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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 Fiscal Quarter Ended
    
    Commission File NumberJanuary 31, 2005
    
    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)
    
    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.

          Yes þ Noo Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act.)

          Yes þ Noo As of February 28, 2005, 45,818,157 shares of common stock were outstanding.




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ZILA, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED JANUARY 31, 2004 TABLE OF CONTENTS PagePart I. FINANCIAL INFORMATION (UNAUDITED)Item 1. Financial StatementsConsolidated Balance Sheets as of January 31, 2005 and July 31, 2004
    
    
    3Consolidated Statements of Operations and Comprehensive Loss for the three-month and
six-month periods ended January 31, 2005 and 2004
    
    
    4Consolidated Statements of Cash Flows for the six-month period ended January 31,
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
    
    
    23Item 4. Controls and Procedures
    
    
    23Part II. OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    24Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    24Item 3. Defaults upon Senior Securities
    
    
    24Item 4. Submission of Matters to a Vote of Security Holders
    
    
    25Item 5. Other Information
    
    
    25Item 6. Exhibits
    
    
    26SIGNATURES
    
    
    26INDEX TO EXHIBITS
    
    
    27Exhibit 10.1Exhibit 10.2Exhibit 10.3Exhibit 10.4Exhibit 31.1Exhibit 31.2Exhibit 32.1Exhibit 32.2
  2




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ZILA, INC. AND SUBSIDIARIES 
 CONSOLIDATED BALANCE SHEETS January 31,
    
    
    July 31,2005
    
    
    2004(Unaudited)ASSETSCURRENT ASSETS:Cash and cash equivalents
    
    $
    7,317,688
    
    
    $
    11,679,915Restricted cash collateral
    
    
    519,636
    
    
    
    517,353Trade
receivables - net of allowances of $225,000 (January 31, 2005)
and $281,000 (July 31, 2004)
    
    
    9,797,655
    
    
    
    8,073,585Inventories - net
    
    
    6,255,977
    
    
    
    6,769,546Prepaid expenses and other current assets
    
    
    1,666,972
    
    
    
    1,827,026Total current assets
    
    
    25,557,928
    
    
    
    28,867,425PROPERTY AND
EQUIPMENT - net
    
    
    8,928,246
    
    
    
    9,141,785PURCHASED
TECHNOLOGY RIGHTS - net
    
    
    3,270,950
    
    
    
    3,510,288GOODWILL - net
    
    
    6,930,192
    
    
    
    6,930,192TRADEMARKS
AND OTHER INTANGIBLE ASSETS - net
    
    
    13,175,295
    
    
    
    13,240,319OTHER ASSETS
    
    
    398,210
    
    
    
    418,634TOTAL
    
    $
    58,260,821
    
    
    $
    62,108,643LIABILITIES AND SHAREHOLDERS EQUITYCURRENT LIABILITIES:Accounts payable
    
    $
    5,422,491
    
    
    $
    4,275,679Accrued liabilities
    
    
    3,221,157
    
    
    
    3,077,071Short-term borrowings
    
    
    202,162
    
    
    
    Current portion of long-term debt and capital lease obligations
    
    
    341,775
    
    
    
    343,403Total current liabilities
    
    
    9,187,585
    
    
    
    7,696,153Deferred gain on sale leaseback
    
    
    458,099
    
    
    
    534,587Long-term
debt and capital lease obligations - net of current portion
    
    
    3,484,895
    
    
    
    3,649,733Total liabilities
    
    
    13,130,579
    
    
    
    11,880,473COMMITMENTS AND CONTINGENCIES (Note 11)SHAREHOLDERS EQUITY:Preferred
stock - Series B, $.001 par value - authorized 2,500,000 shares,
issued 100,000 shares
    
    
    462,500
    
    
    
    462,500Common
stock, $.001 par value - authorized 65,000,000 shares, issued
45,818,157 shares (January 31, 2005) and 45,723,296 shares (July 31, 2004)
    
    
    45,818
    
    
    
    45,723Capital in excess of par value
    
    
    84,242,461
    
    
    
    83,968,913Accumulated other comprehensive loss
    
    
    (77,860
    )
    
    
    (73,453
    )Accumulated deficit
    
    
    (38,991,606
    )
    
    
    (33,604,140
    )Common stock in treasury, at cost, 218,411 shares ( January 31, 2005) and
225,1000 shares (July 31, 2004)
    
    
    (551,071
    )
    
    
    (571,373
    )Total shareholders equity
    
    
    45,130,242
    
    
    
    50,228,170TOTAL
    
    $
    58,260,821
    
    
    $
    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 January 31,
    
    
    Six months ended January 31,2005
    
    
    2004
    
    
    2005
    
    
    2004NET REVENUES
    
    $
    13,292,825
    
    
    $
    13,603,714
    
    
    $
    25,112,493
    
    
    $
    25,656,434Cost of products sold
    
    
    4,450,747
    
    
    
    5,591,569
    
    
    
    8,595,170
    
    
    
    10,584,516Gross profit
    
    
    8,842,078
    
    
    
    8,012,145
    
    
    
    16,517,323
    
    
    
    15,071,918OPERATING EXPENSES:Marketing and selling
    
    
    6,093,179
    
    
    
    4,201,707
    
    
    
    10,855,337
    
    
    
    7,250,481General and administrative
    
    
    3,074,461
    
    
    
    3,413,648
    
    
    
    6,052,937
    
    
    
    7,025,082Research and development
    
    
    1,632,883
    
    
    
    1,001,943
    
    
    
    3,584,618
    
    
    
