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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 
 Form 10-Q QUARTERLY REPORT
Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934 For the Quarterly Period Ended
April 30, 2005
    
    Commission File Number
0-17521
 ZILA, INC. (Exact Name of Registrant as Specified in its Charter) Delaware
    
    86-0619668(State or Other Jurisdiction of
    
    (I.R.S. EmployerIncorporation or Organization)
    
    Identification No.)
 5227 North 7th Street, Phoenix, Arizona 85014-2800 (Address of Principal Executive Offices)
 Registrants telephone number, including area code (602) 266-6700 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. þ o
 Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Exchange Act.) þ o
 As of May 31, 2005, 45,820,657 shares of the registrants common stock, $0.001 par value per
share, were outstanding.




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ZILA, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED APRIL 30, 2005
TABLE OF CONTENTS PagePart I. FINANCIAL INFORMATION (UNAUDITED)Item 1. Financial StatementsConsolidated Balance Sheets as of April 30, 2005 and July 31, 2004
    
    
    3Consolidated Statements of Operations and Comprehensive Loss for the three-month and
nine-month periods ended
April 30, 2005 and 2004
    
    
    4Consolidated Statements of Cash Flows for the nine-month periods ended April 30, 2005 and 2004
    
    
    5Notes to 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
    
    
    24Item 4. Controls and Procedures
    
    
    24Part II. OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    24Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    25Item 3. Defaults upon Senior Securities
    
    
    25Item 4. Submission of Matters to a Vote of Security Holders
    
    
    25Item 5. Other Information
    
    
    25Item 6. Exhibits
    
    
    25SIGNATURES
    
    
    26INDEX TO EXHIBITS
    
    
    26EX-31.1EX-31.2EX-32.1EX-32.2EX-99.1
  2




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ZILA, INC. AND SUBSIDIARIES 
 CONSOLIDATED BALANCE SHEETS
 April 30,
    
    
    July 31,2005
    
    
    2004(Unaudited)ASSETSCURRENT ASSETS:Cash and cash equivalents
    
    $
    4,377,044
    
    
    $
    3,679,915Short-term investments
    
    
    1,000,000
    
    
    
    8,000,000Restricted cash collateral
    
    
    521,060
    
    
    
    517,353Trade
receivables  net of allowances of $258,000 and $299,000
    
    
    10,270,234
    
    
    
    8,073,585Inventories  net
    
    
    6,959,674
    
    
    
    6,769,546Prepaid expenses and other current assets
    
    
    1,901,158
    
    
    
    1,827,026Total current assets
    
    
    25,029,170
    
    
    
    28,867,425PROPERTY AND EQUIPMENT  net
    
    
    9,284,098
    
    
    
    9,141,785PURCHASED TECHNOLOGY RIGHTS  net
    
    
    3,151,282
    
    
    
    3,510,288GOODWILL  net
    
    
    6,930,192
    
    
    
    6,930,192TRADEMARKS AND OTHER INTANGIBLE ASSETS  net
    
    
    13,012,895
    
    
    
    13,240,319OTHER ASSETS
    
    
    394,678
    
    
    
    418,634TOTAL ASSETS
    
    $
    57,802,315
    
    
    $
    62,108,643LIABILITIES AND SHAREHOLDERS EQUITYCURRENT LIABILITIES:Accounts payable
    
    $
    6,503,680
    
    
    $
    4,275,679Accrued liabilities
    
    
    3,910,441
    
    
    
    3,077,071Short-term borrowings
    
    
    255,444
    
    
    
    Current portion of long-term debt and capital lease obligations
    
    
    336,774
    
    
    
    343,403Total current liabilities
    
    
    11,006,339
    
    
    
    7,696,153Deferred gain on sale leaseback
    
    
    419,855
    
    
    
    534,587Long-term debt and capital lease obligations  net of current portion
    
    
    3,402,522
    
    
    
    3,649,733Total liabilities
    
    
    14,828,716
    
    
    
    11,880,473COMMITMENTS AND CONTINGENCIES (Note 10)SHAREHOLDERS EQUITY:Preferred
stock  Series B, $.001 par value  2,500,000 shares authorized,
100,000 shares issued and outstanding
    
    
    462,500
    
    
    
    462,500Common stock, $.001 par value - 65,000,000 shares authorized, 45,820,657 and
45,723,296 shares issued and outstanding
    
    
    45,820
    
    
    
    45,723Capital in excess of par value
    
    
    84,248,196
    
    
    
    83,968,913Accumulated other comprehensive loss
    
    
    (79,732
    )
    
    
    (73,453
    )Accumulated deficit
    
    
    (41,152,114
    )
    
    
    (33,604,140
    )Common stock held in treasury, at cost (218,411 and 225,1000 shares)
    
    
    (551,071
    )
    
    
    (571,373
    )Total shareholders equity
    
    
    42,973,599
    
    
    
    50,228,170TOTAL LIABILITIES AND SHAREHOLDERS EQUITY
    
    $
    57,802,315
    
    
    $
    62,108,643
 See notes to consolidated financial statements. 3




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ZILA, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF OPERATIONS
 (UNAUDITED)
 Three months ended April 30,
    
    
    Nine months ended April 30,2005
    
    
    2004
    
    
    2005
    
    
    2004NET REVENUES
    
    $
    14,067,808
    
    
    $
    12,650,241
    
    
    $
    39,180,301
    
    
    $
    38,306,675Cost of products sold
    
    
    4,589,658
    
    
    
    4,725,038
    
    
    
    13,184,828
    
    
    
    15,309,554Gross profit
    
    
    9,478,150
    
    
    
    7,925,203
    
    
    
    25,995,473
    
    
    
    22,997,121OPERATING EXPENSES:Marketing and selling
    
    
    5,467,549
    
    
    
    3,646,246
    
    
    
    16,322,886
    
    
    
    10,896,726General and administrative
    
    
    3,474,701
    
    
    
    2,934,848
    
    
    
    9,527,638
    
    
    
    9,959,930Other operating costs
    
    
    298,146
    
    
    
    
    
    
    
    298,146
    
    
    
    Research and development
    
    
    1,635,960
    
    
    
    2,063,641
    
    
    
    5,220,578
    
    
    
    4,332,201Depreciation and amortization
    
    
    713,458
    
    
    
    707,245
    
    
    
    2,065,259
    
    
    
    2,088,735Total operating expenses
    
    
    11,589,814
    
    
    
    9,351,980
    
    
    
    33,434,507
    
    
    
    27,277,592LOSS FROM OPERATIONS
    
    
    (2,111,664
    )
    
    
    (1,426,777
    )
    
    
    (7,439,034
    )
    
    
    (4,280,471
    )OTHER INCOME (EXPENSE):Interest income
    
    
    35,212
    
    
    
    24,835
    
    
    
    128,929
    
    
    
    76,921Interest expense
    
    
    (43,675
    )
    
    
    (100,353
    )
    
    
    (143,553
    )
    
    
    (254,216
    )Gain on sale of assets
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    470,462Other income (expense)
    
    
    (30,631
    )
    
    
    (64,644
    )
    
    
    (63,111
    )
    
    
    (109,125
    )(39,094
    )
    
    
    (140,162
    )
    
    
    (77,735
    )
    
    
    184,042LOSS BEFORE INCOME TAXES
    
    
    (2,150,758
    )
    
    
    (1,566,939
    )
    
    
    (7,516,769
    )
    
    
    (4,096,429
    )Income tax expense
    
    
    
    
    
    
    
    
    
    
    (1,955
    )
    
    
    NET LOSS
    
    
    (2,150,758
    )
    
    
    (1,566,939
    )
    
    
    (7,518,724
    )
    
    
    (4,096,429
    )Preferred stock dividends
    
    
    9,750
    
    
    
    9,750
    
    
    
    29,250
    
    
    
    29,250Net loss attributable to common shareholders
    
    $
    (2,160,508
    )
    
    $
    (1,576,689
    )
    
    $
    (7,547,974
    )
    
    $
    (4,125,679
    )BASIC AND DILUTED NET LOSS PER COMMON SHARE:
    
    $
    (0.05
    )
    
    $
    (0.03
    )
    
    $
    (0.17
    )
    
    $
    (0.09
    )Weighted average shares outstanding
    
    
    45,600,364
    
    
    
    45,373,409
    
    
    
    45,550,966
    
    
    
    45,296,744NET LOSS
    
    $
    (2,150,758
    )
    
    $
    (1,566,939
    )
    
    $
    (7,518,724
    )
    
    $
    (4,096,429
    )Foreign currency translation adjustments
    
    
    (1,872
    )
    
    
    7,456
    
    
    
    (6,279
    )
    
    
    2,386COMPREHENSIVE LOSS
    
    $
    (2,152,630
    )
    
    $
    (1,559,483
    )
    
    $
    (7,525,003
    )
    
    $
    (4,094,043
    )
 See notes to consolidated financial statements. 4




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ZILA, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
 (UNAUDITED)
 Nine months ended April 30,2005
    
    
    2004OPERATING ACTIVITIES:Net loss
    
    $
    (7,518,724
    )
    
    $
    (4,096,429
    )Adjustments to reconcile net loss to net cash provided by (used in) operating activities:Depreciation and amortization
    
    
    2,065,259
    
    
    
    2,088,735Amortization of deferred financing costs
    
    
    27,123
    
    
    
    12,489Gain on sale of assets
    
    
    
    
    
    
    (470,462
    )Noncash research and development expense
    
    
    49,000
    
    
    
    216,563Noncash stock based compensation expense
    
    
    24,201
    
    
    
    20,456Other
    
    
    (45,321
    )
    
    
    (45,638
    )Change in assets and liabilities:Receivables  net
    
    
    (2,196,649
    )
    
    
    (853,576
    )Inventories
    
    
    (190,128
    )
    
    
    1,306,197Prepaid expenses and other assets
    
    
    (210,801
    )
    
    
    (871,595
    )Accounts payable and accrued liabilities
    
    
    3,162,774
    
    
    
    (1,333,419
    )Net cash used in operating activities
    
    
    (4,833,266
    )
    
    
    (4,026,679
    )INVESTING ACTIVITIES:Additions to property and equipment, net
    
    
    (1,131,051
    )
    
