Table of Contents

 

 

 

**UNITED STATES SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 
| **x**                                                  | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE  ACT OF 1934** |
|--------------------------------------------------------|-------------------------------------------------------------------------------------------------------------|
| ** **                                             | ** **                                                                                                  |
| **FOR THE  QUARTERLY PERIOD ENDED SEPTEMBER 30, 2009** |
| ** **                                             | ** **                                                                                                  |
| **o**                                                  | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934** |

 

**FOR THE TRANSITION PERIOD FROM                        TO                         .**

 

**Commission File No. 001-31298**

 

**LANNETT COMPANY, INC.**

(Exact Name of Registrant as Specified in its Charter)

 

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

 

**9000 State Road**

**Philadelphia, PA 19136**

**(215) 333-9000**

(Address of principal executive offices and telephonenumber)

 

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

 

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

 

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

 

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

 

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

 

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

 
| **Class**                                 | ** ** | **Outstanding as of November 9, 2009** |
|-------------------------------------------|------------|---------------------------------------------|
| Common stock,  par value $0.001 per share |       | 24,699,089  shares                          |

 

 

 

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Table of Contents

 

**Tableof Contents**

 
| ** **                                                                    | **Page No.**                                                                                                               |
|-------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------------------------------|
|                                                                          |                                                                                                                            |
| **PART I.  FINANCIAL INFORMATION**                                       |                                                                                                                            |
|                                                                          |                                                                                                                            |
| **ITEM  1.**                                                                  | **FINANCIAL STATEMENTS**                                                                                                        |   |
|                                                                          |                                                                                                                            |   |
|                                                                          | Consolidated  Balance Sheets  as of September 30, 2009 (unaudited) and June 30, 2009                                  | 1 |
|                                                                          |                                                                                                                            |   |
|                                                                          | Consolidated  Statements of Operations (unaudited)  for the three months ended September 30, 2009 and 2008                 | 2 |
|                                                                          |                                                                                                                            |   |
|                                                                          | Consolidated  Statement of Changes in Shareholders’ Equity (unaudited)  for the three months ended September 30, 2009 | 3 |
|                                                                          |                                                                                                                            |   |
|                                                                          | Consolidated  Statements of Cash Flows (unaudited)  for the three months ended September 30, 2009 and 2008                 | 4 |
|                                                                          |                                                                                                                            |   |
|                                                                          | Notes to Consolidated Financial Statements (unaudited)                                                                          | 5 |
|                                                                          |                                                                                                                            |   |
| **ITEM 2.**                                                                   | **MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**                                 | 27 |
|                                                                          |                                                                                                                            |   |
|                                                                          |                                                                                                                            |   |
| **ITEM 3.**                                                                   | **QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**                                                                 | 38 |
|                                                                          |                                                                                                                            |   |
| **ITEM 4.**                                                                   | **CONTROLS AND  PROCEDURES**                                                                                                    | 38 |
|                                                                          |                                                                                                                            |   |
| **PART II.  OTHER INFORMATION**                                          |                                                                                                                            |
|                                                                          |                                                                                                                            |   |
| **ITEM 1.**                                                                   | **LEGAL PROCEEDINGS**                                                                                                           | 39 |
|                                                                          |                                                                                                                            |   |
| **ITEM 4.**                                                                   | **SUBMISSION OF  MATTERS TO A VOTE OF SECURITY HOLDERS**                                                                        | 40 |
|                                                                          |                                                                                                                            |   |
| **ITEM  6.**                                                                  | **EXHIBITS**                                                                                                                    | 40 |
|                                                                          |                                                                                                                            |   |
| **CERTIFICATION OF  PRESIDENT & CHIEF EXECUTIVE OFFICER**            |                                                                                                                            |
|                                                                          |                                                                                                                            |
| **CERTIFICATION OF CHIEF  FINANCIAL OFFICER**                                 |                                                                                                                            |
|                                                                          |                                                                                                                            |
| **CERTIFICATION PURSUANT TO SECTION 906 OF SARBANES OXLEY ACT OF  2002** |                                                                                                                            |

 

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# Table of Contents

 

# **PART I.  FINANCIAL INFORMATION**

#  

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

 

**LANNETTCOMPANY, INC. AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                           | ** ** | **(Unaudited)**             | ** **  | ** **             | ** ** |
|--------------------------------------------------------------------------------------|------------|-----------------------------|-------------|------------------------|------------|
| ** **                                                                           | ** ** | **September 30, 2009** | ** **  | **June 30, 2009** | ** ** |
| **ASSETS**                                                                           |       |                        |        |                   |       |
| Current Assets                                                                       |       |                        |        |                   |       |
| Cash and cash  equivalents                                                           |       | $                           | 23,611,254  |                   | $          | 25,832,456 |   |
| Investment securities -  available for sale                                          |       | 747,448                     |        | 347,921                |       |
| Trade accounts  receivable (net of allowance of $132,000 and $132,000, respectively) |       | 30,891,483                  |        | 29,945,748             |       |
| Inventories, net                                                                     |       | 17,010,224                  |        | 16,195,361             |       |
| Interest receivable                                                                  |       | 92,770                      |        | 90,425                 |       |
| Deferred tax assets                                                                  |       | 4,346,311                   |        | 4,296,929              |       |
| Other current assets                                                                 |       | 541,848                     |        | 602,335                |       |
| **Total  Current Assets**                                                            |       | 77,241,338                  |        | 77,311,175             |       |
|                                                                                 |       |                        |        |                   |       |
| Property, plant and  equipment                                                       |       | 41,771,570                  |        | 41,431,158             |       |
| Less accumulated  depreciation                                                       |       | (19,242,024                 | )           | (18,533,773            | )          |
|                                                                                 |       | 22,529,546                  |        | 22,897,385             |       |
|                                                                                 |       |                        |        |                   |       |
| Construction in  progress                                                            |       | 1,318,534                   |        | 591,685                |       |
| Investment securities -  available for sale                                          |       | 398,470                     |        | 801,748                |       |
| Intangible assets  (product rights) - net of accumulated amortization                |       | 9,160,357                   |        | 9,118,710              |       |
| Deferred tax assets                                                                  |       | 13,321,236                  |        | 13,757,545             |       |
| Other assets                                                                         |       | 89,846                      |        | 98,873                 |       |
| **Total  Assets**                                                                    |       | $                           | 124,059,327 |                   | $          | 124,577,121 |   |
|                                                                                 |       |                        |        |                   |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                       |       |                        |        |                   |       |
| **LIABILITIES**                                                                      |       |                        |        |                   |       |
| Current Liabilities                                                                  |       |                        |        |                   |       |
| Accounts payable                                                                     |       | $                           | 15,649,685  |                   | $          | 16,805,468 |   |
| Accrued expenses                                                                     |       | 2,132,314                   |        | 1,842,434              |       |
| Accrued payroll and  payroll related                                                 |       | 2,954,609                   |        | 5,150,104              |       |
| Income taxes payable                                                                 |       | 1,224,663                   |        | 711,073                |       |
| Current portion of  long-term debt                                                   |       | 357,806                     |        | 435,386                |       |
| Rebates, chargebacks  and returns payable                                            |       | 12,656,106                  |        | 13,734,540             |       |
| **Total  Current Liabilities**                                                       |       | 34,975,183                  |        | 38,679,005             |       |
|                                                                                 |       |                        |        |                   |       |
| Long-term debt, less  current portion                                                |       | 7,644,677                   |        | 7,703,382              |       |
| Unearned grant funds                                                                 |       | 500,000                     |        | 500,000                |       |
| Other long-term  liabilities                                                         |       | 11,693                      |        | 47,111                 |       |
| **Total  Liabilities**                                                               |       | 43,131,553                  |        | 46,929,498             |       |
| Commitment and  Contingencies, See notes 10 and 11                                   |       |                        |        |                   |       |
|                                                                                 |       |                        |        |                   |       |
| **SHAREHOLDERS’  EQUITY**                                                       |       |                        |        |                   |       |
| Common stock -  authorized 50,000,000 shares, par value $0.001;                      |       |                        |        |                   |       |
| issued and outstanding,  24,587,281 and 24,517,696 shares, respectively              |       | 24,587                      |        | 24,518                 |       |
| Additional paid in  capital                                                          |       | 76,733,498                  |        | 76,250,309             |       |
| Retained earnings                                                                    |       | 4,600,935                   |        | 1,743,565              |       |
| Noncontrolling interest                                                              |       | 104,548                     |        | 93,654                 |       |
| Accumulated other comprehensive  income                                              |       | 22,500                      |        | 24,751                 |       |
|                                                                                 |       | 81,486,068                  |        | 78,136,797             |       |
| Less: Treasury stock at  cost - 90,160 and 82,228 shares, respectively               |       | (558,294                    | )           | (489,174               | )          |
| **TOTAL  SHAREHOLDERS’ EQUITY**                                                 |       | 80,927,774                  |        | 77,647,623             |       |
|                                                                                 |       |                        |        |                   |       |
| **TOTAL  LIABILITIES AND SHAREHOLDERS’ EQUITY**                                 |       | $                           | 124,059,327 |                   | $          | 124,577,121 |   |

 

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

 

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**LANNETT COMPANY, INC. ANDSUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF OPERATIONS(UNAUDITED)**

 
| ** **                                                    | ** ** | **Three months ended   September  30,** | ** ** |
|---------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                    | ** ** | **2009**                                     | ** ** | **2008** | ** ** |
| ** **                                                    | ** ** | ** **                                   | ** ** | ** ** | ** ** |
| Net sales                                                     |       | $                                            | 31,434,989 |   | $ | 25,567,653 |   |
| Cost of sales                                                 |       | 19,012,318                                   |       | 16,120,195 |   |
| Amortization of  intangible assets                            |       | 448,667                                      |       | 446,166 |   |
| Product royalties                                             |       | 439,774                                      |       | — |   |
|                                                          |       |                                         |       |   |   |
| Gross profit                                                  |       | 11,534,230                                   |       | 9,001,292 |   |
|                                                          |       |                                         |       |   |   |
| Research and  development expenses                            |       | 3,027,841                                    |       | 1,863,113 |   |
| Selling, general, and  administrative expenses                |       | 3,763,161                                    |       | 4,949,144 |   |
| Loss on sale of  investments                                  |       | —                                       |       | 4,931 |   |
|                                                          |       |                                         |       |   |   |
| Operating income                                              |       | 4,743,228                                    |       | 2,184,104 |   |
|                                                          |       |                                         |       |   |   |
| Interest income                                               |       | 23,099                                       |       | 45,767 |   |
| Interest expense                                              |       | (70,413                                      | )          | (66,209 | ) |
|                                                          |       | (47,314                                      | )          | (20,442 | ) |
|                                                          |       |                                         |       |   |   |
| Income before income  tax expense                             |       | 4,695,914                                    |       | 2,163,662 |   |
| Income tax expense                                            |       | 1,827,650                                    |       | 919,990 |   |
| Consolidated net income                                       |       | 2,868,264                                    |       | 1,243,672 |   |
| Less net income from  noncontrolling interest                 |       | (10,894                                      | )          | (17,507 | ) |
|                                                          |       |                                         |       |   |   |
| Net income attributable  to Lannett Company, Inc.        |       | $                                            | 2,857,370  |   | $ | 1,226,165 |   |
|                                                          |       |                                         |       |   |   |
| Basic income per common  share - Lannett Company, Inc.   |       | $                                            | 0.12       |   | $ | 0.05 |   |
| Diluted income per  common share - Lannett Company, Inc. |       | $                                            | 0.11       |   | $ | 0.05 |   |
|                                                          |       |                                         |       |   |   |
| Basic weighted average  number of shares                      |       | 24,533,562                                   |       | 24,306,488 |   |
| Diluted weighted  average number of shares                    |       | 25,054,661                                   |       | 24,382,951 |   |

 

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

 

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**LANNETTCOMPANY, INC. AND SUBSIDIARIES**

