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SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549
   FORM 10-Q
 (Mark One) x Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended   April 30, 2004 or o Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period
from
 to Commission file number 0-17521 ZILA, INC. 
  Delaware
    
    86-0619668(State or Other Jurisdiction of Incorporation or
    
    (I.R.S. Employer Identification No.)Organization)
 5227 North 7th Street, Phoenix, Arizona
    
    
    85014(Address of Principal Executive Offices)
    
    (Zip Code)
 Registrants Telephone Number, Including Area Code (602) 266-6700 Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days Yes x No o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Securities Exchange Act) Yes x No o APPLICABLE ONLY TO CORPORATE ISSUERS Indicate the number of shares outstanding of each of the issuers classes
of common stock, as of the latest practicable date. At May 31, 2004, the number of shares of common stock outstanding was
45,644,052 1




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TABLE OF CONTENTS UPDATE PagePart I FINANCIAL INFORMATION (UNAUDITED)Item 1. Financial StatementsCondensed consolidated balance sheets as of April 30, 2004 and
July 31, 2003
    
    
    3Condensed consolidated statements of operations and comprehensive loss for the three and nine months ended April 30, 2004
and 2003
    
    
    4Condensed consolidated statements of cash flows for the nine months ended April 30, 2004 and 2003
    
    
    5Notes to condensed consolidated financial statements
    
    
    6Item 2. Managements discussion and analysis of financial condition and results of operations
    
    
    16Item 3. Quantitative and qualitative disclosures about market risk
    
    
    28Item 4. Controls and procedures
    
    
    29Part II. OTHER INFORMATIONItem 1. Legal proceedings
    
    
    29Item 2. Changes in securities and use of proceeds
    
    
    30Item 6. Exhibits and Reports on Form 8-K
    
    
    31SIGNATURES
    
    
    31Ex  31.1Ex  31.2Ex  32.1Ex  32.2EX-31.1EX-31.2EX-32.1EX-32.2
  2




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ZILA, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED BALANCE SHEETS April 30, 2004
    
    July 31, 2003(unaudited)ASSETSCurrent assetsCash and cash equivalents
    
    $
    11,838,573
    
    
    $
    16,160,484Restricted cash collateral
    
    
    516,809
    
    
    
    Trade receivables - net
    
    
    8,219,980
    
    
    
    6,754,771Inventories - net
    
    
    6,545,916
    
    
    
    7,847,604Prepaid expenses and other current assets
    
    
    3,613,426
    
    
    
    1,643,285Assets held for sale
    
    
    2,071,465
    
    
    
    2,920,345Total current assets
    
    
    32,806,169
    
    
    
    35,326,489Property, plant and equipment - net
    
    
    7,795,462
    
    
    
    8,162,793Purchased technology rights - net
    
    
    3,629,957
    
    
    
    3,988,964Goodwill - net
    
    
    6,930,192
    
    
    
    6,930,192Trademarks and other intangible assets - net
    
    
    13,385,938
    
    
    
    13,317,747Other assets
    
    
    174,840
    
    
    
    1,294,131Total assets
    
    $
    64,722,558
    
    
    $
    69,020,316LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    5,104,095
    
    
    $
    6,868,037Accrued liabilities
    
    
    3,932,650
    
    
    
    3,269,335Short-term borrowings
    
    
    134,329
    
    
    
    154,793Current
portion of deferred gain on sale leaseback
    
    
    152,976
    
    
    
    Current portion of long-term debt and capital lease obligation
    
    
    335,197
    
    
    
    487,449Liabilities related to assets held for sale
    
    
    456,600
    
    
    
    764,449Total current liabilities
    
    
    10,115,847
    
    
    
    11,544,063Deferred gain on sale leaseback
    
    
    572,831
    
    
    
    Long-term debt and capital lease obligations
    
    
    3,722,392
    
    
    
    3,728,126Total liabilities
    
    
    14,411,070
    
    
    
    15,272,189Commitments and contingenciesShareholders equity:Preferred stock - Series B, $.001 par value - authorized 2,500,000 shares,
issued 100,000 shares
    
    
    462,500
    
    
    
    462,500Common stock, $.001 par value - authorized 65,000,000 shares, issued
45,644,052 (April 30, 2004) and 45,439,893 (July 31, 2003 )
    
    
    46,019
    
    
    
    45,815Capital in excess of par value
    
    
    83,801,608
    
    
    
    83,115,158Accumulated other comprehensive loss
    
    
    (73,258
    )
    
    
    (75,644
    )Accumulated deficit
    
    
    (33,354,008
    )
    
    
    (29,228,329
    )Common stock in treasury, at cost, 225,100 shares (April 30, 2004)
and 225,100 shares (July 31, 2003)
    
    
    (571,373
    )
    
    
    (571,373
    )Total shareholders equity
    
    
    50,311,488
    
    
    
    53,748,127Total liabilities and shareholders equity
    
    $
    64,722,558
    
    
    $
    69,020,316
 See notes to unaudited condensed consolidated financial statements. 3




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ZILA, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
(UNAUDITED) Three months ended April 30,
    
    Nine months ended April 30,2004
    
    2003
    
    2004
    
    2003Net revenues
    
    $
    12,650,241
    
    
    $
    12,424,552
    
    
    $
    38,306,675
    
    
    $
    35,136,507Operating costs and expenses:Cost of products sold
    
    
    4,794,450
    
    
    
    5,132,406
    
    
    
    15,465,839
    
    
    
    14,301,338Marketing and selling
    
    
    3,545,615
    
    
    
    2,829,894
    
    
    
    10,651,609
    
    
    
    8,410,356General and administrative
    
    
    2,892,957
    
    
    
    3,176,077
    
    
    
    9,908,324
    
    
    
    9,544,111Severance and related charges
    
    
    142,522
    
    
    
    251,309
    
    
    
    296,723
    
    
    
    1,310,305Research and development
    
    
    1,994,229
    
    
    
    940,507
    
    
    
    4,175,916
    
    
    
    2,521,569Depreciation and amortization
    
    
    711,802
    
    
    
    615,704
    
    
    
    2,101,224
    
    
    
    1,828,55914,081,575
    
    
    
    12,945,897
    
    
    
    42,599,635
    
    
    
    37,916,238Loss from Operations
    
    
    (1,431,334
    )
    
    
    (521,345
    )
    
    
    (4,292,960
    )
    
    
    (2,779,731
    )Other income (expense)Gain on asset sale
    
    
    
    
    
    
    
    
    
    
    470,462
    
    
    
    Interest income
    
    
    24,835
    
    
    
    964
    
    
    
    76,921
    
    
    
    13,399Interest expense
    
    
    (95,796
    )
    
    
    (98,745
    )
    
    
    (241,727
    )
    
    
    (262,911
    )Other expense
    
    
    (64,644
    )
    
    
    (19,729
    )
    
    
    (109,125
    )
    
    
    (94,865
    )(135,605
    )
    
    
    (117,510
    )
    
    
    196,531
    
    
    
    (344,377
    )Loss before accounting change
    
    
    (1,566,939
    )
    
    
    (638,855
    )
    
    
    (4,096,429
    )
    
    
    (3,124,108
    )Cumulative effect of accounting change
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4,084,193
    )Net loss
    
    
    (1,566,939
    )
    
    
    (638,855
    )
    
    
    (4,096,429
    )
    
    
    (7,208,301
    )Preferred stock dividends
    
    
    9,750
    
    
    
    9,750
    
    
    
    29,250
    
    
    
    29,250Net loss attributable to common shareholders
    
    $
    (1,576,689
    )
    
    $
    (648,605
    )
    
    $
    (4,125,679
    )
    
    $
    (7,237,551
    )Basic and diluted net loss per common share:Loss before accounting change
    
    $
    (0.03
    )
    
    $
    (0.01
    )
    
    $
    (0.09
    )
    
    $
    (0.07
    )Accounting change
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (0.09
    )Net Loss
    
    $
    (0.03
    )
    
    $
    (0.01
    )
    
    $
    (0.09
    )
    
    $
    (0.16
    )Weighted average number of shares outstandingBasic and diluted
    
    
    45,373,409
    
    
    
    45,133,295
    
    
    
    45,296,744
    
    
    
    45,104,341Net loss
    
    $
    (1,566,939
    )
    
    $
    (638,855
    )
    
    $
    (4,096,429
    )
    
    $
    (7,208,301
    )Foreign currency translation adjustments
    
    
    7,456
    
    
    
    (1,085
    )
    
    
    2,386
    
    
    
    4,557Comprehensive loss
    
    $
    (1,559,483
    )
    
    $
    (639,940
    )
    
    $
    (4,094,043
    )
    
    $
    (7,203,744
    )
 See notes to unaudited condensed consolidated financial statements. 4




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ZILA, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED) Nine months ended April 30,2004
    
    2003Operating activities:Net loss
    
    $
    (4,096,429
    )
    
    $
    (7,208,301
    )Adjustments to reconcile net loss to net cash used in operating activities:Depreciation and amortization expense
    
    
    2,101,224
    
    
    
    1,828,559Gain on asset sale
    
    
    (470,462
    )
    
    
    Other
    
    
    
    
    
    
    (85,551
    )Noncash
research and development expense
    
    
    216,563
    
    
    
    Warrants issued for services
    
    
    
    
    
    
    70,568Change in accounting method
    
    
    
    
    
    
    4,084,193Change in assets and liabilities:Receivables - net
    
    
    (1,465,209
    )
    
    
    (3,693,417
    )Inventories - net
    
    
    1,301,688
    
    
    
    2,187,015Prepaid expenses and other assets
    
    
    (354,138
    )
    
    
    (1,905,850
    )Accounts payable and accrued liabilities
    
    
    (1,384,262
    )
    
    
    2,563,104Net cash used in operating activities
    
    
    (4,151,025
    )
    
    
    (2,159,680
    )Investing activitiesProceeds from sale leaseback transaction
    
    
    1,721,876
    
    
    
    Additions to property and equipment, net
    
    
    (721,750
    )
    
    
    (662,579
    )Additions to intangible assets
    
    
    (693,157
    )
    
    
    (191,627
    )Net cash provided by (used in) investing activities
    
    
    306,969
    
    
    
    (854,206
    )Financing activities:Net proceeds (repayments) from short-term borrowings
    
    
    (20,464
    )
    
    
    3,006,441Net proceeds from issuance of common stock
    
    
    442,063
    
    
    
    63,784Acquisition of treasury stock
    
    
    
    
    
    
    (36,253
    )Dividends paid to preferred shareholders
    
    
    (19,500
    )
    
    
    (29,250
    )Restricted cash deposited to collaterize letter of credit
    
    
    (516,809
    )
    
    
    Proceeds from long-term debt
    
    
    
    
    
    
    248,540Repayment of long-term debt
    
    
    (363,145
    )
    
    
    Net cash (used in) provided by financing activities
    
    
    (477,855
    )
    