    
    (803,846
    )Net proceeds from sale of assets
    
    
    
    
    
    
    1,721,876Additions to intangible assets, net
    
    
    (484,290
    )
    
    
    (697,212
    )Proceeds from sale of short-term investments
    
    
    7,000,000
    
    
    
    3,950,000Purchases of short-term investments
    
    
    
    
    
    
    (11,950,000
    )Net cash provided by (used in) investing activities
    
    
    5,384,659
    
    
    
    (7,779,182
    )FINANCING ACTIVITIES:Net proceeds (repayments) from short-term borrowings
    
    
    255,444
    
    
    
    (20,464
    )Proceeds from issuance of common stock
    
    
    212,134
    
    
    
    421,607Dividends paid to preferred stockholders
    
    
    (58,500
    )
    
    
    (19,500
    )Restricted cash
    
    
    (3,707
    )
    
    
    (516,809
    )Financing costs
    
    
    
    
    
    
    (17,739
    )Principal payments on long-term debt
    
    
    (259,635
    )
    
    
    (363,145
    )Net cash provided by (used in) financing activities
    
    
    145,736
    
    
    
    (516,050
    )NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
    
    
    697,129
    
    
    
    (12,321,911
    )CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
    
    
    3,679,915
    
    
    
    16,160,484CASH AND CASH EQUIVALENTS, END OF PERIOD
    
    $
    4,377,044
    
    
    $
    3,838,573
 See notes to consolidated financial statements. 5




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ZILA, INC. AND SUBSIDIARIES 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 1. ORGANIZATION AND BASIS OF PRESENTATION Zila, Inc., a Delaware corporation, and subsidiaries (Zila) is an innovator in preventative
healthcare technologies and products, focusing on enhanced body defense and the detection and
treatment of pre-disease states. Our business is organized into the following Business Units: Nutraceuticals, Pharmaceuticals
and Biotechnology. The Nutraceuticals Business Unit is comprised of Zila Nutraceuticals, Inc., a
manufacturer and marketer of Ester-C® and Ester-E®, patented, branded, advanced protection forms of
vitamin C and vitamin E for enhanced body defense. The Zila Pharmaceuticals Business Unit includes
Zila Pharmaceuticals, Inc. and the ViziLite® chemiluminescent light for illumination of oral
mucosal abnormalities, Peridex® prescription periodontal rinse, the Zilactin® family of over-the
counter oral care products, and the plastic molded products of Zila Swab Technologies, Inc., which
does business under the name Innovative Swab Technologies (IST). The Zila Biotechnology Unit
includes Zila Biotechnology Inc., Zila Technical, Inc., Zila
Technologies, Inc. and Zila Limited, and is a research,
development and licensing business specializing in pre-cancer/cancer detection through its patented
Zila® Tolonium Chloride and OraTest® technologies and the manager of the OraTest® product, an oral
cancer diagnostic system, which is currently in Food and Drug Administration (FDA) phase III
clinical trials. On January 1, 2005, Oxycal Laboratories, Inc. (Oxycal) was renamed Zila Nutraceuticals, Inc.
after the merger with its wholly-owned subsidiary, Zila Nutraceuticals, Inc. The accompanying consolidated financial statements are unaudited and 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. We believe that the accompanying consolidated financial
statements reflect all adjustments (which are of a normal recurring nature) that are necessary for
a fair presentation of the interim results of operation, financial position and cash flows. The
results reported in these interim consolidated financial statements should not be regarded as being
necessarily indicative of results that might be expected for the full fiscal year. The accompanying unaudited quarterly financial statements represent the consolidation of Zila,
Inc. and its wholly-owned subsidiaries, Zila Pharmaceuticals, Inc., Zila International, Inc., Zila,
Limited, Zila Biotechnology, Inc., Bio-Dental Technologies Corporation (Bio-Dental), which did
business under the name Zila Dental Supply (ZDS), Zila Technical, Inc., Zila Technologies, Inc.,
Zila Swab Technologies, Inc. and Zila Nutraceuticals, Inc. 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, 2004. All significant intercompany balances and transactions
have been eliminated in consolidation. We reclassified certain prior period amounts to conform to the current period presentation.
Auction rate securities in the amount of $8 million have been reclassified from cash and cash
equivalents to short-term investments in the July 31, 2004 consolidated balance sheet to conform to
the fiscal 2005 financial statement presentation. Accordingly, the statements of cash flows for the
nine months ended April 30, 2005 and 2004, respectively, reflect this presentation. 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 (dollars in thousands, except per share amounts). 6




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Three months ended
    
    
    Nine months endedApril 30
    
    
    April 302005
    
    
    2004
    
    
    2005
    
    
    2004Net loss attributable to common shareholders, as reported
    
    $
    (2,161
    )
    
    $
    (1,577
    )
    
    $
    (7,548
    )
    
    $
    (4,126
    )Deduct: Stock-based employee compensation expense determined under fair
value based method for all awards, net of related tax effects, if any
    
    
    2,980
    
    
    
    158
    
    
    
    3,756
    
    
    
    763Pro forma net loss attributable to common shareholders
    
    $
    (5,141
    )
    
    $
    (1,735
    )
    
    $
    (11,304
    )
    
    $
    (4,889
    )Net loss attributable to common shareholders per share  basic and diluted:As reported
    
    $
    (0.05
    )
    
    $
    (0.03
    )
    
    $
    (0.17
    )
    
    $
    (0.09
    )Pro forma
    
    $
    (0.11
    )
    
    $
    (0.04
    )
    
    $
    (0.25
    )
    
    $
    (0.11
    )
 On December 16, 2004, the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standards No. 123R, Share-Based Payment (SFAS No. 123R), which requires
companies to measure and recognize compensation expense for all stock-based payments at fair value.
Stock-based payments include stock option grants. We grant options periodically to purchase common
stock to our employees and directors under our stock award plans at prices equal to the market
value of the stock on the dates the options were granted. SFAS No. 123R will be effective for us
beginning August 1, 2005. SFAS No. 123R will negatively impact our earnings; however, we have not
completed an analysis of all of the differences between Statement No. 123R and SFAS No. 123,
including the specific transition method to be utilized upon adoption. On March 3, 2005 our Board of Directors approved the immediate vesting of all outstanding and
unvested stock options previously granted under our Stock Award Plan to officers and employees, for
which the option exercise price was above the closing price for our common stock on April 29, 2005.
On such date, the closing price was $3.09. Options held by non-employee directors were excluded
from this acceleration. The immediate vesting of these options will avoid the compensation expense
in future periods on these options. In light of the new accounting regulation, our Board of
Directors took this action with the belief that it will reduce the Companys reported compensation
expense in future periods. As a result of this action, approximately 1.1 million options with varying remaining vesting
schedules were subject to the acceleration provision and became immediately exercisable. The total
pro-forma stock-based employee compensation expense for the three and nine month periods ended
April 30, 2005 includes compensation expense of approximately $2.6 million resulting from this
acceleration provision. The pro forma amounts reflected above may not be reflective of future disclosures since the
estimated fair value of stock options is amortized to expense as the options vest and additional
options may be granted in future years. The fair value of employee stock options plans was
estimated on the date of the grant using the Black-Scholes option-pricing model and forfeitures are
recognized as they occur. The option valuation model requires the input of subjective assumptions
including the expected volatility and expected lives. We used the following assumptions to value
grants for the three month periods ended April 30, 2005 and 2004, respectively: dividend yield of
0.0%, respectively; expected volatility of 74% and 75%, respectively; risk-free interest rates of
4.2% and 3.7%, respectively; and expected lives of 7 and 6 years, respectively. 3. NET LOSS PER COMMON SHARE Since a loss from continuing operations was incurred for the three-month and nine-month
periods ended April 30, 2005 and 2004, 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 nine-month period periods ended April
30, 2005 were 483,000 and 509,000, respectively, and for the three month and nine-month period
periods ended April 30, 2004 were 848,000 and 818,000, respectively. Dilutive common shares give
effect to securities, such as stock options, warrants and convertible preferred stock, which have
the potential to be exercised. 7




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##### Table of Contents



4. INVENTORIES Inventories consist of the following (in thousands): April 30,
    
    
    July 31,2005
    
    

    2004Finished goods
    
    $
    2,347
    
    
    $
    2,188Work in process
    
    
    668
    
    
    
    339Raw materials
    
    
    4,055
    
    
    
    4,440Inventory reserves
    
    
    (110
    )
    
    
    (197
    )$
    6,960
    
    
    $
    6,770
 5. INTANGIBLE ASSETS A summary of intangible assets is presented below (in thousands): April 30, 2005
    
    
    July 31, 2004Gross
    
    
    
    
    
    
    Net
    
    
    Gross
    
    
    
    
    
    
    NetCarrying
    
    
    Accumulated
    
    
    Carrying
    
    
    Carrying
    
    
    Accumulated
    
    
    CarryingAmount
    
    
    Amortization
    
    
    Amount
    
    
    Amount
    
    
    Amortization
    
    
    AmountAmortizable intangibles:Purchased technology rights
    
    $
    7,419
    
    
    $
    4,268
    
    
    $
    3,151
    
    
    $
    7,419
    
    
    $
    3,909
    
    
    $
    3,510Trademarks and other intangible assets:Trademarks
    
    
    11,683
    
    
    
    3,486
    
    
    
    8,197
    
    
    
    11,627
    
    
    
    3,119
    
    
    
    8,508Patents
    
    
    3,697
    
    
    
    1,036
    
    
    
    2,661
    
    
    
    3,586
    
    
    
    1,128
    
    
    
    2,458Licensing costs
    
    
    3,250
    
    
    
    1,095
    
    
    
    2,155
    
    
    
    3,100
    
    
    
    826
    
    
    
    2,274Total trademarks and other intangible assets
    
    
    18,630
    
    
    
    5,617
    
    
    
    13,013
    
    
    
    18,313
    
    
    
    5,073
    
    
    
    13,240Total amortizable intangible assets
    
    
    26,049
    
    
    
    9,885
    
    
    
    16,164
    
    
    
    25,732
    
    
    
    8,982
    
    
    
    16,750Unamortizable intangible asset:Goodwill
    
    
    12,401
    
    
    
    5,471
    
    
    
    6,930
    
    
    
    12,401
    
    
    
