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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
October 31, 2004
    
    Commission File Number
0-17521
 ZILA, INC. (Exact Name of Registrant as Specified in its Charter)
 Delaware(State or Other Jurisdiction of
Incorporation)
    
    86-0619668(I.R.S. Employer
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. x o
 Indicate by check mark whether the registrant is an accelerated filer (as defined
in Rule 12b-2 of the Exchange Act.) x o
 As of November 30, 2004, 45,735,031 shares of common stock were outstanding.




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ZILA, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED OCTOBER 31, 2004 TABLE OF CONTENTS PagePart I FINANCIAL INFORMATION (UNAUDITED)Item 1. Financial StatementsConsolidated Balance Sheets as of October 31, 2004 and July 31, 2004
    
    
    3Consolidated Statements of Operations and Comprehensive Loss for the three-month periods ended October 31, 2004 and 2003
    
    
    4Consolidated Statements of Cash Flows for the three-month periods ended October 31, 2004 and 2003
    
    
    5Notes to Consolidated Financial Statements
    
    
    6Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    13Item 3.Quantitative and Qualitative Disclosures about Market Risk
    
    
    21Item 4. Controls and Procedures
    
    
    21Part II. OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    22Item 2. Unregistered Sales of Securities and Use of Proceeds
    
    
    22Item 3. Defaults upon Senior Securities
    
    
    22Item 4. Submission of Matters to a Vote of Security Holders
    
    
    22Item 5. Other Information
    
    
    22Item 6. Exhibits
    
    
    23SIGNATURES
    
    
    23INDEX TO EXHIBITS
    
    
    24Exhibit 31.1Exhibit 31.2Exhibit 32.1Exhibit 32.2
  2




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ZILA, INC. AND SUBSIDIARIES 
 CONSOLIDATED BALANCE SHEETS October 31,
    
    July 31,2004
    
    2004ASSETSCURRENT ASSETS:Cash and cash equivalents
    
    $
    9,706,214
    
    
    $
    11,679,915Restricted cash collateral
    
    
    518,839
    
    
    
    517,353Trade
receivables - net of allowances of $320,000 (October 31) and $281,000 (July 31)
    
    
    8,605,223
    
    
    
    8,073,585Inventories - net
    
    
    6,966,218
    
    
    
    6,769,546Prepaid expenses and other current assets
    
    
    1,891,806
    
    
    
    1,827,026Total current assets
    
    
    27,688,300
    
    
    
    28,867,425PROPERTY AND EQUIPMENT - net
    
    
    9,094,750
    
    
    
    9,141,785PURCHASED TECHNOLOGY RIGHTS - net
    
    
    3,390,619
    
    
    
    3,510,288GOODWILL - net
    
    
    6,930,192
    
    
    
    6,930,192TRADEMARKS AND OTHER INTANGIBLE ASSETS - net
    
    
    13,319,141
    
    
    
    13,240,319OTHER ASSETS
    
    
    409,753
    
    
    
    418,634TOTAL
    
    $
    60,832,755
    
    
    $
    62,108,643LIABILITIES AND SHAREHOLDERS EQUITYCURRENT LIABILITIES:Accounts payable
    
    $
    5,366,498
    
    
    $
    4,275,679Accrued liabilities
    
    
    3,241,068
    
    
    
    3,077,071Short-term borrowings
    
    
    301,004
    
    
    
    Current portion of long-term debt and capital lease obligations
    
    
    342,136
    
    
    
    343,403Total current liabilities
    
    
    9,250,706
    
    
    
    7,696,153Deferred gain on sale leaseback
    
    
    496,343
    
    
    
    534,587Long-term debt and capital lease obligations - net of current portion
    
    
    3,565,334
    
    
    
    3,649,733Total liabilities
    
    
    13,312,383
    
    
    
    11,880,473COMMITMENTS AND CONTINGENCIES (Note 12)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
45,730,031 shares (October 31, 2004) and 45,723,296 shares (July 31, 2004)
    
    
    45,730
    
    
    
    45,723Capital in excess of par value
    
    
    83,984,375
    
    
    
    83,968,913Accumulated other comprehensive loss
    
    
    (75,078
    )
    
    
    (73,453
    )Accumulated deficit
    
    
    (36,325,782
    )
    
    
    (33,604,140
    )Common stock in treasury, at cost, 225,100 shares (October 31 and July 31, 2004)
    
    
    (571,373
    )
    
    
    (571,373
    )Total shareholders equity
    
    
    47,520,372
    
    
    
    50,228,170TOTAL
    
    $
    60,832,755
    
    
    $
    62,108,643
 See notes to consolidated financial statements. 3




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ZILA, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF OPERATIONS Three months ended October 31,2004
    