    2,268,560Depreciation and amortization
    
    
    675,435
    
    
    
    759,189
    
    
    
    1,351,801
    
    
    
    1,381,490Total operating expenses
    
    
    11,475,958
    
    
    
    9,376,487
    
    
    
    21,844,693
    
    
    
    17,925,613LOSS FROM OPERATIONS
    
    
    (2,633,880
    )
    
    
    (1,364,342
    )
    
    
    (5,327,370
    )
    
    
    (2,853,695
    )OTHER INCOME (EXPENSE):Interest income
    
    
    41,023
    
    
    
    24,336
    
    
    
    93,717
    
    
    
    52,086Interest expense
    
    
    (52,080
    )
    
    
    (74,713
    )
    
    
    (99,878
    )
    
    
    (153,863
    )Gain on sale of assets
    
    
    
    
    
    
    470,462
    
    
    
    
    
    
    
    470,462Other income (expense)
    
    
    (11,137
    )
    
    
    (16,890
    )
    
    
    (32,480
    )
    
    
    (44,478
    )(22,194
    )
    
    
    403,195
    
    
    
    (38,641
    )
    
    
    324,207LOSS BEFORE INCOME TAXES
    
    
    (2,656,074
    )
    
    
    (961,147
    )
    
    
    (5,366,011
    )
    
    
    (2,529,488
    )Income tax expense
    
    
    
    
    
    
    
    
    
    
    (1,955
    )
    
    
    NET LOSS
    
    
    (2,656,074
    )
    
    
    (961,147
    )
    
    
    (5,367,966
    )
    
    
    (2,529,488
    )Preferred stock dividends
    
    
    9,750
    
    
    
    9,750
    
    
    
    19,500
    
    
    
    19,500Net loss attributable to common shareholders
    
    $
    (2,665,824
    )
    
    $
    (970,897
    )
    
    $
    (5,387,466
    )
    
    $
    (2,548,988
    )BASIC AND DILUTED NET LOSS PER COMMON SHARE:
    
    $
    (0.06
    )
    
    $
    (0.02
    )
    
    $
    (0.12
    )
    
    $
    (0.06
    )Weighted average shares outstanding
    
    
    45,557,785
    
    
    
    45,298,437
    
    
    
    45,527,786
    
    
    
    45,259,040NET LOSS
    
    
    (2,656,074
    )
    
    
    (961,147
    )
    
    
    (5,367,966
    )
    
    
    (2,529,488
    )Foreign currency translation adjustments
    
    
    (2,782
    )
    
    
    (1,337
    )
    
    
    (4,407
    )
    
    
    (5,070
    )COMPREHENSIVE LOSS
    
    $
    (2,658,856
    )
    
    $
    (962,484
    )
    
    $
    (5,372,373
    )
    
    $
    (2,534,558
    )
 See notes to consolidated financial statements. 4




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ZILA, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED) Six months ended January 31,2005
    
    
    2004OPERATING ACTIVITIES:Net loss
    
    $
    (5,367,966
    )
    
    $
    (2,529,488
    )Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:Depreciation and amortization
    
    
    1,351,801
    
    
    
    1,381,490Amortization of deferred financing costs
    
    
    25,955
    
    
    
    7,932Gain on sale of assets
    
    
    
    
    
    
    (470,462
    )Noncash research and development expense
    
    
    49,000
    
    
    
    Noncash stock based compensation expense
    
    
    18,246
    
    
    
    11,709Other
    
    
    (26,613
    )
    
    
    (5,301
    )Change in assets and liabilities:Receivables - net
    
    
    (1,724,070
    )
    
    
    (1,811,095
    )Inventories
    
    
    513,569
    
    
    
    878,606Prepaid expenses and other assets
    
    
    65,865
    
    
    
    (194,696
    )Accounts payable and accrued liabilities
    
    
    1,365,073
    
    
    
    (2,066,561
    )Net cash used in operating activities
    
    
    (3,729,140
    )
    
    
    (4,797,866
    )INVESTING ACTIVITIES:Additions to property and equipment, net
    
    
    (424,514
    )
    
    
    (451,873
    )Net proceeds from sale of assets
    
    
    
    
    
    
    1,721,876Additions to intangible assets, net
    
    
    (403,587
    )
    
    
    (322,537
    )Net cash used in (provided by) investing activities
    
    
    (828,101
    )
    
    
    947,466FINANCING ACTIVITIES:Net proceeds from short-term borrowings
    
    
    202,162
    
    
    
    112,695Proceeds from issuance of common stock
    
    
    206,397
    
    
    
    360,956Dividends paid to preferred stockholders
    
    
    (39,000
    )
    
    
    (19,500
    )Restricted cash deposited to collaterize letter of credit
    
    
    (2,283
    )
    
    
    Principal payments on long-term debt
    
    
    (172,262
    )
    
    
    (247,936
    )Net cash provided by financing activities
    
    
    195,014
    
    
    
    206,215NET DECREASE IN CASH AND CASH EQUIVALENTS
    
    
    (4,362,227
    )
    
    
    (3,644,185
    )CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
    
    
    11,679,915
    
    
    
    16,160,484CASH AND CASH EQUIVALENTS, END OF PERIOD
    
    $
    7,317,688
    
    
    $
    12,516,299
 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., dba Innovative Swab Technologies (IST). The Zila Biotechnology Unit includes Zila
Biotechnology Inc., Zila Technology, 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 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,
Ltd., 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.
Note 5 of Notes to Consolidated Financial Statements (unaudited) discusses reclassifications
related to IST. 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
    
