been issued underthe ESPP.  Compensation expense of $4,701 and $5,098 has been recognizedfor the three months ended December 31, 2008 and 2007, respectively,relating to the ESPP. Compensation expense of 

 

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$31,292and $14,867 has been recognized for the six months ended December 31, 2008and 2007, respectively, relating to the ESPP.

 

**Note 15.  IncomeTaxes**

 

TheCompany uses the liability method specified by Statement of FinancialAccounting Standards No. 109 (FAS 109), *Accountingfor Income Taxes.*  Deferredtax assets and liabilities are determined based on the difference between thefinancial statement and tax bases of assets and liabilities as measured by theenacted tax rates which will be in effect when these differences reverse.  Deferred tax expense/(benefit) is the resultof changes in deferred tax assets and liabilities.

 

The provision forfederal, state and local income taxes for the three months ended December 31,2008 and 2007 was a tax expense of approximately $925,000 and a tax benefit ofapproximately $160,000, respectively, with effective tax rates of 37% and 20%,respectively. The provision for income taxes for the six months ended December 31,2008 and 2007 was a tax expense of approximately $1,845,000 and a tax benefitof approximately $206,000, respectively, with effective tax rates of 40% and21%, respectively. The tax rate for the six month period ended December 31,2008 is higher than the three month period ended December 31, 2008 dueprimarily to the IRS’s reestablishment of the R&D tax credit during theCompany’s second quarter of 2009.  Theeffective tax rate for the three and six month periods ended December 31,2007 was a lower benefit due primarily to no state NOLs being available for theCody Lab losses.

 

On July 1, 2007, we adopted the provisions of *FIN 48, Accounting for Uncertainty in Income Taxes –an interpretation of FASB Statement No. 109*, (“FIN 48”) whichprovides a financial statement recognition threshold and measurement attributefor a tax position taken or expected to be taken in a tax return. Under FIN 48,the Company may recognize the tax benefit from an uncertain tax position onlyif it is more likely than not that the tax position will be sustained onexamination by the taxing authorities, based on the technical merits of theposition. The tax benefits recognized in the financial statements from such aposition should be measured based on the largest benefit that has a greaterthan 50% likelihood of being realized upon ultimate settlement. FIN 48 alsoprovides guidance on de-recognition of income tax assets and liabilities,classification of current and deferred income tax assets and liabilities,accounting for interest and penalties associated with tax positions, and incometax disclosures.

 

The Company did not recognize any additionalcurrent or deferred income tax assets or liabilities as a result of theimplementation of FIN 48.  As a result,the Company has not recorded any amount for unrecognized tax positions at December 31,2008.

 

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.

 

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 Statement of FinancialAccounting Standards No. 141, Business Combinations.

 

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**Note 16.  Consolidationof Variable Interest Entity**

 

Lannettconsolidates any Variable Interest Entity (“VIE”) of which it is the primarybeneficiary. The liabilities recognized as a result of consolidating a VIE donot represent additional claims on our general assets; rather, they representclaims against the specific assets of the consolidated VIE. Conversely, assetsrecognized as a result of consolidating a VIE do not represent additionalassets that could be used to satisfy claims against our general assets.Reflected in the December 31, 2008 and June 30, 2008 balance sheetsare consolidated 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 December 31,2008 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.

 

**Note 17.  RelatedParty Transactions**

 

TheCompany had sales of approximately $384,000 and $251,000 during the six monthsended December 31, 2008 and 2007, 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 $70,000 and $125,000 at December 31, 2008 and 2007,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 futureroyalty payments the proprietary rights to manufacture and distribute a productfor which 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 a quarterly basis.  Arthur Bedrosian, President of the Company, Inc.was formerly the President and Chief Executive Officer and currently owns 100%of Pharmeral, Inc.  This transactionwas approved by the Board of Directors of the Company and in their opinion theterms were not more favorable to the related party than they would have been toa non-related party.  In May 2008, Mr. 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 December 31, 2008, the Company had approximately$644,000 of deferred revenue, representing payments received from ProvellPharmaceuticals, LLC (“Provell”) for inventory purchased from Lannett. TheCompany recognized revenue of approximately $311,000 during the quarter ended December 31,2008.  Accounts receivable includes amounts due from the related party ofapproximately $104,000 at December 31, 2008.  Provell is a jointventure to distribute pharmaceutical products through mail order outlets. Lannett was originally given a 33% ownership of this venture in exchange foraccess to Lannett’s drug providers.  This ownership was recently decreasedto 25% due to the additional issuance of shares by Provell in which Lannett didnot participate. The investment is valued at zero, due to losses incurred todate by Provell.