    2003NET REVENUES
    
    $
    11,819,668
    
    
    $
    12,052,720OPERATING COSTS AND EXPENSES:Cost of products sold
    
    
    4,144,423
    
    
    
    4,992,946Marketing and selling
    
    
    4,762,158
    
    
    
    3,048,774General and administrative
    
    
    2,978,476
    
    
    
    3,611,434Research and development
    
    
    1,951,735
    
    
    
    1,266,617Depreciation and amortization
    
    
    676,366
    
    
    
    622,30214,513,158
    
    
    
    13,542,073LOSS FROM OPERATIONS
    
    
    (2,693,490
    )
    
    
    (1,489,353
    )OTHER INCOME (EXPENSE):Interest income
    
    
    52,694
    
    
    
    27,750Interest expense
    
    
    (47,798
    )
    
    
    (79,150
    )Other income (expense)
    
    
    (21,343
    )
    
    
    (27,588
    )(16,447
    )
    
    
    (78,988
    )LOSS BEFORE INCOME TAXES
    
    
    (2,709,937
    )
    
    
    (1,568,341
    )Income tax benefit (expense)
    
    
    (1,955
    )
    
    
    NET LOSS
    
    
    (2,711,892
    )
    
    
    (1,568,341
    )Preferred stock dividends
    
    
    9,750
    
    
    
    9,750Net loss attributable to common shareholders
    
    $
    (2,721,642
    )
    
    $
    (1,578,091
    )BASIC AND DILUTED NET LOSS PER COMMON SHARE:
    
    $
    (0.06
    )
    
    $
    (0.04
    )Weighted average shares outstanding
    
    
    45,500,890
    
    
    
    45,219,211NET LOSS
    
    
    (2,711,892
    )
    
    
    (1,568,341
    )Foreign currency translation adjustments
    
    
    (1,625
    )
    
    
    (3,733
    )COMPREHENSIVE LOSS
    
    $
    (2,713,517
    )
    
    $
    (1,572,074
    )
 See notes to consolidated financial statements. 4




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ZILA, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF CASH FLOWS Three months ended October 31,2004
    
    2003OPERATING ACTIVITIES:Net loss
    
    $
    (2,711,892
    )
    
    $
    (1,568,341
    )Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:Depreciation and amortization
    
    
    676,366
    
    
    
    622,302Amortization of deferred financing costs
    
    
    12,977
    
    
    
    3,965Other
    
    
    (8,768
    )
    
    
    (3,733
    )Change in assets and liabilities:Receivables - net
    
    
    (531,638
    )
    
    
    660,751Inventories
    
    
    (196,672
    )
    
    
    (630,622
    )Prepaid expenses and other assets
    
    
    (117,165
    )
    
    
    (497,783
    )Accounts payable and accrued liabilities
    
    
    1,301,253
    
    
    
    (1,674,857
    )Net cash used in operating activities
    
    
    (1,575,539
    )
    
    
    (3,088,318
    )INVESTING ACTIVITIES:Additions to property and equipment, net
    
    
    (277,615
    )
    
    
    (369,251
    )Additions to intangible assets, net
    
    
    (310,868
    )
    
    
    (104,175
    )Net cash used in investing activities
    
    
    (588,483
    )
    
    
    (473,426
    )FINANCING ACTIVITIES:Net proceeds from short-term borrowings
    
    
    301,004
    
    
    
    284,004Proceeds from issuance of common stock
    
    
    15,469
    
    
    
    34,007Dividends paid to preferred stockholders
    
    
    (39,000
    )
    
    
    (9,750
    )Restricted cash deposited to collaterize letter of credit
    
    
    (1,486
    )
    
    
    Principal payments on long-term debt
    
    
    (85,666
    )
    
    
    (23,464
    )Net cash provided by financing activities
    
    
    190,321
    
    
    
    284,797NET DECREASE IN CASH AND CASH EQUIVALENTS
    
    
    (1,973,701
    )
    
    
    (3,276,947
    )CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
    
    
    11,679,915
    
    
    
    16,160,484CASH AND CASH EQUIVALENTS, END OF PERIOD
    
    $
    9,706,214
    
    
    $
    12,883,537
 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. and subsidiaries (Zila), a Delaware corporation, 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 Oxycal Laboratories, Inc. (Oxycal) and its subsidiary,
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 the research, development
and licensing business specializing in pre-cancer/cancer detection through its
patented Zila® Tolonium Chloride and OraTest® technologies and manages the
OraTest® product, an oral cancer diagnostic system, which is currently in Food
and Drug Administration (FDA) phase III clinical trials. 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 condensed 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., Oxycal Laboratories,
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. (See Note 5 for further discussion of 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 EndedOctober 31,2004
    
    2003Net loss attributable to common shareholders, as reported
    
    $
    (2,722
    )
    
