##### 



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 October 31, 2003 or

o
    
    Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934


For the transition period from            to

Commission file number 0-17521

ZILA, INC.

(Exact Name of Registrant as Specified In Its Charter)


Delaware
    
    86-0619668(State or Other Jurisdiction of
Incorporation or Organization)
    
    (I.R.S. Employer Identification No.)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 o No x

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 November 30, 2003, the number of shares of common stock outstanding was
45,221,893.

1



---



##### 



TABLE OF CONTENTS

PagePart I
    
    FINANCIAL INFORMATION (UNAUDITED)Item 1.
    
    Financial StatementsCondensed consolidated balance sheets as of October 31, 2003 and
July 31, 2003
    
    
    3Condensed consolidated statements of operations and
comprehensive loss for the three months ended October 31, 2003
and 2002
    
    
    4Condensed
consolidated statements of cash flows for the three months ended October 31, 2003 and 2002
    
    
    5Notes to condensed consolidated financial statements
    
    
    6-14Item 2.
    
    Managements discussion and analysis of financial condition and
results of operations
    
    
    15-24Item 3.
    
    Quantitative and qualitative disclosures about market risk
    
    
    24Item 4.
    
    Controls and procedures
    
    
    24Part II.
    
    OTHER INFORMATIONItem 1.
    
    Legal proceedings
    
    
    25Item 6.
    
    Exhibits and Reports on Form 8-K
    
    
    26SIGNATURES
    
    
    27


Ex  31.1
Ex  31.2
Ex  32.1
Ex  32.2

2



---



##### 



ZILA, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)

October 31, 2003
    
    July 31, 2003ASSETSCURRENT ASSETS:Cash and cash equivalents
    
    $
    12,883,537
    
    
    $
    16,160,484Trade receivables  net
    
    
    6,889,984
    
    
    
    7,550,735Inventories  net
    
    
    8,718,844
    
    
    
    8,088,222Prepaid expenses and other current assets
    
    
    2,289,224
    
    
    
    1,760,710Total current assets
    
    
    30,781,589
    
    
    
    33,560,151PROPERTY AND EQUIPMENT  net
    
    
    9,548,029
    
    
    
    9,481,307PURCHASED TECHNOLOGY RIGHTS  net
    
    
    3,869,295
    
    
    
    3,988,964GOODWILL  net
    
    
    6,930,192
    
    
    
    6,930,192TRADEMARKS AND OTHER INTANGIBLE ASSETS  net
    
    
    13,620,128
    
    
    
    13,720,022OTHER ASSETS
    
    
    1,308,939
    
    
    
    1,339,680TOTAL
    
    $
    66,058,172
    
    
    $
    69,020,316LIABILITIES AND SHAREHOLDERS EQUITYCURRENT LIABILITIES:Accounts payable
    
    $
    5,792,067
    
    
    $
    7,399,416Accrued liabilities
    
    
    3,406,869
    
    
    
    3,502,405Short-term borrowings
    
    
    438,797
    
    
    
    154,793Current portion of long-term debt and capital lease obligation
    
    
    500,245
    
    
    
    487,449Total current liabilities
    
    
    10,137,978
    
    
    
    11,544,063LONG-TERM DEBT AND CAPITAL LEASE
OBLIGATION  net of current portion
    
    
    3,691,866
    
    
    
    3,728,126Total liabilities
    
    
    13,829,844
    
    
    
    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
45,202,393 shares (October 31, 2003) and 45,439,893 (July 31, 2003)
    
    
    45,827
    
    
    
    45,815Capital in excess of par value
    
    
    83,177,171
    
    
    
    83,115,158Accumulated other comprehensive loss
    
    
    (79,377
    )
    
    
    (75,644
    )Accumulated deficit
    
    
    (30,806,420
    )
    
    
    (29,228,329
    )Common stock in treasury, at cost, 225,100 shares (October 31, 2003)
and 225,100 shares (July 31, 2003)
    
    
    (571,373
    )
    
    
    (571,373
    )Total shareholders equity
    
    
    52,228,328
    
    
    
    53,748,127TOTAL
    
    $
    66,058,172
    
    
    $
    69,020,316


See notes to unaudited condensed consolidated financial statements.