    
    Six months endedJanuary 31
    
    
    January 312005
    
    
    2004
    
    
    2005
    
    
    2004Net loss attributable to common shareholders, as reported
    
    $
    (2,666
    )
    
    $
    (971
    )
    
    $
    (5,388
    )
    
    $
    (2,549
    )Deduct: Stock-based employee compensation expense
determined under fair value based method for all awards,
net of related tax effects, if any
    
    
    415
    
    
    
    444
    
    
    
    773
    
    
    
    793Pro forma net loss attributable to common shareholders
    
    $
    (3,081
    )
    
    $
    (1,415
    )
    
    $
    (6,161
    )
    
    $
    (3,342
    )Net loss attributable to common shareholders per share -
basic and diluted:As reported
    
    $
    (0.06
    )
    
    $
    (0.02
    )
    
    $
    (0.12
    )
    
    $
    (0.06
    )Pro forma
    
    $
    (0.07
    )
    
    $
    (0.03
    )
    
    $
    (0.14
    )
    
    $
    (0.07
    )
 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. 3. NET LOSS PER COMMON SHARE Since a loss from continuing operations was incurred for the three-month and six-month
periods ended January 31, 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 both the three month and six-month period periods ended
January 31, 2005 were 536,000 and for the three month and six-month period periods ended January
31, 2004 were 716,625 and 614,328, respectively. Dilutive common shares give effect to securities,
such as stock options, warrants and convertible preferred stock, which have the potential to be
exercised. 4. INVENTORIES Inventories consist of the following (in thousands): January 31,
    
    
    July 31,2005
    
    
    2004Finished goods
    
    $
    1,350
    
    
    $
    2,188Work in process
    
    
    590
    
    
    
    339Raw materials
    
    
    4,518
    
    
    
    4,440Inventory reserves
    
    
    (202
    )
    
    
    (197
    )$
    6,256
    
    
    $
    6,770
 5. IST In March 2004, our Board of Directors authorized the divestiture of the net assets of IST, our
plastic molded products manufacturing subsidiary, in order to focus on our core business
operations. IST is a reporting unit within our Pharmaceuticals Business Unit. We reclassified all
of the assets and related liabilities to assets held for sale and liabilities related to assets
held for sale, respectively. In September 2004, our Board of Directors reversed the divestiture decision and withdrew IST
from the market. Management is planning to grow ISTs business prior to reevaluating its strategic
fit and its importance to future operations. As 7




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a result of this decision, we reclassified ISTs assets held for sale and liabilities
related to assets held for sale, as of July 31, 2004, to the categories presented below.
Information at January 31, 2005 is presented for comparative purposes. Summarized balance sheet information for IST follows (in thousands): January 31,
    
    
    July 31,2005
    
    
    2004Current assets
    
    $
    237
    
    
    $
    250Property, plant and equipment, net
    
    
    939
    
    
    
    1,026Patents, net
    
    
    193
    
    
    
    217Other
    
    
    7
    
    
    
    13Assets
    
    $
    1,376
    
    
    $
    1,506Current liabilities
    
    $
    226
    
    
    $
    233
 6. INTANGIBLE ASSETS A summary of intangible assets is presented below (in thousands): January 31, 2005
    
    
    July 31, 2004Gross
    
    
    
    
    
    
    Net
    
    
    Gross
    
    
    
    
    
    
    NetCarrying
    
    
    Accumulated
    
    
    Carrying
    
    
    Carrying
    
    
    Accumulated
    
    
    CarryingAmount
    
    
    Amortization
    
    
    Amount
    
    
    Amount
    
    
    Amortization
    
    
    AmountAmortizable
intangibles:Purchased
technology rights
    
    $
    7,419
    
    
    $
    4,148
    
    
    $
    3,271
    
    
    $
    7,419
    
    
    $
    3,909
    
    
    $
    3,510Trademarks and
other intangible
assets:Trademarks
    
    
    11,649
    
    
    
    3,364
    
    
    
    8,285
    
    
    
    11,627
    
    
    
    3,119
    
    
    
    8,508Patents
    
    
    3,827
    
    
    
    1,184
    
    
    
    2,643
    
    
    
    3,586
    
    
    
    1,128
    
    
    
    2,458Licensing costs
    
    
    3,250
    
    
    
    1,003
    
    
    
    2,247
    
    
    
    3,100
    
    
    
    826
    
    
    
    2,274Total trademarks
and other
intangible assets
    
    
    18,726
    
    
    
    5,551
    
    
    
    13,175
    
    
    
    18,313
    
    
    
    5,073
    
    
    
    13,240Total amortizable
intangible assets
    
    
    26,145
    
    
    
    9,699
    
    
    
    16,446
    
    
    
    25,732
    
    
    
    8,982
    
    
    
    16,750Unamortizable
intangible asset:Goodwill
    
    
    12,401
    
    
    
    5,471
    
    
    
    6,930
    
    
    
    12,401
    
    
    
    5,471
    
    
    
    6,930Total intangible
assets
    
    $
    38,546
    
    
    $
    15,170
    
    
    $
    23,376
    
    
    $
    38,133
    
    
    $
    14,453
    
    
    $
    23,680
 There were no changes in the carrying amount of goodwill for the three and six months
ended January 31, 2005. Intangible asset amortization expense for the three-month and six-month periods ended January
31, 2005 was $356,000 and $708,000, respectively. For fiscal years 2006 through 2010, the
amortization of intangibles is estimated to be $1.4 million each year. 8




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7. DEBT AND LEASE OBLIGATIONS Debt consisted of the following (in thousands): January 31,
    