    $
    (1,578
    )Deduct: Stock-based employee compensation expense determined under fair
value based method for all awards, net of related tax effects, if any
    
    
    (378
    )
    
    
    (349
    )Pro forma net loss attributable to common shareholders
    
    $
    (3,100
    )
    
    $
    (1,927
    )Net loss
attributable to common shareholders per share - basic and diluted:As reported
    
    $
    (0.06
    )
    
    $
    (0.04
    )Pro forma
    
    $
    (0.07
    )
    
    $
    (0.04
    )Black-Scholes model assumptions:Risk-free interest rate
    
    
    3.8
    %
    
    
    3.2
    %Expected volatility
    
    
    75
    %
    
    
    74
    %Expected term (in years)
    
    
    6.5
    
    
    
    5.8Dividend yield
    
    
    0
    %
    
    
    0
    %
 3. NET LOSS PER COMMON SHARE Since a loss from continuing operations was incurred for the three month
periods ended October 31, 2004 and 2003, potentially dilutive shares applicable
to convertible preferred stock, options, and warrants to purchase shares of
common stock were not included in the computation of diluted net loss per
common share because their effect would be antidilutive. Potentially dilutive
common shares for the three month periods ended October 31, 2004 and 2003 were
455,000 and 535,000, respectively. Dilutive common shares give effect to
securities, such as stock options, warrants and convertible preferred stock,
which have the potential to be exercised. 4. INVENTORIES Inventories consist of the following (in thousands): October 31,
    
    July 31,2004
    
    2004Finished goods
    
    $
    1,764
    
    
    $
    2,188Work in process
    
    
    910
    
    
    
    339Raw materials
    
    
    4,570
    
    
    
    4,440Inventory reserves
    
    
    (278
    )
    
    
    (197
    )$
    6,966
    
    
    $
    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 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 October 31, 2004 is
presented for comparative purposes. 7




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Summarized balance sheet information for IST follows (in thousands): October 31,
    
    July 31,2004
    
    2004Current assets
    
    $
    268
    
    
    $
    250Property, plant and equipment, net
    
    
    975
    
    
    
    1,026Patents, net
    
    
    205
    
    
    
    217Other
    
    
    7
    
    
    
    13Assets
    
    $
    1,455
    
    
    $
    1,506Current liabilities
    
    $
    206
    
    
    $
    233
 6. INTANGIBLE ASSETS A summary of intangible assets is presented below (in thousands): October 31, 2004
    
    July 31, 2004Gross
    
    
    
    
    
    Net
    
    Gross
    
    
    
    
    
    NetCarrying
    
    Accumulated
    
    Carrying
    
    Carrying
    
    Accumulated
    
    CarryingAmount
    
    Amortization
    
    Amount
    
    Amount
    
    Amortization
    
    AmountAmortizable
intangibles:Purchased
technology rights
    
    $
    7,419
    
    
    $
    4,028
    
    
    $
    3,391
    
    
    $
    7,419
    
    
    $
    3,909
    
    
    $
    3,510Trademarks and
other intangible
assets:Trademarks
    
    
    11,643
    
    
    
    3,236
    
    
    
    8,407
    
    
    
    11,627
    
    
    
    3,119
    
    
    
    8,508Patents
    
    
    3,730
    
    
    
    1,155
    
    
    
    2,575
    
    
    
    3,586
    
    
    
    1,128
    
    
    
    2,458Licensing costs
    
    
    3,250
    
    
    
    913
    
    
    
    2,337
    
    
    
    3,100
    
    
    
    826
    
    
    
    2,274Total trademarks
and other
intangible assets
    
    
    18,623
    
    
    
    5,304
    
    
    
    13,319
    
    
    
    18,313
    
    
    
    5,073
    
    
    
    13,240Total amortizable
intangible assets
    
    
    26,042
    
    
    
    9,332
    
    
    
    16,710
    
    
    
    25,732
    
    
    
    8,982
    
    
    
    16,750Unamortizable
intangible asset:Goodwill
    
    
    12,401
    
    
    
    5,471
    
    
    
    6,930
    
    
    
    12,401
    
    
    
    5,471
    
    
    
    6,930Total intangible
assets
    
    $
    38,443
    
    
    $
    14,803
    
    
    $
    23,640
    
    
    $
    38,133
    
    
    $
    14,453
    
    
    $
    23,680
 There were no changes in the carrying amount of goodwill for the three
months ended October 31, 2004. Intangible asset amortization expense for the three months ended October
31, 2004 and 2003 was $352,000 and $326,000, respectively. For fiscal years
2006 through 2010, the amortization of intangibles is estimated to be $1.4
million each year. 7. DEBT AND LEASE OBLIGATIONS Debt consisted of the following (in thousands): October 31,
    