    
    3,253,262(Decrease) increase in cash and cash equivalents
    
    
    (4,321,911
    )
    
    
    239,376Cash and cash equivalents, beginning of period
    
    
    16,160,484
    
    
    
    1,604,205Cash and cash equivalents, end of period
    
    $
    11,838,573
    
    
    $
    1,843,581Cash paid during the period for:Cash paid for interest
    
    $
    117,773
    
    
    $
    139,558Cash paid for income taxes
    
    $
    192,000
    
    
    $
    192Non-cash financing activities:Capital lease obligation for new equipment
    
    $
    205,159
    
    
    $
    Liability
satisfied through the issue of warrants
    
    $
    28,028
    
    
    $
    
 See notes to unaudited condensed consolidated financial statements. 5




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ZILA, INC. AND SUBSIDIARIES 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 1. ORGANIZATION AND BASIS OF PRESENTATION Zila, Inc. and its subsidiaries are innovators in preventative healthcare
technologies and products, focusing on enhanced body defense and the detection
of pre-disease states. Zilas business units are aligned under three reporting
segments: Zila Nutraceuticals, Zila Pharmaceuticals and Zila Biotechnology. In
this Report, Zila, the Company, we, us, or our refer to Zila, Inc.
and its wholly-owned subsidiaries. Zila Nutraceuticals manufactures and markets patented Ester-C®, a branded,
highly effective form of vitamin C sold in 43 countries worldwide and commenced
its first commercial shipments of Ester-E, an enhanced form of vitamin E, in
May 2004. Zila Nutraceuticals includes Oxycal Laboratories, Inc., an Arizona
corporation (Oxycal), and its subsidiary, Zila Nutraceuticals, Inc.
(Nutraceuticals), also an Arizona corporation. Zila Pharmaceuticals includes Zila Pharmaceuticals, Inc. and the ViziLite®
chemiluminescent disposable light product for the illumination of oral mucosal
abnormalities, Peridex® prescription mouth rinse, the Zilactin® family of
over-the-counter products (OTC), and the plastic molded products of Zila Swab
Technologies, Inc., an Arizona corporation dba Innovative Swab Technologies
(IST) - see Note 5. Zila Biotechnology is a research, development and licensing business
specializing in pre-cancer/cancer detection through its patented Zila®Tolonium
Chloride (ZTC) and OraTest® technologies and managing the OraTest® product,
an oral cancer diagnostic system, which is currently in Food and Drug
Administration (FDA) phase III clinical trials. The accompanying unaudited quarterly financial statements represent the
consolidation of Zila, Inc. and its wholly-owned subsidiaries, Zila
Pharmaceuticals, Inc., Zila International, Inc., Zila, Ltd., Zila
Biotechnology, Inc., Bio-Dental Technologies Corporation (Bio-Dental), which
did business under the name Zila Dental Supply (ZDS), Zila Technical, Inc.,
Zila Technologies, Inc., Zila Swab Technologies, Inc. (ZST) dba Innovative
Swab Technologies (IST) (See Note 5) and Oxycal Laboratories, Inc.
(Oxycal). This information should be read in conjunction with the financial
statements set forth in the Zila, Inc. Annual Report on Form 10-K for the
fiscal year ended July 31, 2003. All significant intercompany balances and
transactions have been eliminated in consolidation. We reclassified certain
prior period amounts to conform to the current period presentation. Our unaudited consolidated financial statements have been prepared in
accordance with accounting principles generally accepted in the United States
of America for interim financial information. Accordingly, such financial
statements do not include all the information and footnotes required by
accounting principles generally accepted in the United States of America for
annual financial statements. In the opinion of management, the accompanying
condensed consolidated financial statements reflect all adjustments (which are
of a normal recurring nature) that are necessary for a fair presentation of the
interim results of operation, financial position and cash flows. The results
reported in these interim condensed consolidated financial statements should
not be regarded as being necessarily indicative of results that might be
expected for the full year. 6




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2. STOCK-BASED COMPENSATION We have stock option incentive plans for our employees and directors. As
permitted by SFAS No. 123, Accounting for Stock-based Compensation (SFAS
No.123), we apply the provisions of APB Opinion No. 25, Accounting for Stock
Issued to Employees, and related interpretations, in accounting for
compensation expense for grants of equity instruments under these plans.
Accordingly, no compensation cost is recognized for the stock options, because
all options granted under those plans had an exercise price equal to the market
value of the underlying common stock on the date of grant. The following table illustrates the effect on net loss attributable to
common shareholders and on loss per share if we had applied the fair value
based recognition method of SFAS No. 123 to stock-based employee compensation. Three months ended
    
    Nine months endedApril 30,
    
    April 30,2004
    
    2003
    
    2004
    
    2003Net loss attributable to common shareholders as reported
    
    $
    (1,576,689
    )
    
    $
    (648,605
    )
    
    $
    (4,125,679
    )
    
    $
    (7,237,551
    )Deduct: Stock-based employee compensation expense
determined under fair value based method for all
awards, net of related tax effects
    
    
    158,257
    
    
    
    35,170
    
    
    
    762,769
    
    
    
    323,289Pro forma net loss attributable to common shareholders
    
    $
    (1,734,946
    )
    
    $
    (683,775
    )
    
    $
    (4,888,448
    )
    
    $
    (7,560,840
    )Net loss attributable to common shareholders per basic
and diluted share outstanding:As reported
    
    $
    (0.03
    )
    
    $
    (0.01
    )
    
    $
    (0.09
    )
    
    $
    (0.16
    )Pro forma
    
    $
    (0.04
    )
    
    $
    (0.02
    )
    
    $
    (0.11
    )
    
    $
    (0.17
    )
 The fair value was estimated using the Black-Scholes option pricing model
with the following assumptions used for grants: risk-free interest rates of 3.39% and 2.93%, respectively;
expected volatility of 64% and 90%, respectively; expected terms of 5.7 years
and 5.2 years, respectively; and dividend yield of 0% for both quarters. Warrants issued for services are valued on the measurement date and
expensed when the warrant holders performance is complete. The measurement
date is generally the earlier of the date at which a commitment for performance
by the warrant holder to earn the warrant is reached or the date at which the
warrant holders performance is complete. 3. NET LOSS PER COMMON SHARE Since a loss from continuing operations was incurred for the three and
nine month periods ended April 30, 2004 and 2003, potentially dilutive shares
applicable to convertible preferred stock, options, and warrants to purchase
shares of common stock were not included in the computation of diluted net loss
per common share because their effect would be antidilutive. Potentially
dilutive common shares for the three month and nine month periods ended April
30, 2004 were 848,070 and 817,883, respectively, and for the three and nine
month periods ended April 30, 2003 were 69,528 and 77,121, respectively.
Dilutive common shares give effect to securities, such as stock options,
warrants and convertible preferred stock, which have the potential to be
exercised. The increase in the number of potentially dilutive shares in the
three and nine month periods ended April 30, 2004, over the prior year periods
results primarily from the increase in the current market price of our common
stock in comparison to the exercise price of our outstanding stock options,
warrants and convertible preferred stock. 7




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4. INVENTORIES Inventories consist of the following: April 30,
    
    July 31,2004
    
    2003Finished goods
    
    $
    2,292,661
    
    
    $
    2,200,814Work in process
    
    
    385,394
    
    
    
    501,389Raw materials
    
    
    4,046,108
    
    
    
    5,499,945Inventory reserves
    
    
    (178,247
    )
    
    
    (354,544
    )$
    6,545,916
    
    
    $
    7,847,604
 5. ASSETS HELD FOR SALE 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 included in
our Pharmaceuticals Business Unit. As of April, 30, 2004, we reclassified all
of the assets and related liabilities to assets held for sale and
liabilities related to assets held for sale, respectively. We anticipate that
the sale of ISTs net assets will be completed within the next twelve months
and believe that the fair value less costs to sell of these net assets will be equal to
or above their carrying values. However, the estimate of fair value
less costs to sell may be revised in future periods based on negotiations for the sale of these
net assets. In April 2004, we ceased depreciation and amortization of ISTs
assets. After the sale of IST, we anticipate that IST will continue to
produce plastic molded products for us and, therefore, the
divestiture has not been presented as a discontinued operation. Summarized balance sheet information for IST is set forth below: April 30,
    
    July 31,2004
    
    2003Current assets
    
    $
    553,847
    
    
    $
    1,154,007Property, plant and equipment, net
    
    
    1,241,733
    
    
    
    1,318,514Patents, net
    
    
    268,275
    
    
    
    402,275Other
    
    
    7,610
    
    
    
    45,549Total assets held for sale
    
    $
    2,071,465
    
    
    $
    2,920,345Current liabilities
    
    
    456,600
    
    
    
    764,449Total liabilities related to assets held for sale
    
    $
    456,600
    
    
    $
    764,449
 IST has future minimum lease payments of $284,000 due under a
non-cancelable operating lease. 6. INTANGIBLE ASSETS As of August 1, 2002, we adopted SFAS No. 142, Goodwill and Other
Intangible Assets (SFAS No. 142). SFAS No. 142 specifies that goodwill and
certain intangible assets with indefinite lives no longer be amortized but
instead be subject to annual impairment testing using a fair value methodology.
We elected to test annually for goodwill impairment in our third quarter ended
April 30. Goodwill of a reporting unit will also be tested for impairment
between annuals tests if a triggering 8




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event occurs, as defined by SFAS No. 142, which could potentially reduce
the fair value of the reporting unit below its carrying value. We stopped amortizing goodwill effective August 1, 2002. We also
determined that purchased technology rights, patents and trademarks and other
intangible assets had finite lives and, therefore, no transitional impairment
test was required. Under the impairment testing required by SFAS No. 142, we determined that
impairment existed in the reporting units within the Pharmaceuticals Business
Unit as of August 1, 2002, and a non-cash charge of $4.1 million was recorded.
The fair value of the reporting units was estimated using the expected present
value of future cash flows. We completed our fiscal year 2004 goodwill impairment test of our
identified reporting units as of April 30, 2004, and determined that there has
been no additional goodwill impairment. Intangible assets with finite lives will continue to be amortized over
their respective useful lives and will be tested for impairment in accordance
with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived
Assets (SFAS No. 144). A summary of intangible assets is presented below: April 30, 2004
    
    July 31,2003Gross
    
    
    
    
    
    Net
    
    Gross
    
    
    
    
    
    NetCarrying
    
    Accumulated
    
    Carrying
    
    Carrying
    
    Accumulated
    
    CarryingAmount
    
    Amortization
    
    Amount
    
    Amount
    
    Amortization
    
    AmountAmortizable intangibles:Purchased technology
rights
    
    $
    7,419,473
    
    
    $
    3,789,516
    
    
    $
    3,629,957
    
    
    $
    7,419,473
    
    
    $
    3,430,509
    
    
    $
    3,988,964Trademarks and other
intangible assets:Trademarks
    
    
    11,622,158
    
    
    
    3,003,960
    
    
    
    8,618,198
    
    
    