3



---



##### 



ZILA, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
(UNAUDITED)

Three months ended October 31,2003
    
    2002NET REVENUES
    
    $
    12,052,720
    
    
    $
    10,734,433OPERATING COSTS AND EXPENSES:Cost of products sold
    
    
    5,033,914
    
    
    
    4,257,848Marketing and selling
    
    
    3,013,399
    
    
    
    2,667,316General and administrative
    
    
    3,725,562
    
    
    
    3,068,296Severance and related charges
    
    
    39,585
    
    
    
    879,874Research and development
    
    
    1,107,311
    
    
    
    764,010Depreciation and amortization
    
    
    626,267
    
    
    
    591,21013,546,038
    
    
    
    12,228,554LOSS FROM OPERATIONS
    
    
    (1,493,318
    )
    
    
    (1,494,121
    )OTHER INCOME (EXPENSE):Interest income
    
    
    27,750
    
    
    
    7,367Interest expense
    
    
    (75,185
    )
    
    
    (74,870
    )Other expense
    
    
    (27,588
    )
    
    
    (47,581
    )(75,023
    )
    
    
    (115,084
    )LOSS BEFORE ACCOUNTING CHANGE
    
    
    (1,568,341
    )
    
    
    (1,609,205
    )Cumulative effect of accounting change
    
    
    
    
    
    
    (4,084,193
    )NET LOSS
    
    
    (1,568,341
    )
    
    
    (5,693,398
    )Preferred stock dividends
    
    
    9,750
    
    
    
    9,750Net loss attributable to common shareholders
    
    $
    (1,578,091
    )
    
    $
    (5,703,148
    )BASIC AND DILUTED NET LOSS PER COMMON SHARE:Loss before accounting change
    
    $
    (0.04
    )
    
    $
    (0.04
    )Accounting change
    
    
    0.00
    
    
    
    (0.09
    )NET LOSS
    
    $
    (0.04
    )
    
    $
    (0.13
    )WEIGHTED AVERAGE NUMBER OF SHARES OUTSTANDINGBASIC AND DILUTED
    
    
    44,969,211
    
    
    
    45,090,260NET LOSS
    
    $
    (1,568,341
    )
    
    $
    (5,693,398
    )Foreign currency translation adjustments
    
    
    (3,733
    )
    
    
    (2,217
    )COMPREHENSIVE LOSS
    
    $
    (1,572,074
    )
    
    $
    (5,695,615
    )


See notes to unaudited condensed consolidated financial statements.

4



---



##### 



ZILA, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

Three months ended October 31,2003
    
    2002OPERATING ACTIVITIES:Net loss
    
    $
    (1,568,341
    )
    
    $
    (5,693,398
    )Adjustments to reconcile net loss to net cash used in operating activities:Depreciation and amortization
    
    
    626,267
    
    
    
    591,210Foreign currency and other
    
    
    (3,733
    )
    
    
    (6,434
    )Change in accounting method
    
    
    
    
    
    
    4,084,193Change in assets and liabilities:Receivables  net
    
    
    660,751
    
    
    
    (1,763,957
    )Inventories  net
    
    
    (630,622
    )
    
    
    1,282,210Prepaid expenses and other assets
    
    
    (497,783
    )
    
    
    (728,964
    )Accounts payable and accrued liabilities
    
    
    (1,674,857
    )
    
    
    1,796,016Net cash used in operating activities
    
    
    (3,088,318
    )
    
    
    (439,124
    )INVESTING ACTIVITIES:Purchases of property and equipment
    
    
    (369,251
    )
    
    
    (365,325
    )Purchases of intangible assets
    
    
    (104,175
    )
    
    
    (102,269
    )Net cash used in provided by investing activities
    
    
    (473,426
    )
    
    
    (467,594
    )FINANCING ACTIVITIES:Net proceeds (repayments) from short-term borrowings
    
    
    284,004
    
    
    