 

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**Note 18.  Material Contract with Supplier**

 

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 65% and 69% of the Company’s inventorypurchases during the three and six month periods ended December 31, 2008and 65% and 66% during the three and six month periods ended December 31,2007, respectively.  On March 23,2004,****the Company entered into an agreementwith JSP for the exclusive distribution rights in the United States to thecurrent line of JSP products, in exchange for four million (4,000,000) sharesof the Company’s common stock.  The JSPproducts covered under the agreement included Butalbital, Aspirin, Caffeinewith Codeine Phosphate capsules, Digoxin tablets and Levothyroxine Sodiumtablets, sold generically and under the brand name Unithroid®.  The term of the agreement is ten years,beginning on March 23, 2004 and continuing through March 22,2014.  Both Lannett and JSP have theright to terminate the contract if one of the parties does not cure a materialbreach of the contract within thirty (30) days of notice from the non-breachingparty.

 

Duringthe term of the agreement, the Company is required to use commercially reasonableefforts to purchase minimum dollar quantities of JSP’s products beingdistributed by the Company.  The minimumquantity 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 theSarbanes-Oxley Act of 2002.  As of December 31,2008, 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 as discussed above in Note 2 Summaryof Significant Accounting Policies– Intangible Assets for additional disclosure and discussion of thisimpairment.

 

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.  Purchases of finished goodsinventory from this provider accounted for approximately 6% and 0% ofthe Company’s inventory purchases during the three and six month periods ended December 31,2008.  Purchases of finished goodsinventory from this provider accounted for approximately 16% and 17%of the Company’s inventory purchases during the three and six month periodsended December 31, 2007. The term of the agreement was three years,beginning on August 22, 2005 and continuing through August 21,2008.  Following its expiration on August 21,2008, the agreement was not renewed.

 

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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 operations arebased upon our consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United Statesof America. The preparation of these financial statements requires us to makeestimates 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 additional assetsthat could be used to satisfy claims against our general assets.  Reflected in the December 31, 2008 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 December 31, 2008 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 itscustomers and applies this rate to customer sales.  The only variable iscustomer mix, and this assumption is based on historical data and sales expectations. The chargeback/rebate reserve is reviewed on a monthly basis by managementusing several ratios and calculated metrics.  As we continue to obtainadditional information about our historical experience for chargebacks, rebatesand returns, we also update our estimates of the required reserves.

 

***Chargebacks***– The provision for chargebacks is the mostsignificant and complex estimate used in the recognition of revenue.  TheCompany sells its products directly to wholesale distributors, generic distributors,retail pharmacy chains, and mail-order pharmacies.  The Company also sellsits products indirectly to independent pharmacies, managed care organizations,hospitals, nursing homes, and group purchasing organizations, collectivelyreferred to as “indirect customers.”  Lannett enters into agreements withits indirect customers to establish pricing for certain products.  Theindirect customers then independently select a wholesaler from which toactually purchase the products at these agreed-upon prices.  Lannett willprovide credit to the wholesaler for the difference between the agreed-uponprice with the indirect customer and the wholesaler’s invoice price if theprice sold to the indirect customer is lower than the direct price to thewholesaler.  This credit is called a chargeback.  The provision forchargebacks is based on expected sell-through levels by the Company’s wholesalecustomers to the indirect customers and estimated wholesaler inventorylevels.  As sales by the Company to the large wholesale customers, such asCardinal Health, AmerisourceBergen, and McKesson, increase, the reserve forchargebacks will also generally increase.  However, the size of theincrease depends on the expected mix of product sales to the indirect customers.The Company continually monitors the reserve for chargebacks and makesadjustments when management believes that expected chargebacks on actual salesmay differ from the amounts that were assumed in the establishment of thechargeback 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, theCompany has a product returns policy that allows certain customers to returnproduct within 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 requires that the customer obtainpre-approval from the Company for any qualifying return.  The Companyestimates its provision for returns based on historical experience, adjustedfor any changes in business practices or conditions that would cause managementto believe that future product returns may differ from those returns assumed inthe establishment of reserves.  Generally, the reserve for returnsincreases as sales increase and decrease when 

 

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credits are issued or payments are made for actualreturns received.  The reserve for returns is included in the rebates andchargebacks 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 becomesavailable.  Other adjustments are included in the rebates and chargebackspayable account on the balance sheet.  When competitors enter the marketfor existing 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 sixmonths ended December 31, 2008 and 2007:

 

**For the six months ended December 31, 2008**

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

 

**For the six months ended December 31, 2007**

 
| **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                     |       | (4,010,074      | )          | (1,700,473  | )          | (146,916    | )          | —    |       | (5,857,463  | )          |
| 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 |       | 14,619,361      |       | 4,729,061   |       | 1,108,662   |       | 110,000   |       | 20,567,084  |       |
| Actual credits  issued related to sales recorded in Fiscal 2008                            |       | (11,294,160     | )          | (3,244,688  | )          | (97,147     | )          | (110,129  | )          | (14,746,124 | )          |
| Reserve Balance  as of December 31, 2007                                              |       | $               | 3,964,605  |        | $          | 1,525,704   |       | $         | 1,027,912  |        | $          | 2,105 |   | $ | 6,520,326 |   |

 

The total reserve for chargebacks, rebates, returns and otheradjustments decreased from $18,326,417 at June 30, 2008 to $12,004,030 at December 31,2008.  The increase in chargeback reserves between June 30, 2008 and December 31,2008 was primarily due to an increase in inventory levels at wholesalerdistribution centers. The significant decrease in the returns reserve balancewas primarily the result of credits issued during the first half of Fiscal 2009related to the returns of the Prenatal Multivitamin product shipped in Fiscal2008.  It is our expectation that all of the product will be returnedbased on our inability to have the product specified as a brand 

 

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equivalent, and information from our customers regarding theirintentions to return the product.  As of December 31, 2008approximately $8,627,000 of the return reserve was applied to accountsreceivable for customers who had returned the Prenatal Multivitamin product bythat date.