    11,574,237
    
    
    
    2,652,207
    
    
    
    8,922,030Patents
    
    
    2,962,656
    
    
    
    755,283
    
    
    
    2,207,373
    
    
    
    2,621,843
    
    
    
    710,541
    
    
    
    1,911,302Licensing costs
    
    
    2,984,032
    
    
    
    692,274
    
    
    
    2,291,758
    
    
    
    2,709,144
    
    
    
    488,084
    
    
    
    2,221,060Other
    
    
    553,919
    
    
    
    285,310
    
    
    
    268,609
    
    
    
    536,180
    
    
    
    272,825
    
    
    
    263,355Total trademarks and
other intangible assets
    
    
    18,122,765
    
    
    
    4,736,827
    
    
    
    13,385,938
    
    
    
    17,441,404
    
    
    
    4,123,657
    
    
    
    13,317,747Total amortizable
intangible assets
    
    
    25,542,238
    
    
    
    8,526,343
    
    
    
    17,015,895
    
    
    
    24,860,877
    
    
    
    7,554,166
    
    
    
    17,306,711Unamortizable intangible asset:Goodwill
    
    
    12,400,716
    
    
    
    5,470,524
    
    
    
    6,930,192
    
    
    
    12,400,716
    
    
    
    5,470,524
    
    
    
    6,930,192Total intangible assets
    
    $
    37,942,954
    
    
    $
    13,996,867
    
    
    $
    23,946,087
    
    
    $
    37,261,593
    
    
    $
    13,024,690
    
    
    $
    24,236,903
 Intangible asset amortization
expense for the three months and nine months ended April 30, 2004 was $348,000
and $1,140,000, respectively. For fiscal years 2004 through 2008, the
amortization of intangibles is estimated to be $1.4 million each year. The net carrying amounts of goodwill by segment at April 30, 2004 and July
31, 2003 follow: 9




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Zila Nutraceuticals
    
    $
    2,896,926Zila Pharmaceuticals
    
    
    4,033,266Total
    
    $
    6,930,192
 7. SHORT-TERM BORROWINGS, LONG-TERM DEBT AND LEASE OBLIGATIONS At April 30, 2004, we had (i) short-term notes payable of $133,000 at 5.6%
for installments due on various insurance policies and (ii) a short-term
equipment loan of $1,000. On August 27, 2001, we entered into a Loan and Security Agreement (the
Congress Agreement) with Congress Financial Corporation (Congress) whereby
Congress would provide a $12 million revolving line of credit to us at an
interest rate equal to the prime rate plus 3/4 percent or 4.75 percent at April
30, 2004. The amount of funding available to us from the line of credit is
based upon a percentage of the value of eligible receivables and inventory
which were $8.5 million as of April 30, 2004. The obligations under the
Congress Agreement are collateralized by various assets, including, but not
limited to, trade accounts receivable, inventories, equipment and intangible
assets of certain of our operating subsidiaries. We and all of our direct and
indirect operating subsidiaries guarantee the obligations under the Congress
Agreement. Under the Congress Agreement, we are required to maintain adjusted
tangible net worth, as defined, of $12 million. At April 30, 2004, our adjusted tangible net
worth, as defined, was $27.2 million. The Congress Agreement expires August 17,
2004. There were no borrowings outstanding under this line of credit as of
April 30, 2004. On February 6, 2004, we entered into a Credit and Security Agreement with
Wells Fargo Business Credit (WFBC) that will provide a $10 million revolving
line of credit. We will not be able to borrow under this agreement until the
expiration of the Congress Agreement on August 17, 2004, and the perfection of
certain security interests by WFBC. This credit facility will bear interest
equal to the prime rate. Funds available under the line of credit will be based
upon a percentage of the value of eligible receivables and inventory. Under
this agreement, financial covenants will require maintenance of minimum net
worth levels and limitations on the amount of capital expenditures. On December 18, 2002, we entered into an agreement with PharmaBio
Development, Inc., (PharmaBio) the strategic investment group of Quintiles
Transnational Corp., whereby PharmaBio invested $500,000 in us. In return for
the investment, we agreed to pay to PharmaBio an amount equal to 5% of all net
sales of the OraTest® product in the European Union and the United States (the
Royalty). The aggregate amount of the Royalty cannot exceed $1.25 million.
Any Royalty due is to be paid quarterly. The investment was recorded as
long-term debt and will be amortized using the effective interest method. In April 1999, Zila Nutraceuticals, through Oxycal, entered into a
transaction with The Industrial Development Authority of the County of Yavapai
(the Authority) in which the Authority issued $5.0 million in Industrial
Development Revenue Bonds (the Bonds). The proceeds were loaned to Zila
Nutraceuticals for the construction of a new manufacturing and laboratory
facility. As of April 30, 2004, the Bonds outstanding consisted of $3.3 million
Series A bonds, which bear a variable interest rate that was 1.3% at April 30,
2004. The Bonds mature in 2019. In connection with the issuance of the Bonds,
the Authority required that Zila Nutraceuticals obtain, for the benefit of the
Bondholders, an irrevocable direct-pay letter of credit to secure payment of
principal and interest. We 10




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guaranteed the letter of credit. The previous letter of credit expired on
March 15, 2004, and we obtained a replacement letter of credit through Wells
Fargo Business Credit, Inc. that expires on March 15, 2009. We guaranteed the
replacement letter of credit. Under the terms of the Reimbursement Agreement between Zila Nutraceuticals
and WFBC for the replacement letter of credit, on February 6, 2004 we placed
$517,000 in a cash collateral account representing the difference between the
letter of credit amount and the maximum commitment amount defined in the
Reimbursement Agreement. During the nine months ended April 30, 2004, we entered into capital lease
arrangements for equipment of $205,000 with terms from three to five years.
Total capital lease obligations at April 30, 2004 were $187,000. As described in Note 11, in January 2004, we executed the sale and a
five-year operating leaseback of our headquarters facility. The initial monthly
payment is $14,000 and the payment will increase 2% annually over the five-year
term of the lease. We remain responsible for real property taxes, insurance and
maintenance. Our future minimum lease payments under non-cancelable operating leases
are as follows: Remaining
2004
    
    $
    238,0922005
    
    
    435,0852006
    
    
    212,6062007
    
    
    172,0562008
    
    
    175,5002009
    
    
    88,620Total
    
    $
    1,321,959
 8. SEVERANCE AND RELATED CHARGES We incurred severance and other costs related to employee terminations,
recruiting fees and relocation expenses of $143,000 and $297,000, respectively,
during the three months and nine months ended April 30, 2004, and $251,000 and
$1,310,000, respectively, during the three months and nine months ended April
30, 2003. 9. INCOME TAXES Deferred income taxes reflect the tax effect of temporary differences
between the amounts of assets and liabilities recognized for financial
reporting and income tax purposes. At the end of each fiscal quarter, we
estimate the effective tax rate expected to be applicable for the full fiscal
year. The rate so determined is used in providing for income taxes on a
current year-to-date basis. In the nine months ended April 30, 2004 and April
30, 2003, we recorded a tax benefit based on the effective tax rate and
generally offset the tax benefit with an increase in the deferred tax asset
valuation reserve. At April 30, 2004, we recorded total net deferred tax assets of
approximately $6.3 million. The total deferred tax assets were offset with a
valuation allowance due to our lack of an earnings history. We believe that
the valuation allowance reduces deferred tax assets to the amount representing
our best estimate of the amount of such deferred tax assets that more likely
than not will be realized. 11




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At April 30, 2004, the Company had income tax net operating loss carry
forwards of approximately $11.1 million that expire in fiscal years 2009
through 2024. 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: (i) the Nutraceuticals Business Unit, which includes Oxycal
Laboratories, Inc. and its wholly-owned subsidiary, Zila Nutraceuticals, Inc.;
(ii) the Pharmaceuticals Business Unit, which includes Zila Pharmaceuticals,
Inc. and the ViziLite® chemiluminescent disposable light product for the
illumination of oral mucosal abnormalities, Peridex® prescription mouth rinse,
the Zilactin® family of over-the-counter products, and the plastic molded
products of IST; and (iii) the Biotechnology Business Unit, the research,
development and licensing business specializing in pre-cancer/cancer detection
through its patented ZTC® and OraTest® technologies and managing the OraTest®
product, an oral cancer diagnostic system currently in FDA phase III clinical
trials. We evaluate performance and allocate resources to segments based on
operating results. As further described in Note 5, 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. As of April, 30, 2004, we reclassified all of the assets and their
related liabilities to assets held for sale and liabilities related to
assets held for sale, respectively, and ceased depreciation and
amortization in April 2004. The table below presents information about reported segments for the three
months ended April 30, 2004 and 2003 (in thousands): Segments
    
    
    
    
    
    ReconcilingItemNutraceuticals
    
    Pharmaceuticals
    
    Biotechnology
    
    Corporate
    
    TotalNet revenues:2004
    
    $
    8,471
    (a)
    
    $
    4,179
    
    
    $
    
    
    
    $
    
    
    
    $
    12,6502003
    
    
    8,137
    (a)
    
    
    4,281
    
    
    
    7
    
    
    
    
    
    
    
    12,425Income (loss) before accounting change:2004
    
    
    1,756
    
    
    
    93
    
    
    
    (2,270
    )(c)
    
    
    (1,146
    )(b)
    
    
    (1,567
    )2003
    
    
    2,082
    
    
    
    253
    
    
    
    (1,463
    )
    
    
    (1,511
    )(b)
    
    
    (639
    )Depreciation and amortization:2004
    
    
    264
    
    
    
    266
    
    
    
    162
    
    
    
    20
    
    
    
    7122003
    
    
    257
    
    
    
    153
    
    
    
    176
    
    
    
    30
    
    
    
    616
 (a)
    
    Includes approximately $8,000 and $561,000 of net revenues in
the three months ended April 30, 2004 and 2003, respectively, for
saw palmetto products that were discontinued in fiscal 2003.(b)
    
    Includes approximately $143,000 and $251,000 of severance and
related costs in the three months ended April 30, 2004 and 2003,
respectively.(c)
    
    Includes a non-cash charge of $217,000 related to the release
of restrictions on certain shares of stock issued in connection with
the acquisition of the ViziLite® technology. The table below presents information about reported segments for the nine
months ended April 30, 2004 and 2003 and segment total assets as of April 30,
2004 and July 31, 2003 (in thousands): 12




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##### Table of Contents



ReconcilingSegments
    
    ItemNutraceuticals
    
    Pharmaceuticals
    
    Biotechnology
    
    Corporate
    
    TotalNet revenues:2004
    
    $
    24,073
    (d)
    
    $
    14,232
    
    
    $
    2
    
    
    $
    
    
    
    $
    38,3072003
    
    
    21,733
    (d)
    
    
    13,387
    
    
    
    17
    
    
    
    
    
    
    
    35,137Income (loss) before accounting change:2004
    
    
    4,197
    
    
    