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

(UNAUDITED)

 
| ** **                                                     | ** ** | **Common  Stock** | ** ** | **Additional** | ** ** | ** **  | ** ** | ** **   | ** ** | ** **   | ** ** | **Accum.  Other**  | ** ** | ** **         | ** ** |
|----------------------------------------------------------------|------------|-------------------|------------|----------------|------------|-------------|------------|--------------|------------|--------------|------------|--------------------|------------|--------------------|------------|
| ** **                                                     | ** ** | **Shares**        | ** ** | ** **     | ** ** | **Paid-in** | ** ** | **Retained** | ** ** | **Treasury** | ** ** | **Noncontrolling** | ** ** | **Comprehensive**  | ** ** | **Shareholders’** | ** ** |
| ** **                                                     | ** ** | **Issued**        | ** ** | **Amount**     | ** ** | **Capital** | ** ** | **Earnings** | ** ** | **Stock**    | ** ** | **Interest**       | ** ** | **Income  (loss)** | ** ** | **Equity** | ** ** |
|                                                           |       |              |       |           |       |        |       |         |       |         |       |               |       |               |       |   |   |
| **Balance,  June  30, 2009**                              |       | 24,517,696        |       | $              | 24,518     |        | $          | 76,250,309   |       | $            | 1,743,565  |               | $          | (489,174           | )          | $ | 93,654 |   | $ | 24,751 |   | $ | 77,647,623 |   |
|                                                           |       |              |       |           |       |        |       |         |       |         |       |               |       |               |       |   |   |
| Exercise of stock  options                                     |       | 36,100            |       | 36             |       | 152,650     |       | —       |       | —       |       | —             |       | —             |       | 152,686 |   |
| Shares issued in  connection with employee stock purchase plan |       | 7,985             |       | 8              |       | 33,249      |       | —       |       | —       |       | —             |       | —             |       | 33,257 |   |
| Share based compensation                                       |       |              |       |           |       |        |       |         |       |         |       |               |       |               |       |   |   |
| Restricted stock                                               |       | —            |       | —         |       | 43,007      |       | —       |       | —       |       | —             |       | —             |       | 43,007 |   |
| Stock options                                                  |       | —            |       | —         |       | 232,868     |       | —       |       | —       |       | —             |       | —             |       | 232,868 |   |
| Employee stock purchase  plan                                  |       | —            |       | —         |       | 21,440      |       | —       |       | —       |       | —             |       | —             |       | 21,440 |   |
| Shares issued in  connection with restricted stock grant       |       | 25,500            |       | 25             |       | (25         | )          | —       |       | —       |       | —             |       | —             |       | — |   |
| Purchase of treasury  stock                                    |       | —            |       | —         |       | —      |       | —       |       | (69,120      | )          | —             |       | —             |       | (69,120 | ) |
| Income from  noncontrolling interest                           |       | —            |       | —         |       | —      |       | —       |       | —       |       | 10,894             |       | —             |       | 10,894 |   |
| Other comprehensive  loss, net of income tax                   |       | —            |       | —         |       | —      |       | —       |       | —       |       | —             |       | (2,251             | )          | (2,251 | ) |
| Net income                                                     |       | —            |       | —         |       | —      |       | 2,857,370    |       | —       |       | —             |       | —             |       | 2,857,370 |   |
|                                                           |       |              |       |           |       |        |       |         |       |         |       |               |       |               |       |   |   |
| **Balance,  September 30, 2009**                          |       | 24,587,281        |       | $              | 24,587     |        | $          | 76,733,498   |       | $            | 4,600,935  |               | $          | (558,294           | )          | $ | 104,548 |   | $ | 22,500 |   | $ | 80,927,774 |   |

 

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

 

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**LANNETTCOMPANY, INC. AND SUBSIDIARIES**

 

### **CONSOLIDATED STATEMENTS OF CASH FLOWS**

(UNAUDITED)

 
| ** **                                                                                  | ** ** | **For the three months ended September 30,** | ** ** |
|---------------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                  | ** ** | **2009**                                          | ** ** | **2008** | ** ** |
|                                                                                        |       |                                              |       |   |   |
| OPERATING ACTIVITIES:                                                                       |       |                                              |       |   |   |
| Net income - Lannett  Company, Inc.                                                    |       | $                                                 | 2,857,370  |   | $ | 1,226,165 |   |
| Adjustments to  reconcile net income tonet cash (used in) provided by operating activities: |       |                                              |       |   |   |
| Depreciation and  amortization                                                              |       | 1,166,604                                         |       | 1,283,617 |   |
| Deferred tax expense                                                                        |       | 388,427                                           |       | 911,872 |   |
| Stock compensation  expense                                                                 |       | 297,315                                           |       | 389,797 |   |
| Other noncash (income)  expenses                                                            |       | (26,391                                           | )          | 1,949 |   |
| Income from  noncontrolling interest                                                        |       | 10,894                                            |       | 17,506 |   |
| Changes in assets and  liabilities which provided (used) cash:                              |       |                                              |       |   |   |
| Trade accounts  receivable                                                                  |       | (1,152,466                                        | )          | 5,341,230 |   |
| Inventories                                                                                 |       | (814,863                                          | )          | 294,571 |   |
| Prepaid and income  taxes payable                                                           |       | 513,590                                           |       | 784,009 |   |
| Prepaid expenses and  other assets                                                          |       | 58,142                                            |       | (106,188 | ) |
| Accounts payable                                                                            |       | (1,155,783                                        | )          | (1,259,114 | ) |
| Accrued expenses                                                                            |       | 289,880                                           |       | 157,703 |   |
| Rebates, chargebacks  and returns payable                                                   |       | (871,703                                          | )          | 20,132 |   |
| Accrued payroll and  payroll related                                                        |       | (2,195,495                                        | )          | 398,639 |   |
| Deferred revenue                                                                            |       | —                                            |       | (258,283 | ) |
| Net cash (used in)  provided by operating activities                                        |       | (634,479                                          | )          | 9,203,605 |   |
|                                                                                        |       |                                              |       |   |   |
| INVESTING ACTIVITIES:                                                                       |       |                                              |       |   |   |
| Purchases of property,  plant and equipment (including construction in progress)            |       | (1,067,261                                        | )          | (209,210 | ) |
| Purchase of intangible  asset (product rights)                                              |       | (500,000                                          | )          | — |   |
| Proceeds from sale of  investment securities - available for sale                           |       | —                                            |       | 316,099 |   |
| Purchase of investment  securities - available for sale                                     |       | —                                            |       | (298,528 | ) |
| Net cash used in  investing activities                                                      |       | (1,567,261                                        | )          | (191,639 | ) |
|                                                                                        |       |                                              |       |   |   |
| FINANCING ACTIVITIES:                                                                       |       |                                              |       |   |   |
| Repayments of debt                                                                          |       | (136,285                                          | )          | (147,583 | ) |
| Proceeds from issuance  of stock                                                            |       | 185,943                                           |       | 31,281 |   |
| Purchase of treasury  stock                                                                 |       | (69,120                                           | )          | (19,950 | ) |
| Net cash used in  financing activities                                                      |       | (19,462                                           | )          | (136,252 | ) |
|                                                                                        |       |                                              |       |   |   |
| NET (DECREASE) INCREASE  IN CASH AND CASH EQUIVALENTS                                       |       | (2,221,202                                        | )          | 8,875,714 |   |
|                                                                                        |       |                                              |       |   |   |
| CASH AND CASH  EQUIVLAENTS, BEGINNING OF PERIOD                                             |       | 25,832,456                                        |       | 6,256,712 |   |
|                                                                                        |       |                                              |       |   |   |
| CASH AND CASH  EQUIVALENTS, END OF PERIOD                                                   |       | $                                                 | 23,611,254 |   | $ | 15,132,426 |   |
|                                                                                        |       |                                              |       |   |   |
| SUPPLEMENTAL DISCLOSURE  OF CASH FLOW INFORMATION -                                         |       |                                              |       |   |   |
| Interest paid                                                                               |       | $                                                 | 41,762     |   | $ | 64,852 |   |
| Income taxes paid                                                                           |       | $                                                 | 925,633    |   | $ | 250,000 |   |
| Lannett stock issued -  contingent consideration - Cody Labs acquistion                     |       | $                                                 | —     |   | $ | 430,500 |   |

 

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

 

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**LANNETT COMPANY, INC.  AND SUBSIDIARIES**

 

### **NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -UNAUDITED**

 

**Note 1.  Interim FinancialInformation**

 

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

 

**Note2.  Summary of Significant AccountingPolicies**

 

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.  As applicableto these consolidated financial statements, the most significant estimates andassumptions relate to sales reserves and allowances, income taxes, inventories,contingencies and valuation of intangible assets.

 

***Principles of Consolidation***- The consolidatedfinancial statements include the accounts of the operating parent company,Lannett Company, Inc., and its wholly owned subsidiaries, Lannett Holdings, Inc.and Cody Laboratories, Inc. (“Cody”). Cody includes the consolidation of Cody LCI Realty, LLC, a variableinterest entity.  See Note 16 regarding the consolidation of this variableinterest entity.  All intercompanyaccounts and transactions have been eliminated.

 

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

 

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

 

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

 

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

 

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

 

***Returns —*** Consistent with industry practice, theCompany has a product returns policy that allows customers to return productwithin a specified period prior to and subsequent to the product’s lotexpiration date in exchange for a credit to be applied to futurepurchases.  The Company’s policy requiresthat the customer obtain pre-approval from the Company for any qualifyingreturn.  The Company estimates itsprovision for returns based on historical experience, changes to businesspractices, and credit terms.  While suchexperience has allowed for reasonable estimations in the past, history may notalways be an accurate indicator of future returns.  The Company continually monitors theprovisions for returns and makes adjustments when management believes thatactual product returns may differ from established reserves.  Generally, the reserve for returns increasesas net sales increase.  The reserve forreturns is included in the rebates, chargebacks and returns payable account onthe balance sheet.

 

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***Other Adjustments —*** Otheradjustments consist primarily of price adjustments, also known as “shelf stockadjustments,” which are credits issued to reflect decreases in the sellingprices of the Company’s products that customers have remaining in theirinventories at the time of the price reduction. Decreases in selling prices are discretionary decisions made by managementto reflect competitive market conditions. Amounts recorded for estimated shelf stock adjustments are based uponspecified terms with direct customers, estimated declines in market prices, andestimates of inventory held by customers. The Company regularly monitors these and other factors and evaluates thereserve as additional information becomes available.  Other adjustments are included in the rebatesand chargebacks payable account on the balance sheet.

