##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
 Washington, DC 20549
 Form 10-Q
 (Mark one)
 þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the quarterly period ended October 31, 2008
 OR
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 For the transition period from to
 Commission File Number 0-17521
 Zila, Inc.
 (Exact Name of Registrant as Specified in its Charter)
 Delaware
    
    86-0619668(State or Other Jurisdiction of 
Incorporation)
    
    (I.R.S. Employer
Identification No.)
 5227 North 7th Street, Phoenix, Arizona, 85014-2800  (Address of Principal Executive Offices) (Zip Code)
 (602) 266-6700  (Registrants telephone number, including area code)
 þ  o
 
 Large accelerated filer o
Accelerated
filer þ
Non-accelerated filer o(Do not check if a smaller reporting company)
Smaller reporting company o
 o þ




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##### 



TABLE OF CONTENTS
    
    PAGEPART I  FINANCIAL INFORMATIONItem 1.
    
    Financial Statements.Condensed Consolidated Balance Sheets as of October 31, 2008 (unaudited) and July
31, 2008
    
    2Unaudited Condensed Consolidated Statements of Operations for the Three Months Ended
October 31, 2008 and 2007
    
    3Unaudited Condensed Consolidated Statement of Shareholders Equity for the Three
Months Ended October 31, 2008
    
    4Unaudited Condensed Consolidated Statements of Cash Flows for the Three Months Ended
October 31, 2008 and 2007
    
    5Notes
to Unaudited Condensed Consolidated Financial Statements
    
    6Item 2.
    
    Managements Discussion and Analysis of Financial Condition and
Results of Operations
    
    17Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    26Item 4.
    
    Controls and Procedures
    
    27PART II  OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    27Item 1A.
    Risk Factors
    
    27Item 2.
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    32Item 3.
    
    Defaults Upon Senior Securities
    
    32Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    33Item 5.
    
    Other Information
    
    33Item 6.
    
    Exhibits
    
    33Signatures
    
    34EX-31.1EX-31.2EX-32.1
  1




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##### Table of Contents



PART I  FINANCIAL INFORMATION
 
 Item 1. Financial Statements
 
 ZILA, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
 October 31,
    
    
    July 31,2008
    
    
    2008(Unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    3,213,295
    
    
    $
    4,462,328Trade receivables  net of allowances of $270,000 and $229,000
    
    
    4,601,828
    
    
    
    5,252,215Inventories  net
    
    
    3,490,816
    
    
    
    3,107,152Prepaid expenses and other current assets
    
    
    1,543,896
    
    
    
    1,853,373Total current assets
    
    
    12,849,835
    
    
    
    14,675,068Property and equipment  net
    
    
    5,038,283
    
    
    
    5,317,061Goodwill
    
    
    10,171,351
    
    
    
    10,171,351Purchased technology  net
    
    
    8,604,589
    
    
    
    8,860,475Trademarks and other intangible assets  net
    
    
    9,191,362
    
    
    
    9,533,024Other assets
    
    
    1,613,698
    
    
    
    1,813,512Total assets
    
    $
    47,469,118
    
    
    $
    50,370,491LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    3,044,986
    
    
    $
    3,843,262Accrued liabilities
    
    
    3,771,582
    
    
    
    4,059,017Deferred gain on sale leaseback
    
    
    37,415
    
    
    
    75,659Short-term borrowings and current portion of long-term debt
    
    
    259,451
    
    
    
    71,252Current liabilities of discontinued operations
    
    
    58,986
    
    
    
    67,532Total current liabilities
    
    
    7,172,420
    
    
    
    8,116,722Long-term debt  net of current portion
    
    
    9,407,499
    
    
    
    8,974,048Total liabilities
    
    
    16,579,919
    
    
    
    17,090,770Shareholders equity:Preferred stock  Series B, $.001 par value    2,500,000 shares
authorized, 100,000 shares issued and outstanding, liquidation
preference of $650,000
    
    
    462,500
    
    
    
    462,500Common stock, $.001 par value   30,000,000 shares authorized,
10,425,037 and 9,953,818 shares issued and outstanding
    
    
    10,425
    
    
    