    July 31,2004
    
    2004Short-term borrowings:Installment
note payable for insurance premiums, 5.98%
    
    $
    301
    
    
    $
    
 8




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October 31,
    
    July 31,2004
    
    2004Current portion of long-term debt:IDA bond payable, Series A
    
    $
    245
    
    
    $
    245Capital lease obligations
    
    
    46
    
    
    
    47Note payable for equipment
    
    
    51
    
    
    
    51Total current portion of long-term debt
    
    $
    342
    
    
    $
    343Long-term debt:IDA bond payable, Series A
    
    $
    3,151
    
    
    $
    3,212PharmaBio
    
    
    500
    
    
    
    500Capital lease obligations
    
    
    188
    
    
    
    201Notes payable for equipment with interest rates between
6.34% and 12.25% with maturities through 2006
    
    
    68
    
    
    
    80Total long-term debt
    
    
    3,907
    
    
    
    3,993Less current portion
    
    
    342
    
    
    
    343Long-term portion
    
    $
    3,565
    
    
    $
    3,650
 On February 6, 2004, our subsidiaries, Zila Nutraceuticals, Inc., Zila
Pharmaceuticals, Inc., Zila Biotechnology, Inc., Zila Swab Technologies, Inc.,
and Oxycal Laboratories, Inc., entered into a Credit and Security Agreement
(the Wells Fargo Agreement) with Wells Fargo Business Credit, Inc. (Wells
Fargo) that provides a $10 million revolving line of credit, effective on
August 17, 2004. Borrowings bear interest equal to the prime rate. The amount
of funds available under the Wells Fargo Agreement is based upon a percentage
of the value of eligible receivables and inventory and was $9.1 million at
October 31, 2004. 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 $1.7 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 October 31, 2004, our net worth, as defined,
was $47.5 million compared to the required amount of $46.0 million.
Additionally, payment of common stock dividends is restricted. The net worth
and capital expenditures covenants are established annually as of August 1. 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, Oxycal 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 Oxycal 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 and mature in 2019. The
Series B were repaid. The Bonds bear a variable interest rate that was 1.9% at
October 31, 2004. In connection with the issuance of the Bonds, the Authority
required that Oxycal 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. 9




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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. 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
    
    $
    223
    
    
    $
    34
    
    
    $
    2572006
    
    
    274
    
    
    
    48
    
    
    
    3222007
    
    
    246
    
    
    
    50
    
    
    
    2962008
    
    
    245
    
    
    
    44
    
    
    
    2892009
    
    
    745
    
    
    
    12
    
    
    
    7572010 and thereafter
    
    
    1,986
    
    
    
    
    
    
    
    1,986Total
    
    
    3,719
    
    
    
    188
    
    
    
    3,907Less current portion
    
    
    296
    
    
    
    46
    
    
    
    342Long-term portion
    
    $
    3,423
    
    
    $
    142
    
    
    $
    3,565
 8. SUPPLEMENTAL CASHFLOW INFORMATION Supplemental cash flow information for the three months ended October 31,
2004 and 2003 was as follows (in thousands): Three months ended October 31,2004
    
    2003Cash paid for interest
    
    $
    30
    
    
    $
    35Cash paid for income taxes
    
    
    
    
    
    
    192Capital lease obligations for new equipment
    
    
    
    
    
    
    96
 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 months ended October 31, 2004
and 2003, we recorded a tax benefit based on the effective tax rate and offset
the tax benefit with an increase in the deferred tax asset valuation reserve.
At October 31, 2004, we recorded total net deferred tax assets of approximately
$7.2 million. The total deferred tax assets were offset with a valuation
allowance due to our lack of an earnings history. At October 31, 2004, the Company had income tax net operating loss carry
forwards of approximately $13.8 million that expire in fiscal years 2009
through 2025. 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 Oxycal
Laboratories, Inc. and its wholly-owned subsidiary, 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 the
research, development and licensing business specializing in pre-cancer/cancer
detection through its patented Zila® Tolonium 10




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##### Table of Contents



Chloride and OraTest® technologies and now manages 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 October 31, 2004 and 2003 and segment total assets as of October
31, 2004 and July 31, 2004 (in thousands): ReconcilingSegments
    
    
    
    
    
    ItemNutraceuticals
    
    Pharmaceuticals
    
    Biotechnology
    
    Corporate
    
    TotalNet revenues:Quarter ended October 31:2004
    
    $
    8,721
    
    
    $
    3,099
    
    
    $
    
    
    
    $
    
    
    
    $
    11,8202003
    
    
    6,990
    
    
    
    5,061
    
    
    
    2
    
    
    
    
    
    
    
    12,053Income (loss) before income
taxes:Quarter ended October 31:2004
    
    
    1,347
    
    
    
    (240
    )
    
    
    (2,285
    )
    
    
    (1,532
    )
    