 

The following tables identify the reserves for each major category ofrevenue allowance and a summary of the activity for the three months ended September 30,2009 and 2008:

 

**For thethree months ended September 30, 2009**

 
| **Reserve Category**                                                                       | ** ** | **Chargebacks** | ** **      | **Rebates** | ** ** | **Returns**     | ** ** | **Other** | ** **      | **Total**  | ** ** |
|--------------------------------------------------------------------------------------------|------------|-----------------|-----------------|-------------|------------|-----------------|------------|-----------|-----------------|------------|------------|
|                                                                                       |       |            |            |        |       |            |       |      |            |       |       |
| Reserve Balance as of  June 30, 2009                                                  |       | $               |  6,089,802 |        | $          |  2,537,746 |       | $         |  5,106,992 |       | $          |  — |   | $ |  13,734,540 |   |
| Actual credits issued  related to sales recorded in prior fiscal years                     |       | (4,767,581      | )               | (1,852,708  | )          | (1,147,720      | )          | —    |            | (7,768,009 | )          |
| Reserves or (reversals)  charged during Fiscal 2010 related to sales in prior fiscal years |       | —          |            | —      |       | —          |       | —    |            | —     |       |
| Reserves charged to net  sales during Fiscal 2010 related to sales recorded in Fiscal 2010 |       | 10,272,936      |            | 4,066,855   |       | 1,140,128       |       | 407,784   |            | 15,887,703 |       |
| Actual credits issued  related to sales recorded in Fiscal 2010                            |       | (7,000,389      | )               | (1,789,955  | )          | —          |       | (407,784  | )               | (9,198,128 | )          |
| Reserve Balance as of  September 30, 2009                                             |       | $               |  4,594,768 |        | $          |  2,961,938 |       | $         |  5,099,400 |       | $          |  — |   | $ |  12,656,106 |   |

 

**For thethree months ended September 30, 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                     |       | (2,865,229      | )               | (255,126    | )          | (6,425,413      | )          | —    |             | (9,545,768 | )          |
| 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 |       | 9,144,349       |            | 2,949,913   |       | 1,142,474       |       | 42,957    |             | 13,279,693 |       |
| Actual credits issued  related to sales recorded in Fiscal 2009                            |       | (5,129,939      | )               | (1,537,556  | )          | —          |       | (40,096   | )                | (6,707,591 | )          |
| Reserve Balance as of  September 30, 2008                                             |       | $               |  5,198,588 |        | $          |  1,789,545 |       | $         |  8,361,757  |       | $          |  2,861 |   | $ |  15,352,751 |   |

 

The total reserve for chargebacks, rebates, returns and otheradjustments decreased from $13,734,540 at June 30, 2009 to $12,656,106 at September 30,2009.   As of September 30, 2009 approximately $9,924,000of the original $10,545,000 return reserve recorded in Fiscal 2008 for PrenatalMultivitamin was applied to accounts receivable for customers who had returnedthe Prenatal Multivitamin product by that date, leaving a balance ofapproximately $621,000 of Multivitamin returns reserve on the consolidatedbalance sheet at September 30, 2009. The decrease in chargeback reservesbetween June 30, 2009 and September 30, 2009 was due primarily to adecrease in inventory levels at wholesaler distribution centers.

 

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The Company ships its products to the warehouses of its wholesale andretail chain customers.  When the Company and a customer enter into anagreement for the supply of a product, the customer will generally continue topurchase the product, stock its warehouse(s), and resell the product to its owncustomers.  The Company’s customer will reorder the product as itswarehouse is depleted.  The Company generally has no minimum size ordersfor its customers.  Additionally, most warehousing customers prefer not tostock excess inventory levels due to the additional carrying costs andinefficiencies created by holding excess inventory.  As such, the Company’scustomers continually reorder the Company’s products.  It is common forthe Company’s customers to order the same products on a monthly basis. For generic pharmaceutical manufacturers, it is critical to ensure thatcustomers’ warehouses are adequately stocked with its products.  This isimportant due to the fact that several generic competitors compete for theconsumer demand for a given product.  Availability of inventory ensuresthat a manufacturer’s product is considered.  Otherwise, retailprescriptions would be filled with competitors’ products.  For thisreason, the Company periodically offers incentives to its customers to purchaseits products.  These incentives are generally up-front discounts off itsstandard prices at the beginning of a generic campaign launch for anewly-approved or newly-introduced product, or when a customer purchases aLannett product for the first time.  Customers generally inform theCompany that such purchases represent an estimate of expected resale for aperiod of time.  This period of time is generally up to threemonths.  The Company records this revenue, net of any discounts offeredand accepted by its customers at the time of shipment.  The Company’sproducts have either 24 months or 36 months of shelf-life at the time ofmanufacture.  The Company monitors its customers’ purchasing trends toattempt to identify any significant lapses in purchasing activity.  If theCompany observes a lack of recent activity, inquiries will be made to suchcustomer regarding the success of the customer’s resale efforts.  TheCompany attempts to minimize any potential return (or shelf life issues) bymaintaining an active dialogue with the customers.

 

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

 

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

 

***Accounts Receivable*** - The Company performsongoing credit evaluations of its customers and adjusts credit limits basedupon payment history and the customer’s current credit worthiness, asdetermined by a review of current credit information. The Company continuouslymonitors collections and payments from its customers and maintains a provisionfor estimated credit losses based upon historical experience and any specificcustomer collection issues that have been identified. While such credit losseshave historically been within both the Company’s expectations and the provisionsestablished, the Company cannot guarantee that it will continue to experiencethe same credit loss rates that it has in the past.

 

***Fair Value of FinancialInstruments*** - The Company’s financial instruments consistprimarily of cash and cash equivalents, accounts receivable, accounts payable,accrued expenses and debt obligations. The carrying values of these assets andliabilities approximate fair value based upon the short-term nature of theseinstruments.  The 

 

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Company has estimated thatthe fair value of long-term debt associated with the 20 year mortgage on itsland and building in Cody, Wyoming approximates the discounted amount of futurepayments to the mortgage-holder.

 

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

 

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

 

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

 

***Intangible Assets***— In March 2004,****the Company entered into an agreement with Jerome StevensPharmaceuticals, Inc. (JSP) for the exclusive marketing and distributionrights in the United States to the current line of JSP products in exchange forfour million (4,000,000) shares of the Company’s common stock.  As a result of the JSP agreement, the Companyrecorded an intangible asset of $67,040,000 for the exclusive marketing anddistribution rights obtained from JSP. The intangible asset was recorded based upon the fair value of the fourmillion (4,000,000) shares at the time of issuance to JSP.   During the quarter ended March 31,2005, the Company recorded a non-cash impairment loss of approximately$46,093,000 to reduce the carrying value of the intangible asset to its fairvalue of approximately $16,062,000 as of the date of the impairment.  As of September 30, 2009 and June 30,2009, management concluded the carrying value of the intangible asset was lessthan its fair value and, therefore, no further impairment was required.  The Company will incur annual amortizationexpense of approximately $1,785,000 for the JSP intangible asset over theremaining term of the agreement.

 

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

 

In January 2005, Lannett Holdings, Inc. 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 May 2008, the Company and Pharmeral waived their rights to anyroyalty payments on the sales of the drug by Lannett, under Lannett’s currentownership structure.  Should Lannettundergo a change in control transaction with a third party, this royalty willbe reinstated.  In Fiscal 2008, theCompany obtained FDA approval to use these proprietary rights.  Accordingly, the Company originallycapitalized these purchased product rights as an indefinite lived intangibleasset and tested this asset for impairment at least on an annual basis.  During the fourth quarter of fiscal 2009, itwas determined that this intangible asset no longer has an indefinitelife.  No impairment 

 

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existed because the estimated fair value exceeded thecarrying amount on that date. Accordingly, the $100,000 carrying amount of thisintangible asset is being amortized on a straight line basis prospectively overits 10 year remaining estimated useful life.

 

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

 

Forthe three months ended September 30, 2009 and 2008, the Company incurredamortization expense of approximately $458,000 and $446,000, respectively. Asof September 30, 2009 and June 30, 2009, accumulated amortizationtotaled approximately $8,083,000 and $7,624,000, respectively.

 

Futureannual amortization expense consists of the following as of September 30,2009:

 
| **Fiscal Year Ending  June 30,** | ** ** | **Annual Amortization  Expense** | ** ** |
|---------------------------------------|------------|----------------------------------|------------|
| 2010                                  |       | $                                | 1,375,059  |   |
| 2011                                  |       | 1,833,412                        |       |
| 2012                                  |       | 1,833,412                        |       |
| 2013                                  |       | 1,833,412                        |       |
| 2014                                  |       | 1,387,245                        |       |
| Thereafter                            |       | 397,817                          |       |
|                                  |       | $                                | 8,660,357  |   |

 

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

 

***Advertising Costs*** - The Company chargesadvertising costs to operations as incurred. Advertising expense for the three months ended September 30, 2009and 2008 was approximately $10,000 and $13,000, respectively.

 

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

 

***Segment Information***- The Companyoperates one business segment - generic pharmaceuticals; accordingly theCompany has one reporting segment.  TheCompany aggregates its financial information for all products and reports asone operating segment.  The followingtable identifies the Company’s approximate net product sales by medicalindication for the three months ended September 30, 2009 and 2008:

 

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| ** **             | ** ** | **For the Three Months Ended  September 30,** | ** **       |
|------------------------|------------|----------------------------------------------------|------------------|
| **Medical Indication** | ** ** | **2009**                                           | ** **       | **2008** | ** ** |
|                   |       |                                               |             |   |   |
| Migraine Headache      |       | $                                                  |  2,663,000  |   | $ |  2,319,000 |   |
| Epilepsy               |       | 611,000                                            |             | 680,000 |   |
| Prescription Vitamin   |       | 1,489,000                                          |             | — |   |
| Heart Failure          |       | 4,852,000                                          |             | 6,348,000 |   |
| Thyroid Deficiency     |       | 13,024,000                                         |             | 11,466,000 |   |
| Antibiotic             |       | 1,661,000                                          |             | 1,496,000 |   |
| Pain Management        |       | 2,880,000                                          |             | 276,000 |   |
| Other                  |       | 4,255,000                                          |             | 2,983,000 |   |
|                   |       |                                               |             |   |   |
| Total                  |       | $                                                  |  31,435,000 |   | $ |  25,568,000 |   |

 

***Concentration of Market and Credit Risk*** - Five of theCompany’s products, defined as generics containing the same active ingredientor combination of ingredients, accounted for approximately 41%, 15%, 9%, 8% and5%, respectively of net sales for the three months ended September 30,2009.  Those same products accounted for45%, 25%, 1%, 9% and 0% respectively, of net sales for the three months ended September 30,2008.

 

Fourof the Company’s customers accounted for 26%, 14%, 9%, and 8%, respectively, ofnet sales for the three months ended September 30, 2009, and 29%, 5%, 3%,and 8%, respectively, of net sales for the three months ended September 30,2008.  At September 30, 2009, thesefour customers accounted for 60% of the Company’s accounts receivablebalances.  At June 30, 2009, thesefour customers accounted for 54% of the Company’s accounts receivable balances.

 

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

 

AtSeptember 30, 2009, the Company had three stock-based employeecompensation plans (the “Old Plan,” the “2003 Plan,” and the Long-termIncentive Plan, or “LTIP”).

 

Duringthe three months ended September 30, 2008, the Company awarded 30,000shares of restricted stock under the LTIP which vested immediately.  Stock compensation expense of $101,400 wasrecognized during the three months ended September 30, 2008, related tothese shares of restricted stock.

 

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

 

TheCompany measures the fair value of share-based compensation cost for optionsusing the Black-Scholes option pricing model. The following table presents the weighted average assumptions used toestimate fair values of the stock options granted and the estimated forfeiturerates during the three months ended September 30:

 

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| ** **                                    | ** ** | **Incentive Stock  Options** | ** ** | **Non-qualified  Stock Options** | ** ** | **Incentive Stock  Options** | ** ** | **Non-qualified  Stock Options** | ** ** |
|-----------------------------------------------|------------|------------------------------|------------|----------------------------------|------------|------------------------------|------------|----------------------------------|------------|
| ** **                                    | ** ** | **FY 2010**                  | ** ** | **FY 2010**                      | ** ** | **FY 2009**                  | ** ** | **FY 2009**                      | ** ** |
| Risk-free  interest rate                      |       | 2.4                          | %          | —                           | %          | 2.5                          | %          | 2.5                              | %          |
| Expected  volatility                          |       | 67.1                         | %          | —                           | %          | 56.5                         | %          | 56.5                             | %          |
| Expected  dividend yield                      |       | 0.0                          | %          | —                           | %          | 0.0                          | %          | 0.0                              | %          |
| Forfeiture  rate                              |       | 5.0                          | %          | —                           | %          | 5.0                          | %          | 5.0                              | %          |
| Expected  term                                |       | 5.0 years                    |       | n/a                              |       | 5.0 years                    |       | 5.0 years                        |       |
| Weighted  average fair value at date of grant |       | $                            | 4.86       |                             | $          | —                       |       | $                                | 1.41       |   | $ | 1.41 |   |
|                                               |            |                              |            |                                  |            |                              |            |                                  |            |  |  |  |  |

 

Therewere no options issued under the LTIP during the three months ended September 30,2009.  Approximately 100,000 options wereissued under the LTIP during the three months ended September 30,2008.  There were 36,100 and zero sharesunder option that were exercised in the three months ended September 30,2009 and 2008, respectively.  At September 30,2009, there were 1,563,181 options outstanding. Of those, 571,800 were options issued under the LTIP, 780,148 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 20,490 sharesunder option having already been exercised under that plan.  2,500,000 shares were authorized to be issuedunder the LTIP, with 34,100 shares under option having already been exercisedunder that plan.

