##### Table of Contents



SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549
   FORM 10-Q (Mark One) x Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended January 31, 2004 or o Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period
from ________ to ____________ Commission file number 0-17521 ZILA, INC.  Delaware
(State or Other Jurisdiction of Incorporation or
Organization)
    
    86-0619668
(I.R.S. Employer Identification No.)
 5227 North 7th Street, Phoenix, Arizona
(Address of Principal Executive Offices)
    
    85014
(Zip Code)
 Registrants Telephone Number, Including Area Code (602) 266-6700 Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days Yes x No o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Securities Exchange Act) Yes x No o APPLICABLE ONLY TO CORPORATE ISSUERS Indicate the number of shares outstanding of each of the issuers classes
of common stock, as of the latest practicable date. At February 29, 2004, the number of shares of common stock outstanding was
45,339,719. 1




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TABLE OF CONTENTS  Part I - Financial Information (Unaudited)Item 1. Financial StatementsCONDENSED CONSOLIDATED BALANCE SHEETSCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSSCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWSNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTSItem 2. Managements Discussion and Analysis of Financial Condition and Results of OperationsItem 3. Quantitative and Qualitative Disclosures about Market RiskItem 4. Controls and ProceduresPart II - Other InformationItem 1. Legal ProceedingsItem 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity SecuritiesItem 3. Defaults upon Senior SecuritiesItem 4. Submission of Matters to a Vote of Security HoldersItem 5. Other InformationItem 6. Exhibits and Reports on Form 8-KSIGNATURESINDEX TO EXHIBITSEX-31.1EX-31.2EX-32.1EX-32.2EX-99.1EX-99.2EX-99.3EX-99.4EX-99.5    Table of Contents  TABLE OF CONTENTS PagePart I
    
    FINANCIAL INFORMATION (UNAUDITED)Item 1.
    
    Financial StatementsCondensed consolidated balance sheets as of January 31, 2004 and July 31, 2003
    
    
    3Condensed consolidated statements of operations and comprehensive loss for the three and six months ended January 31, 2004 and 2003
    
    
    4Condensed consolidated statements of cash flows for the six months ended January 31, 2004 and 2003
    
    
    5Notes to condensed consolidated financial statements
    
    
    6Item 2.
    
    Managements discussion and analysis of financial condition and results   of operations
    
    
    14Item 3.
    
    Quantitative and qualitative disclosures about market risk
    
    
    27Item 4.
    
    Controls and procedures
    
    
    27Part II.
    
    OTHER INFORMATIONItem 1.
    
    Legal proceedings
    
    
    28Item 2.
    
    Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
    
    
    29Item 3.
    
    Defaults upon Senior Securities
    
    
    29Item 4.
    
    Submission of matters to a vote of
Shareholders
    
    
    29Item 5.
    
    Other Information
    
    
    30Item 6.
    
    Exhibits and Reports on Form 8-K
    
    
    30SIGNATURES
    
    
    31
 Ex  31.1
Ex  31.2
Ex  32.1
Ex  32.2
Ex  91.1
Ex  91.2
Ex  91.3
Ex  91.4
Ex  91.5 2




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ZILA, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS January 31, 2004
    
    July 31, 2003(unaudited)ASSETSCURRENT ASSETS:Cash and cash equivalents
    
    $
    12,516,299
    
    
    $
    16,160,484Trade
receivables - net
    
    
    9,361,830
    
    
    
    7,550,735Inventories - net
    
    
    7,209,616
    
    
    
    8,088,222Prepaid expenses and other current assets
    
    
    1,988,906
    
    
    
    1,760,710Total current assets
    
    
    31,076,651
    
    
    
    33,560,151PROPERTY AND
EQUIPMENT - net
    
    
    9,049,929
    
    
    
    9,481,307PURCHASED
TECHNOLOGY RIGHTS - net
    
    
    3,749,626
    
    
    
    3,988,964GOODWILL - net
    
    
    6,930,192
    
    
    
    6,930,192TRADEMARKS
AND OTHER INTANGIBLE ASSETS - net
    
    
    13,488,641
    
    
    
    13,720,022OTHER ASSETS
    
    
    1,311,292
    
    
    
    1,339,680TOTAL
    
    $
    65,606,331
    
    
    $
    69,020,316LIABILITIES AND SHAREHOLDERS EQUITYCURRENT LIABILITIES:Accounts payable
    
    $
    5,135,437
    
    
    $
    7,399,416Accrued liabilities
    
    
    3,683,504
    
    
    
    3,502,405Short-term borrowings
    
    
    267,488
    
    
    
    154,793Current portion of gain on sale leaseback
    
    
    152,976
    
    
    
    Current portion of long-term debt and capital lease obligation
    
    
    515,648
    
    
    
    487,449Total current liabilities
    
    
    9,755,053
    
    
    
    11,544,063DEFERRED GAIN ON SALE LEASEBACK
    
    
    611,075
    
    
    
    LONG-TERM DEBT AND CAPITAL LEASE
OBLIGATIONS - net of current portion
    
    
    3,657,150
    
    
    
    3,728,126Total liabilities
    
    
    14,023,278
    
    
    
    15,272,189COMMITMENTS AND CONTINGENCIESSHAREHOLDERS EQUITY:Preferred
stock - Series B, $.001 par value - authorized 2,500,000 shares,
issued
100,000 shares
    
    
    462,500
    
    
    
    462,500Common
stock, $.001 par value - authorized 65,000,000 shares, issued
45,958,619
shares (January 31, 2004) and 45,439,893 shares (July 31, 2003 )
    
    
    45,959
    
    
    
    45,815Capital in excess of par value
    
    
    83,503,998
    
    
    
    83,115,158Accumulated other comprehensive loss
    
    
    (80,714
    )
    
    
    (75,644
    )Accumulated deficit
    
    
    (31,777,317
    )
    
    
    (29,228,329
    )Common stock in treasury, at cost, 225,100 shares
    
    
    (571,373
    )
    
    
    (571,373
    )Total shareholders equity
    
    
    51,583,053
    
    
    
    53,748,127TOTAL
    
    $
    65,606,331
    
    
    $
    69,020,316
 See notes to unaudited condensed consolidated financial statements. 3




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ZILA, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS (UNAUDITED) Three months ended January 31,
    
    Six months ended January 31,2004
    
    2003
    
    2004
    
    2003NET REVENUES
    
    $
    13,603,714
    
    
    $
    11,977,522
    
    
    $
    25,656,434
    
    
    $
    22,711,955OPERATING COSTS AND EXPENSES:Cost of products sold (exclusive of depreciation shown
separately below)
    
    
    5,637,475
    
    
    
    4,911,084
    
    
    
    10,671,389
    
    
    
    9,168,932Marketing and selling
    
    
    4,092,595
    
    
    
    2,913,146
    
    
    
    7,105,994
    
    
    
    5,580,462General and administrative
    
    
    3,408,144
    
    
    
    3,299,738
    
    
    
    7,015,368
    
    
    
    6,368,034Severance and related charges
    
    
    114,616
    
    
    
    179,122
    
    
    
    154,201
    
    
    
    1,058,996Research and development
    
    
    956,037
    
    
    
    817,052
    
    
    
    2,181,687
    
    
    
    1,581,062Depreciation and amortization
    
    
    763,155
    
    
    
    621,645
    
    
    
    1,389,422
    
    
    
    1,212,85514,972,022
    
    
    
    12,741,787
    
    
    
    28,518,061
    
    
    
    24,970,341LOSS FROM OPERATIONS
    
    
    (1,368,308
    )
    
    
    (764,265
    )
    
    
    (2,861,627
    )
    
    
    (2,258,386
    )OTHER INCOME (EXPENSE):Gain on asset sale
    
    
    470,462
    
    
    
    
    
    
    
    470,462
    
    
    
    Interest income
    
    
    24,336
    
    
    
    5,068
    
    
    
    52,086
    
    
    
    12,435Interest expense
    
    
    (70,746
    )
    
    
    (89,296
    )
    
    
    (145,931
    )
    
    
    (164,166
    )Other expense
    
    
    (16,891
    )
    
    
    (27,555
    )
    
    
    (44,478
    )
    
    
    (75,136
    )407,161
    
    
    
    (111,783
    )
    
    
    332,139
    
    
    
    (226,867
    )LOSS BEFORE ACCOUNTING CHANGE
    
    
    (961,147
    )
    
    
    (876,048
    )
    
    
    (2,529,488
    )
    
    
    (2,485,253
    )Cumulative effect of accounting change
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4,084,193
    )NET LOSS
    
    
    (961,147
    )
    
    
    (876,048
    )
    
    
    (2,529,488
    )
    
    
    (6,569,446
    )Preferred stock dividends
    
    
    9,750
    
    
    
    9,750
    
    
    
    19,500
    
    
    
    19,500Net loss attributable to common shareholders
    
    $
    (970,897
    )
    
    $
    (885,798
    )
    
    $
    (2,548,988
    )
    
    $
    (6,588,946
    )BASIC AND DILUTED NET LOSS PER COMMON SHARE:Loss before accounting change
    
    $
    (0.02
    )
    
    $
    (0.02
    )
    
    $
    (0.06
    )
    
    $
    (0.06
    )Accounting change
    
    
    (0.00
    )
    
    
    (0.00
    )
    
    
    (0.00
    )
    
    
    (0.09
    )NET LOSS
    
    $
    (0.02
    )
    
    $
    (0.02
    )
    
    $
    (0.06
    )
    
    $
    (0.15
    )WEIGHTED AVERAGE NUMBER OF SHARES OUTSTANDING
BASIC AND DILUTED
    
    
    45,048,437
    
    
    
    45,090,260
    
    
    
    45,009,040
    
    
    
    45,090,260NET LOSS
    
    $
    (961,147
    )
    
    $
    (876,048
    )
    
    $
    (2,529,488
    )
    
    $
    (6,569,446
    )Foreign currency translation adjustments
    
    
    (1,337
    )
    
    
    7,859
    
    
    
    (5,070
    )
    
    
    5,642COMPREHENSIVE LOSS
    
    $
    (962,484
    )
    
    $
    (868,189
    )
    
    $
    (2,534,558
    )
    
    $
    (6,563,804
    )
 See notes to unaudited condensed consolidated financial statements. 4




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ZILA, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED
STATEMENTS OF CASH FLOWS(UNAUDITED) 
 Six months ended January 31,2004
    
    2003OPERATING ACTIVITIES:Net loss
    
    $
    (2,529,488
    )
    
    $
    (6,569,446
    )Adjustments to reconcile net loss to net cash used in operating activities:Depreciation and amortization
    
    
    1,389,422
    
    
    
    1,212,855Gain on asset sale
    
    
    (470,462
    )
    
    
    Foreign currency and other
    
    
    (5,301
    )
    
    
    (37,920
    )Change in accounting method
    
    
    
    
    
    
    4,084,193Change in assets and liabilities:Receivables
- net
    
    
    (1,811,095
    )
    
    
    (2,656,501
    )Inventories
- net
    
    
    878,606
    
    
    
    2,131,030Prepaid expenses and other assets
    
    
    (194,696
    )
    