    954,192Net proceeds from issuance of common stock
    
    
    34,007
    
    
    
    20,810Acquisition of treasury stock
    
    
    
    
    
    
    (36,253
    )Dividends paid to preferred shareholders
    
    
    (9,750
    )
    
    
    (19,500
    )Net proceeds (repayments) of long-term debt
    
    
    (23,464
    )
    
    
    (122,326
    )Net cash provided by financing activities
    
    
    284,797
    
    
    
    796,923NET DECREASE IN CASH AND CASH EQUIVALENTS
    
    
    (3,276,947
    )
    
    
    (109,795
    )CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
    
    
    16,160,484
    
    
    
    1,604,205CASH AND CASH EQUIVALENTS, END OF PERIOD
    
    $
    12,883,537
    
    
    $
    1,494,410SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:Cash paid for interest
    
    $
    34,895
    
    
    $
    44,392Cash paid for income taxes
    
    
    192,000
    
    
    
    146SUPPLEMENTAL SCHEDULE OF NONCASH FINANCING ACTIVITIES:Capital lease obligation for new equipment
    
    $
    96,000
    
    
    $


See notes to unaudited condensed consolidated financial statements.

5



---



##### 



ZILA, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1. ORGANIZATION AND BASIS OF PRESENTATION

Zila, Inc. is an innovator 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 it
wholly-owned subsidiaries.

Zila Nutraceuticals manufactures and markets patented Ester-C®, a branded,
highly effective form of vitamin C sold in 38 countries worldwide and plans to
launch Ester-E, an enhanced form of vitamin E, in fiscal 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 the Zilactin® family of over-the-counter
products (OTC), Peridex® prescription mouth rinse, the ViziLite®
chemiluminescent disposable light product for the illumination of oral mucosal
abnormalities, and the plastic molded products of Zila Swab Technologies, Inc.,
an Arizona corporation dba Innovative Swab Technologies (IST). Zila
Pharmaceuticals, except for IST, operates as a wholly-owned subsidiary of the
Company, Zila Pharmaceuticals, Inc.

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 manages the OraTest® product,
an oral cancer diagnostic system, which is currently in Federal 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 Technologies,
Inc., Zila Swab Technologies, Inc. (ZST) dba Innovative Swab Technologies
(IST) 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 statement of the
results 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 necessarily indicative of results that
might be expected for the full year.

6



---



##### 



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, as 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 endedOctober 31,2003
    
    2002Net loss attributable to common shareholders, as reported
    
    $
    (1,578,091
    )
    
    $
    (5,703,148
    )Deduct: total stock-based employee compensation expense
determined under fair value based method for all awards,
net of related tax effects
    
    
    (348,903
    )
    
    
    (221,910
    )Pro forma net loss attributable to common shareholders
    
    $
    (1,926,994
    )
    
    $
    (5,925,058
    )Net loss attributable to common shareholders per basic
and diluted share outstanding:As reported
    
    $
    (0.04
    )
    
    $
    (0.13
    )Pro forma
    
    $
    (0.04
    )
    
    $
    (0.13
    )Black-Scholes model assumptions:Risk-free interest rate
    
    
    3.19
    %
    
    
    2.95
    %Expected volatility
    
    
    74
    %
    
    
    88
    %Expected term (in years)
    
    
    5.8
    
    
    
    5.3Dividend yield
    
    
    0
    %
    
    
    0
    %


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

The following is a reconciliation of the numerator and denominator of
basic and diluted loss per common share:

Three months endedOctober 31,2003
    
    2002Loss before accounting change
    
    $
    (1,568,341
    )
    
    $
    (1,609,205
    )Accounting change
    
    
    
    
    
    
    (4,084,193
    )Net loss
    
    
    (1,568,341
    )
    
    
    (5,693,398
    )Preferred stock dividends
    
    
    9,750
    
    
    
    9,750Net loss attributable to common shareholders
    
    $
    (1,578,091
    )
    
    $
    (5,703,148
    )


7



---



##### 



Average number of common shares outstanding:Basic and diluted
    
    
    44,969,211
    
    
    