    
    July 31,2005
    
    
    2004Short-term borrowings:Installment note payable for insurance premiums
    
    $
    202
    
    
    $
    Current portion of long-term debt:IDA bond payable, Series A
    
    $
    245
    
    
    $
    245Capital lease obligations
    
    
    45
    
    
    
    47Note payable for equipment
    
    
    52
    
    
    
    51Total current portion of long-term debt
    
    $
    342
    
    
    $
    343Long-term debt:IDA bond payable, Series A
    
    $
    3,089
    
    
    $
    3,212PharmaBio
    
    
    500
    
    
    
    500Capital lease obligations
    
    
    182
    
    
    
    201Note payable for equipment
    
    
    56
    
    
    
    80Total long-term debt
    
    
    3,827
    
    
    
    3,993Less current portion
    
    
    342
    
    
    
    343Long-term portion
    
    $
    3,485
    
    
    $
    3,650
 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 $8.4 million at
January 31, 2005. Obligations under the 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 January 31, 2005, our net worth, as defined, was
$45.1 million compared to the required amount of $41.5 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 consist 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
2.0% at January 31, 2005. In connection with the 9




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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. 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
    
    $
    149
    
    
    $
    22
    
    
    $
    1712006
    
    
    274
    
    
    
    49
    
    
    
    3232007
    
    
    245
    
    
    
    52
    
    
    
    2972008
    
    
    245
    
    
    
    45
    
    
    
    2902009
    
    
    746
    
    
    
    14
    
    
    
    7602010 and thereafter
    
    
    1,986
    
    
    
    
    
    
    
    1,986Total
    
    
    3,645
    
    
    
    182
    
    
    
    3,827Less current portion
    
    
    297
    
    
    
    45
    
    
    
    342Long-term portion
    
    $
    3,348
    
    
    $
    137
    
    
    $
    3,485
 8. SUPPLEMENTAL CASHFLOW INFORMATION Supplemental cash flow information follows (in thousands): Six months endedJanuary 312005
    
    
    2004Cash paid for interest
    
    $
    84
    
    
    $
    64Cash paid for income taxes
    
    
    
    
    
    
    192Capital lease obligations for new equipment
    
    
    6
    
    
    
    205
 9. 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
six months ended January 31, 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
January 31, 2005, we recorded total net deferred tax assets of approximately $7.9 million. The
total deferred tax assets were offset with a valuation allowance due to our lack of an earnings
history. At January 31, 2005, the Company had income tax net operating loss carry forwards of
approximately $16.7 million that expire in fiscal years 2009 through 2025. 10




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10. 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 Technology, 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
January 31, 2005 and 2004 (in thousands): ReconcilingSegments
    
    
    
    
    
    
    ItemNutraceuticals
    
    
    Pharmaceuticals
    
    
    Biotechnology
    
    
    Corporate
    
    
    TotalNet revenues:Three months ended January 31:2005
    
    $
    9,801
    
    
    $
    3,492
    
    
    $
    
    
    
    $
    
    
    
    $
    13,2932004
    
    
    8,612
    
    
    
    4,992
    
    
    
    
    
    
    
    
    
    
    
    13,604Income (loss) before income
taxes:Three months ended January 31:2005
    
    
    1,525
    
    
    
    (711
    )
    
    
    (1,886
    )
    
    
    (1,584
    )
    
    
    (2,656
    )2004
    
    
    1,426
    
    
    
    (220
    )
    
    
    (1,339
    )
    
    
    (828
    )
    
    
    (961
    )Depreciation and amortization:Three months ended January 31:2005
    
    
    283
    
    
    
    170
    
    
    
    173
    
    
    
    49
    
    
    
    6752004
    
    
    254
    
    
    
    304
    
    
    
    174
    
    
    
    27
    
    
    
    759
 The table below presents information about reported segments for the six months ended January
31, 2005 and 2004 and segment total assets as of January 31, 2005 and July 31, 2004 (in thousands): ReconcilingSegments
    
    
    
    
    
    
    ItemNutraceuticals
    
    
    Pharmaceuticals
    
    
    Biotechnology
    
    
    Corporate
    
    
    TotalNet revenues:Six months ended January 31:2005
    
    $
    18,522
    
    
    $
    6,590
    
    
    $
    
    
    
    $
    
    
    
    $
    25,1122004
    
    
    15,602
    
    
    
    10,053
    
    
    
    1
    
    
    
    
    
    
    
    25,656Income (loss) before income
taxes:Six months ended January 31:2005
    
    
    2,872
    
    
    
    (951
    )
    
    
    (4,171
    )
    
    
    (3,116
    )
    
    

    (5,366
    )2004
    
    
    2,441
    
    
    
    193
    
    
    
    (2,943
    )
    
    
    (2,220
    )
    
    
    (2,529
    )Depreciation and amortization:Six months ended January 31:2005
    
    
    564
    
    
    
    338
    
    
    
    346
    
    
    
    104
    
    
    
    1,3522004
    
    
    508
    
    
    
    466
    
    
    
    350
    
    
    
    57
    
    
    
    1,381Total assets as of:January 31, 2005
    
    
    32,203
    
    
    
    11,369
    
    
    
    11,455
    
    
    
    3,234
    
    
    
    58,261July 31, 2004
    
    
    31,469
    
    
    
    11,499
    
    
    
    15,583
    
    
    
    3,558
    
    
    