    69,677Additional paid-in capital
    
    
    126,377,827
    
    
    
    125,901,682Accumulated deficit
    
    
    (95,279,380
    )
    
    
    (92,471,235
    )Accumulated other comprehensive loss
    
    
    (131,102
    )
    
    
    (131,832
    )Treasury stock, at cost (31,202 common shares)
    
    
    (551,071
    )
    
    
    (551,071
    )Total shareholders equity
    
    
    30,889,199
    
    
    
    33,279,721Total liabilities and shareholders equity
    
    $
    47,469,118
    
    
    $
    50,370,491
  2




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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
 Three Months Ended October 31,2008
    
    
    2007Net revenues
    
    $
    9,640,849
    
    
    $
    11,440,437Cost of products sold
    
    
    3,776,002
    
    
    
    4,581,652Gross profit
    
    
    5,864,847
    
    
    
    6,858,785Operating costs and expenses:Marketing and selling
    
    
    4,370,981
    
    
    
    5,296,597General and administrative
    
    
    2,223,042
    
    
    
    3,473,677Research and development
    
    
    166,522
    
    
    
    1,201,785Depreciation and amortization
    
    
    923,869
    
    
    
    915,013Total operating costs and expenses
    
    
    7,684,414
    
    
    
    10,887,072Loss from operations
    
    
    (1,819,567
    )
    
    
    (4,028,287
    )Other income (expense):Interest income
    
    
    15,816
    
    
    
    124,182Interest expense
    
    
    (922,391
    )
    
    
    (766,708
    )Derivative expense
    
    
    
    
    
    
    (23,600
    )Other income (expense)
    
    
    (47,821
    )
    
    
    22,772Other expense  net
    
    
    (954,396
    )
    
    
    (643,354
    )Loss from continuing operations before income taxes
    
    
    (2,773,963
    )
    
    
    (4,671,641
    )Income tax expense
    
    
    (13,197
    )
    
    
    (11,592
    )Loss from continuing operations
    
    
    (2,787,160
    )
    
    
    (4,683,233
    )Loss from discontinued operations, net of income tax expense
of nil
    
    
    (11,235
    )
    
    
    (172,269
    )Net loss
    
    
    (2,798,395
    )
    
    
    (4,855,502
    )Preferred stock dividends
    
    
    9,750
    
    
    
    9,750Net loss attributable to common shareholders
    
    $
    (2,808,145
    )
    
    $
    (4,865,252
    )Basic and diluted net loss per common share:Loss from continuing operations
    
    $
    (0.28
    )
    
    $
    (0.53
    )Loss from discontinued operations
    
    
    
    
    
    
    (0.02
    )Net loss attributable to common shareholders
    
    $
    (0.28
    )
    
    $
    (0.55
    )Weighted average common shares outstanding  basic and diluted
    
    
    9,944,709
    
    
    
    8,772,032
  3




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ZILA, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY
For the Three Months Ended October 31, 2008
 AccumulatedAdditional
    
    
    
    
    
    
    Other
    
    
    
    
    
    
    TotalPreferred Stock
    
    
    Common Stock
    
    
    Paid-in
    
    
    Accumulated
    
    
    Comprehensive
    
    
    Treasury
    
    
    ShareholdersShares
    
    
    Amount
    
    
    Shares
    
    
    Amount
    
    
    Capital
    
    
    Deficit
    
    
    Loss
    
    
    Stock
    
    
    EquityBalance  July 31,
2008
    
    
    100,000
    
    
    $
    462,500
    
    
    
    9,953,818
    
    
    $
    69,677
    
    
    $
    125,901,682
    
    
    $
    (92,471,235
    )
    
    $
    (131,832
    )
    
    $
    (551,071
    )
    
    $
    33,279,721Stock-based
compensation
expense
    
    
    
    
    
    
    
    
    
    
    40,952
    
    
    
    202
    
    
    
    189,516
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    189,718Common shares
withheld
for income taxes
    
    
    
    
    
    
    
    
    
    
    (10,847
    )
    
    
    (49
    )
    