    45,090,260Basic and Diluted Net Loss per Common Share:Loss before accounting change
    
    $
    (0.04
    )
    
    $
    (0.04
    )Accounting change
    
    
    (0.00
    )
    
    
    (0.09
    )Net loss per share
    
    $
    (0.04
    )
    
    $
    (0.13
    )


Since a loss from continuing operations was incurred for the three month
periods ended October 31, 2003 and 2002, 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 since their effect would be antidilutive. Potentially dilutive
common shares for the three month periods ended October 31, 2003 and 2002 were
534,988 and 97,118, 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 month period ended October 31, 2003,
over the prior year period 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.

4. INVENTORIES

Inventories consist of the following:

October 31,
    
    July 31,2003
    
    2002Finished goods
    
    $
    2,829,800
    
    
    $
    2,217,396Work in process
    
    
    495,203
    
    
    
    555,153Raw materials
    
    
    5,541,127
    
    
    
    5,670,217Inventory reserves
    
    
    (147,286
    )
    
    
    (354,544
    )$
    8,718,844
    
    
    $
    8,088,222


5. INTANGIBLE ASSETS

SFAS No. 142, Goodwill and Other Intangible Assets (SFAS No. 142) became
effective for us as of August 1, 2002. SFAS No. 142 specifies that goodwill and
certain intangible assets with indefinite lives no longer be amortized but
instead be subject to periodic impairment testing using a fair value
methodology. 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 segment 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.

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.

8



---



##### 



A summary of intangible assets is presented below:

At October 31, 2003
    
    At July 31,2003Gross
    
    
    
    
    
    Net
    
    Gross
    
    
    
    
    
    NetCarrying
    
    Accumulated
    
    Carrying
    
    Carrying
    
    Accumulated
    
    CarryingAmount
    
    Amortization
    
    Amount
    
    Amount
    
    Amortization
    
    AmountAmortizable intangibles:Purchased technology
rights
    
    $
    7,419,473
    
    
    $
    3,550,178
    
    
    $
    3,869,295
    
    
    $
    7,419,473
    
    
    $
    3,430,509
    
    
    $
    3,988,964Trademarks and other
intangible assets:Trademarks
    
    
    11,596,822
    
    
    
    2,769,246
    
    
    
    8,827,576
    
    
    
    11,574,237
    
    
    
    2,652,207
    
    
    
    8,922,030Patents
    
    
    3,130,879
    
    
    
    752,800
    
    
    
    2,378,079
    
    
    
    3,049,289
    
    
    
    735,712
    
    
    
    2,313,577Licensing costs
    
    
    2,709,144
    
    
    
    554,061
    
    
    
    2,155,083
    
    
    
    2,709,144
    
    
    
    488,084
    
    
    
    2,221,060Other
    
    
    536,180
    
    
    
    276,790
    
    
    
    259,390
    
    
    
    536,180
    
    
    
    272,825
    
    
    
    263,355Total trademarks and
other intangible assets
    
    
    17,973,025
    
    
    
    4,352,897
    
    
    
    13,620,128
    
    
    
    17,868,850
    
    
    
    4,148,828
    
    
    
    13,720,022Total amortizable
Intangible assets
    
    
    25,392,498
    
    
    
    7,903,075
    
    
    
    17,489,423
    
    
    
    25,288,323
    
    
    
    7,579,337
    
    
    
    17,708,986Unamortizable intangible
asset:Goodwill
    
    
    12,446,792
    
    
    
    5,516,600
    
    
    
    6,930,192
    
    
    
    12,446,792
    
    
    
    5,516,600
    
    
    
    6,930,192Total intangible assets
    
    $
    37,839,290
    
    
    $
    13,419,675
    
    
    $
    24,419,615
    
    
    $
    37,735,115
    
    
    $
    13,095,937
    
    
    $
    24,639,178


During the three months ended October 31, 2003, we capitalized $94,000 of
legal fees associated with patent applications. Intangible asset amortization
expense for the three months ended October 31, 2003 was $326,000. For fiscal
years 2004 through 2008, the amortization of intangibles is estimated to be
$1.3 million each year.