    
    (381,613
    )Accounts payable and accrued liabilities
    
    
    (2,054,852
    )
    
    
    945,286Net cash used in operating activities
    
    
    (4,797,866
    )
    
    
    (1,272,116
    )INVESTING ACTIVITIES:Proceeds from sale leaseback transaction
    
    
    1,721,876
    
    
    
    Additions to property and equipment
    
    
    (451,873
    )
    
    
    (1,332,476
    )Additions to intangible assets
    
    
    (322,537
    )
    
    
    (113,231
    )Net cash
provided by (used in) provided by investing activities
    
    
    947,466
    
    
    
    (1,445,707
    )FINANCING ACTIVITIES:Net proceeds (repayments) from short-term borrowings
    
    
    112,695
    
    
    
    2,359,775Net proceeds from issuance of common stock
    
    
    360,956
    
    
    
    20,812Acquisition of treasury stock
    
    
    
    
    
    
    (36,253
    )Dividends paid to preferred shareholders
    
    
    (19,500
    )
    
    
    (29,250
    )Proceeds from long-term debt
    
    
    
    
    
    
    500,000Repayment of long-term debt
    
    
    (247,936
    )
    
    
    (245,254
    )Net cash provided by financing activities
    
    
    206,215
    
    
    
    2,569,830NET DECREASE IN CASH AND CASH EQUIVALENTS
    
    

    (3,644,185
    )
    
    
    (147,993
    )CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
    
    
    16,160,484
    
    
    
    1,604,205CASH AND CASH EQUIVALENTS, END OF PERIOD
    
    $
    12,516,299
    
    
    $
    1,456,212SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:Cash paid for interest
    
    $
    64,143
    
    
    $
    87,123Cash paid for income taxes
    
    $
    192,000
    
    
    $
    192SUPPLEMENTAL SCHEDULE OF NONCASH FINANCING ACTIVITIES:Capital
lease obligations for new equipment
    
    $
    205,000
    
    
    $
    
 See notes to unaudited condensed consolidated financial statements. 5




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ZILA, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 
 1. ORGANIZATION AND BASIS OF PRESENTATION Zila,
Inc. and its subsidiaries are innovators in preventative healthcare
technologies and products, focusing on enhanced body defense and the detection
of pre-disease states. Zilas business units are aligned under three reporting
segments: Zila Nutraceuticals, Zila Pharmaceuticals and Zila Biotechnology. In
this Report, Zila, the Company, we, us, or our refer to Zila, Inc.
and its wholly-owned subsidiaries. Zila Nutraceuticals manufactures and markets patented Ester-C®, a branded,
highly effective form of vitamin C sold in 43 countries worldwide and plans to
launch Ester-E, an enhanced form of vitamin E, in the third and/or fourth
quarters of fiscal year 2004. Zila Nutraceuticals includes Oxycal Laboratories,
Inc., an Arizona corporation (Oxycal), and its subsidiary, Zila
Nutraceuticals, Inc. (Nutraceuticals), also an Arizona corporation. Zila Pharmaceuticals includes Zila Pharmaceuticals, Inc. and the ViziLite®
chemiluminescent disposable light product for the illumination of oral mucosal
abnormalities, Peridex® prescription mouth rinse, the Zilactin® family of
over-the-counter products (OTC), and the plastic molded products of Zila Swab
Technologies, Inc., an Arizona corporation dba Innovative Swab Technologies
(IST). Zila Biotechnology is a research, development and licensing business
specializing in pre-cancer/cancer detection through its patented Zila®Tolonium
Chloride (ZTC) and OraTest® technologies and managing the OraTest® product,
an oral cancer diagnostic system, which is currently in Food and Drug
Administration (FDA) phase III clinical trials. The accompanying unaudited quarterly financial statements represent the
consolidation of Zila, Inc. and its wholly-owned subsidiaries, Zila
Pharmaceuticals, Inc., Zila International, Inc., Zila, Ltd., Zila
Biotechnology, Inc., Bio-Dental Technologies Corporation (Bio-Dental), which
did business under the name Zila Dental Supply (ZDS), Zila Technologies,
Inc., Zila Swab Technologies, Inc. (ZST) dba Innovative Swab Technologies
(IST) and Oxycal Laboratories, Inc. (Oxycal). This information should be
read in conjunction with the financial statements set forth in the Zila, Inc.
Annual Report on Form 10-K for the fiscal year ended July 31, 2003. All
significant intercompany balances and transactions have been eliminated in
consolidation. We reclassified certain prior period amounts to conform to the
current period presentation. Our unaudited consolidated financial statements have been prepared in
accordance with accounting principles generally accepted in the United States
of America for interim financial information. Accordingly, such financial
statements do not include all the information and footnotes required by
accounting principles generally accepted in the United States of America for
annual financial statements. In the opinion of management, the accompanying
condensed consolidated financial statements reflect all adjustments (which are
of a normal recurring nature) that are necessary for a fair presentation of the
results of the interim results of operation, financial position and cash flows.
The results reported in these interim condensed consolidated financial
statements should not be regarded as being necessarily indicative of results
that might be expected for the full year. 6




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2. STOCK-BASED COMPENSATION We have stock option incentive plans for our employees and directors. As
permitted by SFAS No. 123, Accounting for Stock-based Compensation (SFAS
No.123), we apply the provisions of APB Opinion No. 25, Accounting for Stock
Issued to Employees, and related interpretations, in accounting for
compensation expense for grants of equity instruments under these plans.
Accordingly, no compensation cost is recognized for the stock options, because
all options granted under those plans had an exercise price equal to the market
value of the underlying common stock on the date of grant. The following table illustrates the effect on net loss attributable to
common shareholders and on loss per share if we had applied the fair value
based recognition method of SFAS No. 123 to stock-based employee compensation. Three months ended
    
    Six months endedJanuary 31,
    
    January 31,2004
    
    2003
    
    2004
    
    2003Net loss attributable to common shareholders as reported
    
    $
    (970,897
    )
    
    $
    (885,798
    )
    
    $
    (2,548,988
    )
    
    $
    (6,588,946
    )Deduct: Stock-based employee compensation expense
determined under fair value based method for all
awards, net of related tax effects
    
    
    444,126
    
    
    
    66,209
    
    
    
    793,030
    
    
    
    288,119Pro forma net loss attributable to common shareholders
    
    $
    (1,415,023
    )
    
    $
    (952,007
    )
    
    $
    (3,342,018
    )
    
    $
    (6,877,065
    )Net loss attributable to common shareholders per basic
and diluted share outstanding:As reported
    
    $
    (0.02
    )
    
    $
    (0.02
    )
    
    $
    (0.06
    )
    
    $
    (0.15
    )Pro forma
    
    $
    (0.03
    )
    
    $
    (0.02
    )
    
    $
    (0.07
    )
    
    $
    (0.15
    )
 The fair value was estimated using the Black-Scholes option pricing model
with the following assumptions used for grants in the second quarter of fiscal
2004 and 2003: risk-free interest rates of 3.12 and 3.05, respectively;
expected volatility of 67% and 88%, respectively; expected terms of 5.8 years
and 5.3 years, respectively; and dividend yield of 0% for both quarters. Warrants issued for services are valued on the measurement date and
expensed when the warrant holders performance is complete. The measurement
date is generally the earlier of the date at which a commitment for performance
by the warrant holder to earn the warrant is reached or the date at which the
warrant holders performance is complete. 3. NET LOSS PER COMMON SHARE Since a loss from continuing operations was incurred for the six month
periods ended January 31, 2004 and 2003, potentially dilutive shares applicable
to convertible preferred stock, options, and warrants to purchase shares of
common stock were not included in the computation of diluted net loss per
common share because their effect would be antidilutive. Potentially dilutive
common shares for the three month and six month periods ended January 31, 2004
were 716,625 and 614,328, respectively, and for the three and six month periods
ended January 31, 2003 were 51,455 and 74,663, respectively. Dilutive common
shares give effect to securities, such as stock options, warrants and
convertible preferred stock, which have the potential to be exercised. The
increase in the number of potentially dilutive shares in the six month period
ended January 31, 2004, over the prior year period results primarily from the
increase in the current market price of our common stock in comparison to the
exercise price of our outstanding stock options, warrants and convertible
preferred stock. 7




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4. INVENTORIES Inventories consist of the following: January 31,
    
    July 31,2004
    
    2003Finished goods
    
    $
    2,401,804
    
    
    $
    2,217,396Work in process
    
    
    486,981
    
    
    
    555,153Raw materials
    
    
    4,700,928
    
    
    
    5,670,217Inventory reserves
    
    
    (380,097
    )
    
    
    (354,544
    )$
    7,209,616
    
    
    $
    8,088,222
 5. INTANGIBLE ASSETS SFAS No. 142, Goodwill and Other Intangible Assets (SFAS No. 142)
became effective for us as of August 1, 2002. SFAS No. 142 specifies that
goodwill and certain intangible assets with indefinite lives no longer be
amortized but instead be subject to periodic impairment testing using a fair
value methodology. We stopped amortizing goodwill effective August 1, 2002. We
also determined that purchased technology rights, patents and trademarks and
other intangible assets had finite lives and, therefore, no transitional
impairment test was required. Under the impairment testing required by SFAS No. 142, we determined that
impairment existed in the reporting units within the Pharmaceuticals segment as
of August 1, 2002, and a non-cash charge of $4.1 million was recorded. The fair
value of the reporting units was estimated using the expected present value of
future cash flows. Intangible assets with finite lives will continue to be amortized over
their respective useful lives and will be tested for impairment in accordance
with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived
Assets (SFAS No. 144). A summary of intangible assets is presented below: January 31, 2004
    
    July 31, 2003Gross
    
    
    
    
    
    Net
    
    Gross
    
    
    
    
    
    NetCarrying
    
    Accumulated
    
    Carrying
    
    Carrying
    
    Accumulated
    
    CarryingAmount
    
    Amortization
    
    Amount
    
    Amount
    
    Amortization
    
    AmountAmortizable intangibles:Purchased technology
rights
    
    $
    7,419,473
    
    
    $
    3,669,847
    
    
    $
    3,749,626
    
    
    $
    7,419,473
    
    
    $
    3,430,509
    
    
    $
    3,988,964Trademarks and other
intangible assets:Trademarks
    
    
    11,608,585
    
    
    
    2,886,450
    
    
    
    8,722,135
    
    
    
    11,574,237
    
    
    
    2,652,207
    
    
    
    8,922,030Patents
    
    
    3,307,477
    
    
    
    909,924
    
    
    
    2,397,553
    
    
    
    3,049,289
    
    
    
    735,712
    
    
    
    2,313,577Licensing costs
    
    
    2,734,031
    
    
    
    620,504
    
    
    
    2,113,527
    
    
    
    2,709,144
    
    
    
    488,084
    
    
    
    2,221,060Other
    
    
    536,180
    
    
    
    280,754
    
    
    
    255,426
    
    
    
    536,180
    
    
    
    272,825
    
    
    
    263,355Total trademarks and
other intangible assets
    
    
    18,186,273
    
    
    
    4,697,632
    
    
    
    13,488,641
    
    
    
    17,868,850
    
    
    
    4,148,828
    
    
    