    285
    
    
    
    (5,212
    )(f)
    
    
    (3,366
    )(e)
    
    
    (4,096
    )2003
    
    
    5,211
    
    
    
    837
    
    
    
    (3,782
    )
    
    
    (5,390
    )(e)
    
    
    (3,124
    )Depreciation and amortization:2004
    
    
    780
    
    
    
    733
    
    
    
    511
    
    
    
    77
    
    
    
    2,1012003
    
    
    776
    
    
    
    425
    
    
    
    537
    
    
    
    91
    
    
    
    1,829Total assets as of:April 30, 2004
    
    
    31,386
    
    
    
    12,980
    
    
    
    16,853
    
    
    
    3,504
    
    
    
    64,723July 31, 2003
    
    
    29,290
    
    
    
    14,473
    
    
    
    7,983
    
    
    
    17,274
    
    
    
    69,020
  (d)
    
    Includes approximately $45,000 and $1,876,000 of net revenues
in the nine months ended April 30, 2004, and 2003, respectively, for saw palmetto products that were discontinued in fiscal 2003.(e)
    
    Includes approximately $297,000 and $1,310,000 of severance and
related costs in the nine months ended April 30, 2004 and 2003,
respectively.(f)
    
    Includes a non-cash charge of $217,000 related to the release
of restrictions on certain shares of stock issued in connection with
the acquisition of the ViziLite® technology. 11. SALE AND LEASEBACK OF CORPORATE HEADQUARTERS As part of our strategy to employ financial assets in core business
competencies, on January 30, 2004, we completed the sale and a five-year
leaseback of our corporate headquarters for approximately $1.8 million in cash.
We realized a gain of $1.2 million, of which we recognized approximately
$470,000 in the quarter ended January 31, 2004. The $470,000 gain represents
the excess of the net proceeds over the net present value of the future lease
payments. The balance of the gain of $765,000 was deferred and will be
amortized on a straight-line basis over the five-year lease term as a reduction
of rent expense in general and administrative expenses. The leaseback is
accounted for as an operating lease. 12. COMMITMENTS AND CONTINGENCIES FDA approval of the OraTest® product In December 2002, we transitioned the OraTest clinical program to
Quintiles Transnational, the nations largest pharmaceutical services company.
This was the result of an extensive review of several proposals received from
some of the largest, highest quality and most prominent contract research
organizations with worldwide capabilities. Quintiles completed the transition
successfully without compromising the study data. Factors that will affect the
cost and timing of completion of the clinical program include but are not
limited to: (i) patient enrollment rates, (ii) tumor formation rate within the
study population, (iii) compliance with the study protocol and related
monitoring, (iv) level of available funding throughout the study, and (v)
protocol and clinical program modifications. 13




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##### Table of Contents



OraTest® Product At April 30, 2004,we had approximately $362,000 of ZTC drug substance,
the active ingredient in the OraTest® product, at our manufacturing facility in
Phoenix, AZ. We intend to realize the value of this drug substance during the
next twelve months (1) through its consumption during the conduct of the
clinical trials, toxicology studies and validation testing of our manufacturing
process and (2) through sales in Europe and Asia prior to the date that we
expect sales in the United States. The drug substance currently has expiration
dates in 2004, 2005 and 2006. Previous testing has indicated that the drug
substance is stable and we anticipate being able to extend the expiration dates
of the entire drug substance in the event that our plans are delayed. However,
no assurance can be given in this regard. ViziLite® On October 15, 2003, we completed a settlement agreement that was the
result of a mediated settlement with Trylon. As part of the settlement, we
agreed to eliminate the contractual restrictions relating to sales milestones
associated with 500,000 shares of the previously restricted common stock. The
contractual restrictions on 250,000 of these shares will be removed upon
achievement of a product development milestone. The contractual restrictions
on the remaining 250,000 shares will be removed upon Trylons obtaining of the
required governmental approvals relating to the product development milestone.
As part of the settlement, we also agreed that Trylons royalty rates for net
sales of the ViziLite product will be reduced from 10% to 5% for the first
five years, and from 5% to 2.5% for the second five years. Thereafter, the
royalty payments end. On March 26, 2004, we entered into a modification of the settlement
agreement with Trylon. The modification agreement addressed the timing for the
removal of contractual restrictions and escrow restrictions on 1,250,000 shares
of common stock issued in connection with the acquisition of the
ViziLite®
product from Trylon in December, 2001. The shares covered by the modification
agreement include the shares discussed above that were previously
covered in the October 15, 2003 settlement agreement. Upon execution of the
modification, we removed the contractual restrictions on 312,500 of the
1,250,000 shares in recognition of the achievement of a milestone. As
a result of this release of the restrictions, we recorded a non-cash
charge of approximately $217,000, reflecting the estimated difference
in the fair market value of these shares with and without the restrictions. If Trylon meets all of the timing requirements set forth in
the modification agreement with respect to achievement of another product development
milestone, we have agreed to release the contractual restrictions on the
remaining shares and to allow delivery to Trylon of 375,000 shares being held in
escrow. If Trylon fails to meet certain timing requirements, then contractual
restrictions may remain in place on some of the remaining shares and/or the
shares in escrow may be forfeited by Trylon. We may be required to
record additional charges in the fourth quarter of fiscal 2004 and in
later periods through 2011 in
connection with the achievement of product development milestones,
and completion of certain holding periods. Issuance of the 375,000
shares being held in escrow, should it occur, would result in a
charge equal to the fair market value of the shares on the date of
issuance. The charge would then be recorded as additional research
and development expense. We had $258,000 of ViziLite® product in inventory and approximately $2.0
million of associated intangible assets as of April 30, 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®. 14




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Litigation In connection with the acquisition of patent rights in 1980, we agreed to
pay to Dr. James E. Tinnell (Tinnell), the inventor of one of our treatment
compositions, a royalty of 5% of gross sales of the invention disclosed in his
then pending patent application. In September 2000, we notified Tinnell that we would no longer pay such
royalties since the obligations ceased in August 1998 when the related product
patents expired and we requested reimbursement of royalties paid since August
1998. We then filed suit in the Federal District Court requesting a declaratory
judgment that we had no royalty obligations to Tinnell and a judgment for the
overpaid royalties. Tinnell asserted several counterclaims. The Court has since
ruled in our favor stating that we do not owe royalty obligations to Tinnell
and denied several of Tinnells counterclaims. However, one of Tinnells
counterclaims is still outstanding for breach of contract. Furthermore, the
Court dismissed our request for reimbursement of overpaid royalties. Tinnell
filed a motion asking the trial court to certify the issue of our royalty
obligation for immediate appeal. We have joined the request and also asked the
trial court to certify the issue of our right to reimbursement of the overpaid
royalties. The trial court has Tinnells and Zilas joint motion under
advisement. We are subject to other legal proceedings and claims that arise in the
ordinary course of business. In the opinion of management, the amount of
ultimate liability with respect to these actions will not materially affect our
financial position or results of operations. Vital Health Sciences Ltd. License Agreement On October 31, 2003, we entered into a license agreement with Vital Health
Sciences Limited (Vital Health) of Australia that grants us the exclusive
rights in the dietary supplement market for certain issued and pending patents,
know-how and data pertaining to tocopherol phosphate in the United States,
Canada and Indonesia. The initial term of the license is five years, and we
have the right, unilaterally, to extend the term until the expiration of the
last of the licensed patents. Several of such patents are recently issued
while other patent applications are still pending. We also have a right of
first refusal for certain other international markets under the agreement.
Zila Nutraceuticals is currently using Vital Healths patented process for
manufacturing tocopherol phosphate, as well as numerous pending patent
applications, to develop its Ester-E product tailored for the dietary
supplement market. In May 2004, we commenced our first commercial shipments of
Ester-E product. Under the agreement, we are required to make royalty payments
based on certain levels of sales volume and subject to minimum annual
payment amounts, as defined. 13. SUBSEQUENT EVENT On May 20, 2004, our wholly-owned subsidiary, Zila Nutraceuticals, Inc.
entered into a three- year $18.1 million supply agreement with a major producer
of ascorbic acid. Ascorbic acid is the primary ingredient in our Ester-C®
products. Purchases under this agreement are scheduled to begin in July 2004.
The agreement provides a substantial portion of our current annual requirements
for ascorbic acid and will provide important cost predictability during the
term of the agreement. 15




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ZILA, INC. AND SUBSIDIARIES 
 Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations 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 document will, in fact,
transpire or prove to be accurate. Factors that could cause or contribute to our actual results differing
materially from those discussed herein or for our stock price to be adversely
affected include, but are not limited to: (i) our failure to maintain
compliance with the covenants of our outstanding debt instruments; (ii)
industry trends, including a downturn or slowing of the growth of the dietary
supplement industry and the consumer oral care, over-the-counter and
prescription industries; (iii) increased competition from current competitors
and new market entrants; (iv) our reliance on single source manufacturing
locations for several of our products; (v) adverse publicity regarding the
industries in which we market our products; (vi) our dependence upon our
ability to develop new products; (vii) our ability to gain or expand
distribution within new or existing channels of trade; (viii) an increase in
the cost of obtaining and maintaining shelf space with major national retailers
who demand various forms of incentives from their suppliers, such as slotting
fees, coop advertising, or rebates; (ix) adverse changes in government
regulations; (x) our suppliers and our ability to continue to comply with
current good manufacturing practices (cGMP) and other applicable regulatory
requirements; (xi) exposure to product liability claims; (xii) dependence on
significant customers; (xiii) our ability to keep and attract key management
employees; (xiv) our inability to manage growth and execute our business plan;
(xv) sales and earnings volatility; (xvi) volatility of the stock market;
(xvii) our reliance on independent brokers to sell many of our products;
(xviii) our inability to protect our intellectual property; (xix) impairment
charges resulting from an impairment of our goodwill and intangible assets;
(xx) our ability to secure long-term supply arrangements for a sufficient
quantity of ascorbic acid at stable and more traditional pricing levels; (xxi)
our ability to successfully complete the commercial launch of our Ester-E
product; (xxii) the market acceptance of the ViziLite® and Ester-E products;
(xxiv) our ability to complete a sale of the net assets of IST at their
carrying value or above; and (xxv) a general downturn in the national economy as a
whole. 16