The changes in the carrying amount of goodwill for the three months ended
October 31, 2003 were as follows:

Zila Nutraceuticals
    
    Zila Pharmaceuticals
    
    TotalBalance at July 31, 2003
    
    $
    2,896,926
    
    
    $
    4,033,266
    
    
    $
    6,930,192Change
    
    
    
    
    
    
    
    
    
    
    Balance at October 31, 2003
    
    $
    2,896,926
    
    
    $
    4,033,266
    
    
    $
    6,930,192


6. SHORT-TERM BORROWINGS, LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS

At October 31, 2003, we had (i) short-term notes payable of $426,000 at
5.6% for installments due on various insurance policies and (ii) a short-term
equipment loan of $12,800.

Under our Loan and Security Agreement with Congress Financial (Congress),
we have a $12 million revolving line of credit facility at an interest rate
equal to the prime rate plus 3/4 percent. The amount of funds available from
the line of credit is based upon a percentage of the value of eligible
receivables and inventory and was $8.0 million at October 31, 2003. Under the
Agreement, we are required to maintain adjusted tangible net worth, as defined
in the agreement. At October 31, 2003, our adjusted tangible net worth, as
defined, was $27.8 million compared to the required amount of $12.0 million.
At October 31, 2003, there were no borrowings outstanding under this line of
credit.

9



---



##### 



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.
The Royalty shall be calculated and paid quarterly. The investment was recorded
as long-term debt and will be amortized using the effective interest method.

In April 1999, Oxycal entered into a transaction with The Industrial
Development Authority of the County of Yavapai (the Authority) in which the
Authority issued $5.0 million in Industrial Development Revenue Bonds (the
Bonds). The proceeds were loaned to Oxycal for the construction of a new
manufacturing and laboratory facility. As of October 31, 2003, the Bonds
outstanding consisted of $3.5 million Series A bonds, which bear a variable
interest rate that was 1.3% at October 31, 2003. The bonds mature in 2019. In
connection with the issuance of the Bonds, the Authority required that Oxycal
obtain, for the benefit of the Bondholders, an irrevocable direct-pay letter of
credit to secure payment of principal and interest. Zila, Inc. guaranteed the
letter of credit. The letter of credit expires on March 15, 2004, and the Bond
Trustee must be notified by February 1, 2004 that a replacement letter of
credit has been obtained. We are in the process of evaluating financial
institutions to secure a replacement letter of credit for these bonds. If,
however, we are unable to replace this letter of credit, we would have to seek
an alternative debt financing source to fund the repayment of these bonds or
pay off the bonds from our available cash resources. There can be no assurance
that any new financing, if available, will be on terms and conditions as
favorable as our current financing or will be otherwise acceptable to us.

In October 2003, we entered into a five year capital lease arrangement for
equipment. The capital lease obligation at October 30, 2003 was $96,000.

7. SEVERANCE AND RELATED CHARGES

We incurred severance and other costs related to employee terminations,
recruiting fees and relocation expenses of $40,000 and $880,000, respectively,
during the three months ended October 31, 2003 and 2002.

8. 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 three months ended October 31, 2003 and
October 31, 2002, we recorded a tax benefit based on the effective tax rate and
offset the tax benefit with an increase in the deferred tax asset valuation
reserve.

At October 31, 2003, we recorded total deferred tax assets of
approximately $6.0 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.

At October 31, 2003, the Company had income tax net operating loss carry
forwards of approximately $7.1 million that expire in fiscal years 2021 through
2024 and a capital loss carry forward of $475,000 that expires in 2008.

10



---



##### 



9. SEGMENT INFORMATION

Our business is organized into three major groups, all of which have
distinct product lines, brand names and are managed as autonomous business
units. The following reporting segments have been identified for purposes of
applying SFAS No. 131, Disclosures about Segments of an Enterprise and Related
Information: Nutraceuticals, which includes Oxycal Laboratories, Inc. and its
wholly-owned subsidiary, Zila Nutraceuticals, Inc.; Pharmaceuticals, which
includes Zila Pharmaceuticals, Inc. and the Zilactin® family of
over-the-counter products, Peridex® prescription mouth rinse, the ViziLite®
chemiluminescent disposable light product for the illumination of oral mucosal
abnormalities, and the plastic molded products of IST; and Biotechnology, the
research, development and licensing business specializing in pre-cancer/cancer
detection through its patented ZTC® and OraTest® technologies and manages 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.