    
    (2,710
    )2003
    
    
    1,015
    
    
    
    412
    
    
    
    (1,603
    )
    
    
    (1,392
    )
    
    
    (1,568
    )Depreciation and amortization:Quarter ended October 31:2004
    
    
    281
    
    
    
    168
    
    
    
    173
    
    
    
    54
    
    
    
    6762003
    
    
    254
    
    
    
    163
    
    
    
    175
    
    
    
    30
    
    
    
    622Total assets as of:October 31, 2004
    
    
    32,320
    
    
    
    11,272
    
    
    
    14,794
    
    
    
    2,447
    
    
    
    60,833July 31, 2004
    
    
    31,469
    
    
    
    11,499
    
    
    
    15,583
    
    
    
    3,558
    
    
    
    62,109
 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 October 31, 2004, we had approximately $533,000 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 during fiscal 2005 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 early 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 $243,000 of ViziLite® product in inventory and approximately $2.0
million of associated net long-lived assets as of October 31, 2004. As part of
our strategy to educate the dental profession on the benefits of using
ViziLite® and to widen distribution, in the third quarter of fiscal 2003 we
modified our exclusive distributorship agreement with Patterson Dental Company
to convert it to a non-exclusive agreement for the dental industry in the
United States and Canada. We then retained regional distributors and sales groups with a roster of
independent sales representatives. With the introduction of independent sales
representative and regional distributors, we are modifying our plan to reach
both opinion leaders and end-users in the oral cavity screening process.
However, if sales do not ultimately reach certain levels, we may have to reduce
the carrying value of the assets related to ViziLite®. 11




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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. Tinnell asserted
several counterclaims. The Court has ruled in our favor, stating that we do not owe royalty
obligations to Tinnell, dismissed our request for reimbursement of overpaid
royalties and dismissed all but one of Tinnells counterclaims. In November 2004, Tinnell agreed to dismiss his remaining counterclaim.
Tinnell has indicated that he will appeal the Courts prior rulings in our
favor. The time for making such an appeal has not yet expired. 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 formally served with this lawsuit;
however, if we and IST are made parties to the lawsuit, we will contest it
vigorously. After a preliminary review, we believe that the
plaintiffs claims
with respect to us and IST are without merit. 12. RECENT ACCOUNTING PRONOUNCEMENTS On November 24, 2004, the Financial Accounting Standards Board issued
Statement of 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. 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. 12




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##### Table of Contents



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 keep and attract key management
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. 13




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##### Table of Contents



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 endedOctober 31,2004
    
    2003EBITDA
    
    $
    (2,038
    )
    
    $
    (895
    )Interest Income
    
    
    52
    
    
    
    28Interest Expense
    
    
    (48
    )
    
    
    (79
    )Depreciation and Amortization
    
    
    (676
    )
    
    
    (622
    )Income Tax Expense
    
    
    (2
    )
    
    
    Net loss
    
    $
    (2,712
    )
    
    $
    (1,568
    )
 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 Protection
Ester-C® and Ester-E®, proprietary, branded, highly effective forms of
vitamins C and E.  
    
    Zila Pharmaceuticals, manufacturer and marketer of superior 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, which are 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 U.S. Food and Drug Administration
(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
historical levels as we accelerate our efforts to advance our clinical program.
Accordingly, unless our other business units 14




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##### Table of Contents



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®. No assurances can be made that the FDA will agree to our proposed program
modifications or that the clinical objectives will be achieved. We have
assimilated and implemented the FDAs non-binding comments to our proposed
program modifications and in September 2004 we submitted our revised clinical
test protocols for FDA review. We are awaiting the FDAs input regarding these
revised protocols. In the meantime, we continue to prepare for execution of the
modified program. Effective March 31, 2004, ISTs contract with a major customer expired.
Sales under this contract represented approximately 80% of ISTs net revenues.
As a result, ISTs net revenues in the three months ended October 31, 2004 were
$195,000 compared to $1.6 million in the previous year and ISTs operating loss
was $365,000 compared to operating income of $46,000 in the prior year period.
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 months ended October 31, 2004 with the three months
ended October 31, 2003 Total Company The following table summarizes our results of operations and related
statistical information for the three months periods ended October 31, 2004 and
2003 (dollars in thousands): Percent of
    
    
    
    
    
    Percent ofNet
    
    
    
    
    
    Net2004
    
    Revenues
    
    2003
    
    Revenues
    
    ChangeNet revenues
    
    $
    11,820
    
    
    
    100
    %
    
    $
    12,053
    
    
    
    100
    %
    
    
    (2
    )%Operating Costs and Expenses:Cost of products sold
    
    
    4,144
    
    
    
    35
    
    
    
    4,993
    
    
    
    41
    
    
    