    13,720,022Total amortizable
intangible assets
    
    
    25,605,746
    
    
    
    8,367,479
    
    
    
    17,238,267
    
    
    
    25,288,323
    
    
    
    7,579,337
    
    
    
    17,708,986
 8




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##### Table of Contents



January 31, 2004
    
    July 31, 2003Gross
    
    
    
    
    
    Net
    
    Gross
    
    
    
    
    
    NetCarrying
    
    Accumulated
    
    Carrying
    
    Carrying
    
    Accumulated
    
    CarryingAmount
    
    Amortization
    
    Amount
    
    Amount
    
    Amortization
    
    AmountUnamortizable intangible
asset:Goodwill
    
    
    12,446,792
    
    
    
    5,516,600
    
    
    
    6,930,192
    
    
    
    12,446,792
    
    
    
    5,516,600
    
    
    
    6,930,192Total intangible assets
    
    $
    38,052,538
    
    
    $
    13,884,079
    
    
    $
    24,168,459
    
    
    $
    37,735,115
    
    
    $
    13,095,937
    
    
    $
    24,639,178
 During the six months ended January 31, 2004, we capitalized $323,000 of
legal fees associated with patent applications. Intangible asset amortization
expense for the three months and six months ended January 31, 2004 was $469,000
and $797,000, respectively. For fiscal years 2004 through 2008, the
amortization of intangibles is estimated to be $1.3 million each year. The net carrying amounts of goodwill by segment at January 31, 2004 and
July 31, 2003 follow: Zila Nutraceuticals
    
    $
    2,896,926Zila Pharmaceuticals
    
    
    4,033,266Total
    
    $
    6,930,192
 6. SHORT-TERM BORROWINGS, LONG-TERM DEBT AND LEASE OBLIGATIONS At January 31, 2004, we had (i) short-term notes payable of $264,000 at
5.6% for installments due on various insurance policies and (ii) a short-term
equipment loan of $3,000. Under our Loan and Security Agreement with Congress Financial
(Congress), we have a $12 million revolving line of credit facility at an
interest rate equal to the prime rate plus 3/4 percent. The amount of funds
available from the line of credit is based upon a percentage of the value of
eligible receivables and inventory and was $9.0 million at January 31, 2004.
Under the Agreement, we are required to maintain adjusted tangible net worth,
as defined in the Agreement. At January 31, 2004, our adjusted tangible net
worth, as defined, was $28.5 million compared to the required amount of $12.0
million. At January 31, 2004, there were no borrowings outstanding under this
line of credit. On December 18, 2002, we entered into an agreement with PharmaBio
Development, Inc., (PharmaBio) the strategic investment group of Quintiles
Transnational Corp., whereby PharmaBio invested $500,000 in us. In return for
the investment, we agreed to pay to PharmaBio an amount equal to 5% of all net
sales of the OraTest® product in the European Union and the United States (the
Royalty). The aggregate amount of the Royalty cannot exceed $1.25 million.
Any Royalty due is to be paid quarterly. The investment was recorded as
long-term debt and will be amortized using the effective interest method. In April 1999, Zila Nutraceuticals, through Oxycal, entered into a
transaction with The Industrial Development Authority of the County of Yavapai
(the Authority) in which the Authority issued $5.0 million in Industrial
Development Revenue Bonds (the Bonds). The proceeds were loaned to Zila
Nutraceuticals for the construction of a new manufacturing and laboratory
facility. As of January 31, 2004, the Bonds outstanding consisted of $3.5
million Series A bonds, which bear a variable interest rate that was 1.3% at
January 31, 2004. The Bonds mature in 2019. In connection with the issuance of
the Bonds, the Authority required that Zila Nutraceuticals obtain, for the
benefit of the Bondholders, an irrevocable direct-pay letter of credit to
secure payment of principal and interest. We guaranteed the letter of credit.
The existing letter of credit expired on March 15, 2004, and we obtained a
replacement letter of credit through Wells Fargo Business Credit, Inc. that
expires on March 15, 2009. We guaranteed the replacement letter of credit. 9




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During the six months ended January 31, 2004, we entered into capital
lease arrangements for equipment of $205,000 with terms from three to five
years. Long-term capital lease obligations at January 31, 2004 were $198,525. As
described in Note 10, in January 2004, we executed the sale and
a five-year operating leaseback of our headquarters facility. The initial monthly payment
is $14,000 and the payment will increase 2% annually over the five-year term of
the lease. We remain responsible for real property taxes, insurance and
maintenance. Our future minimum lease payments under non-cancelable operating leases
are as follows: 2005
    
    $
    432,9832006
    
    
    283,7832007
    
    
    241,8782008
    
    
    209,6292009
    
    
    88,620Total
    
    $
    1,256,893
 7. SEVERANCE AND RELATED CHARGES We incurred severance and other costs related to employee terminations,
recruiting fees and relocation expenses of $115,000 and $154,000, respectively,
during the three months and six months ended January 31, 2004, and $179,000 and
$1,059,000, respectively, during the three months and six months ended January
31, 2003. 8. INCOME TAXES Deferred income taxes reflect the tax effect of temporary differences
between the amounts of assets and liabilities recognized for financial
reporting and income tax purposes. At the end of each fiscal quarter, we
estimate the effective tax rate expected to be applicable for the full fiscal
year. The rate so determined is used in providing for income taxes on a
current year-to-date basis. In the six months ended January 31, 2004 and
January 31, 2003, we recorded a tax benefit based on the effective tax rate and
offset the tax benefit with an increase in the deferred tax asset valuation
reserve. At January 31, 2004, we recorded total deferred tax assets of
approximately $6.6 million. The total deferred tax assets were offset with a
valuation allowance due to our lack of an earnings history. We believe that
the valuation allowance reduces deferred tax assets to the amount representing
our best estimate of the amount of such deferred tax assets that more likely
than not will be realized. At January 31, 2004, the Company had income tax net operating loss carry
forwards of approximately $9.8 million that expire in fiscal years 2010 through
2024. 9. SEGMENT INFORMATION Our business is organized into three major groups, all of which have
distinct product lines, brand names and are managed as autonomous business
units. The following reporting segments have been identified for purposes of
applying SFAS No. 131, Disclosures about Segments of an Enterprise and Related
Information: (i) Nutraceuticals, which includes Oxycal Laboratories, Inc. and
its wholly-owned subsidiary, Zila Nutraceuticals, Inc.; (ii) Pharmaceuticals,
which includes Zila Pharmaceuticals, Inc. and the ViziLite® chemiluminescent
disposable light product for the illumination of oral mucosal abnormalities,
Peridex® prescription mouth rinse, the Zilactin® family of over-the-counter
products, 10




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##### Table of Contents



and the plastic molded products of IST; and (iii) Biotechnology, the
research, development and licensing business specializing in pre-cancer/cancer
detection through its patented ZTC® and OraTest® technologies and managing the
OraTest® product, an oral cancer diagnostic system currently in FDA phase III
clinical trials. We evaluate performance and allocate resources to segments
based on operating results. The table below presents information about reported segments for the three
months ended January 31, 2004 and 2003 (in thousands): Nutraceuticals
    
    Pharmaceuticals
    
    Biotechnology
    
    Corporate
    
    TotalNet revenues:2004
    
    $
    8,612
    
    
    $
    4,992
    
    
    $
    
    
    
    $
    
    
    
    $
    13,6042003
    
    
    7,116
    
    
    
    4,859
    
    
    
    3
    
    
    
    
    
    
    
    11,978Income (loss) before
income taxes and
accounting change:2004
    
    
    1,426
    
    
    
    (220
    )
    
    
    (1,339
    )
    
    
    (828
    ) (a)
    
    
    (961
    )2003
    
    
    1,285
    
    
    
    631
    
    
    
    (1,234
    )
    
    
    (1,558
    ) (a)
    
    
    (876
    )Depreciation and
amortization:2004
    
    
    258
    
    
    
    304
    
    
    
    174
    
    
    
    27
    
    
    
    7632003
    
    
    258
    
    
    
    152
    
    
    
    182
    
    
    
    30
    
    
    
    622
  (a)
    
    Includes approximately $115,000 and $179,000 of severance and
related costs in the three months ended January 31, 2004 and 2003,
respectively. The table below presents information about reported segments for the six
months ended January 31, 2004 and 2003 and segment total assets as of January
31, 2004 and July 31, 2003 (in thousands): Nutraceuticals
    
    Pharmaceuticals
    
    Biotechnology
    
    Corporate
    
    TotalNet revenues:2004
    
    $
    15,602
    
    
    $
    10,053
    
    
    $
    1
    
    
    $
    
    
    
    $
    25,6562003
    
    
    13,596
    
    
    
    9,106
    
    
    
    10
    
    
    
    
    
    
    
    22,712Income (loss) before
income taxes and
accounting change:2004
    
    
    2,441
    
    
    
    193
    
    
    
    (2,943
    )
    
    
    (2,220
    ) (b)
    
    
    (2,529
    )2003
    
    
    3,129
    
    
    
    584
    
    
    
    (2,255
    )
    
    
    (3,943
    ) (b)
    
    
    (2,485
    )Depreciation and
amortization:2004
    
    
    516
    
    
    
    466
    
    
    
    350
    
    
    
    57
    
    
    
    1,3892003
    
    
    519
    
    
    
    272
    
    
    
    361
    
    
    
    61
    
    
    
    1,213Total assets as of:January 31, 2004
    
    
    31,453
    
    
    
    12,876
    
    
    
    16,774
    
    
    
    4,503
    
    
    
    65,606July 31, 2003
    
    
    29,290
    
    
    
    14,520
    
    
    
    7,983
    
    
    
    17,227
    
    
    
    69,020
 11




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##### Table of Contents



(b)
    