    5,471
    
    
    
    6,930Total intangible assets
    
    $
    38,450
    
    
    $
    15,356
    
    
    $
    23,094
    
    
    $
    38,133
    
    
    $
    14,453
    
    
    $
    23,680
 There were no changes in the carrying amount of goodwill for the three and nine
months ended April 30, 2005. Intangible asset amortization expense for the three-month and nine-month periods ended April
30, 2005 was $363,000 and $1,071,000, respectively. For fiscal years 2006 through 2010, the
amortization of intangibles is estimated to be $1.5 million each year. During the quarter ended April 30, 2005, we changed the date of our annual goodwill impairment
test from April 30 to May 1, the first day of our fourth fiscal quarter. The results of our
impairment testing will be reported in our Annual Report on Form 10-K. We selected this date to
perform our annual goodwill impairment test because we believe that such date better aligns with
our annual planning and budgeting process, providing efficiencies and savings in professional fees.
We believe that the change will not delay, accelerate or avoid an impairment charge. Accordingly,
we believe that the accounting change described above is to an alternative date which is
preferable. 8




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6. DEBT AND LEASE OBLIGATIONS Debt consisted of the following (in thousands): April 30,
    
    
    July 31,2005
    
    
    2004Short-term borrowings:Installment notes payable
    
    $
    255
    
    
    $
    Current portion of long-term debt:IDA bond payable, Series A
    
    $
    245
    
    
    $
    245Capital lease obligations
    
    
    49
    
    
    
    47Note payable for equipment
    
    
    43
    
    
    
    51Total current portion of long-term debt
    
    $
    337
    
    
    $
    343Long-term debt:IDA bond payable, Series A
    
    $
    3,028
    
    
    $
    3,212PharmaBio
    
    
    500
    
    
    
    500Capital lease obligations
    
    
    169
    
    
    
    201Note payable for equipment
    
    
    43
    
    
    
    80Total long-term debt
    
    
    3,740
    
    
    
    3,993Less current portion
    
    
    337
    
    
    
    343Long-term portion
    
    $
    3,403
    
    
    $
    3,650
 On April 30, 2005, we had short-term borrowings of $255,000 for installments due on
certain insurance policies with interest rates ranging from 6.0% to 7.6%. On February 6, 2004, our subsidiaries, Zila Nutraceuticals, Inc., Zila Pharmaceuticals, Inc.,
Zila Biotechnology, Inc., and Zila Swab Technologies, Inc., entered into a Credit and Security
Agreement (the Wells Fargo Agreement) with Wells Fargo Business Credit, Inc. (Wells Fargo) that
provides a $10 million revolving line of credit, effective on August 17, 2004. Borrowings bear
interest equal to the prime rate. The amount of funds available under the Wells Fargo Agreement is
based upon a percentage of the value of eligible receivables and inventory and was $9.7 million at
April 30, 2005. Obligations under the Wells Fargo Agreement are collateralized by various assets,
including, but not limited to trade accounts receivable, inventories, equipment and intangible
assets. The parent company, Zila, Inc., guarantees the obligations under the Wells Fargo Agreement. Under the Wells Fargo Agreement, we are required to maintain defined minimum levels of net
worth at the end of each fiscal quarter and to limit capital expenditures to $3.0 million in fiscal
2005. Our minimum net worth requirement under the Wells Fargo Agreement varies each quarter in
relation to our planned operating results. At April 30, 2005, our net worth, as defined, was $43.0
million compared to the required amount of $38.0 million. Additionally, payment of common stock
dividends is restricted. The net worth and capital expenditures covenants are established annually
as of August 1 and were amended on January 25, 2005 to increase the capital expenditures limit and
to reduce the required net worth amount to the amounts described above. The Wells Fargo Agreement
contains a provision whereby Wells Fargo can call for immediate repayment of all amounts due under
the line upon its sole determination that a material adverse change has occurred. As a result of
this provision, any borrowings under the Wells Fargo Agreement will be classified as short-term
debt. There have been no borrowings under the Wells Fargo Agreement. In December 2002, we entered into an agreement with PharmaBio Development, Inc. (PharmaBio),
the strategic investment group of Quintiles Transnational Corp., our contract research
organization. Under this agreement, PharmaBio invested $500,000 in us. In return for the
investment, we agreed to pay PharmaBio an amount equal to 5% of all net sales of the OraTest®
product in the European Union and the United States. The aggregated amount of the royalty cannot
exceed $1.25 million and the royalty is payable quarterly. The investment was recorded as long-term
debt and will be amortized using the effective interest method. In April 1999, Zila Nutraceuticals, Inc. entered into a transaction with The Industrial
Development Authority of the County of Yavapai (the Authority) in which the Authority issued
Industrial Development Revenue Bonds (the Bonds). The proceeds from the Bonds were loaned to Zila
Nutraceuticals, Inc. for the construction of a new manufacturing and laboratory facility. The
initial offerings of Bonds consisted of $3.9 million Series A and $104,000 Taxable Series B Bonds
and mature in 2019. The 9




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Series B Bonds were repaid. The Bonds bear a variable interest rate that
was 3.2% at April 30, 2005. In connection with the issuance of the Bonds, the Authority
required that Zila Nutraceuticals, Inc. maintain, for the benefit of the Bondholders, an
irrevocable direct-pay letter of credit to secure payment of principal and interest. Zila, Inc.
guarantees the letter of credit. Wells Fargo provides such letter of credit (Replacement Letter of
Credit) in conjunction with the Wells Fargo Agreement. This Replacement Letter of Credit replaced
an earlier letter of credit provided by Bank One, which expired in March 2004. Under the terms of the Replacement Letter of Credit, on February 6, 2004, we placed $517,000
in an interest bearing collateral account representing the difference between the Replacement
Letter of Credit amount and the maximum commitment amount, as defined. We lease facilities and equipment, some of which are required to be capitalized in accordance
with SFAS No. 13, Accounting for Leases (SFAS No. 13). SFAS No. 13 requires the capitalization
of leases meeting certain criteria, with the related asset being recorded in property and equipment
and an offsetting amount recorded as a liability. The note payable for equipment matures in 2006 and bears interest at 13.4%. Aggregate annual maturities of long-term debt and minimum payments under capital leases for
the fiscal years ending July 31 are as follows (in thousands): Long-term
    
    
    Capital
    
    
    TotalDebt
    
    
    Leases
    
    
    DebtRemaining 2005
    
    $
    75
    
    
    $
    12
    
    
    $
    872006
    
    
    274
    
    
    
    49
    
    
    
    3232007
    
    
    245
    
    
    
    52
    
    
    
    2972008
    
    
    245
    
    
    
    43
    
    
    
    2882009
    
    
    746
    
    
    
    13
    
    
    
    7592010 and thereafter
    
    
    1,986
    
    
    
    
    
    
    
    1,986Total
    
    
    3,571
    
    
    
    169
    
    
    
    3,740Less current portion
    
    
    288
    
    
    
    49
    
    
    
    337Long-term portion
    
    $
    3,283
    
    
    $
    120
    
    
    $
    3,403
 7. SUPPLEMENTAL CASHFLOW INFORMATION Supplemental cash flow information follows (in thousands): Nine months endedApril 302005
    
    
    2004Cash paid for interest
    
    $
    127
    
    
    $
    118Cash paid for income taxes
    
    
    
    
    
    
    192Capital lease obligations for new equipment
    
    
    6
    
    
    
    205Liability satisfied through the issuance of warrants
    
    
    
    
    
    
    28
 8. INCOME TAXES 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. 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. In the three and
nine months ended April 30, 2005 and 2004, 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
April 30, 2005, we recorded total net deferred tax assets of approximately $8.8 million. The total
deferred tax assets were offset with a valuation allowance due to our lack of an earnings history. 10




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At April 30, 2005, the Company had income tax net operating loss carry forwards of
approximately $18.9 million that expire in fiscal years 2009 through 2025. 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:the Nutraceuticals Business Unit, which includes Zila Nutraceuticals,
Inc.; the Pharmaceuticals Business Unit, which includes Zila Pharmaceuticals, Inc. and the
Zilactin® family of over-the-counter products, Peridex® prescription mouth rinse, the ViziLite®
chemiluminescent disposable light product for the illumination of oral mucosal abnormalities, and
the plastic molded products of Zila Swab Technologies, Inc., an Arizona corporation dba Innovative
Swab Technologies (IST); and the Zila Biotechnology Business Unit, which includes Zila
Biotechnology Inc., Zila Technical, Inc., Zila Technologies, Inc. and Zila Limited, and is a research, development and
licensing business specializing in pre-cancer/cancer detection through its patented Zila® Tolonium
Chloride and OraTest® technologies and the manager of the OraTest® product, an oral cancer
diagnostic system, which is currently in Food and Drug Administration (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 April
30, 2005 and 2004 (in thousands): ReconcilingSegments
    
    
    ItemNutraceuticals
    
    
    Pharmaceuticals
    
    
    Biotechnology
    
    
    Corporate
    
    
    TotalNet revenues:Three months ended April 30:2005
    
    $
    10,432
    
    
    $
    3,636
    
    
    $
    
    
    
    $
    
    
    
    $
    14,0682004
    
    
    8,471
    
    
    
    4,179
    
    
    
    
    
    
    
    
    
    
    
    12,650Income (loss) before income taxes:Three months ended April 30:2005
    
    
    2,619
    
    
    
    (915
    )
    
    
    (2,094
    )
    
    
    (1,761
    )
    
    
    (2,151
    )2004
    
    
    1,756
    
    
    
    93
    
    
    
    (2,270
    )
    
    
    (1,146
    )
    
    
    (1,567
    )Depreciation and amortization:Three months ended April 30:2005
    
    
    282
    
    
    
    167
    
    
    
    213
    
    
    
    51
    
    
    
    7132004
    
    
    259
    
    
    
    266
    
    
    
    162
    
    
    
    20
    
    
    
    707
 The table below presents information about reported segments for the nine months ended April
30, 2005 and 2004 and segment total assets as of April 30, 2005 and July 31, 2004 (in thousands): ReconcilingSegments
    
    
    ItemNutraceuticals
    
    
    Pharmaceuticals
    
    
    Biotechnology
    
    
    Corporate
    
    
    TotalNet revenues:Nine months ended April 30:2005
    
    $
    28,953
    
    
    $
    10,227
    
    
    $
    
    
    