    (17
    )Marketing & selling
    
    
    4,762
    
    
    
    40
    
    
    
    3,049
    
    
    
    25
    
    
    
    56General & administrative
    
    
    2,979
    
    
    
    25
    
    
    
    3,611
    
    
    
    30
    
    
    
    (18
    )Research & development
    
    
    1,952
    
    
    
    17
    
    
    
    1,267
    
    
    
    11
    
    
    
    54Depreciation & amortization
    
    
    676
    
    
    
    6
    
    
    
    622
    
    
    
    5
    
    
    
    914,513
    
    
    
    123
    
    
    
    13,542
    
    
    
    112
    
    
    
    7Loss from operations
    
    
    (2,693
    )
    
    
    (23
    )
    
    
    (1,489
    )
    
    
    (12
    )
    
    
    81Other expense, net
    
    
    (17
    )
    
    
    
    
    
    
    (79
    )
    
    
    (1
    )
    
    
    (78
    )Loss before income taxes
    
    
    (2,710
    )
    
    
    (23
    )
    
    
    (1,568
    )
    
    
    (13
    )
    
    
    73Income tax expense
    
    
    (2
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net loss
    
    $
    (2,712
    )
    
    
    (23
    )
    
    $
    (1,568
    )
    
    
    (13
    )
    
    
    73
 15




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Net revenues decreased 2% to $11.8 million for the three months ended
October 31, 2004, compared to revenues of $12.1 million for the three months
ended October 31, 2003. For this period, an increase of 25% in net revenues in
the Nutraceuticals Business Unit was reduced by a 39% decrease in the
Pharmaceuticals Business Unit. 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 timing of quarterly Zilactin® sales and a distribution
loss that we believe to be temporary; and (iii) a change in annualized
purchasing patterns by our largest Peridex® customer. ISTs net revenues were
$195,000 (net of intercompany sales), a decline of $1.4 million from the prior
year level of $1.6 million. Net revenues, without the effect of IST, increased
11% over the prior year. Cost of products sold as a percentage of net revenues decreased to 35%
from 41% for the three months ended October 31, 2004 compared to the same
period in fiscal 2003. The primary factor in this decrease was the reduced cost
of ascorbic acid, the major raw material in our Ester-C® products. Marketing and selling expenses for the three months ended October 31, 2004
as a percentage of net revenues increased to 40% from 25% in the prior year.
Increased spending for brand and media advertising support for Ester-C® and the
launch of Ester-E® and increased marketing and selling expenditures for
ViziLite® were the primary reasons for this increase. General and administrative expenses were $3.0 million, or 25% of net
revenues, for the three months ended October 31, 2004, compared to $3.6
million, or 30% of net revenue, for the three months ended October 31, 2003.
The reduction of general and administrative expenses at IST was the primary
factor in the decrease as IST downsized its operations after the loss of its
major customer. Additionally, legal fees were lower in the three months ended
October 31, 2004 than the prior year period as a result of the settlement of
litigation that was pending the prior fiscal year. Research and development expenses increased $685,000, or 54%, to $2.0
million for the three months ended October 31, 2004 from $1.3 million in the
three months ended October 31, 2003. The increase is due primarily to an
increase in the OraTest® regulatory program expenses of $656,000, or 56%. Depreciation and amortization expenses increased $54,000, or 9%, to
$676,000 for the three months ended October 31, 2004 from $622,000 for the
three months ended October 31, 2003. The increase was attributable primarily to
additions of property and equipment and patents and trademarks in the
Nutraceuticals and Pharmaceuticals Business Units and corporate computer system
software. Nutraceuticals Business Unit Selected financial information for the Nutraceuticals Business Unit
follows (dollars in thousands): Three months endedOctober 312004
    
    2003
    
    ChangeNet revenues
    
    $
    8,721
    
    
    $
    6,990
    
    
    
    25
    %Segment income before income taxes
    
    
    1,347
    
    
    
    1,015
    
    
    
    33
 Net revenues for the Nutraceuticals Business Unit for the three months
ended October 31, 2004 increased 25% over the prior year period. This growth
was primarily in domestic sales for Ester-C® and was driven principally by
increased radio and television advertising support for the Ester-C® products in
our continuing strategy of brand development. Net income before taxes for the Nutraceuticals Business Unit for the three
months ended October 31, 2004, was $1.3 million, an increase of 33% over the
prior year period. Gross margins improved to 68% in 2004 compared to 59% in
2003 as a result of reductions in the cost of ascorbic acid. Increased spending
for brand and media advertising support for Ester-C®and for the launch of
Ester-E® offset the gross margin improvement. The improvements in gross margin
and cost control measures in general and administrative expenses allowed net
income before income taxes to increase at a rate higher than the increase in
net revenues. 16