 

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

 

Theforfeiture rate assumption is the estimated annual rate at which unvestedawards are expected to be forfeited during the vesting period. This assumptionis based on our historical forfeiture rate. Periodically, management willassess whether it is necessary to adjust the estimated rate to reflect changesin actual forfeitures or changes in expectations. For example, adjustments maybe needed if forfeitures were affected by turnover that resulted from abusiness restructuring that is not expected to recur.  The Company will incur additional expense ifthe actual forfeiture rate is lower than originally estimated. A recovery ofprior expense will be recorded if the actual rate is higher than originallyestimated.

 

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

 
| ** **                     | ** ** | **Three  Months Ended********September 30,** | ** ** |
|--------------------------------|------------|---------------------------------------------------|------------|
| ** **                     | ** ** | **2009**                                          | ** ** | **2008** | ** ** |
|                           |       |                                              |       |   |   |
| Share  based compensation      |       |                                              |       |   |   |
| Stock  options                 |       | $                                                 | 232,868    |   | $ | 218,799 |   |
| Employee  stock purchase plan  |       | 21,440                                            |       | 26,591 |   |
| Restricted  stock              |       | 43,007                                            |       | 144,407 |   |
| Tax  benefit at effective rate |       | 27,604                                            |       | 22,180 |   |
|                                |            |                                                   |            |  |  |  |  |

 

Optionsoutstanding that have vested and are expected to vest as of September 30,2009 are as follows:

 

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| ** **                        | ** ** | **Awards** | ** ** | **Weighted -  Average  Exercise  Price** | ** ** | **Aggregate  Intrinsic  Value** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** |
|-----------------------------------|------------|------------|------------|------------------------------------------|------------|---------------------------------|------------|-----------------------------------------------------|------------|
| Options vested                    |       | 1,149,641  |       | $                                        | 8.73       |                            | $          | 1,575,149                                           |       | 5.7 |   |
| Options expected to vest          |       | 392,863    |       | $                                        | 4.62       |                            | $          | 1,143,046                                           |       | 8.5 |   |
| Total vested and expected to vest |       | 1,542,504  |       | $                                        | 7.68       |                            | $          | 2,718,195                                           |       | 6.4 |   |

 

Asummary of nonvested restricted stock award activity as of September 30,2009 and changes during the three months then ended, is presented below:

 
| ** **                           | ** ** | **Awards** | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------------|------------|------------|------------|-----------------------------------------------|------------|------------|------------|------------|------------|
| Nonvested at July 1, 2009       |       | 77,198     |       | $                                             | 311,108    |       | ** ** | ** ** | ** ** | ** ** |
| Granted                              |       | —     |       | —                                        |       | ** ** | ** ** | ** ** | ** ** |
| Vested                               |       | (25,500    | )          | (102,765                                      | )          | ** ** | ** ** | ** ** | ** ** |
| Forfeited                            |       | (6,200     | )          | (24,986                                       | )          | ** ** | ** ** | ** ** | ** ** |
| Nonvested at September 30, 2009 |       | 45,498     |       | $                                             | 183,357    |       | ** ** | ** ** | ** ** | ** ** |

 

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Asummary of award activity under the Plans as of September 30, 2009 and2008, and changes during the three months then ended, is presented below:

 
| ** **                                                 | ** ** | **Incentive  Stock Options** | ** ** | **Nonqualified  Stock Options** | ** ** |
|------------------------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **                                                 | ** ** | ** **                   | ** ** | ** **                      | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                                                 | ** ** | ** **                   | ** ** | **Weighted-**                   | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | **Weighted-** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                                 | ** ** | ** **                   | ** ** | **Average**                     | ** ** | **Aggregate** | ** ** | **Remaining** | ** ** | ** ** | ** ** | **Average** | ** ** | **Aggregate** | ** ** | **Remaining** | ** ** |
| ** **                                                 | ** ** | ** **                   | ** ** | **Exercise**                    | ** ** | **Intrinsic** | ** ** | **Contractual** | ** ** | ** ** | ** ** | **Exercise** | ** ** | **Intrinsic** | ** ** | **Contractual** | ** ** |
| ** **                                                 | ** ** | **Awards**                   | ** ** | **Price**                       | ** ** | **Value** | ** ** | **Life** | ** ** | **Awards** | ** ** | **Price** | ** ** | **Value** | ** ** | **Life** | ** ** |
|                                                       |       |                         |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Outstanding at  July 1, 2009                          |       | 958,909                      |       | $                               | 5.60       |   |   |   |   |   | 626,772 |   | $ | 10.52 |   |   |   |   |   |
| Granted                                                    |       | 20,000                       |       | $                               | 8.48       |   |   |   |   |   | — |   | $ | — |   |   |   |   |   |
| Exercised                                                  |       | (36,100                      | )          | $                               | 4.23       |   |   |   |   |   | — |   | — |   |   |   |   |   |
| Forfeited, expired or  repurchased                         |       | (6,400                       | )          | $                               | 5.38       |   |   |   |   |   | — |   | $ | — |   |   |   |   |   |
| Outstanding at  September 30, 2009                    |       | 936,409                      |       | $                               | 5.71       |   | $ | 2,217,739 |   | 7.2 |   | 626,772 |   | $ | 10.52 |   | $ | 551,242 |   | 5.3 |   |
|                                                       |       |                         |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Outstanding at  September 30, 2009 and not yet vested |       | 350,474                      |       | $                               | 4.64       |   | $ | 1,015,723 |   | 8.6 |   | 63,067 |   | $ | 4.51 |   | $ | 187,483 |   | 8.1 |   |
| Exercisable at  September 30, 2009                    |       | 585,935                      |       | $                               | 6.36       |   | $ | 1,202,016 |   | 6.3 |   | 563,705 |   | $ | 11.19 |   | $ | 373,133 |   | 4.9 |   |

 
| ** **                                                 | ** ** | **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                                                    |       | 62,002                       |       | $                               | 2.80       |   |   |   |   |   | 37,998 |   | $ | 2.80 |   |   |   |   |   |
| Exercised                                                  |       | —                       |       | —                          |       |   |   |   |   | — |   | — |   |   |   |   |   |
| Forfeited or expired                                       |       | (42,000                      | )          | $                               | 4.89       |   |   |   |   |   | (25,000 | ) | $ | 5.02 |   |   |   |   |   |
| Outstanding at  September 30, 2008                    |       | 1,011,269                    |       | $                               | 5.62       |   | $ | 3,000 |   | 7.9 |   | 716,062 |   | $ | 9.95 |   | — |   | 6.4 |   |
|                                                       |       |                         |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Outstanding at  September 30, 2008 and not yet vested |       | 521,180                      |       | $                               | 4.45       |   | — |   | 8.9 |   | 163,288 |   | $ | 4.75 |   | — |   | 8.8 |   |
| Exercisable at  September 30, 2008                    |       | 490,089                      |       | $                               | 6.86       |   | $ | 3,000 |   | 6.8 |   | 552,774 |   | $ | 11.48 |   | — |   | 5.7 |   |

 

Optionswith a fair value of $421,281 vested during the three months ended September 30,2009.  As of September 30,2009, there was $946,124 of total unrecognized compensation cost related tononvested share-based compensation awards granted under the Plans.  Thatcost is expected to be recognized over a weighted average period of 1.4years. As of September 30, 2008, there was approximately $1,663,000of total unrecognized compensation cost related to nonvested share-basedcompensation awards granted under the Plans. The Company issues new shares when stock options are exercised.

 

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

 

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

 
| ** **                                                        | ** ** | **2009**        | ** ** | **2008**          | ** ** |
|-------------------------------------------------------------------|------------|-----------------|------------|-------------------|------------|
| ** **                                                        | ** ** | **Net  Income** | ** ** | **Shares**        | ** ** | **Net  Loss** | ** ** | **Shares** | ** ** |
| ** **                                                        | ** ** | **(Numerator)** | ** ** | **(Denominator)** | ** ** | **(Numerator)** | ** ** | **(Denominator)** | ** ** |
|                                                              |       |            |       |              |       |   |   |   |   |
| Basic  earnings per share factors                                 |       | $               | 2,857,370  |              | 24,533,562 |   | $ | 1,226,165 |   | 24,306,488 |   |
|                                                              |       |            |       |              |       |   |   |   |   |
| Effect  of potentially dilutive option and restricted stock plans |       | —          |       | 521,099           |       | — |   | 76,463 |   |
|                                                              |       |            |       |              |       |   |   |   |   |
| Diluted  earnings per share factors                               |       | $               | 2,857,370  |              | 25,054,661 |   | $ | 1,226,165 |   | 24,382,951 |   |
|                                                              |       |            |       |              |       |   |   |   |   |
| Basic  earnings per share                                         |       | $               | 0.12       |              |       |   | $ | 0.05 |   |   |   |
| Diluted  earnings per share                                       |       | $               | 0.11       |              |       |   | $ | 0.05 |   |   |   |

 

The number of anti-dilutive shares that have been excluded in thecomputation of diluted earnings per share for the three months ended September 30,2009 and 2008 were 352,845 and 1,807,529, respectively.

 

**Note 3.  New Accounting Standards**

 

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

 

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

 

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In December 2007,the FASB issued authoritative guidance to establish accounting and reportingstandards for the noncontrolling (minority) interest in a subsidiary and forthe deconsolidation of a subsidiary. It clarifies that a noncontrollinginterest in a subsidiary is an ownership interest in the consolidated entitythat should be reported as equity in the consolidated financial statements andestablishes a single method of accounting for changes in a parent’s ownershipinterest in a subsidiary that do not result in deconsolidation. We adopted thisauthoritative guidance effective July 1, 2009. As a result of theadoption, the Company presents noncontrolling interests as a component ofequity on its consolidated balance sheets. Minority interest expense is now shown below net income under theheading “net income from noncontrolling interest”.  Prior year financial statements have beenreclassified to reflect the adoption of this guidance.  The adoption of this guidance did not haveany other significant impact on our consolidated financial statements.

 

In April 2008, theFASB issued authoritative guidance which amends the factors that should beconsidered in developing renewal or extension assumptions used to determine theuseful life of a recognized intangible asset. The guidance is intended toimprove the consistency between the useful life of a recognized intangibleasset and the period of expected cash flows used to measure the fair value ofthe asset. We adopted this authoritative guidance effective July 1,2009.  The adoption of this guidance didnot have a significant impact on our consolidated financial statements.

 

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

 

**Note4.  Inventories**

 

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

 

Inventoriesconsist of the following:

 
| ** **          | ** ** | **September 30, 2009** | ** ** | **June 30, 2009** | ** ** |
|---------------------|------------|-----------------------------|------------|------------------------|------------|
|                |       |                        |       |                   |       |
| Raw  materials      |       | $                           | 5,023,930  |                   | $          | 5,755,982 |   |
| Work-in-process     |       | 3,328,786                   |       | 2,846,600              |       |
| Finished  goods     |       | 7,688,876                   |       | 6,664,193              |       |
| Packaging  supplies |       | 968,632                     |       | 928,586                |       |
|                |       | $                           | 17,010,224 |                   | $          | 16,195,361 |   |

 

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The preceding amounts are net of inventory reserves of $2,792,384 and$2,744,305 at September 30, 2009 and June 30, 2009, respectively.