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Included among the factors affecting the OraTest® product are (i)
successful completion of the clinical program; (ii) the FDAs decision
regarding the proposed modifications for the OraTest® clinical program; (iii)
our ability to accelerate, expand and fund the clinical study under terms that
are reasonable and prudent for us; (iv) the FDAs ultimate decision regarding
the OraTest® clinical program and product; (v) the length, size and expense of
our clinical program and the FDA review process; (vi) stability of the ZTC
drug substance; (vii) the limitations on indicated uses for which the OraTest®
product may be marketed if we receive FDA approval; and (viii) if approved, the
market reception to the OraTest® product and any post-marketing reports or
surveillance programs to monitor usage or side effects of the OraTest® product.
There can be no assurance that the forward-looking statements contained in this
document will, in fact, transpire or prove to be accurate. For a more detailed
description of these and other cautionary factors that may affect our future
results, please refer to our Annual Report on Form 10-K for the fiscal year
ended July 31, 2003 filed with the Securities and Exchange Commission. Critical Accounting Policies 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 at the date of shipment based upon
historical activity and current customer commitments. We also provide for an
allowance for doubtful accounts based on historical experience and a review of
our receivables. Receivables are presented net of an allowances for doubtful
accounts and for sales returns of $531,000 at April 30, 2004 and
$547,000 at
July 31, 2003. We evaluate these estimates on a quarterly basis and revise them
as necessary. On occasion, we enter into arrangements to license our technology on
specifically approved products. For those arrangements where we have continuing
involvement with the licensee, nonrefundable, upfront license fees are
recognized systematically as they are earned over the life of the agreement.
Fees associated with substantive, at risk, performance milestones are
recognized as revenue upon their completion, as defined in the respective
agreements. For perpetual licenses or manufacturing rights agreements, where
(i) we have no further continuing involvement with the licensee; (ii) the fees
are nonrefundable; and (iii) the fees are not a prepayment of future royalties,
we recognize the fees as revenue at the time the arrangement becomes effective.
The assessment of existence or extent of continuing involvement requires
significant judgment and analysis of the contractual requirements and other
factors relating to the business relationship between the parties. Use of Estimates- The preparation of financial statements in conformity
with accounting principles generally accepted in the United States of America
necessarily requires management to make estimates and assumptions that affect
the reported amounts of assets and liabilities, disclosure of contingent assets
and liabilities at the date of the financial statements and the reported
amounts of revenue and expenses during the reporting period. Actual results
could differ from those estimates. Significant estimates include the following: The cash flows used to measure long-lived assets related to the OraTest®
product are dependent upon obtaining FDA approval and generating sufficient
revenues from sales of the OraTest® product. The rigorous clinical testing and
an extensive regulatory approval process 17




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mandated by the FDA and equivalent foreign authorities before any new drug
can be marketed by us can take a number of years and require the expenditure of
substantial resources. However, obtaining such approvals and completing such
testing is a costly and time-consuming process, and approval may not be
ultimately obtained. The length of the FDA review period varies considerably,
as does the amount of clinical data required to demonstrate the safety and
efficacy of a specific product. Net long-lived assets related to the OraTest®
product as of April 30, 2004 of $5.7 million have been capitalized. The cash flows used to measure long-lived assets related to the ViziLite®
product are dependent upon our ability to market and sell the product to a
sufficient number of dental offices so it becomes integrated within their
practice and becomes a commercially viable product. ViziLite® is a
chemiluminescent light technology used in combination with traditional oral
screening methods 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, we have revised
our business model with current sales and costs assumptions. We have added
marketing, sales and educational costs targeted towards achieving market
acceptance within a reasonable timeframe. Net long-lived assets related to the
ViziLite® product as of April 30, 2004 of $2.0 million have been capitalized. We anticipate that our current cash balances, along with cash generated
from our Nutraceuticals and Pharmaceuticals business units and our line of
credit, will be adequate to support the activities described above for both the
Vizilite® and OraTest® products. Goodwill and Intangible Assets The following is a summary of goodwill
and the significant classes of intangible assets and our impairment methodology
for each. In accordance with SFAS No. 142, our policy is to review the carrying
amounts of goodwill at least annually or whenever events or changes in
circumstances indicate that the carrying amount of the asset may not be
recoverable. Such events or circumstances might include a significant decline
in market share, a significant decline in profits, rapid changes in technology,
significant litigation or other items. In evaluating the recoverability of
goodwill and certain intangible assets, our policy is to compare the carrying
amounts of such assets with the estimated undiscounted future operating cash
flows. If we have changes in 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. We completed our fiscal year 2004 goodwill impairment test
of our identified reporting units as of April 30, 2004, and determined that
there was no goodwill impairment. OraTest®- The recoverability of the $3.6 million net purchased technology
rights is dependent upon obtaining FDA approval and generating sufficient
revenues from future sales of the OraTest® products. Net fixed assets of
approximately $751,000 (primarily related to a manufacturing facility), patents
and patents pending of $1.3 million, and $577,000 of active ingredient and
related components associated with the OraTest® products are grouped with the
purchased technology rights for the purpose of testing recoverability. We have
prepared a probability-weighted analysis of potential future cash flows under
various possible outcomes. Significant assumptions in the analysis include the
expected date and overall likelihood of FDA approval, cost of the remaining
phase III clinical trials, cost of the marketing roll out, future net cash
flows associated with sales of the products and the probabilities assigned to
each possible outcome. The assumptions included in the analysis are updated
whenever events or changes in circumstances indicate that the carrying amount
may not be recoverable. 18




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Zila Pharmaceuticals Goodwill This goodwill is related to the Peridex®
product that was acquired from Procter & Gamble in November 1997 and to the IST
acquisition that occurred in February 2001. As part of the implementation of
SFAS No. 142, Goodwill and Other Intangible Assets on August 1, 2002, we
retained an independent financial advisor who compared the fair values and
corresponding carrying values of the Peridex® and IST assets as of the adoption
date for SFAS No. 142. Based upon the financial advisor findings, we determined
that approximately $4.1 million of goodwill was impaired, thus reducing
goodwill to approximately $4.0 million (net of accumulated amortization of $4.6
million). This transitional impairment charge of $4.1 million was recorded as a
change in accounting principle and retroactively restated to August 1, 2002,
the beginning of our fiscal year. Zila Nutraceuticals Goodwill and Intangibles- Goodwill and intangibles
totaling approximately $12.8 million, net of accumulated amortization of $4.2
million) are related to the Ester-C® group of products. These assets were
acquired by merger in 1997, and we forecast that cash flows associated with the
Ester-C®products will allow recovery of the total intangible asset balance in
approximately five years if net cash flows continue at current levels. Income Taxes We regularly review our deferred tax assets and related
valuation allowances in accordance with SFAS No. 109, Accounting for Income
Taxes. SFAS No. 109 requires us to assess all available evidence, both
positive and negative, to determine whether a valuation allowance is needed
based on the weight of that evidence. For the nine months ended April 30, 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.
As of April 30, 2004, all of our deferred tax assets were offset by a valuation
allowance. COMPANY OVERVIEW We are an innovator in preventative healthcare technologies with
nutraceutical, pharmaceutical and biotechnology products, focusing on enhanced
body defense and the detection of pre-disease states. In August 2002, in order
to support continued growth, we re-aligned several of our business units into
three focused operating divisions. Zila Nutraceuticals manufactures and markets
patented Ester-C®, a branded, highly effective form of vitamin C and Ester-E,
an enhanced form of vitamin E, a new product that commenced its first
commercial shipments in May 2004. Zila Pharmaceuticals includes the Zilactin®
family of over-the-counter products, Peridex® prescription mouth rinse, the
ViziLite® disposable light for illumination of oral mucosal abnormalities, and
the plastic molded products from Innovative Swab Technologies (IST). Zila
Biotechnology includes the OraTest® product, an oral cancer detection system,
and the ZTC technologies for cancer and pre-cancer detection. Our strategic approach to the management of our business units is driven
by our commitment to grow our Nutraceutical and Pharmaceutical businesses while
we successfully complete the OraTest® clinical trials. To that end, we are
investing more aggressively in our core nutraceutical and pharmaceutical
products to drive greater profitability and the required cash flows to fund the
research and development efforts being managed by the Biotechnology Business
Unit. In doing so, our corporate goal is to manage the entire portfolio of
business units in a manner such that over the course of a given fiscal year,
our earnings before interest, taxes, depreciation and amortization
(EBITDA) would be at
a near break-even level. We expect to continue with this goal until such time
as we obtain the requisite clearances from the U.S. Food and Drug
Administration (FDA) to bring our OraTest® product to market in the United
States. Market forces, such as the market acceptance of new products such as
our new Ester-E, and other such variables and risk factors, can and do
influence our ability to accomplish this goal. We will fall short of
this goal in fiscal 2004 due primarily to the impact of abnormally
high ascorbic acid costs that reduced our profit margins on our
Ester-C® products, the launch of Ester-E, that was delayed
until May 2004, and
accelerated biotechnology investment. See page 16 for further
discussion of the risk factors that we face in our businesses. Additionally,
our 19




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level of research and development activities, and the associated cost,
will likely trend above our historical levels as we accelerate our efforts to
advance our clinical program. Unless our other business units produce
a sufficient, higher level of EBITDA to offset these additional
costs, we will operate on a slightly negative EBITDA basis during
such period. We believe that our current cash balances, cash
generated from our operations, net proceeds from our investing
activities through the planned sale of IST and the availability of
cash under our line of credit are sufficient to finance our level of
operations, the OraTest® clinical program, the launch of
Ester-ETM, and anticipated capital expenditures during
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 are
currently assimilating and implementing the FDAs non-binding comments to
our proposed program modifications. In the meantime, we continue to collect
patient data from our on-going phase III clinical trial and we are preparing for
execution of the program modification. In this regard, we held a
clinical investigator meeting in Europe in early May with over 30
investigators from the UK, France and Germany. 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 included within
our Pharmaceuticals Business Unit. We anticipate that the sale of ISTs net
assets will be completed within the next twelve months and believe that the
fair value less costs to sell of these net assets will be equal to or above their carrying
values. However, the estimate of fair value less costs to sell may be revised in future
periods based on negotiations for the sale of these net assets. Effective March 31, 2004, ISTs contract with a major customer expired.
Sales under this contract represented approximately 80% of ISTs net revenues.
Cost reduction measures underway at IST will mitigate the loss of net revenues
at IST until new customer arrangements replace the loss of this contract. The following discussion should be read in conjunction with the
accompanying unaudited Condensed Consolidated Financial Statements and Notes to
Condensed Consolidated Financial Statements (Unaudited). RESULTS OF OPERATIONS Comparison of the three months ended April 30, 2004 with the three months ended
April 30, 2003 Total Company Net revenues increased 1.8% to $12.7 million for the three months ended
April 30, 2004, compared to revenues of $12.4 million for the three months
ended April 30, 2003. The increase is due to a 4.1% sales increase in the
Nutraceuticals Business Unit, reduced by a 2.4% decrease in the Pharmaceuticals
Business Unit. When the sales of the discontinued Saw Palmetto oil product line
are removed from the prior year, net revenues increased 11.7% at Nutraceuticals
and 6.6% for the total Company. Increased spending on advertising and
promotional programs contributed to the sales increases. Cost of products sold as a percentage of net revenues decreased to 37.9%
from 41.3% for the three months ended April 30, 2004. This decrease resulted
primarily from the effect of sales of the low 20