    62,109
 11




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11. 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 formation 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 January 31, 2005, we had approximately $514,000 of OraTest® clinical 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 (i) its consumption during the conduct of the clinical trials, process
development, toxicology studies and validation testing of our manufacturing process and (ii)
international sales. The drug substance currently has shelf lives with varying expiration dates
which will expire through July 2006. 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 these dates if our plans are delayed. However, no assurance can be given in this regard. ViziLite® We had $213,000 of ViziLite® product in inventory and approximately $1.9 million of
associated net long-lived assets as of January 31, 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. 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. A briefing schedule
has been established by 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. On January 25, 2005, we were sued in the Superior Court of the State of Arizona by a former
employee for alleged 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. 12




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12. RECENT ACCOUNTING PRONOUNCEMENTS On December 16, 2004, the Financial Accounting Standards Board (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 all interim or 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. Unless early adoption
is elected, SFAS No. 123R will become effective for us beginning August 1, 2005. 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. 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.
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 are currently
reviewing the requirements of SFAS No. 151; however, 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 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 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 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. 14




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Non-GAAP Measures The following discussion includes a presentation of Earnings before Interest, Income taxes,
Depreciation and Amortization (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 income for the periods set forth below follows (in
thousands): Three months ended
    
    
    Six months endedJanuary 31
    
    
    January 312005
    
    
    2004
    
    
    2005
    
    
    2004EBITDA
    
    $
    (1,970
    )
    
    $
    (151
    )
    
    $
    (4,008
    )
    
    $
    (1,046
    )Interest Income
    
    
    41
    
    
    
    24
    
    
    
    94
    
    
    
    52Interest Expense
    
    
    (52
    )
    
    
    (75
    )
    
    
    (100
    )
    
    
    (154
    )Depreciation and Amortization
    
    
    (675
    )
    
    
    (759
    )
    
    
    (1,352
    )
    
    
    (1,381
    )Income Tax Expense
    
    
    
    
    
    
    
    
    
    
    (2
    )
    
    
    Net loss
    
    $
    (2,656
    )
    
    $
    (961
    )
    
    $
    (5,368
    )
    
    $
    (2,529
    )
 COMPANY 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 ProtectionEster-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 EBITDA would be at a near break-even level, although we did not
achieve this goal in fiscal 2004. 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 such 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 15




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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. 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®. We received preliminary comments from the FDA on the proposed amendments to the clinical
program. The comments that we received were technical in nature and centered on clarifications to
previously submitted materials and the statistical metrics that would be used to evaluate the data
gathered during the clinical trial. The primary goal of 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 these comments, 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 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. Effective March 31, 2004, ISTs contract with a major customer expired. As a result,
ISTs net revenues (net of intercompany eliminations) in the three months and six months ended
January 31, 2005 were $115,000 and $309,000, respectively, compared to $1.7 million and $3.3
million, respectively in the previous year. ISTs net losses (net of inter-company eliminations)
for the three months and six months ended January 31, 2005 were $360,000 and $726,000,
respectively, compared to net income of $93,000 and $139,000 in the previous year. Cost reduction
measures underway at IST are anticipated to mitigate part of the loss of net revenues and profit
margins at IST while we seek to obtain new customers to replace the loss of this contract. The following discussion should be read in conjunction with the accompanying unaudited
Consolidated Financial Statements and Notes to Consolidated Financial Statements (Unaudited). RESULTS OF OPERATIONS Comparison of the three month and six month periods ended January 31, 2005 and January 31, 2004 Total Company The following tables summarize our results of operations and related statistical information
for the three-month and six-month periods ended January 31, 2005 and 2004 (dollars in thousands): 16




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Three months ended January 31, 2005 and 2004Percent of
    
    
    
    
    
    
    Percent ofNet
    
    
    
    
    
    
    Net2005
    
    
    Revenues
    
    
    2004
    
    
    Revenues
    
    
    ChangeNet revenues
    
    $
    13,293
    
    
    
    100
    %
    
    $
    13,604
    
    
    
    100
    %
    
    
    (2
    %)Cost of products sold
    
    
    4,451
    
    
    
    33
    
    
    
    5,592
    
    
    
    41
    
    
    
    (20
    )Gross profit
    
    
    8,842
    
    
    
    67
    
    
    
    8,012
    
    
    
    59
    
    
    
    10Operating Expenses:Marketing & selling
    
    
    6,093
    
    
    
    46
    
    
    
    4,202
    
    
    
    31
    
    
    
    45General & administrative
    
    
    3,075
    
    
    
    23
    
    
    
    3,414
    
    
    
    25
    
    
    
    (10
    )Research & development
    
    
    1,633
    
    
    
    13
    
    
    
    1,001
    
    
    
    7
    
    
    
    63Depreciation & amortization
    
    
    675
    
    
    
    5
    
    
    
    759
    
    
    
    6
    
    
    
    (11
    )11,476
    
    
    
    87
    
    
    
    9,376
    
    
    
    69
    
    
    
    22Loss from operations
    
    
    (2,634
    )
    
    
    (20
    )
    
    
    (1,364
    )
    
    
    (10
    )
    
    
    93Other income (expense), net
    
    
    (22
    )
    
    
    
    
    
    
    403
    
    
    
    3
    
    
    
    (106
    )Loss before income taxes
    
    
    (2,656
    )
    
    
    (20
    )
    
    
    (961
    )
    
    
    (7
    )
    
    
    176Income tax expense
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net loss
    
    $
    (2,656
    )
    
    
    (20
    )
    
    $
    (961
    )
    
    
    (7
    )
    
    
    176
 Six months ended January 31, 2005 and 2004Percent of
    
    
    
    
    
    
    Percent ofNet
    
    
    