 

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 currentconditions.

 

The rates of reserves will vary, as well as the category under whichthe credit falls.  This variability comesabout when the Company is working with indirect customers to compete with 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 reduce thepotential for human error, but also will result in more in-depth analysis andimproved 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 $12,004,030 at December 31, 2008 from$18,326,417 at June 30, 2008 is due to the timing of credits being processedby the customers and by the Company. Approximately $14,492,000 or 79% of the reserve balance from June 30,2008 has been processed through the first half of Fiscal 2009.  Approximately $8,627,000 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 creditevaluations of its customers and adjusts credit limits based upon paymenthistory and the customer’s current credit worthiness, as determined by a reviewof available credit information. The Company continuously monitors collectionsand payments from its customers and maintains a provision for estimated creditlosses based upon historical experience and any specific customer collectionissues that have been identified.  Whilesuch credit losses have historically been within both the Company’sexpectations and the provisions established, the Company cannot guarantee thatit will continue to experience the same credit loss rates that it has in thepast.

 

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.

 
| ** **           | ** ** | **Six months   ended   12/31/08** | ** ** | **Fiscal Year   ended   6/30/08** | ** ** | **Six months   ended   12/31/07** | ** ** |
|----------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| Net DSO (in  days)   |       | 54                                               |       | 65                                               |       | 84                                               |       |
| Gross DSO (in  days) |       | 60                                               |       | 70                                               |       | 76                                               |       |

 

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TheGross DSO above shows the result of the same calculation without regard torebates and chargebacks. The Company monitors both Net DSO and Gross DSO as anoverall check on collections and reasonableness of reserves.  In order to be effective indicators, bothtypes of DSO are evaluated on a quarterly basis.  The Gross DSO calculation provides managementwith an understanding of the frequency of customer payments, and the ability toprocess customer payments and deductions. The Net DSO calculation provides management with an understanding of therelationship of the A/R balance net of the reserve liability compared to netsales 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 second quarter of Fiscal2009, net of rebates and chargebacks, decreased as a result of timing of returncredits being taken by certain customers. At December 31, 2008 a significant portion of the credits appliedto customer accounts have not been deducted. This caused net accounts receivable to be artificially low.Approximately $2,452,000 of multivitamin credits are affected by this timingdifference, if the amount was added back to the accounts receivable balance theNet DSO calculation would be 60 days, which is consistent withexpectation.  Management expects the DSOcalculation normal levels to be 60 to 70 days. Significant variances 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*,” (123(R)) was adoptedeffective July 1, 2005.  Share-basedcompensation cost is measured using the Black-Scholes option pricingmodel.  The following table highlightsrelevant stock-option plan information for the six months ended:

 
| ** **                                                               | ** ** | **December 31,  2008** | ** ** | **December 31,  2007** | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| Share based  compensation expense                                        |       |                        |       |                        |       |
| Stock options                                                            |       | $                           | 438,000    |                        | $          | 420,000 |   |
| Employee stock  purchase plan                                            |       | $                           | 31,000     |                        | $          | 15,000 |   |
| Restricted stock                                                         |       | $                           | 187,000    |                        | $          | 49,000 |   |
| Total  compensation cost related to non-vested awards not yet recognized |       | $                           | 1,466,000  |                        | $          | 2,260,000 |   |
| Weighted average  period over which it is to be recognized               |       | 1.4 years                   |       | 1.7 years                   |       |

 

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***Resultsof Operations - Three months ended December 31, 2008 compared with threemonths ended December 31, 2007***

 

Net sales for the threemonths ended December 31, 2008 (“Fiscal 2009”) increased 67% to$29,224,000 from $17,535,000 for the three months ended December 31, 2007(“Fiscal 2008”). The increase was primarily due to increases in demand for Lannett’s products usedfor the treatment of congestive heart failure and thyroid deficiency.  The increase can also be attributed to theinitial sales of $4,559,000 of our prenatal vitamins launched during our secondquarter of Fiscal 2009. The Company looks to continue increasing the number ofproducts available for sale to our customers. FDA approvals are needed to continue this growth.  Several recent FDA approvals have resulted inmore sales of new products in the current fiscal year compared to the priorfiscal year.  The 67% sales increase of$11,689,000 is primarily due to the following significant causes on existingproducts:

 
| **Medical indication** | ** ** | **Sales volume  change %** | ** ** | **Sales price  change %** | ** ** |
|-----------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| Congestive Heart  Failure   |       | 302                                  | %          | 34                                  | %          |
| Antibiotics                 |       | 5                                    | %          | -45                                 | %          |
| Thyroid                     |       | 26                                   | %          | - 7                                 | %          |
| Migraine  Headache          |       | -6                                   | %          | - 7                                 | %          |

 

Drugsfor the treatment of congestive heart failure experienced a large increase insales price and volume.  Thyroid drugschanges were due to the acquisition of new customers at better prices.  These changes may not be indicative of thefull year sales change.