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margin saw palmetto products in the prior year in our Nutraceuticals
Business Unit as we sought to liquidate our remaining inventories. This
decrease was partially offset by higher product costs related to increased
manufacturing costs in the Pharmaceuticals Business Unit. Marketing and selling expenses for the three months ended April 30, 2004
as a percentage of net revenues increased to 28.0% from 22.8%. This increase
was primarily due to heavy brand and media advertising support for the
Nutraceuticals Business Unit product, Ester-C®. General and administrative expenses were $2.9 million, or 22.9% of net
revenues, for the three months ended April 30, 2004, compared to $3.2 million,
or 25.6% of net revenue, for the three months ended April 30, 2003. Legal fees
of $164,000 associated with the Beutlich and Trylon settlements in this
quarter, diminished the cost reductions over the previous year. Severance and related charges incurred in connection with employee
terminations, recruiting fees and relocation expenses were $143,000 in the
three months ended April 30, 2004, compared to $251,000 in the three months
ended April 30, 2003. Higher severance and related charges were incurred in the
prior year period due primarily to the significant changes in Company
management, focus and the resulting organization. Research
and development expenses increased $1.1 million, or 112.0%, to
$2.0 million for the three months ended April 30, 2004 from $941,000 in the three
months ended April 30, 2003. The increase is due primarily to an increase in
the OraTest® phase III clinical program expenses of $728,000, or
84.7%, and a noncash charge of $217,000 associated with the release
of restrictions on certain outstanding shares of stock that were
issued in connection with the ViziLite® acquisition. Depreciation and amortization expenses increased $96,000, or 15.6%, to
$712,000 for the three months ended April 30, 2004 from $616,000 for the three
months ended April 30, 2003. The increase was attributable primarily to
expenditures for property and equipment and patents and trademarks in the
Nutraceuticals and Pharmaceuticals business units. Nutraceuticals Business Unit Net revenues for the Nutraceuticals Business Unit for the three months
ended April 30, 2004 increased 4.1% to $8.5 million compared to $8.1 million
for the three months ended April 30, 2003. This growth was driven by an 11.7%
increase in Ester-C® sales for the three months ended April 30, 2004 over the
three months ended April 30, 2003, offset by the absence of saw palmetto oil
products revenue in fiscal year 2004. Domestic sales of Ester-C® grew by 21.5%
in the three months ended April 30, 2004 over the same period in the prior
year. Sales of Ester-C® during the quarter were driven principally by increased
radio and television advertising support for the Ester-C® products in our
continuing strategy of brand development. In 2003 we essentially completed our
strategic withdrawal from the saw palmetto market by selling our remaining
inventory of saw palmetto extracted oils. We continue to sell through our small
inventory of saw palmetto powder in the normal course of business in fiscal
year 2004. Cost of products sold as a percentage of net revenues for the
Nutraceuticals Business Unit decreased to 35.2% for the three months ended
April 30, 2004 compared to 40.5% for the three months ended April 30, 2003.
This decrease resulted primarily from the effect of sales of the low margin saw
palmetto products in the prior year in our Nutraceuticals Business Unit as we
sought to liquidate our remaining inventories and to a lesser extent to lower
ascorbic acid costs than were incurred in the second quarter of fiscal 2004. 21




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Ascorbic acid is the principal raw material in our Ester-C® products and
is subject to periodic price fluctuations. While ascorbic acid prices rose
dramatically during fiscal year 2003 and during the first half of fiscal year
2004, we have obtained a supply of ascorbic acid in sufficient quantities and
at prices equivalent to historical averages that provides cost predictability
through the end of fiscal year 2004. As described in Note 13, in May 2004 we
entered into a three-year supply agreement for ascorbic acid that will provide
a substantial portion of our current annual requirements and will provide
important cost predictability during the term of the agreement. We continue to
actively pursue lower cost extended supply arrangements for our remaining
expected needs. On April 1, 2003, a price increase for Ester-C® products was
instituted to partially offset the effects of the higher ascorbic acid prices. Pharmaceuticals Business Unit Net revenues for the Pharmaceuticals Business Unit decreased 2.4% to $4.2
million for the three months ended April 30, 2004 compared to net revenues of
$4.3 million for the three months ended April 30, 2003. The decline in net
revenues was caused by the loss of our major customer at IST upon the
expiration of our contract with this customer on March 31, 2004. Increased U.S.
wholesale demand in the current quarter for Peridex® was offset by decreased
net revenues for the Zilactin® line of products related to the quarterly timing
of customer purchases. Net revenues for the Zilactin® line of products peaked
in our last fiscal quarter due to a more severe cough/cold/flu season in
comparison to the prior year. Cost of products sold as a percentage of net revenues for the
Pharmaceuticals Business Unit increased to 42.2% during the three months ended
April 30, 2004 from 40.3% for the three months ended April 30, 2003, primarily
due to continuing production cost increases incurred as the transfer of certain
Zilactin® product to a contract manufacturer is completed. Biotechnology Business Unit There were no sales of the OraTest® product in the United Kingdom and the
Pacific Rim area during the three months ended April 30, 2004, as we
deemphasized international sales efforts in favor of focusing on obtaining FDA
approval in the United States. Total
operating expenses for the Biotechnology Business Unit were $2.2
million for the three months ended April 30, 2004, a 64.5% increase over the
$1.4 million for the three months ended April 30, 2003. This was driven by an
increase of approximately $728,000, or 84.7% in the phase III clinical trial
expenses related to the OraTest® product and a noncash charge
of $217,000 that was discussed above. Comparison of the nine months ended April 30, 2004 with the nine months ended April 30, 2003 Total Company Net revenues increased 9.0% to $38.3 million for the nine months ended
April 30, 2004, compared to revenues of $35.1 million for the nine months ended
April 30, 2003. The increase is due to a 10.8% net revenue increase in the
Nutraceuticals Business Units and an increase of 6.3% in the Pharmaceuticals
Business Unit. When the sales of the discontinued Saw Palmetto oil product line
are removed from the prior year, net revenues increased 21.0% at the
Nutraceuticals Business Unit and 15.0% for the total Company. Increased
spending in advertising and promotional programs contributed to the sales
increases. 22




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Cost of products sold as a percentage of net revenues decreased to 40.4%
from 40.7% for the nine months ended April 30, 2004. This
decrease is attributable primarily to the lower cost of product at
IST resulting from a March 2003 selling price increase offset by substantially higher costs for ascorbic acid, the principal raw
material used by the Nutraceuticals Business Unit in its Ester-C® products, and
increased product costs related to promotional activities and increased
manufacturing costs in the Pharmaceuticals Business Unit. Marketing and selling expenses as a percentage of net revenues increased
to 27.8% from 23.9% for the nine months ended April 30, 2004. This increase was
primarily due to heavy brand and media advertising support for the
Nutraceuticals Business Unit product, Ester-C®,and increased marketing support
for certain Pharmaceuticals Business Unit products. General
and administrative expenses were $9.9 million, or 25.9% of net
revenues, for the nine months ended April 30, 2004, compared to $9.5 million,
or 27.2% of net revenue, for the nine months ended April 30, 2003. Legal fees
of $900,000 associated with the Beutlich and Trylon settlements, offset cost
reductions over the previous year. Severance and related charges of $297,000 in connection with employee
terminations, recruiting fees and relocation expenses were incurred in the nine
months ended April 30, 2004, compared to $1,310,000 incurred in the nine months
ended April 30, 2003. Higher severance and related charges were incurred in the
prior year period due primarily to the significant changes in Company
management, focus and the resulting organization. Research
and development expenses increased $1.7 million, or 65.6%, to
$4.2 million for the nine months ended April 30, 2004 from $2.5 million for the
nine months ended April 30, 2003. The increase is due primarily to an increase
in the OraTest® phase III clinical program expenses of
$1.5 million, or 72.6%, and a noncash charge of $217,000
discussed above,
offset by a reduction in expenditures in the Pharmaceuticals Business Unit. Depreciation and amortization expenses increased $273,000, or 14.9%, to
$2.1 million for the nine months ended April 30, 2004 from $1.8 million for the
nine months ended April 30, 2003. The increase in depreciation and amortization
relates to expenditures for property and equipment and patents and trademarks
in the Nutraceuticals and Pharmaceuticals business units. Nutraceuticals Business Unit Net revenues for the Nutraceuticals Business Unit for the nine months
ended April 30, 2004 increased 10.8% to $24.1 million compared to $21.7 million
for the nine months ended April 30, 2003. This growth was driven by a 21.0%
increase in Ester-C® sales for the nine months ended April 30, 2004 over the
nine months ended April 30, 2003, partially offset by the absence of saw
palmetto oil products revenue in fiscal 2004 as we have exited that business.
Domestic sales of Ester-C® grew by 26.5% in the nine months ended April 30,
2004 over the same period in the prior year. Sales of Ester-C® were driven
principally by increased radio and television advertising support for the
Ester-C® products in our continuing strategy of brand development. In 2003 we
essentially completed our strategic withdrawal from the saw palmetto market by
selling our remaining inventory of saw palmetto extracted oils. We continue to
sell through our small inventory of saw palmetto powder in the normal course of
business. Cost of products sold as a percentage of net revenues for the
Nutraceuticals Business Unit increased to 38.6% for the nine months ended April
30, 2004 compared to 36.8% for the nine months ended April 30, 2003. This
increase was caused primarily by a $3.3 million increase in Ester-C® cost of
goods due to higher costs of ascorbic acid, principally in the first half of
fiscal 2004. 23