    Includes approximately $154,000 and $1,059,000 of severance and
related costs in the six months ended January 31, 2004 and 2003,
respectively. 10. SALE AND LEASEBACK OF CORPORATE HEADQUARTERS As part of our strategy to employ financial assets in core business
competencies, on January 30, 2004, we completed the sale and five-year
leaseback of our corporate headquarters for approximately $1.8 million in cash.
We realized a gain of $1.2 million, of which we recognized approximately
$470,000 in the quarter ended January 31, 2004. The $470,000 gain represents
the excess of the net proceeds over the net present value of the future lease
payments. The balance of the gain of $765,000 was deferred and will be
amortized on a straight-line basis over the five-year lease term as a reduction
of rent expense in general and administrative expenses. Of this deferred gain,
$611,000 is shown as long-term and the balance is shown as current. The
leaseback is accounted for as an operating lease. 11. COMMITMENTS AND CONTINGENCIES FDA approval of the OraTest® product In December 2002, we transitioned the OraTest clinical program to
Quintiles Transnational, the nations largest pharmaceutical services company.
This was the result of an extensive review of several proposals received from
some of the largest, highest quality and most prominent contract research
organizations with worldwide capabilities. Quintiles completed the transition
successfully without compromising the study data. Factors that will affect the
cost and timing of completion of the clinical program include but are not
limited to: (i) patient enrollment rates, (ii) tumor formation rate within the
study population, (iii) compliance with the study protocol and related
monitoring, (iv) level of available funding throughout the study, and (v)
protocol and clinical program modifications. OraTest® Product At January 31, 2004,we had approximately $362,000 of ZTC drug substance,
the active ingredient in the OraTest® product, at our manufacturing facility in
Phoenix, AZ. We intend to realize the value of this drug substance through
sales in the U.S., if we receive final approval for the OraTest® products from
the FDA, and through sales in Europe and Asia prior to the date that we expect
sales in the United States. The drug substance currently has expiration dates
in 2004, 2005 and 2006. Previous testing has indicated that the drug substance
is stable and we anticipate being able to extend the expiration dates of the
entire drug substance through the date we expect sales in the United States.
However, no assurance can be given in this regard. In addition, if FDA approval
is not granted or is significantly delayed or if the marketing of OraTest® is
not commercially successful, it may not be possible for us to recover the value
of this drug substance. ViziLite® On October 15, 2003, we completed a mediated settlement with Trylon of
various issues. As part of the settlement, we agreed to eliminate the
contractual restrictions relating to sales milestones associated with 500,000
shares of the previously issued restricted common stock. The contractual
restrictions on 250,000 of these shares will be removed upon achievement of a
product development milestone. The contractual restrictions on the remaining
250,000 shares will be removed upon Trylons obtaining of the required
governmental approvals relating to the product development milestone. As part
of the settlement, we also agreed that Trylons royalty rates for net sales of
the ViziLite® product will be reduced from 10% to 5% for the first five years
and from 5% to 2.5% for 12




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##### Table of Contents



the second five years. Thereafter, the royalty payment ends. We had $329,000 of ViziLite® product in inventory and approximately $2.1
million of associated intangible assets as of January 31, 2004. As part of our
strategy to educate the dental profession on the benefits of using ViziLite®
and to widen distribution, in the third quarter of fiscal 2003 we modified our
exclusive distributorship agreement with Patterson Dental Company to convert it
to a non-exclusive agreement for the dental industry in the United States and
Canada. We then retained regional distributors and sales groups with a roster
of independent sales representatives. With the introduction of independent
sales representative and regional distributors, we are modifying our plan to
reach both opinion leaders and end-users in the oral cavity screening process.
However, if sales do not ultimately reach certain levels, we may have to reduce
the carrying value of the assets related to ViziLite®. Litigation In connection with the acquisition of patent rights in 1980, we agreed to
pay to Dr. James E. Tinnell (Tinnell), the inventor of one of our treatment
compositions, a royalty of 5% of gross sales of the invention disclosed in his
then pending patent application. In September 2000, we notified Tinnell that we would no longer pay such
royalties since the obligations ceased in August 1998 when the related product
patents expired and we requested reimbursement of royalties paid since August
1998. We then filed suit in the Federal District Court requesting a declaratory
judgment that we had no royalty obligations to Tinnell and a judgment for the
overpaid royalties. Tinnell asserted several counterclaims. The Court has since
ruled in our favor stating that we do not owe royalty obligations to Tinnell
and denied several of Tinnells counterclaims. However, one of Tinnells
counterclaims is still outstanding for breach of contract. Furthermore, the
Court has not ruled on our request for reimbursement of overpaid royalties. We
intend to request the Court to rule on our claim for reimbursement and prepare
for trial on the remaining breach of contract issue. In November 2001, we filed a suit for trademark infringement and trade
secret misappropriation against Darrel Van Dyke and GMP Products, LLC relating
to ISTs patented swab technology. Subsequent to 2001, GMP Products changed its
name to Viridian Packaging Solutions, LLC (Viridian). In December 2002, the
court entered a final judgment against us and the defendants brought a motion
to recover their attorneys fees and other costs incurred in defending the
action. On September 29, 2003, the court awarded $131,700 to the defendants. In January 2003, we filed a suit for patent infringement against Beutlich
Pharmaceuticals, LP (Beutlich) alleging that it sold dry-handle swabs that
infringe upon our IST product swab patent. In February 2003, the Arizona court
issued a temporary restraining order in our favor that stopped Beutlich from
selling its swabs. In May 2003, Viridian filed a declaratory judgment action in
the Northern District of Illinois that sought a declaration of non-infringement
and patent invalidity. In November 2003, we settled both of these matters. Under the settlement
agreement, we permitted Beutlich and Viridian to sell their products to certain
prospective customers. In addition, we paid Viridian $29,000 of the $131,700
that the court had awarded and Viridian waived the balance. We are subject to other legal proceedings and claims that arise in the
ordinary course of business. In the opinion of management, the amount of
ultimate liability with respect to these actions will not materially affect our
financial position or results of operations. 13




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##### Table of Contents



Vital Health Sciences Ltd. License Agreement On October 31, 2003, we entered into a license agreement with Vital Health
Sciences Limited (Vital Health) of Australia that grants us the exclusive
rights in the dietary supplement market for certain issued and pending patents,
know-how and data pertaining to tocopherol phosphate in the United States,
Canada and Indonesia. The initial term of the license is five years, and we
have the right, unilaterally, to extend the term until the expiration of the
last of the licensed patents. Several of such patents are recently issued
while other patent applications are still pending. We also have a right of
first refusal for certain other international markets under the agreement.
Zila Nutraceuticals is currently using Vital Healths patented process for
manufacturing tocopherol phosphate, as well as numerous pending patent
applications, to develop its Ester-E product tailored for the dietary
supplement market. We have completed successful commercial scale batches, and
we anticipate that the Ester-E product will be launched in the third and/or fourth
quarters of fiscal year 2004. Under the agreement, we are required to make
royalty payments based on certain levels of sales volume. We are also required
to pay certain upfront fees upon the completion of certain market launch
milestones, as defined in the agreement, and minimum annual royalty fees on
sales. 12. SUBSEQUENT EVENT On February 6, 2004, we entered into a $10,000,000 Credit and Security
Agreement with Wells Fargo Business Credit (WFBC). We will not be permitted
to borrow under this agreement until the expiration of our lending agreement
with Congress (see Note 6) and the perfection of certain security interests by
WFBC. This revolving line of credit facility will bear interest equal to the
prime rate. Funds available under the line of credit are based upon a
percentage of the value of eligible receivables and inventory. Under this
agreement, financial covenants will require maintenance of minimum net worth
and limitations on the amount of capital expenditures. As described in Note 6, on February 6, 2004, under the terms of the
Reimbursement Agreement between Zila Nutraceuticals and WFBC, WFBC executed an
irrevocable direct-pay letter of credit for the benefit of the bondholders.
This letter of credit became effective on March 15, 2004 upon the expiration of
the prior letter of credit. Under the terms of the letter of credit, we placed
$513,000 in a restricted cash collateral account representing the difference
between the letter of credit amount and the maximum commitment amount defined
in the Reimbursement Agreement. 
 Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations ZILA, INC. AND SUBSIDIARIES Forward-Looking Information This Report contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934. The words believe, expect, anticipate, intend,
estimate, may, should, could, will, plan, future, continue, and
other expressions that are predictions of or indicate future events and trends
and that do not relate to historical matters identify forward-looking
statements. These forward-looking statements are based largely on our
expectations or forecasts of future events, can be affected by inaccurate
assumptions, and are subject to various business risks and known and unknown
uncertainties, a number of which are beyond our control. Therefore, actual
results could differ 14




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##### Table of Contents



materially from the forward-looking statements contained in this document, and
readers are cautioned not to place undue reliance on such forward-looking
statements. We undertake no obligation to publicly update or revise any
forward-looking statements, whether as a result of new information, future
events or otherwise. A wide variety of factors could cause or contribute to
such differences and could adversely impact revenues, profitability, cash flows
and capital needs. There can be no assurance that the forward-looking
statements contained in this document will, in fact, transpire or prove to be
accurate. Factors that could cause or contribute to our actual results differing

materially from those discussed herein or for our stock price to be adversely
affected include, but are not limited to: (i) our failure to maintain
compliance with the covenants of our outstanding debt instruments; (ii)
industry trends, including a downturn or slowing of the growth of the dietary
supplement industry and the consumer oral care, over-the-counter and
prescription industries; (iii) increased competition from current competitors
and new market entrants; (iv) our reliance on single source manufacturing
locations for several of our products; (v) adverse publicity regarding the
industries in which we market our products; (vi) our dependence upon our
ability to develop new products; (vii) our ability to gain or expand
distribution within new or existing channels of trade; (viii) an increase in
the cost of obtaining and maintaining shelf space with major national retailers
who demand various forms of incentives from their suppliers, such as slotting
fees, coop advertising, or rebates; (ix) adverse changes in government
regulations; (x) our suppliers and our ability to continue to comply with
current good manufacturing practices (cGMP) and other applicable regulatory
requirements; (xi) exposure to product liability claims; (xi) dependence on
significant customers; (xiii) our ability to keep and attract key management
employees; (xiv) our inability to manage growth and execute our business plan;
(xv) sales and earnings volatility; (xvi) volatility of the stock market;
(xvii) our reliance on independent brokers to sell many of our products;
(xviii) our inability to protect our intellectual property; (xix) impairment
charges resulting from an impairment of our goodwill and intangible assets;
(xx) future increases in the cost of ascorbic acid, the primary raw material in
our Ester-C® products, and our ability to pass price increases along to our
customers; (xxi) our ability to secure long-term supply arrangements for a
sufficient quantity of ascorbic acid at stable and more traditional pricing
levels; (xxii) the timing of the commercial launch of our
Ester-E product; (xxiii) the market acceptance of the ViziLite® and Ester-E products;
(xxiv) our ability to add new customers at IST to replace sales volume, in
whole or in part, upon the expiration of our contract on March 30, 2004 with a
major customer representing approximately 80% of ISTs monthly sales; and
(xxv) a general downturn in the national economy as a whole. Included among the factors affecting the OraTest® product are (i)
successful completion of the clinical program; (ii) the
FDAs decision regarding the proposed modifications for the
OraTest® clinical program; (iii) our ability to accelerate,
expand and fund the clinical study under terms that are reasonable and prudent
for us; (iv) the FDAs ultimate decision regarding the OraTest® clinical
program and product; (v) the length, size and expense of our clinical program
and the FDA review process; (vi) stability of the ZTC drug
substance; (vii) the
limitations on indicated uses for which the OraTest® product may be marketed if
we receive FDA approval; and (viii) if approved, the market reception to the
OraTest® product and any post-marketing reports or surveillance programs to
monitor usage or side effects of the OraTest® product. There can be no
assurance that the forward-looking statements contained in this document will,
in fact, transpire or prove to be accurate. For a more detailed description of
these and other cautionary factors that may affect our future results, please
refer to our Annual Report on Form 10-K for the fiscal year ended July 31, 2003
filed with the Securities and Exchange Commission. 15