    $
    
    
    
    $
    39,1802004
    
    
    24,073
    
    
    
    14,232
    
    
    
    2
    
    
    
    
    
    
    
    38,307Income (loss) before income taxes:Nine months ended April 30:2005
    
    
    5,492
    
    
    
    (1,735
    )
    
    
    (6,397
    )
    
    
    (4,877
    )
    
    
    (7,517
    )2004
    
    
    4,197
    
    
    
    285
    
    
    
    (5,212
    )
    
    
    (3,366
    )
    
    
    (4,096
    )Depreciation and amortization:Nine months ended April 30:2005
    
    
    846
    
    
    
    505
    
    
    
    559
    
    
    
    155
    
    
    
    2,0652004
    
    
    768
    
    
    
    733
    
    
    
    511
    
    
    
    77
    
    
    
    2,089
 11




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##### Table of Contents



ReconcilingSegments
    
    
    ItemNutraceuticals
    
    
    Pharmaceuticals
    
    
    Biotechnology
    
    
    Corporate
    
    
    TotalTotal assets as of:April 30, 2005
    
    
    33,785
    
    
    
    11,126
    
    
    
    10,269
    
    
    
    2,622
    
    
    
    57,802July 31, 2004
    
    
    31,469
    
    
    
    11,499
    
    
    
    15,583
    
    
    
    3,558
    
    
    
    62,109
 10. COMMITMENTS AND CONTINGENCIES FDA approval of the OraTest® product We are pursuing FDA approval of a New Drug Application (NDA) for our OraTest® product.
Factors that will affect the cost and timing of completion of the clinical trials include, but are
not limited to: (i) patient enrollment rates; (ii) cancer and pre-cancer rate within the study
population; (iii) compliance with the study protocol and related monitoring; (iv) level of funding
throughout the study; and (v) FDA acceptance of our program modifications. At April 30, 2005, we had approximately $494,000 of OraTest® rinse and swab inventory and ZTC
drug substance, the active ingredient in the OraTest® product, and its related components. We
intend to realize the value of this inventory and drug substance through its consumption during
the conduct of the clinical trials, process development, toxicology studies and validation testing
of our manufacturing process. The drug substance currently has shelf
lives with varying expiration dates. Our periodic testing has
indicated that the drug substance is stable and we anticipate being able to extend the expiration
dates of the entire drug substance beyond their current expiration dates if our plans are delayed. However, no
assurance can be given in this regard. ViziLite® We had $237,000 of ViziLite® product in inventory and approximately $1.9 million of associated
net long-lived assets as of April 30, 2005. In fiscal 2004, we adjusted our product-to-market
strategy for ViziLite® based on our experiences in promoting awareness, education, trial and repeat
purchases of this unique product within the dental profession. The redirected product rollout
strategy is currently in the implementation stage and thus the acceptance of ViziLite® cannot be
determined at this time. If sales do not ultimately reach certain minimum levels, we may have to
reduce the carrying value of the assets related to ViziLite®. Litigation Except as described below, we are not a party to any pending legal proceedings other than
claims and lawsuits that arise in the ordinary course of business. Management believes these
proceedings will not have a material adverse effect on our consolidated financial condition or
results of operations. 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 because 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 requested judgment for the overpaid royalties. On April 22, 2004, the Court, in
part, ruled in our favor, stating that our royalty obligations to Tinnell ceased in August 1998,
however, our request for reimbursement of overpaid royalties was dismissed. Tinnell filed a notice
of appeal and we have filed a notice of cross-appeal. Opening briefs have been filed by both
parties with the Ninth Circuit Court of Appeals. In early December 2004, we became aware of a purported class action lawsuit filed in the
Superior Court of the State of Arizona for Maricopa County against Matrixx Initiatives, Inc. and a
number of other defendants, including us and IST. The lawsuit alleges that the Zicam Cold Remedy
Product manufactured by Matrixx Initiatives, Inc., a former customer of IST, caused damage to the
sense of smell and/or taste of the plaintiffs. Other defendants in the lawsuit include
manufacturers and retailers. IST had produced swabs and containers for the Zicam Cold Remedy
Product for a limited period that ended in March 2004. We and IST have not yet been served with
this lawsuit; however, if we and IST are made parties to the lawsuit, we will contest it
vigorously. We believe that the plaintiffs claims with respect to us and IST are without merit. 12




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On January 25, 2005, Ronald Fugate, a former employee, filed a law suit in the Superior Court
of the State of Arizona alleging wrongful termination in the case captioned Ronald Fugate
v. Zila, Inc., et al CV2005-001218. The claims made are without merit and we will
vigorously defend against them. 11. RECENT ACCOUNTING PRONOUNCEMENTS On June 1, 2005, the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standards No. 154, Accounting Changes and Error Corrections (SFAS No. 154),
a replacement of APB Opinion No. 20, Accounting Changes and FASB Statement No. 3, Reporting
Accounting Changes in Interim Financial Statements. SFAS No. 154 applies to all voluntary changes
in accounting principle and changes the requirements for accounting for and reporting a change in
accounting principle. SFAS No. 154 requires the retrospective application to prior periods
financial statements of the direct effect of a voluntary change in accounting principle unless it
is impracticable. APB No. 20 required that most voluntary changes in accounting principle be
recognized by including in net income of the period of the change the cumulative effect of changing
to the new accounting principle. The FASB stated that SFAS No. 154 improves financial reporting
because its requirements enhance the consistency of financial information between periods. Unless
early adoption is elected, SFAS No. 154 is effective for fiscal years beginning after December 15,
2005. Early adoption is permitted for fiscal years beginning after June 1, 2005. SFAS No. 154 does
not change the transition provisions of any existing accounting pronouncements, including those
that are in a transition phase as of the effective date of this statement. We anticipate that we
will adopt SFAS No. 154 on August 1, 2005, the beginning of our next fiscal year. On December 16, 2004, the FASB issued Statement of Financial Accounting Standards No. 123
(revised 2004), Share-Based Payment (SFAS No. 123R). SFAS No. 123R is a revision of FASB
Statement No. 123, Accounting for Stock-Based Compensation (SFAS No. 123) and supersedes APB
Opinion No. 25, Accounting for Stock Issued to Employees, and its related implementation
guidance. SFAS No. 123R requires companies to measure and recognize compensation expense for all
stock-based payments at fair value. Stock-based payments include stock option grants. We grant
options to purchase common stock to some of our employees and directors at prices equal to the
market value of the stock on the dates the options were granted. SFAS No. 123R is effective for
public companies for annual periods beginning after June 15, 2005. Early adoption is encouraged and
retroactive application of the provisions of SFAS No. 123R to the beginning of the fiscal year that
includes the effective date is permitted, but not required. SFAS No. 123R will become effective for
us beginning August 1, 2005, the beginning of our next fiscal year. We have not completed an
analysis of all of the differences between Statement No. 123R and SFAS No. 123, including the
specific transition method to be utilized upon adoption. We are currently evaluating the expected
impact that the adoption of SFAS No. 123R will have on our consolidated financial position, results
of operations and cash flows; however, SFAS No. 123R will negatively impact our earnings. As more
fully described in Note 2 of Notes to the Consolidated Financial Statements (unaudited), on March
3, 2005 our Board of Directors approved the immediate vesting of all outstanding and unvested stock
options previously granted under our Stock Award Plan to officers and employees, for which the
option exercise price was above the closing price for our common stock on April 29, 2005. On such
date, the closing price was $3.09. Options held by non-employee directors were excluded from this
acceleration. The immediate vesting of these options will avoid the compensation expense in future
periods on these options which were granted prior to the implementation of SFAS No. 123R. On November 24, 2004, the FASB issued Statement of Financial Accounting Standards No. 151
Inventory Costsan amendment of ARB No. 43, Chapter 4 (SFAS No. 151) effective for fiscal years
beginning after June 15, 2005. SFAS No. 151 will become effective for us on August 1, 2005, the
beginning of our next fiscal year. This Statement amends the guidance in ARB No. 43, Chapter 4,
Inventory Pricing, to clarify the accounting for abnormal amounts of idle facility expense,
freight, handling costs, and wasted material (spoilage). This Statement requires that those items be recognized as
current-period charges. In addition, this Statement requires that allocation of fixed production
overheads to the costs of conversion be based on the normal capacity of the production facilities.
We do not believe that the adoption of SFAS No. 151 will have a material effect on our results of
operations or financial position. 13




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Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations ZILA, INC. AND SUBSIDIARIES OVERVIEW We are an innovator in preventive healthcare technologies and nutraceutical, pharmaceutical
and biotechnology products, focusing on enhanced body defense and the detection of pre-disease
states. Our Business Units are aligned as follows:  
    Zila Nutraceuticals, manufacturer and marketer of Advanced Protection
Ester-C® and Ester-E®, proprietary, branded, highly effective forms of
vitamins C and E.
    Zila Pharmaceuticals, manufacturer and marketer of products to promote
oral health and prevent oral disease, including the ViziLite®
chemiluminescent light for illumination of oral mucosal abnormalities,
Peridex® prescription periodontal rinse, the Zilactin® family of OTC
oral care products and the plastic molded products of Zila Swab
Technologies, Inc. (IST).
    Zila Biotechnology, a research, development and licensing business
specializing in pre-cancer/cancer detection through its patented Zila
Tolonium Chloride and OraTest® technologies. The OraTest® product is
in FDA phase III clinical studies. 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®
product 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 (income), Depreciation and
Amortization (EBITDA) and our management of working capital would provide an acceptable level of
cash availability to fund the completion of the OraTest® regulatory program. We plan to continue to
pursue this goal while we seek to obtain the requisite clearances from the FDA to bring our
OraTest® product to market in the United States. Market forces, such as the market acceptance of
new products such as ViziLite® and our new Ester-E® product, and other variables and risk factors,
can and do influence our ability to accomplish this goal. Our level of research and development
activities, and the associated costs, will likely trend above our historical levels as we
accelerate our efforts to advance our clinical program. Accordingly, unless our other business
units produce a sufficient, higher level of EBITDA to offset these additional costs, we will
operate on a negative EBITDA basis during fiscal 2005 and during such future period. We believe
that our current cash balances, cash generated from our operations, net proceeds from our investing
activities and the availability of cash under our line of credit are sufficient to finance our
level of operations, the OraTest® clinical program, the continuation of the launch of Ester-E® and
anticipated capital expenditures for this period. 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. We received
comments from the FDA on the proposed amendments to the clinical program. 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®. The primary modification incorporated into the proposed clinical program is the inclusion of
severe dysplasia as a primary endpoint of the trial. Additionally, certain elements of the amended
program would allow for a substantial reduction in patient visits and the cost and duration of the
program. As a result of receiving comments from the FDA, we have decided to proceed with
certain of the preliminary processes necessary to conduct the amended clinical program, such as
submission of the clinical protocols to the independent review boards at our investigative sites
and the completion of necessary contractual arrangements. We will continue our communications with
FDA aimed at addressing their comments. No assurances can be made that the FDA will not have
further comment on the clinical program or that the clinical objectives of the program will be
achieved. 14