 

Theincrease in product sales can be attributed primarily to three products.  Sales of drugs for the treatment ofcongestive heart failure increased by approximately $4,639,000 in the secondquarter of Fiscal 2009 compared to the second quarter of Fiscal 2008 due to aproduct recall by one of our major competitors. Sales of drugs used in the treatment of thyroid deficiency increased byapproximately $2,609,000.  This increasewas due to an increase in sales to one large existing retail chain customer,and one existing major wholesaler. The increase can also be contributed to theinitial sales of our prenatal vitamins discussed above.

 

TheCompany sells its products to customers in various categories.  The table below identifies the Company’sapproximate net sales to each category for the three months ended December 31,2008 and 2007:

 
| ** **                 | ** ** | **Three Months Ended December 31,** | ** ** |
|----------------------------|------------|---------------------------------------------------------|------------|
| **Customer Category** | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
|                       |       |                                                    |       |   |   |
| Wholesaler/  Distributor   |       | $                                                       | 11,768,000 |   | $ | 7,497,000 |   |
| Retail Chain               |       | 16,176,000                                              |       | 8,983,000 |   |
| Mail-Order  Pharmacy       |       | 1,164,000                                               |       | 925,000 |   |
| Private Label              |       | 116,000                                                 |       | 130,000 |   |
|                       |       |                                                    |       |   |   |
| Total                      |       | $                                                       | 29,224,000 |   | $ | 17,535,000 |   |

 

**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.**

** **

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** **

**Costof sales excluding amortization of intangibles and royalties for the secondquarter increased 40% to $17,712,000 in Fiscal 2009 from $12,619,000 in Fiscal2008.  The increase is due to the 67%increase in sales.  Gross profit margins(excluding amortization of intangible assets and product royalty expense) forthe second quarter of Fiscal 2009 and Fiscal 2008 were 38% and 28%,respectively. Gross profit percentage increased due to strong profit margins onthe new prenatal vitamin, increased margins for our congestive heart failuremedication, and the overall fixed nature of some production costs versus the67% increase in revenues.  While theCompany is continuously striving to keep product costs low, there can be noguarantee that profit margins will not fluctuate in future periods.  Pricing pressure from competitors and costsof producing or purchasing new drugs may also fluctuate in the future. C**hanges in the future sales product mix may also occur. These changes mayaffect the gross profit percentage in future periods.  In the current period, the Company haschanged the presentation of amortization of intangibles and product royaltyexpenses, in order to comply with the SEC’s Staff Accounting Bulletin Topic11-B (SAB 11-B).  SAB 11-B gives guidanceon presentation of depreciation and depletion. Specifically, the SEC states “To avoid placing undue emphasis on “cashflow,” depreciation, depletion and amortization should not be positioned in theincome statement in a manner which results in reporting a figure for incomebefore depreciation.”  Management haspresented amortization and product royalties prior to gross profit in order toalign the financial reporting with this SEC guidance.  Prior periods have been reclassified to beconsistent with the current presentation.

** **

Amortization expense for theintangible asset for each of the three months ended December 31, 2008 and2007 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 half yearsof the contract, the Company will incur annual amortization expense ofapproximately $1,785,000.

 

Research and development (“R&D”) expenses in thesecond quarter increased 95% to $1,841,000 for Fiscal 2009 from $946,000 forFiscal 2008.  The increase is primarilydue to an increase in production of drugs in development and preparation forsubmission to the FDA.  The Companyexpenses all production costs as R&D until the drug is approved by theFDA.  R&D expenses may fluctuate fromperiod to period, based on R&D plans for submission to the FDA.

 

Selling**,**general and administrative expenses in the second quarterincreased 57% to $6,675,000 in Fiscal 2009 from $4,255,000 in Fiscal 2008.  The increase is primarily due to litigationexpenses related to the current patent challenge with KV Pharmaceuticals, aswell as increases in other legal, accounting and professional services comparedto the same period in Fiscal 2008. While the Company is focused on controllingcosts, increases in personnel costs may have an ongoing and longer lastingimpact on the administrative cost structure. Other costs 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 in the second quarter increased to $117,000 inFiscal 2009 from $92,000 in Fiscal 2008 primarily due to interest incurred onan open letter of credit used to purchase raw materials from a new vendor.  Interest income in the second quarterincreased to $92,000 in Fiscal 2009 from $49,000 in Fiscal 2008 due to interestreceived on an income tax refund.