 

**Note 5.  Property, Plant andEquipment**

** **

Property,plant and equipment are stated at cost. Depreciation is provided for by the straight-line method for financialreporting purposes over the estimated useful lives of the assets.  Depreciation expense for the three monthsended September 30, 2009 and 2008 was approximately $708,000 and $837,000,respectively.

 

Property,plant and equipment consist of the following:

 
| ** **                 | ** ** | ** **       | ** ** | **September 30,** | ** **       | **June 30,** | ** ** |
|----------------------------|------------|------------------|------------|------------------------|------------------|-------------------|------------|
| ** **                 | ** ** | **Useful Lives** | ** ** | **2009**               | ** **       | **2009**          | ** ** |
| Land                       |       | —           |       | $                      | 918,314          |              | $          | 918,314 |   |
| Building  and improvements |       | 10  - 39 years   |       | 17,084,701             |             | 17,048,351        |       |
| Machinery  and equipment   |       | 5  - 10 years    |       | 22,871,684             |             | 22,573,324        |       |
| Furniture  and fixtures    |       | 5  - 7 years     |       | 896,871                |             | 891,169           |       |
|                       |       |             |       |                   |  41,771,570 |              |       | 41,431,158 |   |
| Accumulated  depreciation  |       |             |       | (19,242,024            | )                | (18,533,773       | )          |
|                       |       |             |       | $                      | 22,529,546       |              | $          | 22,897,385 |   |

 

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

 

On July 1,2008, the Company adopted the authoritative guidance which clarifies thedefinition of fair value, establishes a framework for measuring fair value, andexpands the disclosures on fair value measurements. Fair value is defined asthe exchange price that would be received for an asset or paid to transfer aliability (an exit price) in the principal or most advantageous market for theasset or liability in an orderly transaction between market participants on themeasurement date. The authoritative guidance also establishes a fair valuehierarchy which requires an entity to maximize the use of observable inputs andminimize the use of unobservable inputs when measuring fair value. Three levelsof inputs were established that may be used to measure fair value:

 

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

 

Level 2 — Observable inputs other thanLevel 1 prices, such as quoted prices for similar assets or liabilities;quoted prices for identical or similar instruments in markets that are notactive; or model-derived valuations whose inputs are observable or whosesignificant value drivers are observable. The Company’s Level 2 assets andliabilities primarily include debt securities with quoted prices that aretraded less frequently than exchange-traded instruments, corporate bonds,U.S. government and agency securities and certain mortgage-backed andasset-backed securities whose values are determined using pricing models withinputs that are observable in the market or can be derived principally from orcorroborated by observable market data. The fair value of the Company’s available-for-sale securities in thetable below are derived solely from level 2 inputs.

 

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

 

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

 

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

 

**September 30,2009**

**Available-for-Sale**

 
| ** **             | ** ** | **Amortized  Cost** | ** **      | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
|------------------------|------------|---------------------|-----------------|------------------------------|------------|-------------------------------|------------|-----------------|------------|
|                   |       |                |            |                         |       |                          |       |            |       |
| U.S. Government Agency |       | $                   | 928,910         |                         | $          | 35,035                        |       | $               | —     |   | $ | 963,945 |   |
| Corporate Bonds        |       | 179,507             |            | 2,466                        |       | —                        |       | 181,973         |       |
|                   |       | $                   |  1,108,417 |                         | $          | 37,501                        |       | $               | —     |   | $ | 1,145,918 |   |

 

**June 30,2009**

**Available-for-Sale**

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

 

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

 
| ** **                              | ** ** | **September 30,  2009  Available for Sale** | ** ** | **June 30,  2009  Available for Sale** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                              | ** ** | **Amortized**                                    | ** ** | **Fair**                                    | ** ** | **Amortized** | ** ** | **Fair** | ** ** |
| ** **                              | ** ** | **Cost**                                         | ** ** | **Value**                                   | ** ** | **Cost** | ** ** | **Value** | ** ** |
| Due in one year or less                 |       | $                                                | 720,238    |                                        | $          | 747,448 |   | $ | 338,159 |   | $ | 347,921 |   |
| Due after one year  through five years  |       | 388,179                                          |       | 398,470                                     |       | 770,258 |   | 801,748 |   |
| Due after five years  through ten years |       | —                                           |       | —                                      |       | — |   | — |   |
| Due after ten years                     |       | —                                           |       | —                                      |       | — |   | — |   |
|                                    |       |                                             |       |                                        |       |   |   |   |   |
| Total  available-for-sale securities    |       | 1,108,417                                        |       | 1,145,918                                   |       | 1,108,417 |   | 1,149,669 |   |
| Less current portion                    |       | 720,238                                          |       | 747,448                                     |       | 338,159 |   | 347,921 |   |
|                                    |       |                                             |       |                                        |       |   |   |   |   |
| Long term available-for-sale  securites |       | $                                                | 388,179    |                                        | $          | 398,470 |   | $ | 770,258 |   | $ | 801,748 |   |

 

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TheCompany uses the specific identification method to determine the cost ofsecurities sold. For the three months ended September 30, 2009, theCompany had no realized gains or losses, whereas for the three months ended September 30,2008, the Company had realized losses of $4,931.

 

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

 

**Note7. Bank Line of Credit**

** **

The Company has a $3,000,000 line of credit fromWachovia Bank, N.A. (“Wachovia”) that bears interest at the prime interest rateless 0.25% (2.75% and 3.00% at September 30 and June 30, 2009,respectively). As of September 30 and June 30, 2009, the Company had$3,000,000 of availability under this line of credit.  The line of credit is collateralized bysubstantially all of the Company’s assets.  The agreement containscovenants with respect to working capital, net worth and certain ratios, aswell as other covenants.  As of September 30,2009, the Company was in compliance with all 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 annually).  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. Previously, the terms of the existing agreement required the Company to at alltimes maintain deposit balances in excess of $3,500,000 with Wachovia Bank forthe balance of the arrangement.  Additionally, the Company was required topay Wachovia an availability fee equal to 0.50% per annum calculated daily, onthe available but unused balance of the line of credit.

 

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

 

**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 September 30, 2009,the Company has had preliminary discussions with the Commonwealth ofPennsylvania to determine whether it will be required to repay any of the fundsprovided under the grant funding program.  Based on information availableat September 30, 2009, 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 debt consistsof the following:

 
| ** **                                                                 | ** ** | **September 30,** | ** ** | **June 30,** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------|------------|-------------------|------------|
| ** **                                                                 | ** ** | **2009**               | ** ** | **2009**          | ** ** |
| PIDC  Regional Center, LP III loan                                         |       | $                      | 4,500,000  |              | $          | 4,500,000 |   |
| Pennsylvania  Industrial Development Authority loan                        |       | 984,007                |       | 1,002,607         |       |
| Pennsylvania  Department of Community & Economic Development loan |       | 157,243                |       | 182,831           |       |
| Tax-exempt  bond loan (PAID)                                               |       | 680,000                |       | 680,000           |       |
| Equipment  loan                                                            |       | —                 |       | 80,130            |       |
| First  National Bank of Cody mortgage                                      |       | 1,681,233              |       | 1,693,200         |       |
|                                                                       |       |                   |       |              |       |
| Total  debt                                                                |       | 8,002,483              |       | 8,138,768         |       |
| Less  current portion                                                      |       | 357,806                |       | 435,386           |       |
|                                                                       |       |                   |       |              |       |
| Long  term debt                                                            |       | $                      | 7,644,677  |              | $          | 7,703,382 |   |

 
| ** **                                                                 | ** ** | **September 30,** | ** ** | **June 30,** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------|------------|-------------------|------------|
| ** **                                                                 | ** ** | **2009**               | ** ** | **2009**          | ** ** |
| Current  Portion of Long Term Debt                                         |       |                   |       |              |       |
| PIDC  Regional Center, LP III loan                                         |       | $                      | —     |              | $          | — |   |
| Pennsylvania  Industrial Development Authority loan                        |       | 75,580                 |       | 75,017            |       |
| Pennsylvania  Department of Community & Economic Development loan |       | 104,130                |       | 103,100           |       |
| Tax-exempt  bond loan (PAID)                                               |       | 125,000                |       | 125,000           |       |
| Equipment  loan                                                            |       | —                 |       | 80,130            |       |
| First  National Bank of Cody mortgage                                      |       | 53,096                 |       | 52,139            |       |
|                                                                       |       |                   |       |              |       |
| Total  current portion of long term debt                                   |       | $                      | 357,806    |              | $          | 435,386 |   |

 

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

 

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

 

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

 

In April 1999, the Company entered into a loan agreement (the “Agreement”)with a governmental authority, the Philadelphia Authority for IndustrialDevelopment (the “Authority” or “PAID”), to finance future construction andgrowth projects of the Company. The Authority issued $3,700,000 in tax-exemptvariable rate demand and fixed rate revenue bonds to provide the funds tofinance such growth projects pursuant to a trust indenture (“the 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 

 

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bonds bear interest at the floating variable rate determined by theorganization responsible for selling the bonds (the “remarketing agent”). The interest rate fluctuates on a weekly basis.  The effective interestrate at September 30, 2009 and June 30, 2009 was 0.69% and 0.62%,respectively.

 

TheCompany entered into agreements (the “2003 Loan Financing”) with Wachovia tofinance the purchase of the Torresdale Avenue facility, the renovation andsetup of the building, and other anticipated capital expenditures.  TheCompany, as part of the 2003 Loan Financing agreement, is required to makeequal payments of principal and interest.  The only portion of the loanthat remained outstanding at June 30, 2009 was the Equipment Loan, whichhad an outstanding balance of $80,130 at June 30, 2009.  This loanwas fully repaid as of September 30, 2009.

 

TheCompany is required to maintain and comply with a debt service coverage ratioof not less than 2 to 1 (to be measured annually).  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. Previously, the terms of the existing agreement required the Company to at alltimes maintain deposit balances in excess of $3,500,000 with Wachovia Bank forthe balance of the arrangement.  Additionally, the Company was required topay Wachovia an availability fee equal to 0.50% per annum calculated daily, onthe available but unused balance of the line of credit.

 

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

 

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

 

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

 

Long-termdebt amounts due, for the twelve month periods ended September 30 are asfollows:

 
| **Twelve**        | ** ** | **Amounts Payable** | ** **      |
|-------------------|------------|---------------------|-----------------|
| **Month Periods** | ** ** | **to Institutions** | ** **      |
|              |       |                |            |
| 2010              |       | $                   |  357,806   |   |
| 2011              |       | 4,818,102           |            |
| 2012              |       | 274,802             |            |
| 2013              |       | 283,934             |            |
| 2014              |       | 279,293             |            |
| Thereafter        |       | 1,988,546           |            |
|              |       |                |            |
|              |       | $                   |  8,002,483 |   |

 

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**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 amotion for a Temporary Restraining Order (“TRO”) to prevent the Company fromlaunching its Multivitamin with Mineral Capsules (“MMCs”), due to allegedpatent and trademark infringement issues.  The TRO was heard and,ultimately, resulted in a conclusion by the court that the Company’s productlabel on the MMCs should be modified.  KV also countered with claimsof infringement by the Company of KV’s patents seeking the Company’s profitsfor sales of MMCs or other monetary relief, preliminary and permanentinjunctive relief, attorney’s fees and a finding of willful infringement.On March 17, 2009 the Company and KV settled the litigation.  In light of the withdrawal of KV’s innovatorprenatal product, and the resulting anticipated decline in sales and decliningmarket for written prescription, the Company decided it was pointless tocontinue the litigation and entered into the settlement arrangement withKV.  Pursuant to the settlement, theCompany will receive a license from KV and will become an authorized genericprovider.  During the terms of thelicense, the Company will pay KV a royalty on all future sales of its Prenatalvitamin product.  Lannett will ceaseoffering its Prenatal vitamin product if and when the brand is restored to themarketplace.