    
    (19,041
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (19,090
    )Issuance of common
stock
under employee
stock
purchase plan
    
    
    
    
    
    
    
    
    
    
    6,031
    
    
    
    42
    
    
    
    890
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    932Effect of reverse
stock
split approved on
September 12,
2008
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (59,882
    )
    
    
    59,882
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Shares issued for
payment
of interest
    
    
    
    
    
    
    
    
    
    
    435,083
    
    
    
    435
    
    
    
    244,898
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    245,333Foreign currency
translation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    730
    
    
    
    
    
    
    
    730Preferred stock
dividends
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (9,750
    )
    
    
    
    
    
    
    
    
    
    
    (9,750
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,798,395
    )
    
    
    
    
    
    
    
    
    
    
    (2,798,395
    )Balance  October
31, 2008
    
    
    100,000
    
    
    $
    462,500
    
    
    
    10,425,037
    
    
    $
    10,425
    
    
    $
    126,377,827
    
    
    $
    (95,279,380
    )
    
    $
    (131,102
    )
    
    $
    (551,071
    )
    
    $
    30,889,199
  4




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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 Three Months Ended October 31,2008
    
    
    2007Cash flows from operating activities:Net loss
    
    $
    (2,798,395
    )
    
    $
    (4,855,502
    )Adjustments to reconcile net loss to net cash used
in operating activities:Depreciation and amortization
    
    
    1,041,791
    
    
    
    1,023,727Non-cash amortization of financing costs
    
    
    225,847
    
    
    
    99,369Non-cash amortization of debt discounts
    
    
    448,671
    
    
    
    447,362Non-cash interest
    
    
    245,333
    
    
    
    Non-cash stock-based compensation expense
    
    
    190,093
    
    
    
    453,327Non-cash derivative expense
    
    
    
    
    
    
    23,600Other non-cash items  net
    
    
    24,228
    
    
    
    (51,663
    )Changes in operating assets and liabilities:Trade receivables
    
    
    650,387
    
    
    
    (1,946,403
    )Inventories
    
    
    (383,664
    )
    
    
    47,498Prepaid expenses and other assets
    
    
    476,981
    
    
    
    183,075Accounts payable and accrued liabilities
    
    
    (1,111,201
    )
    
    
    248,413Net cash used in operating activities
    
    
    (989,929
    )
    
    
    (4,327,197
    )Cash flows from investing activities:Additions to property and equipment
    
    
    (110,934
    )
    
    
    (375,212
    )Additions to intangible assets
    
    
    (119,322
    )
    
    
    (80,235
    )Proceeds from sale of assets
    
    
    903
    
    
    
    462Net cash used in investing activities
    
    
    (229,353
    )
    
    
    (454,985
    )Cash flows from financing activities:Principal payments on debt
    
    
    (20,558
    )
    
    
    (18,258
    )Dividends paid to preferred stockholders
    
    
    (9,750
    )
    
    
    (9,750
    )Payment of obligation to repurchase common stock
and warrants
    
    
    
    
    
    
    (1,399,993
    )Proceeds from issuance of common stock
    
    
    557
    
    
    
    11,200Net cash used in financing activities
    
    
    (29,751
    )
    
    
    (1,416,801
    )Net decrease in cash and cash equivalents
    
    
    (1,249,033
    )
    
    
    (6,198,983
    )Cash and cash equivalents  beginning of period
    
    
    4,462,328
    
    
    
    14,859,159Cash and cash equivalents  end of period
    
    $
    3,213,295
    
    
    $
    8,660,176
  5




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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 1. Description of Business and Basis of Presentation
 Nature of Business Activities and Basis of Presentation
 ® ® ® ® ® ®
     6




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ZILA, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)
  Three Months Ended October 31,2008
    
    2007Options and warrants to purchase
common shares
    
    
    
    
    
    
    12Common stock awards
    
    
    4
    
    
    
    3Convertible preferred stock
    
    
    100
    
    
    
    100Total potentially dilutive securities
    
    
    104
    
    
    