 

TheCompany had income tax expense in the second quarter of 2009 of $925,000compared to a benefit of $160,000 in the second quarter of Fiscal 2008 due to anet loss before income taxes in 2008. The tax rate for the three months ended December 31, 2008 is 37%,compared to 20% for the three months ended December 31, 2007.  The difference is due to the IRS’sreestablishment of the R&D tax credit during the Company’s second quarterof 2009.  The effective tax rate for the three months ended December 31,2007 was a lower benefit due primarily to no state Net Operating Lossesavailable for the Cody Lab.

 

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The Company reported netincome of approximately $1,573,000 in the second quarter of Fiscal 2009, or$0.06 basic and diluted net income per share, as compared to a net loss ofapproximately $658,000 in the second quarter Fiscal 2008, or ($0.03) basic anddiluted loss per share.

 

***Resultsof Operations - Six months ended December 31, 2008 compared with sixmonths ended December 31, 2007***

 

Net sales for the sixmonths ended December 31, 2008 (“Fiscal 2009”) increased 56% to$54,792,000 from $35,075,000 for the six months ended December 31, 2007 (“Fiscal2008”). The increase wasprimarily due to increases in demand for Lannett’s products used for thetreatment of congestive heart failure, and thyroid deficiency.  The increase can also be attributed to theinitial sales of $4,559,000 of our prenatal vitamins launched during our secondquarter of Fiscal 2009. The Company looks to continue increasing the number ofproducts available for sale to our customers. FDA approvals are needed to continue this growth.  Several recent FDA approvals have resulted inmore sales of new products in the current fiscal year compared to the priorfiscal year.  The 56% sales increase of$19,717,000 is primarily due to the following significant causes:

 
| **Medical indication** | ** ** | **Sales volume  change %** | ** ** | **Sales price  change %** | ** ** |
|-----------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| Congestive Heart  Failure   |       | 343                                  | %          | 28                                  | %          |
| Antibiotics                 |       | 84                                   | %          | 40                                  | %          |
| Thyroid                     |       | 30                                   | %          | - 3                                 | %          |
| Migraine  Headache          |       | 2                                    | %          | - 11                                | %          |

 

Drugsfor the treatment of congestive heart failure experienced a large increase insales price and volume.  Thyroid drugschanges were due to the acquisition of new customers at better prices.  These changes may not be indicative of thefull year sales change.

 

Theincrease in product sales can be attributed primarily to three products.  Sales of drugs for the treatment ofcongestive heart failure increased by approximately $9,899,000 for the sixmonths ended December 31, 2008 compared to December 31, 2007 due to aproduct recall by one of our major competitors. Sales of drugs used in the treatment of thyroid deficiency increased byapproximately $4,983,000.  This increasewas due to an increase in sales to one large existing retail chain customer,and one existing major wholesaler/distributor. For the six months ended December 31, 2008, the company had salesof $4,559,000 of the prenatal vitamins.

 

TheCompany sells its products to customers in various categories.  The table below identifies the Company’sapproximate net sales to each category for the six months ended December 31,2008 and 2007:

 
| ** **               | ** ** | **Six Months Ended December 31,** | ** ** |
|--------------------------|------------|-------------------------------------------------------|------------|
| **Customer  Category**   | ** ** | **2008**                                              | ** ** | **2007** | ** ** |
|                     |       |                                                  |       |   |   |
| Wholesaler/  Distributor |       | $                                                     | 23,608,000 |   | $ | 15,624,000 |   |
| Retail Chain             |       | 28,151,000                                            |       | 17,015,000 |   |
| Mail-Order  Pharmacy     |       | 2,800,000                                             |       | 2,181,000 |   |
| Private Label            |       | 233,000                                               |       | 255,000 |   |
|                     |       |                                                  |       |   |   |
| Total                    |       | $                                                     | 54,792,000 |   | $ | 35,075,000 |   |

 

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**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 excluding amortization of intangibles and royalty expense for the sixmonths ended December 31, 2008 increased 39% to $33,833,000 in Fiscal 2009from $24,412,000 in Fiscal 2008.  Theincrease is primarily due to the 56% increase in sales.  Gross profit margins for the six months endedDecember 31, 2008 and 2007 were 37% and 27%, respectively. Gross profitpercentage increased due to strong profit margins on the new prenatal vitamin,a decrease in product royalty expenses, an increase in the margin forcongestive heart failure medication, and the overall fixed nature of someproduction costs versus the 56% 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.  Inthe current period, the Company has changed the presentation of amortization ofintangibles and product royalty expenses, in order to comply with the SEC’sStaff Accounting Bulletin Topic 11-B (SAB 11-B).  SAB 11-B gives guidance on presentation ofdepreciation and depletion. Specifically, the SEC states “To avoid placing undue emphasis on “cashflow,” depreciation, depletion and amortization should not be positioned in theincome statement in a manner which results in reporting a figure for incomebefore depreciation.”  Management haspresented amortization and product royalties prior to gross profit in order toalign the financial reporting with this SEC guidance.  Prior periods have been reclassified to beconsistent with the current presentation.