 

In or about July 2008,Albion International and Albion, Inc. filed suit in the United StatesDistrict Court, District of Utah (Case No. 2:08cv00515) against Lannettasserting claims for patent and trademark infringement, as well as unfaircompetition, arising out of Lannett’s use of product that it purchased fromAlbion and used as an 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 filed an answer to the complaintand counterclaim, asserting, among other things, thatAlbion tortuously interfered with Lannett’s contracts.  Subsequent tothe filing of the answer and counterclaim, Lannett andAlbion reached an agreement in principal to settle the case. Under terms of the settlement, the parties would each dismiss their claims againsteach other and provide releases.  On July 6, 2009, thesettlement agreement was signed and on July 13, 2009 the case wasdismissed.

 

**Note11.   Commitments**

** **

***Leases***

 

**In June 2006, Lannett signed a lease agreement on a66,000 square foot facility located on seven acres in Philadelphia.  The Company purchased this building in October 2009for approximately $3.8 million plus the cost of fit out.  A significant portion of the purchase priceand fit out costs are expected to be financed through a series of loans with abank and a Pennsylvania state run development agency by the third quarter ofFiscal 2010.  This new facility isinitially going to be used for warehouse space with the expectation of makingthis facility the Company’s headquarters and possibly additional manufacturingspace.  The other Philadelphia locationswill continue to be utilized for manufacturing, packaging, and research.**

** **

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

** **

**Rental and lease expense for the three months ended September 30,2009 and 2008 was approximately $82,000 and $110,000, respectively.**

** **

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** **

***Employment Agreements***

 

TheCompany has entered into employment agreements with Arthur P. Bedrosian,President and Chief Executive Officer, Keith R. Ruck, Vice President of Financeand Chief Financial Officer, Kevin Smith, Vice President of Sales andMarketing, William Schreck, Senior Vice President and General Manager, ErnestSabo, Vice President of Regulatory Affairs and Chief Compliance Officer, andStephen Kovary, Vice President of Operations.  Each of the agreementsprovide for an annual base salary and eligibility to receive a bonus.  Thebonus amounts of these executives are determined by the Board ofDirectors.  Additionally, these executives are eligible to receive stockoptions and restricted stock awards, which are granted at the discretion of theBoard of Directors, and in accordance with the Company’s policies regardingstock option and restricted stock grants. Under the agreements, these executive employees may be terminated at anytime with or without cause, or by reason of death or disability.  Incertain termination situations, the Company is liable to pay severancecompensation to these executives of between 18 months and three years.

 

Duringthe third quarter of Fiscal Year 2009, the Company’s former Vice President ofFinance, Treasurer, Secretary and Chief Financial Officer resigned.  As part of his separation agreement, the Companyis obligated to pay to him approximately $670,000 to settle any outstandingobligations from his employment agreement, including any salary, bonus,vacation, stock options and medical benefits. Of this amount, $300,440 was paid in Fiscal 2009 with $165,000designated for the payment of pro rated bonus, and $11,440 was designated forthe payment of accrued but unused paid time off.  As part of the settlement, $124,000 wasdesignated as the portion of the settlement related to the repurchase of hisoutstanding stock options. The Company therefore charged this amount toAdditional Paid in Capital, as it represents the fair value of the optionsrepurchased on the repurchase date. Additional payments totaling approximately $369,000 for severance andbenefits will be paid in Fiscal 2010 and Fiscal 2011 pursuant to the separationagreement.

 

**Note12.  Comprehensive Income**

 

The Company’sother comprehensive income (loss) is comprised of unrealized gains (losses) oninvestment securities classified as available-for-sale.  The components of comprehensive income andrelated taxes consisted of the following as of September 30, 2009 and2008:

 
| ** **                                    | ** ** | **For the Three Months Ended  September 30,** | ** **      |
|-----------------------------------------------|------------|----------------------------------------------------|-----------------|
| ** **                                    | ** ** | **2009**                                           | ** **      | **2008** | ** ** |
|                                          |       |                                               |            |   |   |
| Other  Comprehensive Income (Loss):           |       |                                               |            |   |   |
| Net  Income                                   |       | $                                                  |  2,857,370 |   | $ |  1,226,165 |   |
| Unrealized  Holding (Loss) Gain on Securities |       | (3,751                                             | )               | 7,793 |   |
| Add:  Tax savings at statutory rate           |       | 1,500                                              |            | (3,117 | ) |
|                                          |       |                                               |            |   |   |
| Total  Other Comprehensive (Loss) Income      |       | (2,251                                             | )               | 4,676 |   |
|                                          |       |                                               |            |   |   |
| Total  Comprehensive Income                   |       | $                                                  |  2,855,119 |   | $ |  1,230,841 |   |

 

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**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 September 30,2009 and 2008 were $153,000 and $88,000, 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 September 30, 2009, 183,576 shares have been issuedunder the ESPP.  Compensation expense of $21,440 and $26,591 has beenrecognized for the three months ended September 30, 2009 and 2008,respectively, relating to the ESPP.

 

**Note15.  Income Taxes**

 

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

 

The provision forfederal, state and local income taxes for the three months ended September 30,2009 and 2008 was tax expense of approximately $1,828,000 and $920,000,respectively, with effective tax rates of 39% and 43%, respectively. Theeffective tax rate for the three months ended September 30, 2009 was alower effective tax rate compared to September 30, 2008 due primarily to achange in the Federal rate from the 35% statutory rate to an estimated 34%actual rate, apportionment of income to Wyoming which has no state income tax,and federal income tax credits.

 

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

 

Asof September 30, 2009 and June 30, 2009, the Company reported totalunrecognized benefits of $297,663, all of which would affect the Company’seffective tax rate if recognized.  As aresult of the positions taken during the period, the Company has not recordedany interest and penalties for the period ended September 30, 2009 in thestatement of operations and no cumulative interest and penalties have beenrecorded either in the Company’s statement of financial position as of September 30,2009 and June 30, 2009. The Company will recognize interest accrued onunrecognized tax benefits in interest expense and any related penalties inoperating expenses.  The Company does notbelieve that the total unrecognized tax benefits will significantly increase ordecrease in the next twelve months.

 

The Company files tax returns in the UnitedStates federal jurisdiction, Pennsylvania, New Jersey and California.  TheCompany’s tax returns for Fiscal 2005 and prior generally are no longer subjectto review as such years generally are closed. The Company has been notifiedthat its federal income tax return for Fiscal 2008 will be reviewed by the IRSduring Fiscal 2010.  The Company believes that an unfavorable resolutionfor open tax years would not be material to the financial position of theCompany.

 

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

 

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

 

CodyLCI Realty LLC (“Realty”) is the only VIE that is consolidated.  Realtyhas been consolidated by Cody prior to its acquisition by Lannett.  Realtyis a 50/50 joint venture with a former shareholder of Cody.  Its purposewas to acquire the facility used by Cody.  Until the acquisition ofCody in April 2007, Lannett had not consolidated the VIE because CodyLabs had been the primary beneficiary of the VIE.  The risks associatedwith our interests in this VIE is limited to a decline in the value of the landand building as compared to the balance of the mortgage note on that property,up to Lannett’s 50% share of the venture.  Realty owns the land andbuilding, and Cody leases the building and property from Realty for $15,000 permonth.  All intercompany rent expense is eliminated upon consolidationwith Cody.

 

TheCompany is not involved in any other VIE of which Lannett is the primarybeneficiary.

 

**Note17.  Related Party Transactions**

 

TheCompany had sales of approximately $213,000 and $167,000 during the threemonths ended September 30, 2009 and 2008, respectively, to a genericdistributor, Auburn Pharmaceutical Company. Jeffrey Farber (the “related party”),who is a current board member and the son of the Chairman of the Board ofDirectors and principal shareholder of the Company, William Farber, is theowner of Auburn Pharmaceutical Company. Accounts receivable includes amounts due from the related party ofapproximately $133,000 and $125,000 at September 30, 2009 and June 30,2009, respectively.  In the Company’sopinion, the terms of these transactions were not more favorable to the relatedparty than 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 Companyoriginally capitalized these rights as an indefinite lived intangible asset andtested this asset for impairment at least on an annual basis.  During the fourth quarter of Fiscal 2009, itwas determined that this intangible asset no longer has an indefinitelife.  No impairment existed because theestimated fair value exceeded the carrying amount on that date. Accordingly,the $100,000 carrying amount of this intangible asset is being amortized on a straightline basis prospectively over its 10 year remaining estimated useful life.

 

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

 

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

 

Accountsreceivable includes amounts due from Provell of approximately zero and $55,000at September 30, 2009 and June 30, 2009, respectively. The Companyrecognized revenues from Provell of approximately $75,000 during the threemonths ended September 30, 2008.

 

**Note 18.  Material Contract withSupplier**

 

JeromeStevens Pharmaceuticals agreement:

 

TheCompany’s primary finished product inventory supplier is Jerome StevensPharmaceuticals, Inc. (“JSP”), in Bohemia, New York.  Purchases of finished goods inventory fromJSP accounted for approximately 67% and 75% of the Company’s inventorypurchases during the three month periods ended September 30, 2009 and2008, 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 commerciallyreasonable efforts to purchase minimum dollar quantities of JSP’s productsbeing distributed by the Company.  Theminimum quantity to be purchased in the first year of the agreement is $15million.  Thereafter, the minimumquantity to be purchased increases by $1 million per year up to $24 million forthe last year of the ten-year contract. The Company has met the minimum purchase requirement for the first fiveyears of the contract, but there is no guarantee that the Company will be ableto continue to do so in the future. If the Company does not meet the minimumpurchase requirements, JSP’s sole remedy is to terminate the agreement.

 

Underthe agreement, JSP is entitled to nominate one person to serve on the Company’sBoard of Directors (the “Board”) provided, however, that the Board shall havethe right to reasonably approve any such nominee in order to fulfill itsfiduciary duty by ascertaining that such person is suitable for membership onthe board of a publicly traded corporation. Suitability is determined by, butnot limited to, the requirements of the Securities and Exchange Commission, theAmerican Stock Exchange, and other applicable laws, including theSarbanes-Oxley Act of 2002.  As of September 30,2009, JSP has not exercised the nomination provision of the agreement.

 

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

 

**Note 19.  Subsequent Events**

 

In May 2009,the FASB issued authoritative guidance which defines the period after thebalance sheet date during which a reporting entity’s management should evaluateevents or transactions that may occur for potential recognition or disclosurein the financial statements.  The Companyadopted this authoritative guidance effective with its financial statements asof and for the year ended June 30, 2009. In preparing these financialstatements, the Company has evaluated events and transactions for potentialrecognition or disclosure through November 12, 2009, the date thefinancial statements were issued.

 

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## ***ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS.***

## *** ***

***Introduction***

 

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

 

ThisReport on Form 10-Q and certain information incorporated herein byreference contain forward-looking statements which are not historical factsmade pursuant to the “safe harbor” provisions of the Private SecuritiesLitigation Reform Act of 1995. Forward-looking statements are not promises orguarantees and investors are cautioned that all forward-looking statementsinvolve risks and uncertainties, including but not limited to the impact ofcompetitive products and pricing, product demand and market acceptance, newproduct development, the regulatory environment, including without limitation,reliance on key strategic alliances, availability of raw materials,fluctuations in operating results and other risks detailed from time to time inthe Company’s filings with the Securities and Exchange Commission. Thesestatements are based on management’s current expectations and are naturallysubject to uncertainty and changes in circumstances. We caution you not toplace undue reliance upon any such forward-looking statements which speak onlyas of the date made. Lannett is under no obligation to, and expressly disclaimsany such obligation to, update or alter its forward-looking statements, whetheras a result of new information, future events or otherwise.