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##### Table of Contents



Critical Accounting Policies There are several accounting policies that we believe are significant to
the presentation of our condensed consolidated financial statements. The most
critical policies include those related to revenue recognition, use of
estimates and intangible assets. Revenue Recognition- Revenue from sales of products is recognized when
earned; that is, when the risks and rewards of ownership have transferred to
the customer, which is considered to have occurred when delivery to the
designated location or carrier has occurred. Cash discounts, sales incentives,
and returns are estimated and recognized at the date of shipment based upon
historical activity and current customer commitments. We evaluate these
estimates on a quarterly basis and revise them as necessary. On occasion, we enter into arrangements to license our technology on
specifically approved products. For those arrangements where we have continuing
involvement with the licensee, nonrefundable, upfront license fees are
recognized systematically as they are earned over the life of the agreement.
Fees associated with substantive, at risk, performance milestones are
recognized as revenue upon their completion, as defined in the respective
agreements. For perpetual licenses or manufacturing rights agreements, where
(i) we have no further continuing involvement with the licensee; (ii) the fees
are nonrefundable; and (iii) the fees are not a prepayment of future royalties,
we recognize the fees as revenue at the time the arrangement becomes effective.
The assessment of existence or extent of continuing involvement requires
significant judgment and analysis of the contractual requirements and other
factors relating to the business relationship between the parties. Use of Estimates- The preparation of financial statements in conformity
with accounting principles generally accepted in the United States of America
necessarily requires management to make estimates and assumptions that affect
the reported amounts of assets and liabilities, disclosure of contingent assets
and liabilities at the date of the financial statements and the reported
amounts of revenue and expenses during the reporting period. Actual results
could differ from those estimates. Significant estimates include the following: The cash flows used to measure long-lived assets related to the OraTest®
product are dependent upon obtaining FDA approval and generating sufficient
revenues from sales of the OraTest® product. The rigorous clinical testing and
an extensive regulatory approval process mandated by the FDA and equivalent
foreign authorities before any new drug can be marketed by us can take a number
of years and require the expenditure of substantial resources. However,
obtaining such approvals and completing such testing is a costly and
time-consuming process, and approval may not be ultimately obtained. The length
of the FDA review period varies considerably, as does the amount of clinical
data required to demonstrate the safety and efficacy of a specific product. Net
long-lived assets related to the OraTest® product as of January 31, 2004 of
$6.5 million have been capitalized. The cash flows used to measure long-lived assets related to the ViziLite®
product are dependent upon our ability to market and sell the product to a
sufficient number of dental offices so it becomes integrated within their
practice and becomes a commercially viable product. ViziLite® is a
chemiluminescent light technology used in combination with traditional oral
screening to increase identification, evaluation and monitoring of oral mucosal
abnormalities. Achieving our sales goals 16




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requires significant training and education about the products attributes to
the dental professionals. As a result of organizational and sales strategy
changes in 2003, we have revised our business model with current sales and
costs assumptions. We have added marketing, sales and educational costs
targeted towards achieving market acceptance within a reasonable timeframe. Net
long-lived assets related to the ViziLite® product as of January 31, 2004 of
$2.1 million have been capitalized. We anticipate that our current cash balances, along with cash generated
from our Nutraceuticals and Pharmaceuticals business units and our line of
credit, will be adequate to support the activities described above for both the
Vizilite® and OraTest® products. Intangible Assets The following is a summary of the significant classes
of intangible assets and our impairment methodology for each. In accordance with SFAS No. 142, our policy is to review the carrying
amounts of goodwill at least annually or whenever events or changes in
circumstances indicate that the carrying amount of the asset may not be
recoverable. Such events or circumstances might include a significant decline
in market share, a significant decline in profits, rapid changes in technology,
significant litigation or other items. In evaluating the recoverability of
goodwill and certain intangible assets, our policy is to compare the carrying
amounts of such assets with the estimated undiscounted future operating cash
flows. If we have changes in event or circumstances, including reductions in
anticipated cash flows generated by our operations or determinations to divest
of certain assets, certain assets could be impaired which would result in a
charge to earnings. OraTest®- The recoverability of the $3.7 million net purchased technology
rights is dependent upon obtaining FDA approval and generating sufficient
revenues from future sales of the OraTest® products. Net fixed assets of
approximately $768,000 (primarily related to a manufacturing facility), patents
and patents pending of $1.2 million, long-term deposits of $760,000 and
$544,000 of active ingredient and related components associated with the
OraTest® products are grouped with the purchased technology rights for the
purpose of testing recoverability. We have prepared a probability-weighted
analysis of potential future cash flows under various possible outcomes.
Significant assumptions in the analysis include the expected date and overall
likelihood of FDA approval, cost of the remaining phase III clinical trials,
cost of the marketing roll out, future net cash flows associated with sales of
the products and the probabilities assigned to each possible outcome. The
assumptions included in the analysis are updated whenever events or changes in
circumstances indicate that the carrying amount may not be recoverable. Zila Pharmaceuticals Goodwill This goodwill is related to the Peridex®
product that was acquired from Procter & Gamble in November 1997 and to the IST
acquisition that occurred in February 2001. As part of the implementation of
SFAS No. 142, Goodwill and Other Intangible Assets on August 1, 2002, we
retained an independent financial advisor who compared the fair values and
corresponding carrying values of the Peridex® and IST assets as of the adoption
date for SFAS No. 142. Based upon the financial advisor findings, we determined
that approximately $4.1 million of goodwill was impaired, thus reducing
goodwill to approximately $4.0 million (net of accumulated amortization of $4.6
million). This transitional impairment charge of $4.1 million was recorded as a
change in accounting principle and retroactively restated to August 1, 2002,
the beginning of our fiscal year. Zila Nutraceuticals Goodwill- Goodwill and trademarks totaling
approximately $11.5 million (net of accumulated amortization of $3.8 million)
are related to the Ester-C® group of products. These assets were acquired by
merger in 1997, and we forecast that cash flows associated with the Ester-C® 17




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products will allow recovery of the total intangible asset balance in
approximately five years if net cash flows continue at current levels. Income Taxes We regularly review our deferred tax assets and related
valuation allowances in accordance with SFAS No. 109, Accounting for Income
Taxes. SFAS No. 109 requires us to assess all available evidence, both
positive and negative, to determine whether a valuation allowance is needed
based on the weight of that evidence. For the six months ended January 31, 2004
and 2002, we recorded a tax benefit based on the effective tax rate and offset
the tax benefit with an increase in the deferred tax asset valuation reserve.
As of January 31, 2004, all of our deferred tax assets were offset by a
valuation allowance. COMPANY OVERVIEW We are an innovator in preventative healthcare technologies with
nutraceutical, pharmaceutical and biotechnology products, focusing on enhanced
body defense and the detection of pre-disease states. In August 2002, in order
to support continued growth, we re-aligned several of our business units into
three focused operating divisions. Zila Nutraceuticals manufactures and markets
patented Ester-C®, a branded, highly effective form of vitamin C and plans to
launch Ester-E, an enhanced form of vitamin E, in the third and/or fourth
quarters of fiscal year 2004. Zila Pharmaceuticals includes the Zilactin®
family of over-the-counter products, Peridex® prescription mouth rinse, the
ViziLite® disposable light for illumination of oral mucosal abnormalities, and
the plastic molded products from Innovative Swab Technologies (IST). Zila
Biotechnology includes the OraTest® product, an oral cancer detection system,
and the ZTC technologies for cancer and pre-cancer detection and treatment. Our strategic approach to the management of our business units is driven
by our commitment to grow our Nutraceutical and Pharmaceutical businesses while
we successfully complete the OraTest® clinical trials. To that end, we are
investing more aggressively in our core nutraceutical and pharmaceutical
products to drive greater profitability and the required cash flows to fund the
research and development efforts being managed by the Biotechnology Business
Unit. In doing so, our corporate goal is to manage the entire portfolio of
business units in a manner such that over the course of a given fiscal year,
our earnings before interest, taxes, depreciation and amortization would be at
a near break-even level. We expect to continue with this goal until such time
as we obtain the requisite clearances from the U.S. Food and Drug
Administration (FDA) to bring our OraTest® product to market in the United
States. Market forces, such as the price that we must pay for ascorbic acid and
other such risk factors, can and do influence our ability to accomplish this
goal. See page 15 for further discussion of the risk factors that we face in
our businesses. Additionally, our level of research and development activities,
and the associated cost, will likely trend above our historical levels as we
accelerate our efforts to advance the progress of our clinical trials. In
connection with our dialogue with the FDA, we have proposed
modifications to the current OraTest clinical program aimed at
reducing its overall duration and total cost. It is our goal to
include the evaluation of OraTest® in the accurate
identification of severe dysplasia (pre-cancer) in addition to
carcinoma in-situ and invasive carcinoma (cancer) as acceptable
clinical endpoints in the modified program. It is also our objective
to collect data in an incremental population of individuals at high
risk of oral cancer (primary cancer screening) while still reducing
the cost and duration of the current clinical program. If this
program modification is allowed by the FDA and the clinical
objectives are achieved, it may also permit enlargement of the
post-approval target population and the marketable claims for
OraTest®. No
assurances can be made that the FDA will agree to our proposed
program modifications or that the clinical objectives will be
achieved. We are currently assimilating and implementing the
agencys non-binding comments to our proposed program
modifications. In the meantime, we continue to collect patient data
within our clinical trial and push forward aggressively with the
clinical program. 18




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The following discussion should be read in conjunction with the
accompanying unaudited Condensed Consolidated Financial Statements and Notes to
Condensed Consolidated Financial Statements (Unaudited). RESULTS OF OPERATIONS Comparison of the three months ended January 31, 2004 with the three months
ended January 31, 2003 Total Company Net revenues increased 13.6% to $13.6 million for the three months ended
January 31, 2004, compared to revenues of $12.0 million for the three months
ended January 31, 2003. The increase is due to a 21.0% sales increase in the
Nutraceuticals Business Unit and a 2.8% sales increase in the Pharmaceuticals
Business Unit. When the sales of the discontinued Saw Palmetto oil product line
are removed from the prior year, net revenues increased 38.4% at Nutraceuticals
and 22.7% for the total company. Increased spending in advertising and
promotional programs contributed to the sales increases. Cost of products sold as a percentage of net revenues increased to 41.4%
from 41.0% for the three months ended January 31, 2004. This increase was due
primarily to substantially higher costs for ascorbic acid, the principal raw
material used by the Nutraceuticals Business Unit in its Ester-C® products.
This increase was partially offset by improved gross margins in the
Pharmaceuticals Business Unit as a result of production efficiencies in IST,
along with a reduction in equipment validation costs for the Zilactin®-L
product line. Marketing and selling expenses as a percentage of net revenues increased
to 30.1% from 24.2% for the three months ended January 31, 2004. This increase
was primarily due to heavy brand and media advertising support for the
Nutraceuticals Business Unit product, Ester-C®,and the Pharmaceuticals
Business Unit products, Zilactin® and Vizilite®. General and administrative expenses were $3.4 million, or 25.1% of net
revenues, for the three months ended January 31, 2004, compared to $3.3
million, or 27.5% of net revenue, for the three months ended January 31, 2003.
Legal fees of $344,000, associated with the Beutlich and Trylon settlements,
were the primary cause of the increase over the previous year. Severance and related charges incurred in connection with employee
terminations, recruiting fees and relocation expenses were $115,000 in the
three months ended January 31, 2004, compared to $179,000 in the three months
ended January 31, 2003. Higher severance and related charges were incurred in
the prior year period due primarily to the significant changes in Company
management, focus and the resulting organization. 19