    
    
    
    Net2005
    
    
    Revenues
    
    
    2004
    
    
    Revenues
    
    
    ChangeNet revenues
    
    $
    25,112
    
    
    
    100
    %
    
    $
    25,656
    
    
    
    100
    %
    
    
    (2
    %)Cost of products sold
    
    
    8,595
    
    
    
    34
    
    
    
    10,584
    
    
    
    41
    
    
    
    (19
    )Gross profit
    
    
    16,517
    
    
    
    66
    
    
    
    15,072
    
    
    
    59
    
    
    
    10Operating Expenses:Marketing & selling
    
    
    10,855
    
    
    
    43
    
    
    
    7,251
    
    
    
    28
    
    
    
    50General & administrative
    
    
    6,053
    
    
    
    24
    
    
    
    7,025
    
    
    
    27
    
    
    
    (14
    )Research & development
    
    
    3,584
    
    
    
    15
    
    
    
    2,269
    
    
    
    9
    
    
    
    58Depreciation & amortization
    
    
    1,352
    
    
    
    5
    
    
    
    1,381
    
    
    
    6
    
    
    
    (2
    )21,844
    
    
    
    87
    
    
    
    17,926
    
    
    
    70
    
    
    
    22Loss from operations
    
    
    (5,327
    )
    
    
    (21
    )
    
    
    (2,854
    )
    
    
    (11
    )
    
    
    87Other expense, net
    
    
    (39
    )
    
    
    
    
    
    
    325
    
    
    
    1
    
    
    
    (112
    )Loss before income taxes
    
    
    (5,366
    )
    
    
    (21
    )
    
    
    (2,529
    )
    
    
    (10
    )
    
    
    112Income tax expense
    
    
    2
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net loss
    

    $
    (5,368
    )
    
    
    (21
    )
    
    $
    (2,529
    )
    
    
    (10
    )
    
    
    112
 Net revenues decreased 2% to $13.3 million for the three months ended January 31, 2005,
compared to revenues of $13.6 million for the three months ended January 31, 2004. Net revenues
decreased 2% to $25.1 million for the six months ended January 31, 2005, compared to revenues of
$25.7 million for the six months ended January 31, 2004. For the three and six month periods ended
January 31, 2005 net revenues of the Nutraceuticals Business Unit increased 14% and 19%,
respectively, compared to the prior year periods. These increases were offset by declines in the
Pharmaceuticals Business Unit of 30% and 34%, respectively, for these periods. The decreases in net
revenues in the Pharmaceuticals Business Unit resulted primarily from the loss of a major customer
at IST as the contract with its largest customer ended in March 2004. Without the effect of IST,
net revenues increased 11% over both the three-month and six-month periods of the prior year.
ISTs net revenues were $115,000 and $309,000 (net of intercompany sales) for the three and six
month periods ended January 31, 2005, respectively, a decline of $1.6 million and $3.0 million from
the prior year periods. ISTs net revenues for the three and six month periods ended January 31,
2004, were $1.7 million and $3.3 million, respectively. Gross profit as a percentage of net revenues increased to 67% and 66% for the three month and
six month periods ended January 31, 2005, respectively, compared to 59% for the 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. 17




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##### Table of Contents



Marketing and selling expenses as a percentage of net revenues increased to 46% and 43%,
respectively, for the three and six month periods ended January 31, 2005 compared to 31% 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 Peridex® and ViziLite® were the
primary reasons for these increases. General and administrative expenses were $3.1 million, or 23% of net revenues, for the three
months ended January 31, 2005, and $6.1 million, or 24% of net revenues, for the six month ended
January 31, 2005 compared to $3.4 million, or 25% of net revenue, and $7.0 million or 27% of net
revenue, respectively for the comparable prior year periods. The primary factors in the reduction
of general and administrative expenses were ISTs downsizing of its operations after the loss of
its major customer and overall cost reduction measures throughout all of our business units.
Offsetting these reductions were increased expenses for professional fees incurred at the corporate
level in connection with our Sarbanes-Oxley Section 404 internal control compliance efforts. We
anticipate that these compliance costs will continue to increase over the balance of our fiscal
year. Research and development expenses increased $632,000, or 63%, to $1.6 million for the three
months ended January 31, 2005 and increased $1.3 million, or 58%, to $3.6 million for the six
months ended January 31, 2005. The increase in research and development expenses for these periods
is due primarily to increases in the OraTest® regulatory program expenses. Depreciation and amortization expense decreased $84,000, or 11%, to $675,000 for the three
months ended January 31, 2005 and decreased $29,000, or 2%, to $1.4 million for the six months
ended January 31, 2005. The decreases in depreciation and amortization expense result from the
impairment charge for long-lived assets recorded at IST at July 31, 2004 that has reduced ISTs
depreciation and amortization in the current year. These decreases for the three-month and
six-month periods were reduced by increased depreciation and amortization attributable to additions
of property and equipment and patents and trademarks in the Nutraceuticals and Pharmaceuticals
Business Units and corporate computer system software. Other
expense for the three month and six months ended January 31, 2005 was $22,000 and
$39,000, respectively, compared to other income $403,000 and $325,000, respectively, in the prior
year periods. The prior year periods include 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 six-month periods ended January 31, 2005 and 2004 (dollars in thousands): Three months ended
    
    
    Six months endedJanuary 31
    
    
    January 312005
    
    
    2004
    
    
    Change
    
    
    2005
    
    
    2004
    
    
    ChangeNet revenues
    
    $
    9,801
    
    
    $
    8,612
    
    
    