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NON-GAAP MEASURES The following discussion includes a presentation of EBITDA, which is utilized by management as
one measure of the performance of our business units. We consider EBITDA to be a meaningful measure
of our ongoing operations that assists us in assessing our ability to fund our clinical program and
debt service and to finance the growth of our core businesses. Although we use EBITDA as a financial measure to assess the performance of our business, we do
not use EBITDA alone because it does not consider certain material costs, expenses and other items
necessary to operate our business. These items include debt service costs and non-cash depreciation
and amortization expense associated with long-lived assets. Because EBITDA does not consider these
items, a user of our financial information should also consider net income as an important measure
of our financial performance in that it provides a more complete measure of our performance. A reconciliation of EBITDA to net loss for the periods set forth below follows (in thousands): Three months ended
    
    
    Nine months endedApril 30
    
    
    April 302005
    
    
    2004
    
    
    2005
    
    
    2004EBITDA
    
    $
    (1,429
    )
    
    $
    (785
    )
    
    $
    (5,437
    )
    
    $
    (1,830
    )Interest Income
    
    
    35
    
    
    
    25
    
    
    
    129
    
    
    
    77Interest Expense
    
    
    (44
    )
    
    
    (100
    )
    
    
    (144
    )
    
    
    (254
    )Depreciation and Amortization
    
    
    (713
    )
    
    
    (707
    )
    
    
    (2,065
    )
    
    
    (2,089
    )Income Tax Expense
    
    
    
    
    
    
    
    
    
    
    (2
    )
    
    
    Net loss
    
    $
    (2,151
    )
    
    $
    (1,567
    )
    
    $
    (7,519
    )
    
    $
    (4,096
    )
 RESULTS OF OPERATIONS The following tables summarize our results of operations and related statistical information
for the three-month and nine-month periods ended April 30, 2005 and 2004 (dollars in thousands): Three months ended April 30, 2005 and 2004Percent of
    
    
    
    
    
    
    Percent ofNet
    
    
    
    
    
    
    Net
    
    
    %2005
    
    
    Revenues
    
    
    2004
    
    
    Revenues
    
    
    ChangeNet revenues
    
    $
    14,068
    
    
    
    100
    %
    
    $
    12,650
    
    
    
    100
    %
    
    
    11Cost of products sold
    
    
    4,590
    
    
    
    33
    
    
    
    4,725
    
    
    
    37
    
    
    
    (3
    )Gross profit
    
    
    9,478
    
    
    
    67
    
    
    
    7,925
    
    
    
    63
    
    
    
    20Operating Expenses:Marketing & selling
    
    
    5,468
    
    
    
    39
    
    
    
    3,646
    
    
    
    29
    
    
    
    50General & administrative
    
    
    3,475
    
    
    
    25
    
    
    
    2,935
    
    
    
    23
    
    
    
    18Other operating costs
    
    
    298
    
    
    
    2
    
    
    
    
    
    
    
    
    
    
    
    Research & development
    
    
    1,636
    
    
    
    11
    
    
    
    2,064
    
    
    
    16
    
    
    
    (21
    )Depreciation & amortization
    
    
    713
    
    
    
    5
    
    
    
    707
    
    
    
    6
    
    
    
    111,590
    
    
    
    82
    
    
    
    9,352
    
    
    
    74
    
    
    
    24Loss from operations
    
    
    (2,112
    )
    
    
    (15
    )
    
    
    (1,427
    )
    
    
    (11
    )
    
    
    48Other income (expense), net
    
    
    (39
    )
    
    
    
    
    
    
    (140
    )
    
    
    (1
    )
    
    
    (72
    )Loss before income taxes
    
    
    (2,151
    )
    
    
    (15
    )
    
    
    (1,567
    )
    
    
    (12
    )
    
    
    37Income tax expense
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net loss
    
    $
    (2,151
    )
    
    
    (15
    )
    
    $
    (1,567
    )
    
    
    (12
    )
    
    
    37
 15




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##### Table of Contents



Nine months ended April 30, 2005 and 2004Percent of
    
    
    
    
    
    
    Percent ofNet
    
    
    
    
    
    
    Net
    
    
    %2005
    
    
    Revenues
    
    
    2004
    
    
    Revenues
    
    
    ChangeNet revenues
    
    $
    39,180
    
    
    
    100
    %
    
    $
    38,307
    
    
    
    100
    %
    
    
    2Cost of products sold
    
    
    13,185
    
    
    
    34
    
    
    
    15,310
    
    
    
    40
    
    
    
    (14
    )Gross profit
    
    
    25,995
    
    
    
    66
    
    
    
    22,997
    
    
    
    60
    
    
    
    13Operating Expenses:Marketing & selling
    
    
    16,323
    
    
    
    42
    
    
    
    10,897
    
    
    
    28
    
    
    
    50General & administrative
    
    
    9,528
    
    
    
    24
    
    
    
    9,959
    
    
    
    26
    
    
    
    (4
    )Other operating costs
    
    
    298
    
    
    
    1
    
    
    
    
    
    
    
    
    
    
    
    Research & development
    
    
    5,220
    
    
    
    13
    
    
    
    4,332
    
    
    
    11
    
    
    
    21Depreciation & amortization
    
    
    2,065
    
    
    
    5
    
    
    
    2,089
    
    
    
    6
    
    
    
    (1
    )33,434
    
    
    
    85
    
    
    
    27,277
    
    
    
    71
    
    
    
    23Loss from operations
    
    
    (7,439
    )
    
    
    (19
    )
    
    
    (4,280
    )
    
    
    (11
    )
    
    
    74Other income (expense), net
    
    
    (78
    )
    
    
    
    
    
    
    184
    
    
    
    
    
    
    
    (142
    )Loss before income taxes
    
    
    (7,517
    )
    
    
    (19
    )
    
    
    (4,096
    )
    
    
    (11
    )
    
    
    84Income tax expense
    
    
    (2
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net loss
    
    $
    (7,519
    )
    
    
    (19
    )
    
    $
    (4,096
    )
    
    
    (11
    )
    
    
    84
 Comparison of the three month and nine month periods ended April 30, 2005 and April 30, 2004 Consolidated Net revenues increased 11% to $14.1 million for the three months ended April 30, 2005,
compared to revenues of $12.7 million for the three months ended April 30, 2004. Net revenues
increased 2% to $39.2 million for the nine months ended April 30, 2005, compared to revenues of
$38.3 million for the nine months ended April 30, 2004. We achieved growth in net revenues during
the current fiscal quarter in both our nutraceutical and core pharmaceutical product lines over the
prior year quarter. For the three and nine month periods ended April 30, 2005, net revenues of the
Nutraceuticals Business Unit increased 23% and 20%, respectively, compared to the prior year
periods. Net revenues for the core Pharmaceuticals Business Unit, without the effect of IST (see
the Pharmaceuticals Business Unit section below) increased 18% compared to the prior year quarter
and were relatively flat for the comparable year to date period. Without the effect of IST, total
company net revenues increased 22% and 15%, respectively, for the three and nine month periods
ended April 30, 2005 compared to the prior year periods. Gross profit as a percentage of net revenues increased to 67% and 66% for the three month and
nine month periods ended April 30, 2005, respectively, compared to 63% and 60%, respectively, for
the comparable prior year periods. The primary factor contributing to this improvement was the
reduced cost of ascorbic acid, the major raw material in our Ester-C® products. Marketing and selling expenses as a percentage of net revenues increased to 39% and 42%,
respectively, for the three and nine month periods ended April 30, 2005 compared to 29% and 28%,
respectively, for the comparable prior year periods. Increased spending for brand and media
advertising support for Ester-C®, the launch of Ester-E® and increased marketing and selling
expenditures for Zilactin® and ViziLite® were the primary reasons for these increases. General and administrative expenses were $3.5 million, or 25% of net revenues, for the three
months ended April 30, 2005, and $9.5 million, or 24% of net revenues, for the nine month ended
April 30, 2005 compared to $2.9 million, or 23% of net revenue, and $10.0 million or 26% of net
revenue, respectively for the comparable prior year periods. For the three months ended April 30,
2005, the increased G&A expenses are driven primarily by professional fees incurred at the
corporate level in connection with our Sarbanes-Oxley Section 404 internal control compliance
efforts. We incurred $419,000 and $537,000 for the three and nine months ended April 30, 2005
related to Sarbanes-Oxley 404 compliance. Our compliance efforts will continue over the balance of
our fiscal year resulting in increased expense levels over the prior year period. For the nine
months ended April 30, 2005, general and administrative expenses as a percent of net revenues
decreased 4% from the prior year. Offsetting the increase described above were reductions in
expenses resulting from ISTs downsizing of its operations after the loss of its major customer and
from overall cost reduction measures throughout all of our business units. 16