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##### Table of Contents



Pharmaceuticals Business Unit Selected financial information for the Pharmaceuticals Business Unit
follows (dollars in thousands): Three months endedOctober 312004
    
    2003
    
    ChangeNet revenues
    
    $
    3,099
    
    
    $
    5,061
    
    
    
    (39
    )%Segment income (loss) before income taxes
    
    
    (240
    )
    
    
    412
    
    
    
    (158
    )
 Net revenues for the Pharmaceuticals Business Unit decreased 39% to $3.1
million for the three months ended October 31, 2004 compared to net revenues of
$5.1 million for the prior year period. 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 timing of quarterly Zilactin® sales and a distribution
loss that we believe to be temporary; and (iii) a change in annualized
purchasing patterns by our largest Peridex® customer. ISTs net revenues were
$195,000 (net of intercompany sales), a decline of $1.4 million, or 88%, from
the prior year level of $1.6 million. Without IST, net revenues for the
Pharmaceuticals Business Unit declined 16% for the three months ended October
31, 2004 compared to the prior year period. Net loss before income taxes for the Pharmaceuticals Business Unit for the
three months ended October 31, 2004 was $240,000 compared to net income of
$412,000 in the prior year period, a decrease of 158%. This decline resulted
primarily from the net loss at IST. Biotechnology Business Unit Selected financial information for the Biotechnology Business Unit follows
(dollars in thousands): Three months endedOctober 312004
    
    2003
    
    ChangeNet revenues
    
    $
    
    
    
    $
    2
    
    
    
    (100
    )%Research and development
    
    
    (1,824
    )
    
    
    (1,168
    )
    
    
    56Segment loss before income taxes
    
    
    (2,285
    )
    
    
    (1,603
    )
    
    
    43
 There were no international sales of the OraTest® product during the three
months ended October 31, 2004 as we continued our focus on obtaining FDA
approval in the United States. Total operating expenses for the Biotechnology Business Unit were $2.3
million for the three months ended October 31, 2004, a 43% increase over the
$1.6 million for the three months ended October 31, 2003. This was driven by an
increase of approximately 56% in the regulatory program expenses related to the
OraTest® product. LIQUIDITY AND CAPITAL RESOURCES At October 31, 2004, our primary sources of liquidity included cash and
cash equivalents of $9.7 million and the line of credit discussed below. Net
working capital decreased to $18.4 million at October 31, 2004 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 $1.6 million during the three
months ended October 31, 2004 and was primarily attributable to the net loss
from continuing operations of $2.7 million and an increase of $845,000 in
inventory, receivables and prepaid expenses, primarily at our Nutraceuticals
Business Unit. Offsetting these uses of cash were: $681,000 of depreciation and
amortization and other noncash items and an increase in accounts payable and
other liabilities of $1.3 million, primarily in the Nutraceuticals and
Pharmaceuticals Business Units. 17




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Net cash used in investing activities was $588,000, attributable to funds
used for equipment purchases and patent and trademark filings. Net cash provided by financing activities during the three months ended
October 31, 2004 was $190,000, arising primarily from the increase in
short-term borrowings for insurance premium financing of $301,000, offset by
principal payments on long-term debt and dividends paid to preferred
stockholders. 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., Zila Swab Technologies, Inc.,
and Oxycal Laboratories, Inc., entered into a Credit and Security Agreement
(the Wells Fargo Agreement) with Wells Fargo Business Credit, Inc. (Wells
Fargo) that provides a $10 million revolving line of credit, effective on
August 17, 2004. Borrowings bear interest equal to the prime rate. The amount
of funds available under the Wells Fargo Agreement is based upon a percentage
of the value of eligible receivables and inventory and was $9.1 million at
October 31, 2004. 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 $1.7 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 October 31, 2004, our net worth, as defined,
was $47.5 million compared to the required net worth amount of $46.0 million.
Additionally, payment of common stock dividends is restricted. The net worth
and capital expenditures covenants are established annually as of August 1. 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, Oxycal 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 Oxycal 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 and mature in 2019. The
Series B were repaid. The Bonds bear a variable interest rate that was 1.9% at
October 31, 2004. In connection with the issuance of the Bonds, the Authority
required that Oxycal maintain, for the benefit of the Bondholders, an
irrevocable direct-pay letter of credit to secure payment of principal and
interest. Zila, Inc. guarantees the letter of credit. Wells Fargo provides this
new letter of credit (Replacement Letter of Credit) in conjunction with the
Wells Fargo Agreement. This Replacement Letter of Credit replaced an earlier
letter of credit provided by Bank One, which expired in March 2004. 18