    14
    %
    
    $
    18,522
    
    
    $
    15,602
    
    
    
    19
    %Segment income before income taxes
    
    
    1,525
    
    
    
    1,426
    
    
    
    7
    
    
    
    2,872
    
    
    
    2,441
    
    
    
    18
 Net revenues for the Nutraceuticals Business Unit for the three and six months ended January
31, 2005 increased 14% and 19%, respectively, over the prior year periods. This growth was
primarily in domestic sales for Ester-E® and was driven principally by increased radio and
television advertising support for our Ester-E® and Ester-C® products in our continuing
strategy of brand development. Net income before taxes for the Nutraceuticals Business Unit for the three and six months
ended January 31, 2005, was $1.5 million, and $2.9 million, respectively, increasing by 7% and 18%,
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 six months ended January 31, 2005
increased 52% and 59%, respectively, over the prior year periods. Pharmaceuticals Business Unit Selected financial information for the Pharmaceuticals Business Unit follows for the
three-month and six-month periods ended January 31, 2005 and 2004 (dollars in thousands): 18




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Three months ended
    
    
    Six months endedJanuary 31
    
    
    January 312005
    
    
    2004
    
    
    Change
    
    
    2005
    
    
    2004
    
    
    ChangeNet revenues
    
    $
    3,492
    
    
    $
    4,992
    
    
    
    (30
    %)
    
    $
    6,590
    
    
    $
    10,053
    
    
    
    (34
    %)Segment income
(loss) before
income taxes
    
    
    (711
    )
    
    
    (220
    )
    
    
    223
    
    
    
    (951
    )
    
    
    193
    
    
    
    (593
    )
 Net revenues for the Pharmaceuticals Business Unit for the three and six months ended January
31, 2005 decreased 30% and 34%, respectively, from the comparable prior year periods. The decrease
in net revenues in the Pharmaceuticals Business Unit resulted primarily from (i) the loss of a
major customer at IST as the contract with its largest customer ended in March 2004, (ii) a change
in the annualized buying patterns of our largest Peridex customer, and (iii) a decline in Peridex
sales made to U. S. wholesalers. Without the effect of IST, net revenues for the Pharmaceuticals
Business unit increased 2% from the three month period of the prior year and decreased 7% from the
six month period of the prior year. ISTs net revenues (net of intercompany eliminations) were
$115,000 and $309,000 for the three-month and six-month periods ended January 31, 2005,
respectively. Net revenues for the three-month and six-month periods ended January 31, 2004, were
$1.7 million and $3.3 million, respectively. Net
revenues for ViziLite® in the second quarter of fiscal 2005
increased by 84% over the net revenues generated in the first quarter
of fiscal 2005 and by nearly 500% compared to the second quarter of fiscal 2004. Net loss before income taxes for the Pharmaceuticals Business Unit for the three and six
months ended January 31, 2005 was $711,000 and $951,000, 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 Pharmaceuticals Business Unit offset by cost reduction measures in
general and administrative expenses. Biotechnology Business Unit Selected
financial information for the Biotechnology Business Unit follows for the three-month and
six-month periods ended January 31, 2005 and 2004 (dollars in thousands): Three months ended
    
    
    Six months endedJanuary 31
    
    
    January 312005
    
    
    2004
    
    
    Change
    
    
    2005
    
    
    2004
    
    
    ChangeNet revenues
    
    $
    
    
    
    $
    
    
    
    
    
    %
    
    $
    
    
    
    $
    1
    
    
    
    (100
    %)Segment loss before income taxes
    
    
    (1,886
    )
    
    
    (1,339
    )
    
    
    41
    
    
    
    (4,171
    )
    
    
    (2,943
    )
    
    
    42
 There were no international sales of the OraTest® product during the three and six months
ended January 31, 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 three and six months
ended January 31, 2005 increased 41% and 42%, respectively, over the comparable prior year periods.
Increased regulatory program expenses related to the OraTest® product were the primary factors
causing these changes. LIQUIDITY AND CAPITAL RESOURCES At January 31, 2005, our primary sources of liquidity included cash and cash equivalents of
$7.3 million and the line of credit discussed below. Net working capital decreased to $16.4 million
at January 31, 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 $3.7 million during the six months ended January 31,
2005 and was primarily attributable to the net loss from continuing operations of $5.4 million and
an increase of $1.7 million in receivables primarily at our Nutraceuticals Business Unit.
Offsetting these uses of cash were: (i) $1.4 million of depreciation and amortization and 19




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other non-cash items; and (ii) an increase in accounts payable and other liabilities of $1.4 million and
a reduction of inventory and prepaid expenses and other assets of $579,000. Net cash used in investing activities was $828,000, attributable to funds used for equipment
purchases and patent and trademark filings. Net cash provided by financing activities during the six months ended January 31, 2005 was
$195,000, 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
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 $8.4 million at
January 31, 2005. Obligations under the 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 January 31, 2005, our net worth, as defined, was $45.1 million
compared to the required net worth amount of $41.5 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. We lease facilities and equipment, some of which are required to be capitalized in accordance
with SFAS 13. SFAS 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. 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 consist 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 2.0% at
January 31, 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 20




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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 $225,000 at January 31, 2005 and $281,000 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 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 21




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specific product. Net long-lived assets related to the OraTest® product as of January 31, 2005 of $7.0 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 January 31, 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 circumstances indicate that the
carrying amount of the asset may not be recoverable. 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 January 31, 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 $11.1 million
(net of accumulated amortization of $4.2 million) are related primarily to the Ester-C® group of
products. These assets 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 $3.3 million net purchased technology
rights at January 31, 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 $704,000
(primarily related to our manufacturing facility); (ii) patents and patents pending of $1.5
million; and (iii) $514,000 of OraTest® clinical 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 22