The table below presents information about reported segments for the three
months ended October 31, 2003 and 2002 and segment total assets as October 31,
2003 and July 31, 2003 (in thousands):

Nutraceuticals
    
    Pharmaceuticals
    
    Biotechnology
    
    Corporate
    
    TotalNet revenues:Quarter Ended October 31,2003
    
    $
    6,990
    
    
    $
    5,061
    
    
    $
    2
    
    
    $
    
    
    
    $
    12,0532002
    
    
    6,480
    
    
    
    4,247
    
    
    
    7
    
    
    
    
    
    
    
    10,734Income (loss) before
income taxes and
accounting change:Quarter Ended October 312003
    
    
    1,015
    
    
    
    413
    
    
    
    (1,604
    )
    
    
    (1,392
    ) (a)
    
    
    (1,568
    )2002
    
    
    1,844
    
    
    
    (47
    )
    
    
    (1,021
    )
    
    
    (2,385
    ) (a)
    
    
    (1,609
    )Depreciation and
amortization:Quarter Ended October 31,2003
    
    
    258
    
    
    
    163
    
    
    
    175
    
    
    
    30
    
    
    
    6262002
    
    
    261
    
    
    
    120
    
    
    
    179
    
    
    
    31
    
    
    
    591Total assets as of:October 31, 2003
    
    
    29,739
    
    
    
    13,512
    
    
    
    16,813
    
    
    
    5,994
    
    
    
    66,058July 31, 2003
    
    
    29,290
    
    
    
    14,520
    
    
    
    7,983
    
    
    
    17,227
    
    
    
    69,020




|(a) |  | Includes approximately $40,000 and $880,000 of severance and
related costs in the three months ended October 31, 2003 and 2002,
respectively.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------

10. 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 CROs 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 and clinical program
modifications.

11



---



##### 



OraTest® Product

At October 31, 2003,we have approximately $359,000 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
through sales in the U.S., if we receive final approval for the OraTest®
products from the FDA, and 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 indicates that the
drug substance is stable and we expect to be able to extend the expiration
dates of the entire drug substance through the date we expect sales in the
United States. However, no assurance can be given in this regard. In addition,
should FDA approval not be granted or be significantly delayed or if the
marketing of the Ora Test® is not commercially successful, it may not be
possible for us to recover the value of this drug substance.

ViziLite®

On October 15, 2003, we entered into a mediated settlement with Trylon of
various issues. As part of the settlement, we agreed to eliminate the
contractual restrictions relating to sales milestones associated with 500,000
shares of the previously issued 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 payment
ends.

We have $415,000 of ViziLite® product in inventory as of October 31, 2003.
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 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®.

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 furthermore 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 has not ruled on our request for reimbursement of
overpaid royalties. We intend to request the

12



---



##### 



Court to rule on our claim for reimbursement and prepare for trial on the
remaining breach of contract issue.

In November 2001, we filed a suit for trademark infringement and trade
secret misappropriation against Darrel Van Dyke and GMP Products, LLC relating
to ISTs patented swab technology. Subsequent to 2001, GMP Products changed its
name to Viridian Packaging Solutions, LLC (Viridian). In December 2002, the
court entered a final judgment against us and the defendants brought a motion
to recover their attorneys fees and other costs incurred in defending the
action. On September 29, 2003, the court awarded $131,700 to the defendants.

In January 2003, we filed a suit for patent infringement against Beutlich
Pharmaceuticals, LP (Beutlich) alleging that it sold dry-handle swabs that
infringe upon our IST product swab patent. In February 2003, the Arizona court
issued a temporary restraining order in our favor that stopped Beutlich from
selling its swabs. In May 2003, Viridian filed a declaratory judgment action in
the Northern District of Illinois that sought a declaration of non-infringement
and patent invalidity.