** **

Amortization expense for theintangible asset for the six months ended December 31, 2008 and 2007 wasapproximately $892,000.  The amortizationexpense relates to the March 23, 2004 exclusive marketing and distributionrights agreement with JSP.  For the remaining five and a half yearsof the contract, the Company will incur annual amortization expense of approximately$1,785,000.

 

Research and development (“R&D”) expenses forthe six months increased 68% to $3,704,000 for Fiscal 2009 from $2,198,000 forFiscal 2008.  The increase is primarilydue to an increase in production of drugs in development and preparation forsubmission to the FDA.  The Companyexpenses all production costs as R&D until the drug is approved by theFDA.  R&D expenses may fluctuate fromperiod to period, based on R&D plans for submission to the FDA.

 

Selling**,**general and administrative expenses for the six monthsincreased 41% to $11,624,000 in Fiscal 2009 from $8,235,000 in Fiscal2008.  The increase is primarily due tolitigation expenses related to the current patent challenge with KVPharmaceuticals, as well as increases in other legal, accounting andprofessional services compared to the same period in Fiscal 2008. While theCompany is focused on controlling costs, increases in personnel costs may havean ongoing and longer lasting impact on the administrative cost structure.  Other costs are being incurred to facilitateimprovements in the Company’s infrastructure. These costs are expected to be temporary investments in the future ofthe Company and may not continue at the same level.  However, as the Company continues to investin technology, the Company may need to invest additional funds in technology orprofessional services.

 

TheCompany’s interest expense in the six months ended December 31, 2008decreased to $184,000 from $196,000 in the six months ended December 31,2007 primarily due to lower levels of long-term debt.  Interest income in the six months ended December 31,2008 increased to $138,000 from $106,000 in the six months ended December 31,2007 due to interest income received on a large income tax refund.

 

TheCompany had income tax expense in the six months ended December 31, 2008of $1,845,000 compared to a benefit of $206,000 in the six months ended December 31,2007 due to a net loss before income taxes in the 2008 fiscal period.  The tax rate for the six months ended December 31,2008 is 40%, compared to 21% for the six months ended December 31,2007.  The difference is primarily due topermanent differences between tax and book income and loss during each periodprimarily from the non-deductible portion of the Stock Compensation 

 

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Expense.  The effective tax rate for the six monthsended December 31, 2007 was a lower benefit due to no state Net OperatingLosses available for the Cody Lab losses.

 

The Company reported netincome of approximately $2,799,000 in the first six months of Fiscal 2009, or$0.11 basic and diluted net income per share, as compared to a net loss of approximately$785,000 in the first six months of Fiscal 2008, or ($0.03) basic and dilutedloss per share.

 

***Liquidity andCapital Resources***

 

The Company has historically financed its operationsby cash flow from operations.  AtDecember 31, 2008, working capital was $31,601,000, as compared to$25,945,000 at June 30, 2008, an increase of $5,656,000.  Net cash provided by operating activities of$6,899,000 in the first six months of Fiscal 2009 is due to net income of$2,799,000, adjustments for the effects of non-cash items of $6,180,000 and anet decrease in cash from changes in operating assets and liabilities of$2,080,000.  Significant changes inoperating assets and liabilities are comprised of:

** **

·                  A decrease intrade accounts receivable of $1,097,000 due to collection of significantreceivables outstanding at June 30, 2008 related to sales of multivitaminsfor which related reserves were accrued, but have not yet been taken by all ofthe Company’s customers, partially offset by the increase in the receivablesbalance due to increased sales.

** **

·                  A decrease ininventories of $2,345,000 due to the launch of several products during Fiscal2009 for which inventory had been purchased by June 30, 2008.

** **

·                  A decrease inaccounts payable of $501,000 due to the timing of payments at the end of themonth.

** **

·                  An increase inaccrued expenses due to the accrual of significant patent litigation expensesincurred in the second quarter of Fiscal 2009.

 

The net cash used in investing activities of $442,000for the six months ended December 31, 2008 was due primarily to thepurchases of fixed assets during the period.

** **

The net cash used in financing activities of $258,000for the six months ended December 31, 2008 was due primarily to therepayment of debt during the period.

** **

The following table summarizes the remaining repayments of debt,including sinking fund requirements as of December 31, 2008 for thesubsequent twelve month periods:

 
| **Twelve**             | ** ** | **Amounts Payable** | ** ** |
|------------------------|------------|--------------------------|------------|
| **Month Periods** | ** ** | **to Institutions** | ** ** |
|                   |       |                     |       |
| 2009                   |       | $                        | 638,037    |   |
| 2010                   |       | 4,921,501                |       |
| 2011                   |       | 332,491                  |       |
| 2012                   |       | 275,501                  |       |
| 2013                   |       | 287,448                  |       |
| Thereafter             |       | 2,227,912                |       |
|                   |       |                     |       |
|                   |       | $                        | 8,682,890  |   |

 