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##### Table of Contents



Other operating costs were $298,000 for both the three and nine month periods ended April 30,
2005, or 2% and 1% of net revenues. These costs were incurred at IST and represent engineering and
consulting costs to upgrade ISTs manufacturing and quality control procedures. Research and development expenses decreased $428,000, or 21%, to $1.6 million for the three
months ended April 30, 2005 and increased $888,000, or 21%, to $5.2 million for the nine months
ended April 30, 2005. The decrease in research and development expenses for the three months ended
April 30, 2005 reflects the fact that we have not yet begun to enroll patients under the newly
modified clinical protocols for the conduct of the OraTest® Phase III clinical trials. The
protocols are being submitted to independent review boards for their approval and we currently
anticipate the first patient enrollments to begin late in the summer of 2005. Depreciation and amortization expense increased $6,000, or 1%, to $713,000 for the three
months ended April 30, 2005 and was relatively flat for the nine months ended April 30, 2005. The
year to date decreases in depreciation and amortization expense result from the impairment charge
for long-lived assets recorded at IST at July 31, 2004. For the current quarter, the decrease in
IST depreciation was offset by increased depreciation and amortization attributable to additions of
property and equipment and patents and trademarks in the Nutraceuticals and Pharmaceuticals
Business Units and at the corporate level for computer software. Other expense for the three month and nine months ended April 30, 2005 was $39,000 and
$78,000, respectively, compared to other expense of $140,000 and other income of $184,000,
respectively, in the prior year periods. For both the current year three and nine month periods, a
reduction in short-term borrowing over the prior year period resulted in decreased interest
expense. The prior year nine-month period includes a $470,000 of gain on the sale and leaseback of
our Corporate Headquarters facility on January 30, 2004. Nutraceuticals Business Unit Selected financial information for the Nutraceuticals Business Unit follows for the
three-month and nine-month periods ended April 30, 2005 and 2004 (dollars in thousands): Three months ended
    
    
    Nine months endedApril 30
    
    
    April 302005
    
    
    2004
    
    
    % Change
    
    
    2005
    
    
    2004
    
    
    % ChangeNet revenues
    
    $
    10,432
    
    
    $
    8,471
    
    
    
    23
    
    
    $
    28,953
    
    
    $
    24,073
    
    
    
    20Gross profit
    
    
    7,332
    
    
    
    5,494
    
    
    
    33
    
    
    
    19,976
    
    
    
    14,792
    
    
    
    35Gross profit %
    
    
    70
    %
    
    
    65
    %
    
    
    
    
    
    
    69
    %
    
    
    61
    %Income before income taxes
    
    
    2,619
    
    
    
    1,756
    
    
    
    49
    
    
    
    5,492
    
    
    
    4,197
    
    
    
    31
 Net revenues for the Nutraceuticals Business Unit for the three and nine months ended April
30, 2005 increased 23% and 20%, respectively, over the prior year periods. This growth was
primarily in domestic sales for Ester-C® and was driven principally by increased radio and
television advertising support for our Ester-C® and Ester-E® products in our continuing strategy of
brand development. Ester-E® also contributed marginally to the growth in net revenue. Gross profit
as a percentage of net revenues increased to 70% and 69% for the three month and nine month periods
ended April 30, 2005, respectively, compared to 65% and 61%, respectively, for the comparable prior
year periods. The primary factor contributing to this improvement was the reduced cost of ascorbic
acid, the major raw material in our Ester-C® products. Due to the completion in the fourth quarter
of fiscal 2004 of certain supply agreements for the purchase of ascorbic acid, the rate of
improvement in the gross margin should not be expected to extend beyond the third quarter of fiscal
2005 but rather gross profit should be expected to stabilize and be sustained in the high 60s as a
percent of net revenues. Net income before taxes for the Nutraceuticals Business Unit for the three and nine months
ended April 30, 2005, was $2.6 million, and $5.5 million, respectively, increasing by 49% and 31%,
respectively, over the prior year periods. The primary factors in these increases were gross margin
improvements in the current year as a result of reductions in the cost of ascorbic acid under our
lower cost extended supply agreements and cost reduction measures in general and administrative
expenses. Offsetting these improvements, spending for brand and media advertising support for
Ester-C®and for the launch of Ester-E® for the three and nine months ended April 30, 2005
increased 37% and 51%, respectively, over the prior year periods. 17




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Pharmaceuticals Business Unit Selected financial information for the Pharmaceuticals Business Unit follows for the
three-month and nine-month periods ended April 30, 2005 and 2004 (dollars in thousands): Three months ended
    
    
    Nine months endedApril 30
    
    
    April 302005
    
    
    2004
    
    
    % Change
    
    
    2005
    
    
    2004
    
    
    % ChangeNet revenues
    
    $
    3,636
    
    
    $
    4,179
    
    
    
    (13
    )
    
    $
    10,227
    
    
    $
    14,232
    
    
    
    (28
    )IST net revenues, net of eliminations
    
    
    222
    
    
    
    1,284
    
    
    
    (83
    )
    
    
    531
    
    
    
    4,567
    
    
    
    (88
    )Net revenues without IST
    
    
    3,414
    
    
    
    2,895
    
    
    
    18
    
    
    
    9,696
    
    
    
    9,665
    
    
    
    Gross profit
    
    
    2,150
    
    
    
    2,417
    
    
    
    (11
    )
    
    
    6,027
    
    
    
    8,192
    
    
    
    (26
    )Gross margin %
    
    
    59
    %
    
    
    58
    %
    
    
    
    
    
    
    59
    %
    
    
    58
    %IST gross profit, net of eliminations
    
    
    (135
    )
    
    
    544
    
    
    
    (125
    )
    
    
    (277
    )
    
    
    2081
    
    
    
    (113
    )Gross margin %
    
    
    (61
    )%
    
    
    42
    %
    
    
    
    
    
    
    (52
    )%
    
    
    46
    %Gross profit without IST
    
    
    2,285
    
    
    
    1,873
    
    
    
    22
    
    
    
    6,304
    
    
    
    6,111
    
    
    
    3Gross margin %
    
    
    67
    %
    
    
    65
    %
    
    
    
    
    
    
    65
    %
    
    
    63
    %Income (loss) before income taxes
    
    
    (915
    )
    
    
    93
    
    
    
    (1084
    )
    
    
    (1,735
    )
    
    
    285
    
    
    
    (709
    )IST income (loss) before income taxes
    
    
    (723
    )
    
    
    164
    
    
    
    (541
    )
    
    
    (1,449
    )
    
    
    302
    
    
    
    (580
    )Loss before income taxes without IST
    
    
    (192
    )
    
    
    (71
    )
    
    
    170
    
    
    
    (286
    )
    
    
    (17
    )
    
    
    1582
 Net revenues for the Pharmaceuticals Business Unit for the three and nine months ended April
30, 2005 decreased 13% and 28%, respectively, from the comparable prior year periods. The decreases
in net revenues from the prior year periods were caused by ISTs loss of the contract with its
major customer in March 2004. Without the effect of IST, net revenues for the Pharmaceuticals
Business unit increased 18% from prior quarter and were flat for the nine month period compared to
the prior year. The increase in net revenues for the current quarter, without the effect of IST,
arose primarily from gains in net revenues in our ViziLite® and Zilactin® brands driven largely by
increased marketing efforts. Net revenues for ViziLite® for the third fiscal quarter and fiscal
year-to-date were $390,000 and $688,000, respectively, reflecting increases of more than 500% and
900% compared to the prior year periods. Net revenues for ViziLite® for the third fiscal quarter
increased more than 100% compared to the second fiscal quarter. The growth in ViziLite® net
revenues continues through our strategy of educating the dental professional and broadening
distribution channels. Furthermore, net revenues for the Zilactin® line of products increased 12%
for the three month period ended April 30, 2005 and decreased 2% for the nine-month period ended
April 30, 2005 compared to the prior year periods. Gross profit as a percentage of net revenues increased to 59% for both the three month and
nine month periods ended April 30, 2005, respectively, compared to 58% for the comparable prior
year periods. Improvements in the core Pharmaceuticals Business Unit gross margins were offset by
excess capacity costs at IST resulting from the loss of their major customer. Without the effect of
IST, gross profit as a percentage of net revenues increased to 67% and 65% for both the three month
and nine month periods ended April 30, 2005, respectively, compared to 65% and 63%, respectively,
for the comparable prior year periods. The improvements in gross profit occurred in both ViziLite®
and Zilactin®. In the prior year periods, higher cost of product was experienced as a result of the ViziLite® product launch, Zilactin® promotional events, and the
transition to a third party manufacturer for certain Zilactin® product production. Net loss before income taxes for the Pharmaceuticals Business Unit for the three and nine
months ended April 30, 2005 was $915,000 and $1.7 million, respectively. The increased net loss
from the prior year periods resulted primarily from the net loss at IST and increased selling and
marketing expenses for the core product lines in the Pharmaceuticals Business Unit. 18




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Biotechnology Business Unit Selected financial information for the Biotechnology Business Unit follows for the three-month
and nine-month periods ended April 30, 2005 and 2004 (dollars in thousands): Three months ended
    
    
    Nine months endedApril 30
    
    
    April 302005
    
    
    2004
    
    
    % Change
    
    
    2005
    
    
    2004
    
    
    % ChangeNet revenues
    
    $
    
    
    
    $
    
    
    
    
    
    
    
    $
    
    
    
    $
    2
    
    
    
    (100
    )Research and development
    
    
    1,473
    
    
    
    1,874
    
    
    
    (21
    )
    
    
    4,893
    
    
    
    3,926
    
    
    
    25Loss before income taxes
    
    
    (2,094
    )
    
    
    (2,270
    )
    
    
    (8
    )
    
    
    (6,397
    )
    
    
    (5,212
    )
    