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Research and development expenses increased $139,000, or 17.0%, to
$956,000 for the three months ended January 31, 2004 from $817,000 in the three
months ended January 31, 2003. The increase is due primarily to an increase in
the OraTest® phase III clinical trial expenses of $204,000, or 32.1%, offset by
a reduction in expenditures in the Pharmaceuticals Business Unit. Depreciation and amortization expenses increased $142,000, or 22.8%, to
$763,000 for the three months ended January 31, 2004 from $622,000 for the
three months ended January 31, 2003. The increase was attributable primarily to
a change in the amortization period for certain patents. While we made capital
expenditures for production equipment in the Nutraceuticals Business Unit
during the three months ended January 31, 2004, we did not incur depreciation
expense because we have not placed the new production equipment into service.
We anticipate an increase in depreciation expense as we place these assets into
service over the balance of our fiscal year. Nutraceuticals Business Unit Net revenues for the Nutraceuticals Business Unit for the three months
ended January 31, 2004 increased 21.0% to $8.6 million compared to $7.1 million
for the three months ended January 31, 2003. This growth was driven by a 38%
increase in Ester-C® sales for the three months ended January 31, 2004 over the
three months ended January 31, 2003, partially offset by the absence of saw
palmetto oil products revenue in fiscal year 2004. Domestic sales of Ester-C®
grew by 49% in the three months ended January 31, 2004 over the same period in
the prior year. Sales of Ester-C® during the quarter were driven principally by
increased radio and television advertising support for the Ester-C® products in
our continuing strategy of brand development. In 2003 we essentially completed
our strategic withdrawal from the saw palmetto market by selling our remaining
inventory of saw palmetto extracted oils. We continue to sell through our small
inventory of saw palmetto powder in the normal course of business in fiscal
year 2004. Cost of products sold as a percentage of net revenues for the
Nutraceuticals Business Unit increased to 40.0% for the three months ended
January 31, 2004 compared to 35.9% for the three months ended January 31, 2003.
This increase was caused primarily by a $1.5 million increase in Ester-C® cost
of goods due to higher costs of ascorbic acid. Ascorbic acid is the principal raw material in our Ester-C® products and
is subject to periodic price fluctuations. While ascorbic acid prices rose
dramatically during fiscal year 2003 and during the first half of fiscal year
2004, we believe that our costs will be at more historical averages and less
variable through the balance of fiscal year 2004, although no assurances can be
provided in this regard. We have obtained a stable supply of ascorbic
acid in sufficient quantities and at
prices equivalent to historical averages that assures cost predictability
through the end of fiscal year 2004. These supply arrangements extend into
fiscal year 2005 and will meet a portion of our anticipated ascorbic acid
needs for fiscal year 2005. We continue to actively pursue lower cost extended supply arrangements
at similar lower prices for our remaining expected needs. On April 1, 2003, a
price increase for Ester-C® products was instituted to partially offset the
effects of the higher ascorbic acid prices. Pharmaceuticals Business Unit Net revenues for the Pharmaceuticals Business Unit for the three months
ended January 31, 2004 increased 2.8% to $5.0 million compared to $4.9 million
for the three months ended January 31, 2003. Net revenues of the Zilactin® line
of products were $1.9 million for the three months ended January 31, 2004, an
increase of 0.6% from the same three months in 2003. Net revenues of the
Peridex® product were $1.5 million for the three months ended January 31, 2004,
a decrease of 16.6% 20




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from the three months ended
January 31, 2003. The decline from the prior year was primarily
due to a shift in timing of orders from a significant customer for
Peridex®. Additionally, sales to U.S. wholesalers were lower in the current year period because wholesalers bought
ahead of the March 2003 price increase and did not repeat such purchase volumes
in the three months ended January 31, 2004. Sales for IST (net of intercompany
sales) were $1.7 million, compared to $1.2 million last year, as we increased
production to match the needs of our major customer, Matrixx Initiatives, Inc.
(Matrixx), a US-based healthcare company. However, we will likely lose this
customer in March 2004 when our current contract expires. IST expects to
replace only a small percentage of this business in the balance of fiscal year
2004. Cost of products sold as a percentage of net revenues for the
Pharmaceuticals segment decreased to 43.1% during the three months ended
January 31, 2004 from 46.4% for the three months ended January 31, 2003,
primarily due to the lower cost of product as a percentage of net revenues at
IST and for Zilactin®-L. The lower cost of product at IST resulted from a March
2003 price increase for products made for Matrixx and to a lesser extent from
improvement in manufacturing efficiencies due to the full utilization of new
machinery installed in fiscal year 2003. The decreased cost of product for
Zilactin®-L was due primarily to lower equipment validation costs in the three
months ended January 31, 2004. In the prior year period, higher validation
costs resulted from a change in product suppliers. Biotechnology Business Unit Revenues from sales of the OraTest® product in the United Kingdom and the
Pacific Rim area were nominal during the three months ended January 31, 2004
and 2003, as we deemphasized international sales efforts in favor of focusing
on obtaining FDA approval in the United States. Total operating expenses for the Biotechnology segment were $1.3 million
for the three months ended January 31, 2004, a 24.0% increase over the $1.1
million for the three months ended January 31, 2003. This was driven by an
increase of approximately $204,000, or 32.1%, in the phase III clinical trial
expenses related to the OraTest® product. Comparison of the six months ended January 31, 2004 with the six months ended January 31, 2003 Total Company Net revenues increased 13.0% to $25.7 million for the six months ended
January 31, 2004, compared to revenues of $22.7 million for the six months
ended January 31, 2003. The increase is due to a 14.8% sales increase in the
Nutraceuticals Business Unit and a 10.4% sales increase in the Pharmaceuticals
Business Unit. When the sales of the discontinued Saw Palmetto oil product line
are removed from the prior year, net revenues increased 26.7% at the
Nutraceuticals Business Unit and 19.7% for the total company. Increased
spending in advertising and promotional programs contributed to the sales
increases. Cost of products sold as a percentage of net revenues increased to 41.6%
from 40.4% for the six months ended January 31, 2004. This increase was due
primarily to substantially higher costs for the ascorbic acid, the principal
raw material used by the Nutraceuticals Business Unit in its Ester-C® products,
and increased product costs related to promotional activities and increased
manufacturing 21




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costs in the Pharmaceuticals Business Unit that were partially offset by
improvements in production efficiencies at IST. Marketing and selling expenses as a percentage of net revenues increased
to 27.7% from 24.6% for the six months ended January 31, 2004. This increase
was primarily due to heavy brand and media advertising support for the
Nutraceuticals Business Unit product, Ester-C®,and increased marketing support
for certain Pharmaceuticals Business Unit products. General and administrative expenses were $7.0 million, or 27.3% of net
revenues, for the six months ended January 31, 2004, compared to $6.4 million,
or 28.0% of net revenue, for the six months ended January 31, 2003. Legal fees
of $832,000, associated with the Beutlich and Trylon settlements, were the
primary cause of the increase over the previous year. Severance and related charges of $154,000 in connection with employee
terminations, recruiting fees and relocation expenses were incurred in the six
months ended January 31, 2004, compared to $1,059,000 incurred in the six
months ended January 31, 2003. Higher severance and related charges were
incurred in the prior year period due primarily to the significant changes in
Company management, focus and the resulting organization. Research and development expenses increased $601,000, or 38.0%, to $2.2
million for the six months ended January 31, 2004 from $1.6 million incurred in
the six months ended January 31, 2003. The increase is due primarily to an
increase in the OraTest® phase III clinical trial expenses of $767,000, or
64.0%, offset by a reduction in expenditures in the Pharmaceuticals Business
Unit. Depreciation and amortization expenses increased $177,000, or 14.6%, to
$1,389,000 for the six months ended January 31, 2004 from $1,213,000 for the
six months ended January 31, 2003. The increase was attributable primarily to a
change in the amortization period for certain patents. While we made capital
expenditures for production equipment in the Nutraceuticals Business Unit
during the six months end January 31, 2004, we did not incur depreciation
expense because we have not placed the new production equipment in service. We
anticipate an increase in depreciation expense as we place these assets in
service over the balance of our fiscal year. Nutraceuticals Business Unit Net revenues for the Nutraceuticals Business Unit for the six months ended
January 31, 2004 increased 14.8% to $15.6 million compared to $13.6 million for
the six months ended January 31, 2003. This growth was driven by a 27% increase
in Ester-C® sales for the six months ended January 31, 2004 over the six months
ended January 31, 2003, partially offset by the absence of saw palmetto oil
products revenue in fiscal 2004 as we have exited that business. Domestic sales
of Ester-C® grew by 30% in the six months ended January 31, 2004 over the same
period in the prior year. Sales of Ester-C® were driven principally by
increased radio and television advertising support for the Ester-C® products in
our continuing strategy of brand development. In 2003 we essentially completed
our strategic withdrawal from the saw palmetto market by selling our remaining
inventory of saw palmetto extracted oils. We continue to sell through our small
inventory of saw palmetto powder in the normal course of business. Cost of products sold as a percentage of net revenues for the
Nutraceuticals Business Unit increased to 40.4% for the six months ended
January 31, 2004 compared to 34.6% for the six months ended January 31, 2003.
This increase was caused primarily by a $2.7 million increase in Ester-C® cost
of goods due to higher costs of ascorbic acid. 22




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Ascorbic acid is the principal raw material in our Ester-C® products and
is subject to periodic price fluctuations. While ascorbic acid prices rose
dramatically during fiscal year 2003 and during the first half of fiscal year
2004, we believe that our costs will be closer to historical levels and less
variable through the balance of fiscal year 2004, although no assurances can be
provided in this regard. We have obtained a stable supply of ascorbic acid in sufficient quantity and at
prices equivalent to historical averages that assures cost predictability
through the end of fiscal year 2004. These supply arrangements extend into
fiscal year 2005 and meet a portion of our anticipated ascorbic acid needs for fiscal year 2005. We
continue to actively pursue lower cost extended supply arrangements at similar
lower prices for our remaining needs. On April 1, 2003, a price increase for
Ester-C® products was instituted to partially offset the effects of the higher
ascorbic acid prices. Pharmaceuticals Business Unit Net revenues for the Pharmaceuticals Business Unit for the six months
ended January 31, 2004 increased 10.4% to $10.1 million compared to $9.1
million for the six months ended January 31, 2003. Net revenues of the
Zilactin® line of products were $3.9 million for the six months ended January
31, 2004, an increase of 2.6% from the same six months in 2003. Net revenues
of the Peridex® product were $2.9 million for the six months ended January 31,
2004, a decrease of 10.3% for the six months ended January 31, 2003, driven by
U.S. wholesalers who bought ahead of the March 2003 price increase in the prior
year period. Sales for IST (net of intercompany sales) were $3.3 million, a
57.4% increase compared to the six months ended January 31, 2003, as we
increased production to match the needs of our major customer, Matrixx
Initiatives, Inc. (Matrixx), a US-based healthcare company. However, we will
likely lose this customer in March 2004 when our current contract expires. IST
expects to replace only a small percentage of this business in the balance of
fiscal year 2004. Cost of products sold as a percentage of net revenues for the
Pharmaceuticals segment decreased to 42.6% during the six months ended January
31, 2004 from 45.6% for the six months ended January 31, 2003, primarily due to
the lower cost of product at IST. The lower cost of product at IST resulted
from a March 2003 price increase for products made for Matrixx and to a lesser
extent from improvement in manufacturing efficiencies due to the full
utilization of new machinery installed in fiscal year 2003. The IST improvement
was partially offset by an increase in Zilactin® product costs for the six
months ended January 31, 2004. The increased cost of product was due primarily
to the higher cost of promotional events, along with increased production costs
of Zilactin®-L during the first quarter of this fiscal year. Biotechnology Business Unit Revenues from sales of the OraTest® product in the United Kingdom and the
Pacific Rim area were nominal during the six months ended January 31, 2004 and
2003, as we deemphasized international sales efforts in favor of focusing on
obtaining FDA approval in the United States. Total operating expenses for the Biotechnology segment were $2.9 million
for the six months ended January 31, 2004, a 43.1 % increase over the $2.0
million for the six months ended January 31, 2003. This was driven by an
increase of approximately $767,000, or 64.0%, in the phase III clinical trial
expenses related to the OraTest® product. LIQUIDITY AND CAPITAL RESOURCES At January 31, 2004, our primary sources of liquidity included cash and
cash equivalents of $12.5 million and the line of credit discussed below. Net
working capital decreased to $21.3 million at January 31, 2004 from $22.0
million at July 31, 2003, while the current ratio increased to 3.2 at January
31, 2004 from 2.9 at July 31, 2003. This decrease in net working capital is due
to the funding 23