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Thefollowing table represents annual debt, lease and contractual purchaseobligations as of December 31, 2008:

 
| ** **               | ** ** | **Total**   | ** **  | **Less than 1  year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **more than 5  years** | ** ** |
|--------------------------|------------|-------------|-------------|---------------------------------|------------|--------------------|------------|--------------------|------------|----------------------------------|------------|
|                     |       |        |        |                            |       |               |       |               |       |                             |       |
| Long-Term Debt           |       | $           | 8,682,890   |                            | $          | 638,037            |       | $                  | 5,253,992  |                             | $          | 562,949 |   | $ | 2,227,912 |   |
| Operating Leases         |       | 1,154,911   |        | 451,365                         |       | 696,632            |       | 6,914              |       |                             |       |
| Purchase  Obligations    |       | 115,717,500 |        | 19,911,250                      |       | 43,145,000         |       | 46,661,250         |       | 6,000,000                        |       |
| Interest on  Obligations |       | 1,908,200   |        | 267,184                         |       | 515,591            |       | 293,807            |       | 831,618                          |       |
| Total                    |       | $           | 127,463,501 |                            | $          | 21,267,836         |       | $                  | 49,611,215 |                             | $          | 47,524,920 |   | $ | 9,059,530 |   |

 

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

** **

TheCompany has a $3,000,000 line of credit from Wachovia Bank, N.A. (now asubsidiary of Wells Fargo & Co. as of December 31, 2008) thatbears interest at the prime interest rate less 0.25% (3.75% at December 31,2008). The Company currently has $2,830,079 available under this line ofcredit.  The Company entered into aletter of credit in the amount of $520,000 of which $169,921 is outstanding asof December 31, 2008.  The line of creditwas renewed and extended to November 30, 2009.    The lineof credit 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 December 31, 2008, the Company was in compliance withall 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 the attainmentof standard financial liquidity and net worth ratios.  As of December 31, 2008, the Company isin compliance with all financial covenants under the agreement.**

** **

InJuly 2004, the Company received $500,000 of grant funding from theCommonwealth of Pennsylvania, acting through the Department of Community andEconomic Development.  The grant funding program requires the Company touse the funds for machinery and equipment located at their Pennsylvanialocations, hire an additional 100 full-time employees by June 30, 2006,operate its Pennsylvania locations a minimum of five years 

 

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andmeet certain matching investment requirements.  If the Company fails tocomply with any of the requirements above, the Company would be liable to repaythe full amount of the grant funding ($500,000).  The Company has recordedthe unearned grant funds as a liability until the Company complies with all ofthe requirements of the grant funding program. Through December 31,2008, 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.  Except asset forth in this report, the Company is not aware of any trends, events oruncertainties that have or are reasonably likely to have a material adverseimpact on the Company’s short-term or long-term liquidity or financial condition.

 

**Prospects for the Future**

 

The Company has several generic products under development.  Theseproducts are all orally-administered, topical and parenteral products designedto be generic equivalents to brand named innovator drugs.  The Company’sdevelopmental drug products are intended to treat a diverse range ofindications.  As the oldest generic drug manufacturer in the country,formed in 1942, Lannett currently owns several ANDAs for products which it doesnot manufacture and market.  These ANDAs are simply dormant on the Company’srecords.  Occasionally, the Company reviews such ANDAs to determine if themarket potential for any of these older drugs has recently changed, so as tomake it attractive for Lannett to reconsider manufacturing and sellingit.  If the Company makes the determination to introduce one of theseproducts into the consumer marketplace, it must review the ANDA and relateddocumentation to ensure that the approved product specifications, formulationand other factors meet current FDA requirements for the marketing of thatdrug.  The Company would then redevelop the product and submit it to theFDA for supplemental approval.  The FDA’s approval process for ANDAsupplements is similar to that of a new ANDA.   Generally, in these situations,the Company must file a supplement to the FDA for the applicable ANDA,informing the FDA of any significant changes in the manufacturing process, theformulation, or the raw 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).  The products under development are atvarious stages in the development cycle—formulation, scale-up, and/or clinicaltesting.  Depending on the complexity of the active ingredient’s chemicalcharacteristics, the cost of the raw material, the FDA-mandated requirement ofbioequivalence studies, the cost of such studies and other developmental factors,the cost to develop a new generic product varies and can range from $100,000 to$1 million.  Some of Lannett’s developmental products will requirebioequivalence studies, while others will not—depending on the FDA’s OrangeBook classification.  Since the Company has no control over the FDA reviewprocess, management is unable to anticipate whether or when it will be able tobegin producing and shipping additional 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 outsourcedR&D products are at various stages in the development cycle — formulation,analytical method development and testing and manufacturing scale-up. These products are orally-administered solid dosage products intended to treata diverse range of medical indications.  It is the Company’s intention toultimately transfer the formulation technology and manufacturing process forall of these R&D products to the Company’s own commercial manufacturingsites.  The Company initiated these outsourced R&D efforts tocomplement the progress of its own internal R&D efforts.