    
    23
 There were no international sales of the OraTest® product during the three and nine months
ended April 30, 2005 as we continued our focus on obtaining FDA approval in the United States. Net loss before income taxes for the Biotechnology Business Unit for the third fiscal quarter
decreased 8% over the prior year period while year-to date our net loss increased 23% compared to
the prior year period. We received preliminary comments from the FDA on the proposed amendments to
the clinical program and we are proceeding with certain of the preliminary processes necessary to
conduct the amended clinical program, such as submission of the clinical protocols to the
independent review boards at our investigative sites and the completion of necessary contractual
arrangements. Expenditures for these activities have been at a reduced level during the current
quarter compared to prior periods. We will continue our communications with FDA aimed at addressing
their preliminary comments. No assurances can be made that the FDA will not have further comment on
the clinical program or that the clinical objectives of the program will be achieved. LIQUIDITY AND CAPITAL RESOURCES At April 30, 2005, our primary sources of liquidity included cash and cash equivalents of $4.4
million, short-term investments of $1.0 million and the line of credit discussed below. Net working
capital decreased to $14.0 million at April 30, 2005 from $21.2 million at July 31, 2004. The
decrease in net working capital is due to the funding of the operating loss and the capital
expenditures for property and equipment and intangibles. Net cash used in operating activities was $4.8 million during the nine months ended April 30,
2005 and was primarily attributable to the net loss from continuing operations of $7.5 million, an
increase of $2.6 million in receivables, inventories and other current assets, primarily at our
Nutraceuticals Business Unit. Offsetting these uses of cash were: (i) $2.1 million of depreciation
and amortization and other non-cash items; and (ii) an increase in accounts payable and
other liabilities of $3.2 million. Net cash provided by investing activities was $5.4 million resulting from the sale of $7.0
million of short-term investments offset by expenditures of $1.6 million used for equipment
purchases and patent and trademark filings. Net cash provided by financing activities during the nine months ended April 30, 2005 was
$146,000, primarily related to proceeds from the exercise of stock options. Short-term debt
borrowings during the period offset cash utilized for debt repayments and preferred stock dividend
payments. We believe that our current cash balances, cash generated from our operations and the
availability of cash under our line of credit are sufficient to finance our level of operations,
the OraTest® clinical program, the continued launch of Ester-E® and ViziLite®, and anticipated
capital expenditures through the next 12 months. Bank Financing On February 6, 2004, our subsidiaries, Zila Nutraceuticals, Inc., Zila Pharmaceuticals, Inc.,
Zila Biotechnology, Inc., and Zila Swab Technologies, Inc. entered into a Credit and Security
Agreement (the Wells Fargo Agreement) with Wells Fargo Business Credit, Inc. (Wells Fargo) that
provides a $10 million revolving line of credit, effective on August 17, 2004. Borrowings bear 19




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##### Table of Contents



interest equal to the prime rate. The amount of funds available under the Wells Fargo Agreement is
based upon a percentage of the value of eligible receivables and inventory and was $9.7 million at
April 30, 2005. Obligations under the Wells Fargo Agreement are collateralized by various assets,
including, but not limited to trade accounts receivable, inventories, equipment and intangible
assets. The parent company, Zila, Inc., guarantees the obligations under the Wells Fargo Agreement. Under the Wells Fargo Agreement, we are required to maintain defined minimum levels of net
worth at the end of each fiscal quarter and to limit capital expenditures to $3.0 in fiscal 2005.
Our minimum net worth requirement under the Wells Fargo Agreement varies each quarter in relation
to our planned operating results. At April 30, 2005, our net worth, as defined, was $43.0 million
compared to the required net worth amount of $38.0 million. Additionally, payment of common stock
dividends is restricted. The net worth and capital expenditures covenants are established annually
as of August 1 and were amended on January 25, 2005 to increase the capital expenditures limit and
to reduce the required net worth amount to the amounts described above. The Wells Fargo Agreement
contains a provision whereby Wells Fargo can call for immediate repayment of all amounts due under
the line upon its sole determination that a material adverse change has occurred. As a result of
this provision, any borrowings under the Wells Fargo Agreement will be classified as short-term
debt. There have been no borrowings under the Wells Fargo Agreement. PharmaBio Investment In December 2002, we entered into an agreement with PharmaBio Development, Inc. (PharmaBio),
the strategic investment group of Quintiles Transnational Corp., our contract research
organization. Under this agreement, PharmaBio invested $500,000 in us. In return for the
investment, we agreed to pay PharmaBio an amount equal to 5% of all net sales of the OraTest®
product in the European Union and the United States. The aggregated amount of the royalty cannot
exceed $1.25 million and the royalty is payable quarterly. The investment was recorded as long-term
debt and will be amortized using the effective interest method. Long-Term Debt Financing In April 1999, Zila Nutraceuticals, Inc. entered into a transaction with The Industrial
Development Authority of the County of Yavapai (the Authority) in which the Authority issued
Industrial Development Revenue Bonds (the Bonds). The proceeds from the Bonds were loaned to Zila
Nutraceuticals, Inc. for the construction of a new manufacturing and laboratory facility. The
initial offerings of Bonds consisted of $3.9 million Series A and $104,000 Taxable Series B Bonds
and mature in 2019. The Series B Bonds were repaid. The Bonds bear a variable interest rate that
was 3.2% at April 30, 2005. In connection with the issuance of the Bonds, the Authority required
that Zila Nutraceuticals, Inc. maintain, for the benefit of the Bondholders, an irrevocable
direct-pay letter of credit to secure payment of principal and interest. Zila, Inc. guarantees the
letter of credit. Wells Fargo provides this new letter of credit (Replacement Letter of
Credit) in conjunction with the Wells Fargo Agreement. This Replacement Letter of Credit replaced
an earlier letter of credit provided by Bank One, which expired in March 2004. Under the terms of the Replacement Letter of Credit, on February 6, 2004, we placed $517,000
in a cash collateral account representing the difference between the Replacement Letter of Credit
amount and the maximum commitment amount, as defined. Summary of Critical Accounting Policies and Estimates There are several accounting policies that we believe are significant to the fair 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 as a reduction of revenue at the time of sale
based upon historical activity and current customer commitments. We evaluate these estimates on a
quarterly basis and revise them as necessary. We provide for allowances for doubtful accounts and sales returns based on historical
experience and a review of our receivables. Receivables are presented net of allowances for
doubtful accounts and for sales returns of $258,000 at April 30,
2005 and $299,000 at July 31,
2004. 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 20




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##### Table of Contents



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 that we make
estimates and assumptions that affect the reported amounts of assets and liabilities, as well as
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. The accounting estimates used
in the preparation of our consolidated financial statements will change as new events occur, as
more experience is acquired, as additional information is obtained and as our operating environment
changes. Actual results could differ from those estimates. Significant estimates include: (i) useful lives of intangibles; (ii) impairment analyses;
(iii) depreciable lives of assets; (iv) income tax valuation allowances; (v) contingency and
litigation reserves; (vi) inventory valuation; (vii) the valuation of the lack of marketability
discount for restricted common stock; and (viii) allowances for accounts receivable, cash
discounts, sales incentives and sales returns. We make changes in estimates as appropriate, and as we become aware of circumstances
surrounding those estimates. Such changes and refinements in estimation methodologies are reflected
in reported results of operations in the period in which the changes are made and, if material,
their effects are disclosed in the Notes to Consolidated Financial Statements. Our impairment analyses include significant estimates with respect to cash flows and fair
values. The factors that affect these 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. 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 April 30, 2005 of $5.5 million have
been capitalized. The cash flows used to measure long-lived assets related to the ViziLite® product are
dependent upon our ability to properly market the product to a sufficient number of dentists so it
becomes integrated within their practice. 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 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 and 2004, we have revised our business model with current sales
and costs assumptions. We have added significant 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 April 30, 2005 of $1.9 million have been capitalized. Goodwill, Intangibles and Other Long-Lived Assets We have made acquisitions of products and
businesses that include goodwill, license agreements, patents and trademarks, product rights and
other intangible and long-lived assets. We assess the carrying amounts of goodwill, intangibles and other long-lived assets whenever events or changes in
circumstances indicate that the carrying amount of any of these assets may not be recoverable. Such
events or circumstances might include a significant decline in market share and/or significant
negative industry or economic trends, a significant decline in profits and/or significant
underperformance relative to expected historical or projected operating results, significant
changes in the manner of our use of the acquired assets or the strategy for our overall business,
rapid changes in technology, significant litigation or other items. In evaluating the
recoverability of goodwill, intangibles and other long-lived 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 events 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. In accordance with SFAS No. 142  Goodwill and Other Intangibles, our policy is to review
the carrying amounts of goodwill and certain intangible assets with indefinite lives at least
annually or, as described above, whenever events or changes in 21




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circumstances indicate that the carrying amount of the asset may not be recoverable. During the quarter ended April 30, 2005, we
changed the date of our annual goodwill impairment test from April 30 to May 1, the first day of
our fourth fiscal quarter. The results of our impairment testing will be reported in our Annual
Report on Form 10-K. We selected this date to perform our annual goodwill impairment test because
we believe that such date better aligns with our annual planning and budgeting process, providing
efficiencies and savings in professional fees. We believe that the change will not delay,
accelerate or avoid an impairment charge. Accordingly, we believe that the accounting change
described above is to an alternative date which is preferable. The following is a summary of the significant components of our goodwill and intangible assets
and our impairment methodology for each. Zila Pharmaceuticals Goodwill Goodwill of $4.0 million at April 30, 2005 is related to the
Peridex® product which was acquired from Procter & Gamble in November 1997. As part of the
implementation for SFAS No. 142, Goodwill and Other
Intangible Assets on August 1, 2002, the Company 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s findings, we determined that approximately $3.0 million of the Peridex®
goodwill and the entire $1.1 million of IST goodwill acquired in February 2001 was impaired thus
reducing goodwill to approximately $4.0 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. We review the carrying value of Zila Pharmaceuticals
goodwill at least annually or, as described above, whenever events or changes in circumstances
indicate that the carrying amount of the asset may not be recoverable. Zila Nutraceuticals Goodwill Goodwill and trademarks totaling approximately $11.0 million
(net of accumulated amortization of $4.4 million) are related primarily to the Ester-C® group of
products. The goodwill and the majority of the trademarks were acquired by merger in 1997 and are
combined for purposes of testing for impairment. We review the carrying value of Zila
Nutraceuticals goodwill at least annually or, as described above, whenever events or changes in
circumstances indicate that the carrying amount of the asset may not be recoverable. OraTest®The purchase of CTM eliminated our obligation to pay royalties to CTM on future
sales of the OraTest® product. The recoverability of the $3.2 million net purchased technology
rights at April 30, 2005 is dependent upon obtaining FDA approval and generating sufficient
revenues from future sales of the OraTest® products. For purposes of testing recoverability, the
following are grouped with purchased technology rights: (i) fixed assets of approximately $815,000
(primarily related to our manufacturing facility); (ii) patents and patents pending of $1.6
million; and (iii) $494,000 of OraTest® rinse and swab inventory, ZTC drug substance, the
active ingredient in the OraTest® product, and its related components. 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. We are currently
reviewing the impact that our new ZTC marker product may have on our analysis. We do not
anticipate that it will negatively affect the recoverability of any of our assets at April 30,
2005. 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. As of April 30, 2005, all of our deferred tax assets
were offset by a valuation allowance. 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
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 22