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of the operating loss and the capital expenditures for property and equipment
and intangibles, offset by the proceeds from the sale leaseback of our
corporate headquarters facility. Net cash used in operating activities was $4.8 million during the six
months ended January 31, 2004 and was attributable to the net loss of $2.5
million, offset by non-cash items of $919,000 for depreciation and amortization
and the gain on asset sale. Significant changes in operating assets and
liabilities were primarily comprised of (i) an increase in accounts receivable
of $1.8 million related to increased sales; (ii) a decrease in inventory of
$879,000 as we attempt to better balance our production capacity with customer
orders; and (iii) a decrease in accounts payable and accrued expenses of $2.1
million, primarily in the Nutraceuticals and Pharmaceuticals Business Units, to
be more in line with industry standards. Net cash provided by investing activities was $947,000, attributable to
the sale of our corporate headquarters, offset primarily by funds used for
equipment purchases at Zila Nutraceuticals and patent filings for Zila
Nutraceuticals and the OraTest® product. Net cash provided by financing activities during the six months ended
January 31, 2004 was $206,000, arising primarily from the proceeds from the
issuances of common stock under our stock options and employee stock purchase
plans. We believe that our current cash balances, cash generated from our
operations, our investing activities and the availability of cash under our
line of credit are sufficient to finance our level of operations, the OraTest®
clinical trial, the launch of Ester-E, and anticipated capital expenditures
through the next 12 months. Bank Financing On August 27, 2001, we entered into a Loan and Security Agreement (the
Congress Agreement) with Congress Financial Corporation (Congress) whereby
Congress would provide a $12 million revolving line of credit to us at an
interest rate equal to the prime rate plus 3/4 percent. The amount of funds
available to us from the line of credit is based upon a percentage of the value
of eligible receivables and inventory and was $9.0 million as of January 31,
2004. The obligations under the Congress Agreement are collateralized by
various assets, including, but not limited to, our trade accounts receivable,
inventories, equipment and intangible assets of certain of our operating
subsidiaries. We and all of our direct and indirect operating subsidiaries
guarantee the obligations under the Congress Agreement. The Congress Agreement
expires August 17, 2004. There were no borrowings outstanding under this line
of credit as of January 31, 2004. Under the Congress Agreement, we are required to maintain adjusted
tangible net worth (as defined) of $12 million. At January 31, 2004, our
adjusted tangible net worth, as defined, was $28.5 million compared to the
required amount of $12.0 million. If we continue to incur additional operating
losses, reduce the value of our tangible assets, or incur additional debt, we
may become out of compliance with the covenant. On February 6, 2004, we entered into a Credit and Security Agreement with
Wells Fargo Business Credit (WFBC) that will provide a $10 million revolving
line of credit. We will not be able to borrow under this agreement until the
expiration of the Congress Agreement and the perfection of certain security
interests by WFBC. This credit facility will bear interest equal to the prime
rate compared to prime plus 3/4% under the Congress Agreement. Funds
available under the line of credit will be based upon a percentage of the value
of eligible receivables and inventory. Under this 24




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agreement, financial covenants will require maintenance of minimum net worth
and limitations on the amount of capital expenditures. PharmaBio Investment On December 18, 2002, we entered into an Investment Agreement with
PharmaBio Development, Inc. (PharmaBio), the strategic investment group of
Quintiles Transnational Corp. whereby PharmaBio invested $500,000 in us. In
return for the investment, we agreed to pay to PharmaBio an amount equal to 5%
of all net sales of the OraTest® product in the European Union and the United
States (the Royalty). The aggregate amount of the Royalty cannot exceed $1.25
million. This investment was recorded as long-term debt. Long-Term Debt Financing In April 1999, Zila Nutraceuticals, through Oxycal, entered into a
transaction with The Industrial Development Authority of the County of Yavapai
(the Authority) in which the Authority issued $5.0 million in Industrial
Development Revenue Bonds (the Bonds). The proceeds were loaned to Zila
Nutraceuticals for the construction of a new manufacturing and laboratory
facility. As of January 31, 2004, the Bonds outstanding consisted of $3.4
million Series A bonds, which bear a variable interest rate that was 1.3% at
January 31, 2004. The Bonds mature in 2019. In connection with the issuance of
the Bonds, the Authority required that Zila Nutraceuticals obtain, for the
benefit of the Bondholders, an irrevocable direct-pay letter of credit to
secure payment of principal and interest. We guaranteed the letter of credit.
The letter of credit expired on March 15, 2004, and the Bond Trustee was
notified by February 1, 2004 that a replacement letter of credit was obtained
with Wells Fargo Business Credit (WFBC). We guaranteed the replacement letter
of credit. Restricted Cash As described in Note 6 of the Notes to the Condensed Consolidated
Financial Statements, under the terms of the Reimbursement Agreement between
Zila Nutraceuticals and WFBC for the replacement letter of credit, on February
6, 2004 we placed $513,000 in a restricted cash collateral account representing
the difference between the letter of credit amount and the maximum commitment
amount defined in the Reimbursement Agreement. Stock Repurchases On November 10, 1999, we announced that our Board of Directors authorized
the repurchase of up to one million shares of Zila common stock. Purchases are
made on the open market depending on market conditions and other factors.
During the six months ended January 31, 2003, we repurchased 30,100 shares of
our common stock for $36,253. No shares were repurchased during the six months
ended January 31, 2004. As of January 31, 2004, we had repurchased 225,100
shares of common stock at an aggregate cost of $571,000 and we have temporarily
suspended the repurchase program. Preferred Stock Financing On February 5, 2001, we issued 100,000 shares of Series B Convertible
Preferred Stock as part of the IST acquisition. The holders of the Preferred
Stock are entitled to receive cumulative quarterly dividends at a rate of
$0.0975 per share per fiscal quarter, payable in arrears. During the six months
ended January 31, 2004, we paid dividends of $19,500 and have accumulated
accrued dividends of $19,500 as of January 31, 2004. 25




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Future Contractual Obligations The table below summarizes our future cash contractual obligations: Long-
    
    Short-Term
    
    Operating
    
    Capital Lease
    
    PurchaseTerm Debt
    
    Debt
    
    Leases
    
    Obligations
    
    Obligations
    
    TotalRemaining 2004
    
    $
    250,342
    
    
    $
    267,488
    
    
    $
    284,054
    
    
    $
    14,560
    
    
    $
    3,486,821
    
    
    $
    4,303,2652005 & 2006
    
    
    923,513
    
    
    
    
    
    
    
    716,766
    
    
    
    73,586
    
    
    
    
    
    
    
    1,713,8652007 & 2008
    
    
    851,568
    
    
    
    
    
    
    
    451,507
    
    
    
    73,586
    
    
    
    
    
    
    
    1,376,661Thereafter
    
    
    1,948,850
    
    
    
    
    
    
    
    88,620
    
    
    
    36,793
    
    
    
    
    
    
    
    2,074,263Total
    
    $
    3,974,273
    
    
    $
    267,488
    
    
    $
    1,540,947
    
    
    $
    198,525
    
    
    $
    3,486,821
    
    
    $
    9,468,054
 Purchase obligations include commitments for advertising. OraTest® In December 2002, we transitioned the OraTest® clinical program to
Quintiles. This was the result of an extensive review of several proposals
received from some of the largest, highest quality and most prominent contract
research organizations with worldwide capabilities. Quintiles completed the
transition successfully without compromising the study data. Factors that will
affect the cost and timing of completion of the clinical program include but
are not limited to: (i) patient enrollment rates, (ii) tumor formation rate
within the study population, (iii) compliance with the study protocol and
related monitoring, (iv) level of funding throughout the study, and (v)
protocol modifications and clinical program modifications. At January 31, 2004, we had approximately $362,000 of ZTC, the active
ingredient in the OraTest® product, at our manufacturing facility in Phoenix,
AZ. We intend to realize the value of this active ingredient through sales in
the U.S., if we obtain final approval for the OraTest® products from the FDA,
and through sales in Europe and Asia prior to the date we expect sales in the
United States. The drug substance currently has expiration dates in 2004, 2005
and 2006. Previous testing has indicated that the drug substance is stable and
we expect to be able to extend the expiration dates of the entire drug
substance inventory through the date we expect sales in the United States.
However, no assurance can be given in this regard. In addition, should FDA
approval not be granted or be significantly delayed, it may not be possible for
us to recover the value of this drug substance. ViziLite® On October 15, 2003, we completed a mediated settlement with Trylon of
various issues. As part of the settlement, we agreed to eliminate the
contractual restrictions relating to sales milestones associated with 500,000
shares of the previously issued restricted common stock. The contractual
restrictions on 250,000 of these shares will be removed upon achievement of a
product development milestone. The contractual restrictions on the remaining
250,000 shares will be removed upon Trylons obtaining of the required
governmental approvals relating to the product development milestone. As part
of the settlement, we also agreed that Trylons royalty rates for net sales of
the ViziLite® product will be reduced from 10% to 5% for the first five years,
and from 5% to 2.5% for the second five years. Thereafter, the royalty payment
ends. 26