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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 January 31,
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 January 31, 2005, all of our deferred tax assets
were offset by a valuation allowance. Recent Accounting Pronouncements On December 16, 2004, the Financial Accounting Standards Board (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 all interim or 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. Unless early adoption
is elected, SFAS No. 123R will become effective for us beginning August 1, 2005. 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. 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.
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 are currently
reviewing the requirements of SFAS No. 151; however, 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. (5.25 percent at January 31,
2005). At January 31, 2005, we had no borrowings outstanding under this line of credit. The impact
of a 10 percent 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 2.0% at January 31, 2005. A 10 percent 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 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 are
effective. There were no changes in our internal control over financial reporting during the period
covered by this report that materially affected, or are reasonably likely to materially affect, our
internal control over financial reporting. 23




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Disclosure controls and procedures are controls and other procedures that are designed to
ensure that information required to be disclosed in the reports filed or submitted by us under the
Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within
the time periods specified in the SECs rules and forms. Disclosure controls and procedures include
controls and procedures designed to ensure that information required to be disclosed by us in such
reports is accumulated and communicated to our management, including our Chief Executive Officer and
Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Our disclosure controls and procedures are designed to provide a reasonable level of
assurance of reaching our desired disclosure objectives and are effective in reaching that level of
reasonable assurance. 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. 
 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. 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. A briefing schedule
has been established by 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 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, the Company was sued in the Superior Court of the State of Arizona by a
former employee for alleged wrongful termination in the case captioned Ronald Fugate v.
Zila, Inc., et al CV2005-001218. The claims made are without merit and will be vigorously
defended by the Company. 
 Item 2. Unregistered
Sales of Equity Securities and Use of Proceeds. Not Applicable 
 Item 3. Defaults upon Senior Securities. Not Applicable 24




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Item 4. Submission of Matters to a Vote of Security Holders. The Company held its Annual Meeting of Stockholders in Phoenix, Arizona on December 16, 2004.
A total of 43,300,565 shares of common stock, or 95% of the outstanding shares, were represented
in person or by proxy. The results of the matters voted upon at the Annual Meeting are: ( 1) Election of Directors: Number of SharesName
    
    For
    
    
    WithheldDouglas D. Burkett
    
    
    42,166,627
    
    
    
    1,133,938Morris C. Aaron
    
    
    42,273,990
    
    
    
    1,026,575Leslie H. Green
    
    
    40,258,768
    
    
    
    3,041.797Christopher D. Johnson
    
    
    42,238,064
    
    
    
    1,062,501Michael S. Lesser
    
    
    42,192,915
    
    
    
    1,107,650John Edward Porter
    
    
    40,226,138
    
    
    
    3,074,427S. Timothy Rose, D.D.S.
    
    
    42,296,343
    
    
    
    1,004,222
 (2) Amendment and restatement of the 1997 Stock Option Plan: For
    
    Against
    
    Abstain
    
    Not Voted16,352,975
    
    
    2,765,684
    
    
    
    279,648
    
    
    
    23,902,258
 The foregoing matters are described in more detail in our Definitive Proxy Statement
dated November 8, 2004. 
 Item 5. Other Information On December 15, 2004, we entered into an employment letter agreement with Gary V. Klinefelter
pursuant to which Mr. Klinefelter agreed to serve as our Vice President and General Counsel. The
letter agreement is attached to this report as Exhibit 10.1. On March 7, 2005, we entered into retention agreements with Andrew A. Stevens, Chief Financial
Officer, Betty J. Pecha, Vice President and Corporate Secretary, and Diane E. Klein, Vice President
and Treasurer. The agreements are attached to this report as Exhibits 10.2, 10.3 and 10.4,
respectively. The agreements provide for, among other things,
severance pay to each executive if his or her employment is
terminated following a change in control of Zila, Inc. 25




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Item 6. Exhibits Exhibit Number
    
    Description10.1
    
    Employment letter agreement with
Gary V. Klinefelter effective December 15, 200410.2
    
    Retention agreement with Andrew A.
Stevens effective March 7, 200510.3
    
    Retention agreement with Betty J. Pecha effective March 7, 200510.4
    
    Retention agreement with Diane E. Klein effective March 7, 200531.1
    
    Certification of the Chief Executive Officer Pursuant to Section 302 of the
Sarbanes-Oxley Act of 200231.2
    
    Certification of the Chief Financial Officer Pursuant to Section 302 of the
Sarbanes-Oxley Act of 200232.1
    
    Certification of the Chief Executive Officer Pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 200232.2
    
    Certification of the Chief Financial Officer Pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002
 
 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly
caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Date: March 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)
 26




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INDEX TO EXHIBITS Exhibit Number
    
    Description10.1
    
    Employment letter agreement with
Gary V. Klinefelter effective December 15, 200410.2
    
    Retention agreement with Andrew A. Stevens effective March 7, 200510.3
    
    Retention agreement with Betty J. Pecha effective March 7, 200510.4
    
    Retention agreement with Diane E. Klein effective March 7, 200531.1
    
    Certification of the Chief
Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 200231.2
    
    Certification of the Chief Financial Officer Pursuant to
Section 302 of the Sarbanes-Oxley Act of 200232.1
    
    Certification of the Chief Executive Officer Pursuant to 18 U.S.C.
Section, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 200232.2
    
    Certification of the Chief Financial Officer Pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002
 27