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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 Report 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 affected adversely 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 specific dietary supplements or
the dietary supplement industry and the consumer oral care, OTC medical device 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, expand, or in certain cases, regain
distribution within new or existing channels of trade for our products; (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, co-op advertising, or rebates; (ix)
adverse changes in or interpretations of government regulations, especially those related to
dietary supplements and ingredients in dietary supplements and those related to OTC products; (x)
our suppliers and our ability to comply with current and proposed GMPs and other applicable
regulatory requirements; (xi) exposure to product liability claims; (xii) dependence on significant
customers and our customers ability to repay obligations due to us; (xiii) our ability to attract
and retain key employees; (xiv) our ability 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 ability to protect our intellectual
property; (xix) charges resulting from an impairment of our goodwill, intangible assets and other
long-lived assets; (xx) future decreases in the cost of ascorbic acid that may result in purchases
under our supply arrangements at prices above market; (xxi) our ability to gain market acceptance
of our ViziLite® and Ester-E® products; (xxii) adverse publicity regarding nutraceutical products,
such as vitamins C and E; (xxiii) our ability to replace the loss of ISTs principal customer with
new business; and (xxiv) 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 our 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,
2004 filed with the Securities and Exchange Commission. Recent Accounting Pronouncements On
June 1, 2005, the Financial Accounting Standards Board
(FASB) issued Statement of Financial Accounting Standards
No. 154, Accounting Changes and Error Corrections (SFAS
No. 154), a replacement of APB Opinion No. 20,
Accounting Changes and FASB Statement No. 3,
Reporting Accounting Changes in Interim Financial
Statements. SFAS No. 154 applies to all voluntary changes
in accounting principle and changes the requirements for accounting
for and reporting a change in accounting principle. SFAS No. 154 requires the retrospective
application to prior periods financial statements of the direct
effect of a voluntary change in accounting principle unless it is
impracticable. APB No. 20 required that most voluntary changes
in accounting principle be recognized by including in net income of
the period of the change the cumulative effect of changing to the new
accounting principle. The FASB stated that SFAS No. 154 improves
financial reporting because its requirements enhance the consistency
of financial information between periods. Unless early adoption is
elected, SFAS No. 154 is effective for fiscal years beginning
after December 15, 2005. Early adoption is permitted for fiscal
years beginning after June 1, 2005. SFAS No. 154 does not
change the transition provisions of any existing accounting
pronouncements, including those that are in a transition phase as of
the effective date of this statement. We anticipate that we will
adopt SFAS No. 154 on August 1, 2005, the beginning of our
next fiscal year. On
December 16, 2004, the FASB issued Statement of
Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (SFAS No. 123R).
SFAS No. 123R is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation
(SFAS No. 123) and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and
its related implementation guidance. SFAS No. 123R requires companies to measure and recognize
compensation expense for all stock-based payments at fair value. Stock-based payments include stock
option grants. We grant options to purchase common stock to some of our employees and directors at
prices equal to the market value of the stock on the dates the options were granted. SFAS No. 123R
is effective for public companies for annual periods beginning after June 15, 2005. Early adoption is
encouraged and retroactive application of the provisions of SFAS No. 123R to the beginning of the
fiscal year that includes the effective date is permitted, but not required. SFAS No. 123R will become effective for us beginning
August 1, 2005, the beginning of our next fiscal year. We have not completed an
analysis of all of the differences between Statement No. 123R and SFAS No. 123, including the
specific transition method to be utilized upon adoption. We are currently evaluating the expected
impact that the adoption of SFAS No. 123R will have on our consolidated financial position, results
of operations and cash flows; however, SFAS No. 123R will
negatively impact our earnings. As more fully described in
Note 2 of Notes to the Consolidated Financial Statements
(unaudited), on March 3, 2005 our Board of Directors approved
the immediate vesting of all outstanding and unvested stock options
previously granted under our Stock Award Plan to officers and
employees, for which the option exercise price was above the closing
price for our common stock on April 29, 2005. On such date, the
closing price was $3.09. Options held by non-employee directors were
excluded from this acceleration. The immediate vesting of these
options will avoid the compensation expense in future periods on
these options which were granted prior to the implementation of SFAS
No. 123R. On November 24, 2004, the FASB issued Statement of Financial Accounting Standards No. 151
Inventory Costsan amendment of ARB No. 43, Chapter 4 (SFAS No. 151) effective for fiscal years
beginning after June 15, 2005. SFAS No. 151 will become
effective for us on August 1, 2005, the beginning of our next
fiscal year. This
Statement amends the guidance in ARB No. 43, Chapter 4, Inventory Pricing, to clarify the
accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted
material (spoilage). This Statement requires
that those items be recognized as current-period charges. In addition, this Statement requires 23




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that allocation of fixed production overheads to the
costs of conversion be based on the normal capacity of the production
facilities. We do not believe that the adoption of SFAS
No. 151 will have a material effect on our results of operations or financial position. 
 Item 3. Quantitative and Qualitative Disclosures about Market Risk We are subject to certain market risks arising from transactions in the normal course of our
business, primarily from interest rate fluctuations. We have a revolving line of credit with Wells Fargo Business Credit with a variable interest
rate equal to the prime rate announced by Wells Fargo Bank, N.A. (5.75% at April 30, 2005). At
April 30, 2005, 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 JP Morgan Chase Bank and fluctuate based on market
conditions and our rate was 3.2% at April 30, 2005. A 10% proportional increase in the average
interest rate on the credit line would not be expected to have a material effect. 
 Item 4. Controls and Procedures We
maintain disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)
Securities Exchange Act of 1934, as amended (the Exchange Act)) that are designed: (i) to ensure
that information required to be disclosed in the reports filed or submitted by us under the
Exchange Act is recorded, processed, summarized and reported within the time periods specified in
the SECs rules and forms and (ii) to ensure that such information is accumulated and communicated
to management, including our Chief Executive Office and Chief Financial Officer, as appropriate, to
allow for timely decisions regarding required disclosure. Our management, with the participation of our Chief Executive Officer and Chief Financial
Officer, evaluated the effectiveness of our disclosure controls and procedures as of the end of the
period covered by this quarterly report, and, based on that evaluation, our Chief Executive Officer
and Chief Financial Officer have concluded that our disclosure controls and procedures (as defined
in Rules 13a-15(d) and 15d-15(e) are effective. A control system, no matter how well conceived and operated, can provide only reasonable, not
absolute assurance that the objectives of the control system are met. Because of the inherent
limitations in all control systems, no evaluation of controls can provide absolute assurance that
all control issues, if any, within a company have been detected. There were no changes in our internal control of financial reporting (as defined in Rules
13a-15(f) and 15d-15(f) of the Exchange Act) that have materially affected, or are reasonably
likely to materially affect, our internal control over financial reporting. 
 Part II  Other Information 
 Item 1. Legal Proceedings Except as described below, we are not a party to any pending legal proceedings other than
claims and lawsuits that arise in the ordinary course of business. Management believes these
proceedings will not have a material adverse effect on our consolidated financial condition or
results of operations. 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 because 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 requested judgment for the overpaid
royalties. On April 22, 2004, the Court, in part, ruled in our favor, stating that our royalty
obligations to Tinnell ceased in August 1998, however, our request for reimbursement of overpaid
royalties was dismissed. Tinnell filed a notice of appeal and we have filed a notice of
cross-appeal. Opening briefs have been filed by both parties with the Ninth Circuit Court of
Appeals. 24




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In early December 2004, we became aware of a purported class action lawsuit filed in the
Superior Court of the State of Arizona for Maricopa County against Matrixx Initiatives, Inc. and a
number of other defendants, including us and IST. The lawsuit alleges that the Zicam Cold Remedy
Product manufactured by Matrixx Initiatives, Inc., a former customer of IST, caused damage to the
sense of smell and/or taste of the plaintiffs. Other defendants in the lawsuit include
manufacturers and retailers. IST had produced swabs and containers for the Zicam Cold Remedy
Product for a limited period ending in March 2004. We and IST have not yet been served with this
lawsuit; however, if we and IST are made parties to the lawsuit, we will contest it vigorously. We
believe that the plaintiffs claims with respect to us and IST are without merit. On January 25, 2005, Ronald Fugate, a former employee, filed a law suit in the Superior Court
of the State of Arizona alleging wrongful termination in the case captioned Ronald Fugate
v. Zila, Inc., et al CV2005-001218. The claims made are without merit and we will
vigorously defend against them. 
 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds. Not Applicable 
 Item 3. Defaults upon Senior Securities. Not Applicable 
 Item 4. Submission of Matters to a Vote of Security Holders. Not Applicable 
 Item 5. Other Information Not Applicable 
 Item 6. Exhibits Exhibit Number
    
    Description31.1
    
    Certification of the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002 (filed herewith)31.2
    
    Certification of the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002 (filed herewith)32.1
    
    Certification of the Chief Executive Officer and the Chief Financial Officer Pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (furnished
herewith)32.2
    
    Certification of the Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (furnished
herewith)99.1
    
    Letter of Preferability Regarding Change in Goodwill Impairment Test Date Change from BDO Seidman, LLP
 25




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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: June 9, 2005
    
    By:/s/Douglas D. Burkett, Ph.D.Douglas D. Burkett, Ph.D.President, Chairman and
Chief Executive Officer(Principal Executive Officer)By:/s/Andrew A. StevensAndrew A. StevensVice President and Chief Financial Officer(Principal Financial & Accounting Officer)
 
 INDEX TO EXHIBITS Exhibit Number
    
    Description31.1
    
    Certification of the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002 (filed herewith)31.2
    
    Certification of the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002 (filed herewith)32.1
    
    Certification of the Chief Executive Officer and the Chief Financial Officer Pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (furnished
herewith)32.2
    
    Certification of the Chief Executive Officer and the Chief Financial Officer Pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (furnished
herewith)99.1
    
    Letter of Preferability Regarding Change in Goodwill Impairment Test Date Change from BDO Seidman, LLP
 26