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We had $329,000 of ViziLite® product in inventory and approximately $2.1
million of associated intangible assets as of January 31, 2004. As part of our
strategy to educate the dental profession on the benefits of using ViziLite®
and to widen distribution, in the third quarter of fiscal 2003 we modified our
exclusive distributorship agreement with Patterson Dental Company to convert it
to a non-exclusive agreement for the dental industry in the United States and
Canada. We then retained regional distributors and sales groups with a roster
of independent sales representatives. With the introduction of independent
sales representative and regional distributors, we are modifying our plan to
reach both opinion leaders and end-users in the oral cavity screening process.
However, if sales do not ultimately reach certain levels, we may have to reduce
the carrying value of the assets related to ViziLite®. Ester-E On October 31, 2003, we entered into a license agreement with Vital Health
Sciences Limited (Vital Health) of Australia that grants us the exclusive
rights in the dietary supplement market for certain issued and pending patents,
know-how and data pertaining to tocopherol phosphate in the United States,
Canada and Indonesia. The initial term of the license is five years, and we
have the right, unilaterally, to extend the term until the expiration of the
last of the licensed patents. Several of such patents are recently issued,
while other patent applications are still pending. We also have a right of
first refusal for certain other international markets under the agreement.
Zila Nutraceuticals is currently using Vital Healths patented process for
manufacturing tocopherol phosphate, as well as numerous pending patent
applications, to develop its Ester-E product tailored for the dietary
supplement market. We anticipate that the Ester-E product will be launched in the
third and/or fourth quarters of fiscal year 2004. Under the
agreement, we are required to make royalty payments based on certain levels of sale volume. We
are also required to pay certain upfront fees upon the completion of certain
market launch milestones, as defined in the agreement, and minimum annual
royalty fees on sales. We believe that our current cash position and operating
cash flow are sufficient to fund the Ester-E product launch. 
 Item 3. Quantitative and Qualitative Disclosures about Market Risk We are exposed to market risk primarily from interest rates. We have a revolving line of credit with Congress Financial Corporation
with a variable interest rate equal to three-quarters of one (0.75%) percent
per annum in excess of the prime rate announced by First Union Bank (4.75% at
January 31, 2004). At January 31, 2004, we had no borrowings outstanding under
this line of credit. The impact of a 10% proportional increase in average
interest rates would not be expected to have a material effect on us since
average outstanding balances on the line are not expected to be significant. We
also have long-term debt associated with the Industrial Development Revenue
Bonds that carry a variable interest rate. The rates are set weekly by Bank One
Capital Markets and fluctuate based on market conditions and our rate was 1.3%
at January 31, 2004. Effective March 15, 2004, under the new replacement letter
of credit with Wells Fargo Business Credit, the variable interest rate will be
set by Wells Fargo Bank, N.A. A 10% proportional increase in the average
interest rate on the bonds would not be expected to have a material effect. 
 Item 4. Controls and Procedures (a) Disclosure Controls and Procedures The Companys management, with the participation of the Companys Chief
Executive Officer and Chief Financial Officer, has evaluated the effectiveness
of the Companys disclosure controls and 27




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procedures, as such term is defined in Rules 13a-15(e) and 15-d-15(e) under the
Securities Exchange Act of 1934, as amended (the Exchange Act), as of the end
of the period covered by this report. Based on such evaluation, the Companys
Chief Executive Officer and Chief Financial Officer have concluded that, as of
the end of such period, the Companys disclosure controls and procedures are
effective in recording, processing, summarizing and reporting, on a timely
basis, information required to be disclosed by the Company in the reports that
it files or submits under the Exchange Act. (b) Internal Controls over Financial Reporting As more fully described in Item 9A in our Annual Report on Form 10-K for
the fiscal year ended July 31, 2003, during our annual audit, weaknesses were
found our in general computer controls at our corporate headquarters and at
Zila Nutraceuticals. For the period covered by this Report, we continue efforts
under our strategic plan to improve general computer controls. Except as noted above, there have not been any changes in the Companys
internal control over financial reporting, as such term is defined in Rules
13a-15(f) and 15d-15(f) under the Exchange Act), during the fiscal quarter to
which this Report relates that have materially affected, or are reasonably
likely to materially affect, the Companys internal control over financial
reporting. 
 Part II - Other Information 
 Item 1. Legal Proceedings On October 15, 2003, we completed a mediated settlement with Trylon of
various issues. As part of the settlement, we agreed to eliminate the
contractual restrictions relating to sales milestones associated with 500,000
shares of the previously issued restricted common stock. The contractual
restrictions on 250,000 of these shares will be removed upon achievement of a
product development milestone. The contractual restrictions on the remaining
250,000 shares will be removed upon Trylons obtaining of the required
governmental approvals relating to the product development milestone. As part
of the settlement, we also agreed that Trylons royalty rates for net sales of
the ViziLite® product will be reduced from 10% to 5% for the first five years,
and from 5% to 2.5% for the second five years. Thereafter, the royalty payment
ends. In connection with the acquisition of patent rights in 1980, we agreed to
pay to Dr. James E. Tinnell (Tinnell), the inventor of one of our treatment
compositions, a royalty of 5% of gross sales of the invention disclosed in his
then pending patent application. In September 2000, we notified Tinnell that
we would no longer pay such royalties since the obligations ceased in August
1998 when the related product patents expired and we furthermore requested
reimbursement of royalties paid since August 1998. We then filed suit in the
Federal District Court requesting a declaratory judgment that we had no royalty
obligations to Tinnell and a judgment for the overpaid royalties. Tinnell
asserted several counterclaims. The Court has since ruled in our favor stating
that we do not owe royalty obligations to Tinnell and denied several of
Tinnells counterclaims. However, one of Tinnells counterclaims is still
outstanding for breach of contract. Furthermore, the Court has since not ruled
on our request for reimbursement of overpaid royalties. We intend to request
the Court to rule on our claim for reimbursement and prepare for trial on the
remaining breach of contract issue. In November 2001, we filed a suit for trademark infringement and trade
secret misappropriation against Darrel Van Dyke and GMP Products, LLC relating
to ISTs patented swab technology. Subsequent to 2001, GMP Products changed its
name to Viridian Packaging Solutions, LLC (Viridian). In December 2002, the
court entered a final judgment against us and the 28




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defendants brought a motion to recover their attorneys fees and other
costs incurred in defending the action. On September 29, 2003, the court
awarded $131,700 to the defendants. In January 2003, we filed a suit for patent infringement against Beutlich
Pharmaceuticals, LP (Beutlich) alleging that it sold dry-handle swabs that
infringe upon our IST product swab patent. In February 2003, the Arizona court
issued a temporary restraining order in our favor that stopped Beutlich from
selling its swabs. In May 2003, Viridian filed a declaratory judgment action in
the Northern District of Illinois that sought a declaration of non-infringement
and patent invalidity. In November 2003, we settled of both of these matters. Under the
settlement agreement we permitted Beutlich and Viridian to sell their products
to certain prospective customers. In addition, we paid Viridian $29,000 of the
$131,700 that the court had awarded and Viridian waived the balance. We are subject to other legal proceedings and claims that arise in the
ordinary course of business. In the opinion of management, the amount of
ultimate liability with respect to these actions will not materially affect the
Companys financial position or results of operations. 
 Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities. Not Applicable. 
 Item 3. Defaults upon Senior Securities. Not Applicable 
 Item 4. Submission of Matters to a Vote of Security Holders.  (a)
    
    The Company held its annual meeting of stockholders in Phoenix,
Arizona on December 4, 2003. A total of 40,962,742 shares of common
stock, or 89% of the outstanding shares, were represented in person
or by proxy.(b)
    
    The following seven directors were each elected to a term
expiring at the next annual meeting: Number of SharesName
    
    For
    
    WithheldDouglas D. Burkett
    
    
    40,586,244
    
    
    
    376,498Christopher D. Johnson
    
    
    40,552,936
    
    
    
    409,806Michael S. Lesser
    
    
    39,860,251
    
    
    
    1,102,491Kevin J. Tourek
    
    
    40,531,231
    
    
    
    431,511S. Timothy Rose, D.D.S.
    
    
    40,602,456
    
    
    
    360,286John Edward Porter
    
    
    40,587,719
    
    
    
    375,023Morris C. Aaron
    
    
    40,574,856
    
    
    
    387,886
 29




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Item 5. Other Information Not Applicable 
 Item 6. Exhibits and Reports on Form 8-K (a) Exhibits Exhibit Number
    
    Description31.1
    
    
    Certification of the Chief
Executive Officer pursuant to Section 302 of the Sarbanes Oxley
Act of 200231.2
    
    
    Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes Oxley
Act of 200232.1
    
    
    Certification of the Chief
Executive Officer pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes Oxley Act of 200232.2
    
    
    Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes Oxley Act of 200299.1
    
    
    Credit and Security Agreement between Zila
Nutraceuticals, Inc., Zila Biotechnology, Inc., Zila
Pharmaceuticals, Inc., Zila Swab Technologies, Inc., Oxycal
Laboratories, Incorporated, and Wells Fargo Business Credit, Inc.,
date as of February 6, 2004.99.2
    
    
    Reimbursement Agreement between Oxycal Laboratories,
Incorporated, an Arizona Corporation, and Wells Fargo Business
Credit, Inc. relating to $3,900,000  The Industrial Development
Authority Revenue Bonds (Oxycal Laboratories, Incorporated
Project) Series 1999A, dated as of February 6, 200499.3
    
    
    Employment Agreement between Zila, Inc. and Douglas D.
Burkett, Ph.D., dated as of October 21, 200399.4
    
    
    Purchase Agreement between Zila, Inc. and Gary and Janet
Hedge, dated as of November 7, 200399.5
    
    
    Lease between Zila, Inc. and Phoenix 7 LLC, dated January
30, 2004
 (b) Reports on Form 8-K On February 3, 2004, we filed a Current Report on Form 8-K containing
information pursuant to Item 7 (Financial Statements and Exhibits), dated
February 3, 2004, announcing that we issued a press released related to our
sale and leaseback of our headquarters facility. 30




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. Date: March 16, 2004
    
    
    
    By:/s/Douglas D. Burkett, Ph.D.Douglas D. Burkett, Ph.D.President, Chairman of the Board(Principal Executive Officer)By:/s/Andrew A. StevensAndrew A. StevensVice President and Chief Financial Officer(Principal Financial & Accounting Officer)
 31




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INDEX TO EXHIBITS Exhibit Number
    
    Description31.1
    
    Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes Oxley
Act of 200231.2
    
    Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes Oxley
Act of 200232.1
    
    Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes Oxley Act of 200232.2
    
    Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes Oxley Act of 200299.1
    
    Credit and Security Agreement between Zila
Nutraceuticals, Inc., Zila Biotechnology, Inc., Zila
Pharmaceuticals, Inc., Zila Swab Technologies, Inc., Oxycal
Laboratories, Incorporated, and Wells Fargo Business Credit, Inc.,
date as of February 6, 2004.99.2
    
    Reimbursement Agreement between Oxycal Laboratories,
Incorporated, an Arizona Corporation, and Wells Fargo Business
Credit, Inc. relating to $3,900,000  The Industrial Development
Authority Revenue Bonds (Oxycal Laboratories, Incorporated
Project) Series 1999A, dated as of February 6, 200499.3
    
    Employment Agreement between Zila, Inc. and Douglas D.
Burkett, Ph.D., dated as of October 21, 200399.4
    
    Purchase Agreement between Zila, Inc. and Gary and Janet
Hedge, dated as of November 7, 200399.5
    
    Lease between Zila, Inc. and Phoenix 7 LLC, dated January
30, 2004
 32