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Ascorbic acid is the principal raw material in our Ester-C® products and
is subject to periodic price fluctuations. While ascorbic acid prices rose
dramatically during fiscal year 2003 and during the first half of fiscal year
2004, we have obtained a supply of ascorbic acid in sufficient quantities and
at prices equivalent to historical averages that provides cost predictability
through the end of fiscal year 2004. As described in Note 13, in May 2004 we
entered into a three-year supply agreement for ascorbic acid that will provide
a substantial portion of our current annual requirements and will provide
important cost predictability during the term of the agreement. We continue to
actively pursue lower cost extended supply arrangements for our remaining
expected needs. On April 1, 2003, a price increase for Ester-C® products was
instituted to partially offset the effects of the higher ascorbic acid prices. Pharmaceuticals Business Unit Net revenues for the Pharmaceuticals Business Unit for the nine months
ended April 30, 2004 increased 6.3% to $14.2 million compared to $13.4 million
for the nine months ended April 30, 2003.
This increase is attributable to ISTs increased sales to a major customer. As
noted above, the contract with this customer expired on March 31, 2004, and we
plan to sell the net assets of IST within the next twelve months. Net revenues
of the Zilactin® line of products were essentially flat for the nine month
period end April 30, 2004. Net revenues of the Peridex® product decreased
during this period, driven largely by U.S. wholesalers who bought
ahead of the March 2003 price increase in the prior year period. Cost of products sold as a percentage of net revenues for the
Pharmaceuticals Business Unit decreased to 42.4% during the nine months ended
April 30, 2004 from 43.9% for the nine months ended April 30, 2003, primarily
due to lower cost of product at IST offset by an increase in Zilactin® product
costs. The lower cost of product at IST resulted from a
March 2003 selling price
increase for products made for our major customer and to a lesser extent from
improvement in manufacturing efficiencies due to the full utilization of new
machinery installed in fiscal year 2003. The Zilactin® increase was due to the
higher cost of promotional events, along with increased production costs
incurred as the transfer of certain Zilactin® product production to a contract
manufacturer is completed. Biotechnology Business Unit Revenues from sales of the OraTest® product in the United Kingdom and the
Pacific Rim area were nominal during the nine months ended April 30, 2004 and
2003, as we deemphasized international sales efforts in favor of focusing on
obtaining FDA approval in the United States. Total
operating expenses for the Biotechnology Business Unit were $5.1
million for the nine months ended April 30, 2004, a 51.7% increase over the
$3.4 million for the nine months ended April 30, 2003. This was driven by an
increase of approximately $1.5 million, or 72.6%, in the phase III clinical
trial expenses related to the OraTest® product. LIQUIDITY AND CAPITAL RESOURCES At April 30, 2004, our primary sources of liquidity included cash and cash
equivalents of $11.8 million and the line of credit discussed below. Net
working capital decreased to $22.7 million at April 30, 2004 from $23.8 million
at July 31, 2003, while the current ratio increased to 3.24 at April 30, 2004
from 3.06 at July 31, 2003. This decrease in net working capital is due to the
funding of the operating loss and the capital expenditures for property and
equipment and intangibles, offset by the proceeds from the sale leaseback of
our corporate headquarters facility. Additionally, $1.5 million of ISTs
long-term assets were reclassified to assets held for sale (Note 5), a
current asset, 24




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and $800,000 of long-term deposits
reclassified to current assets for the amounts that will be refunded to us by
our contract research organization. Net cash used in operating activities was $4.2 million during the nine
months ended April 30, 2004 and was attributable to the net loss from
continuing operations of $4.1 million, offset by non-cash items
of $1.8 million
for depreciation and amortization, the gain on asset sale arising from the
sale leaseback of our corporate headquarter facility and a noncash
charge of $217,000 discussed above. Significant changes in
operating assets and liabilities were primarily comprised of (i) an increase in
accounts receivable of $1.5 million related to increased sales; (ii) a decrease
in inventory of $1.3 million as we attempt to better balance our production
capacity with customer orders; and (iii) a decrease in accounts payable and
accrued expenses of $1.4 million, primarily in the Nutraceuticals and
Pharmaceuticals Business Units, to be more in line with industry standards. Net
cash provided by investing activities was $307,000, attributable to
the sale of our corporate headquarters, offset primarily by funds used for
equipment purchases at Zila Nutraceuticals and patent filings for Zila
Nutraceuticals and the OraTest® product. Net cash used in financing activities during the nine months ended April
30, 2004 was $478,000, arising primarily from the deposit of $517,000 into a
cash collateral account for the letter of credit for our Nutraceuticals
Business Unit described in Note 7. We believe that our current cash balances, cash generated from our
operations, net proceeds from our investing activities through the planned sale
of IST and the availability of cash under our line of credit are sufficient to
finance our level of operations, the OraTest® clinical program, the launch of
Ester-E, and anticipated capital expenditures through the next 12 months. Bank Financing On August 17, 2001, we entered into a Loan and Security Agreement (the
Congress Agreement) with Congress Financial Corporation (Congress) whereby
Congress would provide a $12 million revolving line of credit to us at an
interest rate equal to the prime rate plus 3/4 percent or 4.75 percent at April
30, 2004. The amount of funding available to us from the line of credit is
based upon a percentage of the value of eligible receivables and inventory
which were $8.5 million as of April 30, 2004. The obligations under the
Congress Agreement are collateralized by various assets, including, but not
limited to, trade accounts receivable, inventories, equipment and intangible
assets of certain of our operating subsidiaries. We and all of our direct and
indirect operating subsidiaries guarantee the obligations under the Congress
Agreement. Under the Congress Agreement, we are required to maintain adjusted
tangible net worth, as defined, of $12 million. At April 30, 2004, our adjusted tangible net
worth, as defined, was $27.2 million. The Congress Agreement expires August 17,
2004. There were no borrowings outstanding under this line of credit as of
April 30, 2004. On February 6, 2004, we entered into a Credit and Security Agreement with
Wells Fargo Business Credit (WFBC) that will provide a $10 million revolving
line of credit. We will not be able to borrow under this agreement until the
expiration of the Congress Agreement and the perfection of certain security
interests by WFBC. This credit facility will bear interest equal to the prime
rate compared to prime plus 3/4 percent under the Congress Agreement. Funds
available under the line of 25




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credit will be based upon a percentage of the value of eligible receivables and
inventory. Under this agreement, financial covenants will require maintenance
of minimum net worth and limitations on the amount of capital expenditures. As described in Note 7, on February 6, 2004, under the terms of the
Reimbursement Agreement between Zila Nutraceuticals and WFBC, WFBC executed an
irrevocable direct-pay letter of credit for the benefit of the bondholders.
This letter of credit became effective on March 15, 2004 upon the expiration of
the prior letter of credit. Under the terms of the letter of credit, we placed
$517,000 in a cash collateral account representing the difference between the
letter of credit amount and the maximum commitment amount defined in the
Reimbursement Agreement. PharmaBio Investment On December 18, 2002, we entered into an Investment Agreement with
PharmaBio Development, Inc. (PharmaBio), the strategic investment group of
Quintiles Transnational Corp. whereby PharmaBio invested $500,000 in us. In
return for the investment, we agreed to pay to PharmaBio an amount equal to 5%
of all net sales of the OraTest® product in the European Union and the United
States (the Royalty). The aggregate amount of the Royalty cannot exceed $1.25
million. This investment was recorded as long-term debt. Long-Term Debt Financing In April 1999, Zila Nutraceuticals, through Oxycal, entered into a
transaction with The Industrial Development Authority of the County of Yavapai
(the Authority) in which the Authority issued $5.0 million in Industrial
Development Revenue Bonds (the Bonds). The proceeds were loaned to Zila
Nutraceuticals for the construction of a new manufacturing and laboratory
facility. As of April 30, 2004, the Bonds outstanding consisted of $3.3 million
Series A bonds, which bear a variable interest rate that was 1.3% at April 30,
2004. The Bonds mature in 2019. In connection with the issuance of the Bonds,
the Authority required that Zila Nutraceuticals obtain, for the benefit of the
Bondholders, an irrevocable direct-pay letter of credit to secure payment of
principal and interest. We guaranteed the letter of credit. The letter of
credit expired on March 15, 2004, and the Bond Trustee was notified by February
1, 2004 that a replacement letter of credit was obtained with Wells Fargo
Business Credit (WFBC). We guaranteed the replacement letter of credit. Cash Collateral Requirement As described in Note 7, under the terms of the Reimbursement Agreement
between Zila Nutraceuticals and WFBC for the replacement letter of credit, on
February 6, 2004 we placed $517,000 in a cash collateral account representing
the difference between the letter of credit amount and the maximum commitment
amount defined in the Reimbursement Agreement. Stock Repurchases On November 10, 1999, we announced that our Board of Directors authorized
the repurchase of up to one million shares of Zila common stock. Purchases are
made on the open market depending on market conditions and other factors.
During the nine months ended April 30, 2003, we repurchased 30,100 shares of
our common stock for $36,000. No shares were repurchased during the nine months
ended April 30, 2004. As of April 30, 2004, we had repurchased 225,100 shares
of common stock at an aggregate cost of $571,000, and we have currently
suspended purchases under this program. 26




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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 nine
months ended April 30, 2004, we paid dividends of $19,500 and have accumulated
accrued dividends of $29,000 as of April 30, 2004. Future Contractual Obligations The table below summarizes our future cash contractual obligations: Long-
    
    Short-Term
    
    Operating
    
    Capital Lease
    
    PurchaseTerm Debt
    
    Debt
    
    Leases
    
    Obligations
    
    Obligations
    
    TotalRemaining 2004
    
    $
    83,999
    
    
    $
    134,329
    
    
    $
    238,092
    
    
    $
    9,454
    
    
    $
    1,005,848
    
    
    $
    1,471,7222005 & 2006
    
    
    565,018
    
    
    
    
    
    
    
    647,691
    
    
    
    73,586
    
    
    
    10,914,000
    
    
    
    12,200,2952007 & 2008
    
    
    490,667
    
    
    
    
    
    
    
    347,556
    
    
    
    73,586
    
    
    
    6,936,000
    
    
    
    7,847,809Thereafter
    
    
    2,730,802
    
    
    
    
    
    
    
    88,620
    
    
    
    30,477
    
    
    
    
    
    
    
    2,849,899Total
    
    $
    3,870,486
    
    
    $
    134,329
    
    
    $
    1,321,959
    
    
    $
    187,103
    
    
    $
    18,855,848
    
    
    $
    24,369,725
 Purchase obligations include commitments for advertising and raw material
supply arrangements. OraTest® In December 2002, we transitioned the OraTest® clinical program to
Quintiles. This was the result of an extensive review of several proposals
received from some of the largest, highest quality and most prominent contract
research organizations with worldwide capabilities. Quintiles completed the
transition successfully without compromising the study data. Factors that will
affect the cost and timing of completion of the clinical program include but
are not limited to: (i) patient enrollment rates, (ii) tumor formation rate
within the study population, (iii) compliance with the study protocol and
related monitoring, (iv) level of funding throughout the study, and (v)
protocol modifications and clinical program modifications. At April 30, 2004,we had approximately $362,000 of ZTC drug substance,
the active ingredient in the OraTest® product, at our manufacturing facility in
Phoenix, AZ. We intend to realize the value of this drug substance during the
next twelve months (1) through its consumption during the conduct of the
clinical trials, toxicology studies and validation testing of our manufacturing
process and (2) through sales in Europe and Asia prior to the date that we
expect sales in the United States. The drug substance currently has expiration
dates in 2004, 2005 and 2006. Previous testing has indicated that the drug
substance is stable and we anticipate being able to extend the expiration dates
of the entire drug substance in the event that our plans were delayed. However,
no assurance can be given in this regard. ViziLite® On October 15, 2003, we completed a settlement agreement that was the
result of a mediated settlement with Trylon. As part of the settlement, we
agreed to eliminate the contractual restrictions relating to sales milestones
associated with 500,000 shares of the previously restricted common stock. The
contractual restrictions on 250,000 of these shares will be removed upon
achievement of a product development milestone. The contractual restrictions
on the remaining 250,000 shares will be removed 27