 

***Critical Accounting Policies***

 

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

 

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

 

***Consolidation of Variable Interest Entity*** — The Companyconsolidates any Variable Interest Entity (“VIE”) of which we are the primarybeneficiary. The liabilities recognized as a result of consolidating a VIE donot represent additional claims on our general assets; rather, they representclaims against the specific assets of the consolidated VIE. Conversely, assetsrecognized as a result of consolidating a VIE do not represent additionalassets that could be used to satisfy claims against our general assets.  Reflected in the September 30, 2009 and June 30,2009 balance sheets are consolidated VIE assets of approximately $1.9 millionand $1.9 million, respectively, which is comprised mainly of land and abuilding. VIE liabilities consist of a mortgage on that property in the amountof approximately $1.7 and $1.7 million at September 30, 2009 and June 30,2009,

 

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respectively.This VIE was initially consolidated by Cody, as Cody has been the primarybeneficiary.  Cody has then been consolidated within Lannett’s financialstatements since its acquisition in April 2007.

 

***Revenue Recognition*** — The Company recognizesrevenue when its products are shipped.  At this point, title and risk ofloss have transferred to the customer and provisions for rebates, promotionaladjustments, price adjustments, returns, chargebacks, and other potential adjustmentsare reasonably determinable.  Accruals for these provisions are presentedin the consolidated financial statements as rebates, chargebacks and returnspayable and as reductions to net sales. The change in the reserves for varioussales adjustments may not be proportionally equal to the change in salesbecause of changes in both the product and the customer mix. Increased sales towholesalers will generally require additional accruals as they are the primaryrecipient of chargebacks and rebates. Incentives offered to secure sales varyfrom product to product. Provisions for estimated rebates and promotionalcredits are estimated based upon contractual terms.  Provisions for othercustomer credits, such as price adjustments, returns, and chargebacks, require managementto make subjective judgments on customer mix. Unlike branded innovator drugcompanies, Lannett does not use information about product levels indistribution channels from third-party sources, such as IMS and Wolters Kluwer,in estimating future returns and other credits. Lannett calculates achargeback/rebate rate based on contractual terms with its customers andapplies this rate to customer sales.  The only variable is customer 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 indirectcustomers. The Company continually monitors the reserve for chargebacks andmakes adjustments when management believes that expected chargebacks on actualsales may 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 withindustry practice, the Company has a product returns policy that allows certaincustomers to return product within a specified period prior to and subsequentto the product’s lot expiration date

 

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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 credits are issued or paymentsare made for actual returns received.  The reserve for returns is includedin the rebates, chargebacks and returns payable account on the balance sheet.

 

***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 threemonths ended September 30, 2009 and 2008:

 

**For the three months ended September 30,2009**

 
| **Reserve Category**                                                                       | ** ** | **Chargebacks** | ** ** | **Rebates** | ** ** | **Returns** | ** ** | **Other** | ** ** | **Total**  | ** ** |
|--------------------------------------------------------------------------------------------|------------|-----------------|------------|-------------|------------|-------------|------------|-----------|------------|------------|------------|
|                                                                                       |       |            |       |        |       |        |       |      |       |       |       |
| Reserve Balance as of  June 30, 2009                                                  |       | $               | 6,089,802  |        | $          | 2,537,746   |       | $         | 5,106,992  |       | $          | — |   | $ | 13,734,540 |   |
| Actual credits issued  related to sales recorded in prior fiscal years                     |       | (4,767,581      | )          | (1,852,708  | )          | (1,147,720  | )          | —    |       | (7,768,009 | )          |
| Reserves or (reversals)  charged during Fiscal 2010 related to sales in prior fiscal years |       | —          |       | —      |       | —      |       | —    |       | —     |       |
| Reserves charged to net  sales during Fiscal 2010 related to sales recorded in Fiscal 2010 |       | 10,272,936      |       | 4,066,855   |       | 1,140,128   |       | 407,784   |       | 15,887,703 |       |
| Actual credits issued  related to sales recorded in Fiscal 2010                            |       | (7,000,389      | )          | (1,789,955  | )          | —      |       | (407,784  | )          | (9,198,128 | )          |
| Reserve Balance as of  September 30, 2009                                             |       | $               | 4,594,768  |        | $          | 2,961,938   |       | $         | 5,099,400  |       | $          | — |   | $ | 12,656,106 |   |

 

**For the three months endedSeptember 30, 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                     |       | (2,865,229      | )          | (255,126    | )          | (6,425,413  | )          | —    |       | (9,545,768 | )          |
| 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 |       | 9,144,349       |       | 2,949,913   |       | 1,142,474   |       | 42,957    |       | 13,279,693 |       |
| Actual credits issued  related to sales recorded in Fiscal 2009                            |       | (5,129,939      | )          | (1,537,556  | )          | —      |       | (40,096   | )          | (6,707,591 | )          |
| Reserve Balance as of  September 30, 2008                                             |       | $               | 5,198,588  |        | $          | 1,789,545   |       | $         | 8,361,757  |       | $          | 2,861 |   | $ | 15,352,751 |   |

 

The total reserve for chargebacks, rebates, returns and otheradjustments decreased from $13,734,540 at June 30, 2009 to $12,656,106 at September 30,2009.   As of September 30, 2009 approximately $9,924,000of the

 

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original $10,545,000 return reserve recorded in Fiscal 2008 forPrenatal Multivitamin was applied to accounts receivable for customers who hadreturned the Prenatal Multivitamin product by that date, leaving a balance ofapproximately $621,000 of Multivitamin returns reserve on the books at September 30,2009. The decrease in chargeback reserves between June 30, 2009 and September 30,2009 was due primarily to a decrease in inventory levels at wholesalerdistribution centers.

 

Credits issued during the quarter that relate to prior year sales arecharged against the opening balance.  Inaggregate, additional reserves or reversals of reserves have historicallyoffset each other.  The table above showsthe effects of reversals within the rebates, returns and other categories.  It is the Company’s intention that allreserves be charged to sales in the period that the sale is recognized,however, due to the nature of this estimate, it is possible that the Companymay sometimes need to increase or decrease the reserve based on prior period sales.  If that were to occur, management woulddisclose 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 reducethe potential for human error, but also will result in more in-depth analysisand improved customer interaction for resolution of open credits.

 

The rate of credits issued is monitored by the Company at least on aquarterly basis.  The Company may changethe estimate of future reserves based on the amount of credits processed, orthe rate of sales made to indirect customers.  The decrease of reserves to $12,656,106 at September 30, 2009 from$13,734,540 at June 30, 2009 is due to the timing of credits beingprocessed by the customers and by the Company. Approximately $7,768,000 or 57% of the reserve balance from June 30,2009 has been processed through the first three months of Fiscal 2010.  Approximately $207,000 of that amount relatesto credits issued due to the return by customers of the Prenatal Multivitaminproduct through September 30, 2009. Management estimates reserves based on sales mix.  A comparison to wholesaler inventory reportsis performed quarterly, in order to justify the balance of unclaimed chargebacksand rebates.  The Company has historicallyfound a direct correlation between the calculation of the reserve based onsales mix, and the wholesaler inventory analysis.

 

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

 

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

** **

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

** **

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

** **
| ** **          | ** ** | **9/30/09** | ** ** | **6/30/09** | ** ** | **9/30/08** | ** ** |
|---------------------|------------|-------------|------------|-------------|------------|-------------|------------|
| Net DSO (in days)   |       | 68          |       | 55          |       | 38          |       |
| Gross DSO (in days) |       | 62          |       | 53          |       | 61          |       |

 

The level of both net and gross DSO at September 30,2009 is within the Company’s expectation that DSO will be in the 60 to 70 dayrange based on 60 day payment terms for most customers.

 

***Inventories****—*The Company values its inventory at the lower of cost (determined by thefirst-in, first-out method) or market, regularly reviews inventory quantitieson hand, and records a provision for excess and obsolete inventory basedprimarily on estimated forecasts of product demand and production requirements.  The Company’s estimates of future productdemand may prove to be inaccurate, in which case it may have understated oroverstated the provision required for excess and obsolete inventory. In thefuture, if the Company’s inventory is determined to be overvalued, the Companywould be required to recognize such costs in cost of goods sold at the time ofsuch determination. Likewise, if inventory is determined to be undervalued, theCompany may have recognized excess cost of goods sold in previous periods andwould be required to recognize such additional operating income at the time ofsale.

 

***Resultsof Operations - Three months ended September 30, 2009 compared with threemonths ended September 30, 2008***

 

Net sales for the threemonths ended September 30, 2009 (“Fiscal 2010”) increased 23% to$31,435,000 from $25,568,000 for the three months ended September 30, 2008(“Fiscal 2009”). The increase was primarily due to sales of drugs used forpain management totaling $2,880,000 as well as sales of $1,489,000 of our prescription

 

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vitaminsduring the first quarter of Fiscal 2010. The following factors also contributed to the $5,867,000 increase insales:

 
| **Medical indication** | ** ** | **Sales volume  change %** | ** ** | **Sales price  change %** | ** ** |
|------------------------|------------|----------------------------|------------|---------------------------|------------|
| Heart Failure          |       | -30                        | %          | 11                        | %          |
| Antibiotics            |       | 24                         | %          | -8                        | %          |
| Epilepsy               |       | -16                        | %          | 17                        | %          |
| Thyroid Deficiency     |       | 15                         | %          | - 1                       | %          |
| Pain Management        |       | 480                        | %          | 37                        | %          |
| Migraine Headache      |       | —                     | %          | 15                        | %          |

 

Theincrease in product sales can be attributed primarily to four products. Salesof drugs used for pain management increased by approximately $2,604,000 in thefirst quarter of Fiscal 2010 compared to the first quarter of Fiscal 2009 dueto a market withdrawal by one of our major competitors.  Sales of drugs used in the treatment ofthyroid deficiency increased by approximately $1,558,000 as a result of acontinued shift away from branded drugs towards generic prescriptions.  Partially offsetting these increases was adecrease in sales of drugs for the treatment of congestive heart failure byapproximately $1,496,000 in the first quarter of Fiscal 2010 compared to thefirst quarter of Fiscal 2009.  This decreasewas due to a product recall by several of our major competitors which increasedour first quarter of Fiscal 2009 revenues. The increase in sales can also be attributed to the continued sales ofour prescription vitamins discussed above.

 

The Company expects to continue increasing the numberof products available for sale to its customers, which will require additionalFDA approvals. The Company’s receipt of several approvals by the FDA to offernew products has resulted in more sales of new products in Fiscal 2010 comparedto Fiscal 2009.

 

TheCompany sells its products to customers in various categories.  The table below identifies the Company’sapproximate net sales to each category for the three months ended September 30,2009 and 2008:

** **
| **Customer Category**   | ** ** | **2009**   | ** ** | **2008**   | ** ** |
|-------------------------|------------|------------|------------|------------|------------|
|                    |       |       |       |       |       |
| Wholesaler/ Distributor |       | $          | 15,169,000 |       | $          | 11,841,000 |   |
| Retail Chain            |       | 14,732,000 |       | 11,975,000 |       |
| Mail-Order Pharmacy     |       | 1,534,000  |       | 1,636,000  |       |
| Private Label           |       | —     |       | 116,000    |       |
|                    |       |       |       |       |       |
| Total                   |       | $          | 31,435,000 |       | $          | 25,568,000 |   |

 

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

** **

**Costof sales for the first quarter increased 20% to $19,901,000 in Fiscal 2010 from$16,566,000 in Fiscal 2009.  The increasereflected the impact of the 23% increase in sales and royalties ofapproximately $440,000 primarily related to the prescription vitamins.  The increase in cost of sales was less thanthe increase in sales, however, due to the fixed nature of some productioncosts.**

** **

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

 

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Gross profit margins for the first quarter of Fiscal2010 and Fiscal 2009 were 37% and 35%, respectively. Gross profit percentageincreased due to strong profit margins on the pain management products andprescription vitamins, as well as the fixed nature of some productioncosts.  While the Company is continuouslystriving to keep product costs low, there can be no guarantee that profitmargins will not fluctuate in future periods. Pricing pressure from competitors and costs of producing or purchasingnew drugs may also fluctuate in the future. Changes in the future sales product mix may also occur. These changes mayaffect the gross profit percentage in future periods.