    115
  Liquidity
 ® ®
   7




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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)
   2. Recently Issued Accounting Pronouncements and Adopted Accounting
 Fair Value Measurements
       The Fair Value Option for
Financial Assets and Financial Liabilities  including an amendment of FASB Statement No. 115
 Noncontrolling Interests in Consolidated
Financial Statements  an amendment of ARB No. 51
 8




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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)
  Business Combinations
 Disclosures about Derivative Instruments and
Hedging Activities, an amendment of FASB Statement No. 133
 Determination of
the Useful Life of Intangible Assets
 Accounting for
Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash
Settlement)
 3. Inventories
  October 31,
    
    
    July 31,2008
    
    
    2008(Unaudited)Finished goods
    
    $
    884
    
    
    $
    675Work-in-process
    
    
    491
    
    
    
    396Raw materials
    
    
    2,623
    
    
    
    2,470Inventory reserves
    
    
    (507
    )
    
    
    (434
    )Total inventories
    
    $
    3,491
    
    
    $
    3,107
 9




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ZILA, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)
 4. Property and Equipment
  October 31,
    
    
    July 31,2008
    
    
    2008(Unaudited)Land
    
    $
    529
    
    
    $
    529Building and improvements
    
    
    2,168
    
    
    
    2,132Furniture and equipment
    
    
    3,448
    
    
    
    3,408Leasehold improvements and other assets
    
    
    829
    
    
    
    823Production, laboratory and warehouse
equipment
    
    
    4,582
    
    
    
    4,582Total property and equipment
    
    
    11,556
    
    
    
    11,474Less: Accumulated depreciation and
amortization
    
    
    (6,518
    )
    
    
    (6,157
    )Property and equipment  net
    
    $
    5,038
    
    
    $
    5,317
  5. Goodwill and Other Intangible Assets
  October 31, 2008 (Unaudited)
    
    
    July 31, 2008Gross
    
    
    
    
    
    
    Net
    
    
    Gross
    
    
    
    
    
    
    NetCarrying
    
    
    Accumulated
    
    
    Carrying
    
    
    Carrying
    
    
    Accumulated
    
    
    CarryingAmount
    
    
    Amortization
    
    
    Amount
    
    
    Amount
    
    
    Amortization
    
    
    AmountAmortizable intangible assets:Purchased technology
    
    $
    15,592
    
    
    $
    (6,987
    )
    
    $
    8,605
    
    
    $
    15,592
    
    
    $
    (6,732
    )
    
    $
    8,860Trademarks
    
    
    171
    
    
    
    (23
    )
    
    
    148
    
    
    
    168
    
    
    
    (18
    )
    
    
    150Patents
    
    
    2,087
    
    
    
    (411
    )
    
    
    1,676
    
    
    
    2,019
    
    
    
    (385
    )
    
    
    1,634Licensing costs
    
    
    2,674
    
    
    
    (1,842
    )
    
    
    832
    
    
    
    2,674
    
    
    
    (1,777
    )
    
    
    897Covenants not to
compete and other
    
    
    3,556
    
    
    
    (2,470
    )
    
    
    1,086
    
    
    
    3,556
    
    
    
    (2,153
    )
    
    
    1,403Total amortizable
intangible assets
    
    
    24,080
    
    
    
    (11,733
    )
    
    
    12,347
    
    
    
    24,009
    
    
    
    (11,065
    )
    
    
    12,944Unamortizable trademarks
    
    
    5,449
    
    
    
    
    
    
    
    5,449
    
    
    
    5,449
    
    
    
    
    
    
    
    5,449Total other intangible assets
    
    
    29,529
    
    
    
    (11,733
    )
    
    
    17,796
    
    
    
    29,458
    
    
    
    (11,065
    )
    
    
    18,393Goodwill
    
    
    10,171
    
    
    
    
    
    
    
    10,171
    
    
    
    10,171
    
    
    
    
    
    
    
    10,171Total intangible assets
    
    $
    39,700
    
    
    $
    (11,733
    )
    
    $
    27,967
    
    
    $
    39,629
    
    
    $
    (11,065
    )
    
    $
    28,564
 10




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ZILA, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)
  Weighted AverageRange of
    