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##### Table of Contents



upon Trylons obtaining of the required governmental approvals relating to
the product development milestone. As part of the settlement, we also agreed
that Trylons royalty rates for net sales of the ViziLite product will be
reduced from 10% to 5% for the first five years, and from 5% to 2.5% for the
second five years. Thereafter, the royalty payments end. On March 26, 2004, we entered into a modification of the settlement
agreement with Trylon. The modification agreement addressed the timing for the
removal of contractual restrictions and escrow restrictions on 1,250,000 shares
of common stock issued in connection with the acquisition of the
ViziLite®
product from Trylon in December, 2001. The shares covered by the modification
agreement include the shares discussed above that were previously
covered in the October 15, 2003 settlement agreement. Upon execution of the
modification, we removed the contractual restrictions on 312,500 of the
1,250,000 shares in recognition of the achievement of a milestone. As
a result of this release of the restrictions, we recorded a
non-cash charge of approximately $217,000, reflecting the estimated
difference in the fair market value of the shares with and without the
restrictions. If Trylon meets all of the timing requirements set forth in
the modification agreement with respect to achievement of another product development
milestone, we have agreed to release the contractual restrictions on the
remaining shares and to allow delivery to Trylon of 375,000 shares being held in
escrow. If Trylon fails to meet certain timing requirements, then contractual
restrictions may remain in place on some of the remaining shares and/or the
shares in escrow may be forfeited by Trylon. We may be required to
record additional charges in the fourth quarter of fiscal 2004 and in
later periods through 2011 in
connection with the achievement of product development milestones and
completion of certain holding periods. Issuance of the 375,000
shares being held in escrow, should it occur, would result in a
charge equal to the fair market value of the shares on the date of
issuance. The charge would then be recorded as additional research
and development expense. We had $258,000 of ViziLite® product in inventory and approximately $2.0
million of associated intangible assets as of April 30, 2004. As part of our
strategy to educate the dental profession on the benefits of using ViziLite®
and to widen distribution, in the third quarter of fiscal 2003 we modified our
exclusive distributorship agreement with Patterson Dental Company to convert it
to a non-exclusive agreement for the dental industry in the United States and
Canada. We then retained regional distributors and sales groups with a roster
of independent sales representatives. With the introduction of independent
sales representative and regional distributors, we are modifying our plan to
reach both opinion leaders and end-users in the oral cavity screening process.
However, if sales do not ultimately reach certain levels, we may have to reduce
the carrying value of the assets related to ViziLite®. Ester-E On October 31, 2003, we entered into a license agreement with Vital Health
Sciences Limited (Vital Health) of Australia that grants us the exclusive
rights in the dietary supplement market for certain issued and pending patents,
know-how and data pertaining to tocopherol phosphate in the United States,
Canada and Indonesia. The initial term of the license is five years, and we
have the right, unilaterally, to extend the term until the expiration of the
last of the licensed patents. Several of such patents are recently issued,
while other patent applications are still pending. We also have a right of
first refusal for certain other international markets under the agreement.
Zila Nutraceuticals is currently using Vital Healths patented process for
manufacturing tocopherol phosphate, as well as numerous pending patent
applications, to develop its Ester-E product tailored for the dietary
supplement market. In May 2004, we made our first commercial shipments of
Ester-E product. Under the agreement, we are required to make royalty payments
based on certain levels of sale volume and subject to minimum annual
payment amounts, as defined. We believe that our current cash
position and operating cash flow are sufficient to fund the commercialization
of Ester-E. 
 Item 3. Quantitative and Qualitative Disclosures about Market Risk We are exposed to market risk primarily from interest rates. We have a revolving line of credit with Congress Financial Corporation
with a variable interest rate equal to three-quarters of one (0.75) percent per
annum in excess of the prime rate announced by 28




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First Union Bank (4.75 percent at April 30, 2004). At April 30, 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 Trust Company and fluctuate based on
market conditions and our rate was 1.3% at April 30, 2004. Effective March 15,
2004, under the new replacement letter of credit with Wells Fargo Business
Credit, the variable interest rate will be set by Wells Fargo Bank, N.A. A 10
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 (a) Disclosure Controls and Procedures The Companys management, with the participation of the Companys Chief
Executive Officer and Chief Financial Officer, has evaluated the effectiveness
of the Companys disclosure controls and procedures, as such term is defined in
Rules 13a-15(e) and 15-d-15(e) under the Securities Exchange Act of 1934, as
amended (the Exchange Act), as of the end of the period covered by this
report. Based on such evaluation, the Companys Chief Executive Officer and
Chief Financial Officer have concluded that, as of the end of such period, the
Companys disclosure controls and procedures are effective in recording,
processing, summarizing and reporting, on a timely basis, information required
to be disclosed by the Company in the reports that it files or submits under
the Exchange Act. (b) Internal Controls over Financial Reporting As more fully described in Item 9A in our Annual Report on Form 10-K for
the fiscal year ended July 31, 2003, during our annual audit, weaknesses were
found in our general computer controls at our corporate headquarters and at
Zila Nutraceuticals. For the period covered by this Report, we continue efforts
under our strategic plan to improve general computer controls. Except as noted above, there have not been any changes in the Companys
internal control over financial reporting, as such term is defined in Rules
13a-15(f) and 15d-15(f) under the Exchange Act, during the fiscal quarter to
which this Report relates that have materially affected, or are reasonably
likely to materially affect, the Companys internal control over financial
reporting. 
 Part II - Other Information 
 Item 1. Legal Proceedings On October 15, 2003, we completed a settlement agreement that was the
result of a mediated settlement with Trylon. As part of the settlement, we
agreed to eliminate the contractual restrictions relating to sales milestones
associated with 500,000 shares of the previously restricted common stock. The
contractual restrictions on 250,000 of these shares will be removed upon
achievement of a product development milestone. The contractual restrictions
on the remaining 250,000 shares will be removed upon Trylons obtaining of the
required governmental approvals relating to the product development milestone.
As part of the settlement, we also agreed that Trylons royalty rates for net
sales of the ViziLite product will be reduced from 10% to 5% for the first
five years, and from 5% to 2.5% for the second five years. Thereafter, the
royalty payments end. 29




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On March 26, 2004, we entered into a modification of the settlement
agreement with Trylon. The modification agreement addressed the timing for the
removal of contractual restrictions and escrow restrictions on 1,250,000 shares
of common stock issued in connection with the acquisition of the
ViziLite®
product from Trylon in December, 2001. The shares covered by the modification
agreement include the shares discussed above that were previously
covered in the October 15, 2003 settlement agreement. Upon execution of the
modification, we removed the contractual restrictions on 312,500 of the
1,250,000 shares. As a result of this release of the restrictions,
we recorded a non-cash charge of approximately $217,000,
reflecting the estimated difference in the fair market value of the
shares with and without the marketability restrictions in recognition
of the achievement of a milestone. If Trylon meets all of the timing requirements set forth in
the modification agreement with respect to achievement of another product development
milestone, we have agreed to release the contractual restrictions on the
remaining shares and to allow delivery to Trylon of 375,000 shares being held in
escrow. If Trylon fails to meet certain timing requirements, then contractual
restrictions may remain in place on some of the remaining shares and/or the
shares in escrow may be forfeited by Trylon. We may be required to
record additional charges in the fourth quarter of fiscal 2004 and in
later periods through 2011 in
connection with the achievement of a product development milestones and
completion of certain holding periods.  Issuance of the 375,000
shares being held in escrow, should it occur, would result in a
charge equal to the fair market value of the shares on the date of
issuance. The charge would then be recorded as additional research
and development expense. In connection with the acquisition of patent rights in 1980, we agreed to
pay to Dr. James E. Tinnell (Tinnell), the inventor of one of our treatment
compositions, a royalty of 5% of gross sales of the invention disclosed in his
then pending patent application. In September 2000, we notified Tinnell that we would no longer pay such
royalties since the obligations ceased in August 1998 when the related product
patents expired and we requested reimbursement of royalties paid since August
1998. We then filed suit in the Federal District Court requesting a declaratory
judgment that we had no royalty obligations to Tinnell and a judgment for the
overpaid royalties. Tinnell asserted several counterclaims. The Court has since
ruled in our favor stating that we do not owe royalty obligations to Tinnell
and denied several of Tinnells counterclaims. However, one of Tinnells
counterclaims is still outstanding for breach of contract. Furthermore, the
Court dismissed our request for reimbursement of overpaid royalties. Tinnell
filed a motion asking the trial court to certify the issue of our royalty
obligation for immediate appeal. We have joined the request and also asked the
trial court to certify the issue of our right to reimbursement of the overpaid
royalties. The trial court has Tinnells and Zilas joint motion under
advisement. We are subject to other legal proceedings and claims that arise in the
ordinary course of business. In the opinion of management, the amount of
ultimate liability with respect to these actions will not materially affect the
Companys financial position or results of operations. 
 Item 2. Changes in Securities 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 the nine months ended April 30, 2003, we repurchased 30,100 shares of
our common stock for $36,000. No shares were repurchased during the nine months
ended April 30, 2004. As of April 30, 2004, we had repurchased 225,100 shares
of common stock at an aggregate cost of $571,000, and we have currently
suspended purchases under this program. Item 3. Defaults upon Senior Securities. Not Applicable Item 4. Submission of Matters to a Vote of Security Holders. Not Applicable 30




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Item 5. Other Information Not Applicable 
 Item 6. Exhibits and Reports on Form 8-K (a)     Exhibits Exhibit Number
    
    Description31.1
    
    Certification of the Chief Executive Officer Pursuant to
Section 302 of the Sarbanes Oxley Act of 200231.2
    
    Certification of the Chief Financial Officer Pursuant to
Section 302 of the Sarbanes Oxley Act of 200232.1
    
    Certification of the Chief Executive Officer Pursuant to
18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes Oxley Act of 200232.2
    
    Certification of the Chief Financial Officer Pursuant to
18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes Oxley Act of 2002
 (b)     Reports on Form 8-K On February 4, 2004, we filed a Current Report on Form 8-K pursuant to
Item 12 (Results of Operation and Financial Condition) containing a press
release dated February 3, 2004, announcing the sale and leaseback of our
corporate headquarters. March 16, 2004, we filed a Current Report on Form 8-K pursuant to Item 12
(Results of Operation and Financial Condition) containing a press release
dated March 15, 2004, announcing the results of our second quarter ended
January 31, 2004. 
 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. Date: June 10, 2004
    
    By: /s/ Douglas D. Burkett, Ph. D.Douglas D. Burkett, Ph. D.President, Chairman of the Board(Principal Executive Officer)By: /s/ Andrew A. StevensAndrew A. StevensVice President and Chief Financial Officer(Principal Financial & Accounting Officer)
 31




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##### Table of Contents



INDEX TO EXHIBITS Exhibit Number
    
    Description31.1
    
    Certification of the Chief Executive Officer Pursuant to
Section 302 of the Sarbanes Oxley Act of 200231.2
    
    Certification of the Chief Financial Officer Pursuant to
Section 302 of the Sarbanes Oxley Act of 200232.1
    
    Certification of the Chief Executive Officer Pursuant to
18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes Oxley Act of 200232.2
    
    Certification of the Chief Financial Officer Pursuant to
18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes Oxley Act of 2002
 32