 

Occasionally, the Company will work on developing a drug product thatdoes not require FDA approval.  Certain prescription drugs do not requireprior FDA approval before marketing.  For instance, drugs listed as DESIdrugs (Drug Efficacy Study implementation) which are under evaluation by FDA,Grandfathered Drugs, and prescription multivitamin drugs. A genericmanufacturer may sell products which are chemically equivalent to 

 

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innovator drugs, under FDA rules by simply performing andinternally documenting the normal research and development involved in bringinga new product to market.  Under this scenario, a generic company canforego 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 orGrandfathered.  GRASE products are those “old drugs that do not requireprior approval from FDA in order to be marketed because they are generallyrecognized as safe and effective based on published scientific literature.” Similarly, Grandfathered products are those which “entered the market beforethe passage of the 1938 act or the 1962 amendments to the act.”  Under thegrandfather clause, such a product is exempted from the “effectivenessrequirements [of the act] if its composition and labeling have not changedsince 1962 and if, on the day before the 1962 amendments became effective, itwas (1) used or sold commercially in the United States, (2) not a newdrug as defined by the act at that time, and (3) not covered by aneffective application.”

 

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 itsstrong customer relationships to build its market share for such products, andincrease future revenues 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 its outside contracts for productdevelopment and manufacturing supply are material in nature, nor is the Companysubstantially dependent on the services rendered by such outside firms. Since the Company has no control over the FDA review process, management isunable to anticipate whether or when it will be able to begin producing andshipping such additional products.

 

Lannett may increase its focus on certain specialty markets in thegeneric pharmaceutical industry.  Such a focus is intended to provideLannett customers with increased product alternatives in categories withrelatively few market participants.  While there is no guarantee that Lannetthas the 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.  Managementbelieves that mutually beneficial strategic relationships in such areas,including potential financing arrangements, partnerships, joint ventures oracquisitions, could allow for potential competitive advantages in the genericpharmaceutical market.  The Company plans to continue to explore suchareas for potential opportunities to enhance shareholder value.

 

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** **

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

 

**The Company has debt instrumentswith variable interest rates. The Equipment Loan, amounting to $240,390 at December 31,2008, bears interest at a variable rate equal to the LIBOR rate plus 150 basispoints. In addition, the Company has a $3 million line of credit from WachoviaBank, N.A. that bears interest at the prime interest rate less**0.25% (3.75% at December 31, 2008).The lineof credit was renewed and extended to November 30, 2009. The line ofcredit is collateralized by substantially all of the Company’s assets. The agreement containscovenants with respect to working capital, net worth and certain ratios, aswell as other covenants.

** **

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

 

**ITEM 4. CONTROLS AND PROCEDURES**

 

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

 

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

 

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

 

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

 

There has been no change inthe Company’s internal control over financial reporting during the three monthsended December 31, 2008 that has materially affected, or reasonably likelyto materially affect, our internal control over financial reporting.

 

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# **PART II. OTHER INFORMATION**

#  

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

## *** ***

In early June 2008, theCompany filed a declaratory judgment suit in the Federal DistrictCourt of 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 sought declaratoryjudgment of anti-trust violations and federal and state unfair competitionviolations 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 claims ofinfringement by the Company of KV’s patents seeking the Company’s profits forsales of MMCs or other monetary relief, preliminary and permanent injunctiverelief, attorney’s fees and a finding of willful infringement. The case iscurrently in its discovery phase .  Recently the Court moved thetrial date.  A jury trial is now scheduled to begin on March 23,2009.  The Company believes that it has meritorious defenses withrespect to the claims asserted against it and intends to vigorously defend itsposition.

 

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 ingredient in its MMC.  Lannett filed a motion todismiss the complaint on the basis that it purchased the product from Albionand, as such, was authorized to use the product in its MMC.  TheCourt granted the motion and dismissed the complaint but gave Albion leaveto file an amended complaint.  On January 20, 2009, Albion filed anamended complaint.   Lannett’s response to the amendedcomplaint is due on March 3, 2009.  Lannett is no longerpurchasing product from Albion.  If Albion were to prevail on its claims,it may be entitled to a reasonable royalty on the Lannett product thatcontained the Albion ingredient.  The Company believes that Albion’sclaims have no merit and Lannett intends to vigorously defend the suit.

 

***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, the Company periodically responds to inquiries orengages in administrative and judicial proceedings involving regulatoryauthorities, particularly the FDA and the Drug Enforcement Agency.

 

## ***ITEM6. EXHIBITS***

## *** ***

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

 

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# **SIGNATURE**

#  

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

 
| ** **               | ** ** | **LANNETT  COMPANY, INC.**                |
|--------------------------|------------|-------------------------------------------|
|                     |       |                                      |
| Dated: February 11, 2009 | By:        | /s/ Brian Kearns                          |
|                     |       | Brian Kearns                              |
|                     |       | Vice  President of Finance, Treasurer and |
|                     |       | Chief  Financial Officer                  |
|                     |       |                                      |
|                     |       |                                      |
| Dated: February 11, 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 Chief  Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of  2002                              | Filed Herewith |   |
|   |                                                                                                                                   |           |   |
| 32     | Certifications of Chief  Executive Officer and Chief Financial Officer Pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002 | Filed Herewith |   |

 

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