    Remaining Useful LivesUseful Lives
    
    October 31, 2008
    
    July 31, 2008(Unaudited)Purchased technology
    
    
    15
    
    
    
    11.4
    
    
    
    11.5Trademarks
    
    
    7-10
    
    
    
    6.9
    
    
    
    6.6Patents
    
    
    4-17
    
    
    
    7.4
    
    
    
    7.4Licensing costs
    
    
    7-10
    
    
    
    3.2
    
    
    
    3.4Covenants not to compete and other
    
    
    2-15
    
    
    
    7.3
    
    
    
    6.0
 6. Accrued Liabilities
  October 31,
    
    
    July 31,2008
    
    
    2008(Unaudited)Accrued research and development
    
    $
    1,154
    
    
    $
    1,154Accrued employee compensation and related taxes
    
    
    942
    
    
    
    1,000Accrued professional and consulting fees
    
    
    712
    
    
    
    795Other accrued expenses
    
    
    964
    
    
    
    1,110Total accrued expenses
    
    $
    3,772
    
    
    $
    4,059
 7. Debt
  October 31,
    
    
    July 31,2008
    
    
    2008(Unaudited)Short-term borrowings and current portion of long-term debt:Short-term borrowings
    
    $
    193
    
    
    $
    Current portion of capital lease obligations
    
    
    66
    
    
    
    71Total short-term borrowings and current portion of long-term debt
    
    $
    259
    
    
    $
    71Long-term debt:Senior Secured Convertible Notes
    
    $
    12,000
    
    
    $
    12,000Unamortized discount  Senior Secured Convertible Notes
    
    
    (3,111
    )
    
    
    (3,560
    )Senior Secured Convertible Notes  net
    
    
    8,889
    
    
    
    8,440PharmaBio
    
    
    500
    
    
    
    500Capital lease obligations
    
    
    84
    
    
    
    105Total long-term debt
    
    
    9,473
    
    
    
    9,045Less: Current portion of capital lease obligations
    
    
    (66
    )
    
    
    (71
    )Long-term debt  net of current portion
    
    $
    9,407
    
    
    $
    8,974
 Short-term Borrowings
  11




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ZILA, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)
 Senior Secured Convertible Notes
    PharmaBio Development, Inc.
  8. Share-Based Payments
  12




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ZILA, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)
  Risk-free interest rate
    
    
    3
    %Expected volatility
    
    
    60
    %Expected term (in years)
    
    
    5.1Dividend yield
    
    
    0
    %
  Share-Based Payment
  WeightedWeighted
    
    AverageAverage
    
    Remaining
    
    AggregateNumber
    
    Exercise
    
    Contractual
    
    Intrinsicof Options
    
    Price
    
    Term (Years)
    
    ValueOptions outstanding  beginning of period
    
    
    515
    
    
    $
    11.55
    
    
    
    6.7
    
    
    $
    Granted
    
    
    
    
    
    
    Exercised
    
    
    
    
    
    
    Expired
    
    
    (21
    )
    
    
    24.60Forfeited
    
    
    (33
    )
    
    
    8.05Options outstanding  end of period
    
    
    461
    
    
    
    11.18
    
    
    
    6.3
    
    
    
    Options vested or expected to vest  end of
period
    
    
    427
    
    
    
    11.44
    
    
    
    6.1
    
    
    
    Options exercisable  end of period
    
    
    251
    
    
    
    13.73
    
    
    
    4.2
    
    
    
    
  WeightedWeighted
    
    AverageAverage
    
    RemainingNumber
    
    Grant
    
    Recognitionof Shares
    
    Value
    
    Period (Years)Unvested balance  beginning of
period
    
    
    56
    
    
    $
    7.00
    
    
    
    1.1Granted
    
    
    21
    
    
    
    2.10Vested
    
    
    (41
    )
    
    
    4.57Forfeited
    
    
    (4
    )
    
    
    7.98Unvested balance  end of period
    
    
    32
    
    
    
    6.31
    
    
    
    0.9
 13




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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)
  Three Months Ended October 31,2008
    
    
    2007Marketing and selling expense
    
    $
    61
    
    
    $
    55General and administrative expense
    
    
    99
    
    
    