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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. Stock Repurchases On November 10, 1999, we announced that our Board of Directors authorized
the repurchase of up to one million shares of Zila common stock. Purchases are
made on the open market depending on market conditions and other factors.
During fiscal 2003, we repurchased 30,100 shares for $36,000. As of October 31,
2004, 225,100 shares had been repurchased for $571,400. We have made no
purchases of our common stock under this program since fiscal 2003 and have
suspended purchases under the program. Preferred Stock Financing On February 5, 2001, we issued 100,000 shares of Series B Convertible
Preferred Stock as part of the IST acquisition. The holders of the Preferred
Stock are entitled to receive cumulative quarterly dividends at a rate of
$0.0975 per share per fiscal quarter, payable in arrears. During the three
months ended October 31, 2004, we paid dividends of $39,000 and have
accumulated accrued dividends of $9,750 as of October 31, 2004. 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
$320,000 at October 31, 2004 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. 19




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We make changes in estimates as appropriate, and as we become aware of
circumstances surrounding those estimates. Such changes and refinements in
estimation methodologies are reflected in reported results of operations in the
period in which the changes are made and, if material, their effects are
disclosed in the Notes to Consolidated Financial Statements. Our impairment analyses include significant estimates with respect to cash
flows and fair values. The factors that affect these estimates include the
following: The cash flows used to measure long-lived assets related to the OraTest®
product are dependent upon obtaining FDA approval and generating sufficient
revenues from sales of the OraTest® product. The rigorous clinical testing and
an extensive regulatory approval process mandated by the FDA and equivalent
foreign authorities before any new drug can be marketed by us can take a number
of years and require the expenditure of substantial resources. Obtaining such
approvals and completing such testing is a costly and time-consuming process,
and approval may not be ultimately obtained. The length of the FDA review
period varies considerably, as does the amount of clinical data required to
demonstrate the safety and efficacy of a specific product. Net long-lived
assets related to the OraTest® product as of October 31, 2004 of $5.6 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 October 31, 2004 of
$2.0 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 October 31,
2004 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 $11.2 million (net of accumulated amortization of $4.1 million)
are related 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 20




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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 $3.4
million net purchased technology rights at October 31, 2004 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
$702,000 (primarily related to our manufacturing facility); (ii) patents and
patents pending of $1.5 million; and (iii) $533,000 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 changes in
circumstances indicate that the carrying amount may not be recoverable. 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 October 31, 2004, all of our
deferred tax assets were offset by a valuation allowance. Recent Accounting Pronouncements On November 24, 2004, the Financial Accounting Standards Board issued
Statement of 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. 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. (4.00 percent at October 31, 2004). At October 31, 2004, 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 1.9% at October 31, 2004. 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. 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 21




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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. Tinnell asserted
several counterclaims. The Court has ruled in our favor, stating that we do not owe royalty
obligations to Tinnell, dismissed our request for reimbursement of overpaid
royalties and dismissed all but one of Tinnells counterclaims. In November 2004, Tinnell agreed to dismiss his remaining counterclaim.
Tinnell has indicated that he will appeal the Courts prior rulings in our
favor. The time for making such an appeal has not yet expired. 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 formally served with this lawsuit;
however, if we and IST are made parties to the lawsuit, we will contest it
vigorously. After a preliminary review, we believe that the
plaintiffs claims
with respect to us and IST are without merit. 
 Item 2. Unregistered Sales of Securities and Use of Proceeds. On November 10, 1999, we announced that our Board of Directors authorized
the repurchase of up to one million shares of Zila common stock. Purchases are
made on the open market depending on market conditions and other factors.
During fiscal 2003, we repurchased 30,100 shares for $36,000. As of October 31,
2004,225,100 shares had been repurchased for $571,400. We have made no
purchases of our common stock under this program since fiscal 2003 and have
suspended purchases under the program. 
 Item 3. Defaults upon Senior Securities. Not Applicable 
 Item 4. Submission of Matters to a Vote of Security Holders. Not Applicable 
 Item 5. Other Information Not Applicable 22




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Item 6. Exhibits Exhibit Number
    
    Description31.1
    
    Certification of the Chief Executive Officer Pursuant to Section 302 of the Sarbanes Oxley Act of 200231.2
    
    Certification of the Chief Financial Officer Pursuant to Section 302 of the Sarbanes Oxley Act of 200232.1
    
    Certification of the Chief Executive Officer Pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes Oxley Act 0f 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 0f 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: December 8, 2004
    
    By:/s/Douglas D. Burkett,
Ph.D.Douglas D. Burkett, Ph.D.President, Chairman of the
Board(Principal Executive Officer)By:/s/Andrew A. StevensAndrew A. StevensVice President and Chief Financial Officer(Principal Financial & Accounting Officer)
 23




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INDEX TO EXHIBITS Exhibit Number
    
    Description31.1
    
    Certification of the Chief Executive Officer Pursuant to Section 302 of the Sarbanes Oxley Act of 200231.1
    
    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 0f 2002
 24