 

Researchand development (“R&D”) expenses in the first quarter increased 63% to$3,028,000 for Fiscal 2010 from $1,863,000 for Fiscal 2009.  The increase is primarily due to an increasein production of drugs in development and preparation for submission to the FDAas well as increased costs for biostudies. The Company expenses all production costs as R&D until the drug isapproved by the FDA.  R&D expensesmay fluctuate from period to period, based on R&D plans for submission tothe FDA.

 

Selling**,**general and administrative expenses in the first quarterdecreased 24% to $3,763,000 in Fiscal 2010 from $4,949,000 in Fiscal 2009.  The decrease is primarily due to litigationexpenses in Fiscal 2009 related to the patent challenge with KV Pharmaceuticalsof approximately $800,000 which were not incurred in Fiscal 2010. 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.

 

Interestexpense was flat with $70,000 recorded in the first quarter of Fiscal 2010compared to $66,000 in Fiscal 2009. Interest income in the first quarter decreased to $23,000 in Fiscal 2010from $46,000 in Fiscal 2009 due to lower interest earned on investmentsecurities.

 

TheCompany recorded income tax expense in the first quarter of 2010 of $1,828,000compared to $920,000 in the first quarter of Fiscal 2009. The effective taxrate for the three months ended September 30, 2009 was 39%, compared to43% for the three months ended September 30, 2008.  The effective tax rate for the three months ended September 30,2009 was a lower effective tax rate compared to September 30, 2008 dueprimarily to a change in the Federal rate from the 35% statutory rate to anestimated 34% actual rate, apportionment of income to Wyoming which has nostate income tax, and federal income tax credits.

 

The Company reported netincome of approximately $2,857,000 in the first quarter of Fiscal 2010, or$0.12 basic and $0.11 diluted earnings per share, as compared to $1,226,000 inthe first quarter Fiscal 2009, or $0.05 basic and diluted earnings per share.

 

***Liquidityand Capital Resources***

 

**TheCompany has historically financed its operations with cash flow generated fromoperations, supplemented with borrowings from various government agencies andfinancial institutions.  At September 30,2009, working capital was $42,266,000, as compared to $38,632,000 at June 30,2009, an increase of $3,634,000.**

** **

**Net cashused in operating activities of $634,000 in the first three months of Fiscal2010 reflected net income of $2,857,000, after adjusting for non-cash items of$1,837,000, as well as cash used by changes in operating assets and liabilitiesof $5,328,000.  Significant changes inoperating assets and liabilities are comprised of:**

 

·                  An increase in tradeaccounts receivable of $1,152,000 primarily as a result of increased sales inFiscal 2010.  The change in the accountsreceivable balance from June 30, 2009 to September 30, 2009 includesa non-cash decrease of approximately $207,000 related to the issuance ofcredits for the returns of the multivitamin product received by the Companythrough September 30, 2009.

·                  An increase in inventoriesof $815,000 due to increased stocking levels at both Lannett and Cody Labs forseveral products as of September 30, 2009 that are being carried in orderto respond to the increased order volume we are currently experiencing.

 

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·                  An increase in income taxespayable of $514,000 related to Fiscal 2010 taxable income.

·                  A decrease in accountspayable of $1,156,000 due to the timing of payments at the end of the month.

·                  A decrease in rebates,chargebacks and returns payable of $872,000 primarily as a result of a decreasein the chargeback reserve due to lower inventory levels at wholesalerdistribution centers offset by a non-cash decrease of approximately $207,000related to the issuance of credits for the returns of the multivitamin productreceived by the Company through September 30, 2009.

**·**                  A decrease in accrued payroll and payroll related costs of $2,195,000primarily related to the partial payment of the Fiscal 2009 accrued incentivecompensation costs totaling approximately $3,000,000.

** **

**Net cash used in investing activities of $1,567,000 for thethree months ended September 30, 2009 reflected the purchase of property,plant and equipment of $1,067,000 as well as the purchase of an intangibleasset (product rights) for $500,000.**

** **

**Net cash used in financing activities of $19,000 for thethree months ended September 30, 2009 was primarily due to scheduled debtrepayments of $136,000.  Proceeds fromthe issuance of stock of $186,000 were partially offset by the purchase oftreasury stock totaling $69,000.**

** **

Long-termdebt amounts due, for the twelve month periods ended September 30 are asfollows:

 
| **Twelve**        | ** ** | **Amounts Payable** | ** ** |
|-------------------|------------|---------------------|------------|
| **Month Periods** | ** ** | **to Institutions** | ** ** |
|              |       |                |       |
| 2010              |       | $                   | 357,806    |   |
| 2011              |       | 4,818,102           |       |
| 2012              |       | 274,802             |       |
| 2013              |       | 283,934             |       |
| 2014              |       | 279,293             |       |
| Thereafter        |       | 1,988,546           |       |
|              |       |                |       |
|              |       | $                   | 8,002,483  |   |

 

The Company has a $3,000,000 line of credit fromWachovia Bank, N.A. (“Wachovia”) that bears interest at the prime interest rateless 0.25% (2.75% and 3.00% at September 30 and June 30, 2009,respectively). As of September 30 and June 30, 2009, the Company has$3,000,000 of availability under this line of credit.  The line of credit is collateralized bysubstantially all of the Company’s assets.

 

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

 

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** **

**The terms of the line of credit, the loan agreement and therelated letter of credit require that the Company meet certain financialcovenants and reporting standards, including the attainment of standardfinancial liquidity and net worth ratios. As of September 30, 2009, the Company is in compliance with allfinancial 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 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. Through September 30,2009, the Company has had preliminary discussions with the Commonwealth ofPennsylvania to determine whether it will be required to repay any of the fundsprovided under the grant fund. Based on information available at September 30,2009, the Company has recorded the grant funding as a long-term liability underthe caption of Unearned Grant Funds. Except as set forth in this report, the Company is not aware of anytrends, events or uncertainties that have or are reasonably likely to have amaterial adverse impact on the Company’s short-term or long-term liquidity orfinancial condition.

 

**Prospects for the Future**

 

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

 

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

 

TheCompany views its April 2007 acquisition of Cody Laboratories, Inc. (“CodyLabs” or “Cody”) as an important step in becoming a vertically integratednarcotics manufacturer and distributor by allowing it to concentrate ondeveloping and completing its dosage form manufacturing in order to reducenarcotic API costs.

 

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InJuly 2008, the DEA granted Cody Labs a license to directly import rawpoppy straw for conversion into API and/or various pharmaceuticalproducts.  Only six other companies inthe U.S. have been granted this license to date.  This license allows the Company to avoidincreased costs associated with buying narcotic API from othermanufacturers.  The Company anticipatesthat it can use this license to become a vertically integrated manufacturer ofnarcotic products, as well as a supplier of API to the pharmaceutical industry.  The Company believes that the aging domesticpopulation may result in a higher demand for pain management pharmaceuticalproducts and that it will be well-positioned to take advantage of thisincreased demand.

 

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

 

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

 

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

 

Morespecifically, certain products, marketed prior to the Federal Food, Drug andCosmetic Act  may be considered GRASE orGrandfathered.  GRASE products are those “olddrugs that do not require prior approval from FDA in order to be marketedbecause they are generally recognized as safe and effective based on publishedscientific literature.”  Similarly,Grandfathered products are those which “entered the market before the passageof the 1938 act or the 1962 amendments to the act.”  Under the grandfather clause, such a productis exempted from the “effectiveness requirements [of the act] if itscomposition and labeling have not changed since 1962 and if, on the day beforethe 1962 amendments became effective, it was (1) used or sold commerciallyin the United States, (2) not a new drug as defined by the act at thattime, and (3) not covered by an effective application.”

 

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

 

Themajority of the Company’s R&D projects are being developed in-house underLannett’s direct supervision and with Company personnel.  Hence, the Company does not believe that itsoutside contracts for product

 

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developmentand manufacturing supply are material in nature, nor is the Companysubstantially dependent on the services rendered by such outside firms.

 

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

 

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

 

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

 

**The Company has debt instrumentswith variable interest rates.  TheCompany has a $3,000,000 line of credit from Wachovia Bank, N.A. (“Wachovia”)that bears interest at the prime interest rate less 0.25% (2.75% and 3.00% at September 30and June 30, 2009, respectively). As of September 30 and June 30,2009, the Company has $3,000,000 of availability under this line ofcredit.  The line of credit iscollateralized by substantially all of the Company’s assets.  The agreementcontains covenants with respect to working capital, net worth and certainratios, as well as other covenants.  Theexisting line of credit which was to expire on November 30, 2009, wasrenewed and extended to November 30, 2010.**

** **

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

 

**ITEM 4. CONTROLS AND PROCEDURES**

 

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

 

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

 

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

 

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

 

There has been no change inthe Company’s internal control over financial reporting during the three monthsended September 30, 2009 that has materially affected, or reasonablylikely to 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 soughtdeclaratory judgment of anti-trust violations and federal and state unfaircompetition violations for actions taken by KV in securing and enforcing thesepatents.  After the complaint was filed, KV countered with amotion for a Temporary Restraining Order (“TRO”) to prevent the Company fromlaunching its Multivitamin with Mineral Capsules (“MMCs”), due to allegedpatent and trademark infringement issues.  The TRO was heard and,ultimately, resulted in a conclusion by the court that the Company’s productlabel on the MMCs should be modified.  KV also countered with claimsof infringement by the Company of KV’s patents seeking the Company’s profitsfor sales of MMCs or other monetary relief, preliminary and permanentinjunctive relief, attorney’s fees and a finding of willful infringement.On March 17, 2009 the Company and KV settled the litigation.  In light of the withdrawal of KV’s innovatorprenatal product, and the resulting anticipated decline in sales and decliningmarket for written prescription, the Company decided it was pointless tocontinue the litigation and entered into the settlement arrangement withKV.  Pursuant to the settlement, theCompany will receive a license from KV and will become an authorized genericprovider.  During the terms of thelicense, the Company will pay KV a royalty on all future sales of its Prenatalvitamin product.  Lannett will ceaseoffering its Prenatal vitamin product if and when the brand is restored to themarketplace.

 

In or about July 2008,Albion International and Albion, Inc. filed suit in the United StatesDistrict Court, District of Utah (Case No. 2:08cv00515) against Lannettasserting claims for patent and trademark infringement, as well as unfaircompetition, arising out of Lannett’s use of product that it purchased fromAlbion and used as an 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 filed an answer to the complaintand counterclaim, asserting, among other things, thatAlbion tortuously interfered with Lannett’s contracts.  Subsequent tothe filing of the answer and counterclaim, Lannett andAlbion reached an agreement in principal to settle the case. Under terms of the settlement, the parties would each dismiss their claimsagainst each other and provide releases.  On July 6, 2009, thesettlement agreement was signed and on July 13, 2009 the case wasdismissed.

 

***RegulatoryProceedings***

 

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

 

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

 

Nomatters have been submitted to a vote of the Company’s security holders duringthe quarter ended   September 30,2009.

 

## ***ITEM6.  EXHIBITS***

## *** ***

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

 

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# **SIGNATURE**

#  

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

 
|                           |   | **LANNETT  COMPANY, INC.**                             |
|--------------------------------|--------|--------------------------------------------------------|
|                           |   |                                                   |
| Dated: November 12,  2009 | By:    | /s/ Keith R. Ruck                                      |
|                           |   | Keith  R. Ruck                                         |
|                           |   | Vice  President of Finance and Chief Financial Officer |
|                           |   |                                                   |
|                           |   |                                                   |
| Dated: November 12,  2009 | By:    | /s/ Arthur P. Bedrosian                                |
|                           |   | Arthur  P. Bedrosian                                   |
|                           |   | President and Chief Executive Officer                  |

 

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**Exhibit Index**

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