    396Research and development expense
    
    
    1
    
    
    
    1Inventory
    
    
    29
    
    
    
    1Total stock-based compensation
    
    $
    190
    
    
    $
    453
  9. Warrants
  10. Convertible Preferred Stock
  11. Treasury Stock
  12. Supplemental Cash Flow Information
  Three Months Ended October 31,2008
    
    2007Interest paid
    
    $
    2
    
    
    $
    227Income taxes paid
    
    
    16
    
    
    
    35Insurance policy
financed with
short-term
borrowings
    
    
    193
    
    
    
    275
 14




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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)
 13. Comprehensive Loss
  Three Months Ended October 31,2008
    
    
    2007Net loss
    
    $
    (2,798
    )
    
    $
    (4,856
    )Foreign currency
translation
adjustment
    
    
    1
    
    
    
    (13
    )Comprehensive loss
    
    $
    (2,797
    )
    
    $
    (4,869
    )
 14. Commitments and Contingencies
 Legal Proceedings
   ® ®
 Indemnifications
  15




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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued)
 Registration Payment Arrangements
  FDA Observation Letter
  Corporate Office Lease
  16




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##### Table of Contents



Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations.
  Forward-Looking Statements
  Overview
 Business
 ® ® ® ® ® ®
 Recent Developments
  17




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##### Table of Contents



(i)
    
    Initiating discount programs across our product lines to stimulate sales and abate the
sales declines we are experiencing;(ii)
    
    Further reduced headcount from 367 employees at July 31, 2008 to 296 employees at
November 30, 2008, and have implemented other cost reduction programs that should further
reduce expenses in the next several quarters; and(iii)
    
    With the assistance of an investment banker, we are working towards a restructuring.
 Other Key Operating Initiatives
 ® ® ®
 ® ® ®
   18




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##### Table of Contents



Results of Operations
  For the Three Months Ended October 31,% of
    
    
    
    
    
    
    % of
    
    
    %2008
    
    
    Revenue
    
    
    2007
    
    
    Revenue
    
    
    ChangeNet revenues
    
    $
    9,641
    
    
    
    100.0
    %
    
    $
    11,440
    
    
    
    100.0
    %
    
    
    (15.7
    )Cost of products sold
    
    
    3,776
    
    
    
    39.2
    
    
    
    4,581
    
    
    
    40.0
    
    
    
    (17.6
    )Gross profit
    
    
    5,865
    
    
    
    60.8
    
    
    
    6,859
    
    
    
    60.0
    
    
    
    (14.5
    )Operating costs and expenses:Marketing and selling
    
    
    4,371
    
    
    
    45.3
    
    
    
    5,297
    
    
    
    46.3
    
    
    
    (17.5
    )General and administrative
    
    
    2,223
    
    
    
    23.1
    
    
    
    3,473
    
    
    
    30.4
    
    
    
    (36.0
    )Research and development
    
    
    167
    
    
    
    1.7
    
    
    
    1,202
    
    
    
    10.5
    
    
    
    (86.1
    )Depreciation and amortization
    
    
    924
    
    
    
    9.6
    
    
    
    915
    
    
    
    8.0
    
    
    
    1.0Loss from operations
    
    
    (1,820
    )
    
    
    (18.9
    )
    
    
    (4,028
    )
    
    
    (35.2
    )
    
    
    (54.8
    )Other expense  net
    
    
    (954
    )
    
    
    (9.9
    )
    
    
    (644
    )
    
    
    (5.6
    )
    
    
    48.1Loss from continuing operations
before income taxes
    
    
    (2,774
    )
    
    
    (28.8
    )
    
    
    (4,672
    )
    
    
    (40.8
    )
    
    
    (40.6
    )Income tax expense
    
    
    (13
    )
    
    
    (0.1
    )
    
    
    (11
    )
    
    
    (0.1
    )
    
    
    18.2Loss from continuing
operations
    
    $
    (2,787
    )
    
    
    (28.9
    )%
    
    $
    (4,683
    )
    
    
    (40.9
    )%
    
    
    (40.5
    )
 Net Revenues
 ® ® ® ® ®
 Gross Profit
  Marketing and Selling Expense
  19




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##### Table of Contents



General and Administrative Expense
  Three Months Ended October 31,2008
    
    
    2007Cash basis salaries and benefits
    
    $
    819
    
    
    $
    1,210Audit, accounting and other professional fees
    
    
    529
    
    
    
    870Legal and intellectual property related fees
    
    
    239
    
    
    
    292Investment banking fees and shareholder related
expense
    
    
    136
    
    
    
    79Insurance
    
    
    110
    
    
    
    129Non-cash stock-based compensation expense
    
    
    99
    
    
    
    396Other general and administrative expense
    
    
    291
    
    
    
    497Total general and administrative expense
    
    $
    2,223
    
    
    $
    3,473
 Research and Development Expense
  Depreciation and Amortization Expense
  Other Expense  Net
  Three Months Ended October 31,2008
    
    
    2007Senior secured convertible
notes
    
    $
    245
    
    
    $
    216Amortization of financing costs
    
    
    226
    
    
    
    99Amortization of debt discounts
    
    
    449
    
    
    
    447Capital leases and other
    
    
    2
    
    
    
    5Total interest expense
    
    $
    922
    
    
    $
    767
  20




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##### Table of Contents



Income Taxes
  Inflation and Seasonality
  Liquidity and Capital Resources
 Overview
 ® ®
 ® ®
  21




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##### Table of Contents



Selected Cash Flow and Working Capital Information
  Three Months Ended October 31,2008
    
    2007Net cash used in
operating
activities
    
    $
    (990
    )
    
    $
    (4,327
    )Net cash used in
investing
activities
    
    
    (229
    )
    
    
    (455
    )Net cash used in
financing
activities
    
    
    (30
    )
    
    
    (1,417
    )
 October 31,
    
    July 31,2008
    
    2008Cash and cash equivalents
    
    $
    3,213
    
    
    $
    4,462Working capital
    
    
    5,677
    
    
    
    6,558Current ratio
    
    
    1.8
    
    
    
    1.8
  22




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##### Table of Contents



Cash Flows from Operating Activities
  Cash Flows from Investing Activities
  Cash Flows from Financing Activities
  Senior Secured Convertible Notes
    23




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##### Table of Contents



PharmaBio Development, Inc.
  Convertible Preferred Stock
  Off-Balance Sheet Financing Arrangements
  Summary of Critical Accounting Policies and Estimates
  24




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##### Table of Contents



Recently Issued Accounting Pronouncements and Adopted Accounting
 Fair Value Measurements
 
    The Fair Value Option for
Financial Assets and Financial Liabilities  including an amendment of FASB Statement No. 115
 Noncontrolling Interests in Consolidated
Financial Statements  an amendment of ARB No. 51
 25




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##### Table of Contents



Business Combinations
 Disclosures about Derivative Instruments and
Hedging Activities, an amendment of FASB Statement No. 133
 Determination of
the Useful Life of Intangible Assets
 Accounting for
Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash
Settlement)
 
 Item 3. Quantitative and Qualitative Disclosures about Market Risk.
   26




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##### Table of Contents



Item 4. Controls and Procedures.
 Evaluation of Disclosure Controls and Procedures.
  Changes in Internal Control over Financial Reporting
  
 Part II  OTHER INFORMATION
 
 Item 1. Legal Proceedings.
  
 Item 1A. Risk Factors.
 You should consider carefully the risk factors described below, and all other information
contained in this filing and our other filings made with the SEC, before deciding to invest in our
common stock. If any of the following risks actually occur, they may materially harm our business,
financial condition, operating results or cash flow. As a result, the market price of our common
stock could decline, and you could lose all or part of your investment. Additional risks and
uncertainties that are not yet identified or that we think are immaterial may also materially harm
our business, operating results or financial condition and could result in a complete loss of your
investment.
 Trends, Risks and Uncertainties Related to Our Business
 Adverse economic conditions could negatively affect our business and operating results.
 ®
 Our lack of earnings history could adversely affect our financial health and prevent us from
fulfilling our payment obligations, and if we are unable to generate funds or obtain funds on
acceptable terms, we may not be able to develop and market our present and potential products.
 ® ®
 27




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##### Table of Contents




    
    making it more difficult for us to satisfy our obligations with respect to our Senior
Secured Convertible Notes;
    
    increasing our vulnerability to general adverse economic and industry conditions;
    
    limiting our flexibility in planning for, or reacting to, changes in our business and
our industry;
    
    restricting us from making strategic acquisitions, introducing new products or
exploiting business opportunities;
    
    requiring us to dedicate a substantial portion of our cash flow from operations to
payments on our indebtedness, which will reduce the amount of our cash flow available for
other purposes, including capital expenditures and other general corporate purposes;
    
    requiring us to sell debt securities or to sell some of our core assets, possibly on
unfavorable terms;
    
    limiting our ability to obtain additional financing; and
    
    placing us at a possible competitive disadvantage compared to our competitors that may
have greater financial resources.
 We may not be able to maintain compliance with our debt covenants in the future.
   28




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##### Table of Contents



The restrictive covenants contained in our senior debt could adversely affect our business by
limiting our flexibility.
   Historically we have been dependent on a few key products and our future growth is dependent on the
growth of ViziLite ® Plus and on the development and/or acquisition of new products.
 ® ® ® ® ® ®
 ®
 ®
  
    
    difficulties in the production process, controlling the costs to produce, market and
distribute the product on a commercial scale, and our ability to do so with favorable gross
margins and otherwise on a profitable basis;
    
    the inherent difficulty of gaining market acceptance for a new product;
    
    competition from larger, more established companies with greater resources;
    
    changes in raw material supplies that could result in production delays and higher raw
material costs;
    
    difficulties in promoting consumer awareness for the new product;
    
    adverse publicity regarding the industries in which we market our products; and
    
    the cost, timing and ultimate results of regulatory program studies that we undertake.
 29




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##### Table of Contents



Our proprietary rights may prove difficult to enforce.
  We are dependent on our senior management and other key personnel.
  We and our products are subject to regulatory oversight that could substantially interfere with our
ability to do business.
  We are at risk with respect to product liability claims.
  We face significant competition that could adversely affect our results of operation and financial
condition.
  If the use of our technology is determined to infringe on the intellectual property rights of
others, our business could be harmed.
  30




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##### Table of Contents



We require certain raw materials for our manufacturing processes that may only be acquired through
limited sources.
  We have, in the past, received minor deficiencies from regulatory agencies related to our
manufacturing facilities.
  Trends, Risks and Uncertainties Related to Our Capital Stock
 The Private Placements and other financing arrangements or corporate events could significantly
dilute existing ownership.
   31




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##### Table of Contents



In the past, we have experienced volatility in the market price of our common stock and we may
experience such volatility in the future.
   We may take actions which could dilute current equity ownership or prevent or delay a change in our
control.
  Failure to maintain NASDAQ Marketplace Rules could materially and adversely affect our business.
  
 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
  
 Item 3. Defaults Upon Senior Securities.
  32




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##### Table of Contents



Item 4. Submission of Matters to a Vote of Security Holders
  
 Item 5. Other Information.
  
 Item 6. Exhibits.
 ExhibitNumber
    
    Description31.1
    
    Section 302 Certification of the Principal Executive Officer31.2
    
    Section 302 Certification of the Principal Financial Officer32.1
    
    Section 1350 Certification of the Principal Executive Officer and Principal Financial Officer
 33




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##### Table of Contents



SIGNATURES
  Date: December 8, 2008
    Zila, Inc.By:
    /s/ DAVID R. BETHUNEDavid R. BethuneChairman and Interim Chief Executive Officer
(Principal Executive Officer)By:
    /s/ DIANE E. KLEINDiane E. KleinVice President  Finance and Treasurer
(Principal Financial Officer) ExhibitNumber
    
    Description31.1
    
    Section 302 Certification of the Principal Executive Officer31.2
    
    Section 302 Certification of the Principal Financial Officer32.1
    
    Section 1350 Certification of the Principal Executive Officer and Principal Financial Officer
 34