In November 2003, we settled both of these matters. Under the settlement
agreement, we permitted Beutlich and Viridian to sell their products to
certain prospective customers. In addition, we paid Viridian $29,000 of the
$131,700 that the court had awarded and Viridian waived the balance.

We are subject to other legal proceedings and claims, which 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.

11. SUBSEQUENT EVENTS

Proposed Sale/Leaseback of Corporate Headquarters

As part of our corporate strategy to employ financial assets in core
business activities, we have listed our headquarters for sale. Recently we have
signed a purchase agreement to sell our headquarters. We are currently in
negotiations to leaseback the facility for five years. We expect this
transaction to close in the second quarter of 2004.

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. We anticipate that we will launch the Ester-E product in
early 2004. Under the agreement, Zila is required to make royalty payments
based on certain levels of sales volume. We are also required to pay certain
upfront fees upon the completion of certain market launch milestones, as
defined in the agreement, and minimum annual royalty fees on sales.

13



---



##### 



Litigation Settlement

As more fully described in Note 10 above, in November 2003, we settled the
Beutlich and Viridian litigation. We paid Viridian $29,000 of the $131,700 that
the court had awarded and Viridian waived the balance.

14



---



##### 



Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations

ZILA, INC. AND SUBSIDIARIES

Forward-Looking Information

This Report contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934. The words believe, expect, anticipate, intend,
estimate, may, should, could, will, believe, 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; (xi) 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) future increases in the cost of ascorbic acid, the primary raw material in
our Ester-C® products and our ability to pass price increases along to our
customers; (xxi) our ability to secure long-term supply arrangements for
ascorbic acid at stable prices that are lower than those we are currently
paying for part or all of our requirements; (xxii) the market acceptance of the
ViziLite® and Ester-E products; (xxiii) our ability to add new customers at
IST to replace sales volume, in whole or in part, upon the expiration on our
contract on March 30, 2004 with a major customer representing approximately 70%
of ISTs monthly sales; and (xxiv) a general downturn in the national economy
as a whole.

15



---



##### 



Included among the factors affecting the OraTest® product are (i)
successful completion of the clinical program; (ii) our ability to accelerate,
expand and fund the clinical study under terms that are reasonable and prudent
for us; (iii) the FDAs ultimate decision regarding the OraTest® product; (iv)
the length, size and expense of our clinical program and the FDA review
process; (v) stability of the ZTC drug substance; (vi) the limitations on
indicated uses for which the OraTest® product may be marketed if we receive FDA
approval; and (vii) 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 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 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 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. We anticipate
that the net proceeds of approximately $14.8 million received in June 2003 from
the settlement of the contract dispute with our former contract research
organization, along with cash generated from our

16



---



##### 



Nutraceuticals and Pharmaceuticals groups, will be adequate to support
these activities. 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
October 31, 2003 of $6.5 million have been capitalized.

The cash flows used to measure long-lived assets related to the ViziLite®
product are dependent upon our ability to market and sell the product to a
sufficient number of dentists 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 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 October 31, 2003 of $2.2 million have been capitalized.

Intangible Assets The following is a summary of the significant classes
of intangible assets and our impairment methodology for each.

Our policy is to review the carrying amounts of goodwill and certain
intangible assets with indefinite lives 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 event 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.

OraTest®- The purchase of CTM Associates, Inc. (CTM) in June 1996
eliminated our obligation to pay royalties to CTM on future sales of the
OraTest® product. The recoverability of the $3.9 million net purchased
technology rights is dependent upon obtaining FDA approval and generating
sufficient revenues from future sales of the OraTest® products. Fixed assets of
approximately $810,000 (primarily related to a manufacturing facility), patents
and patents pending of $1,057,000, long-term deposits of $760,000 and $578,000
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.

Pharmaceuticals Goodwill This goodwill is related to the Peridex®
product which was acquired from Procter & Gamble in November 1997 and to the
IST acquisition that occurred in February 2001. As part of the implementation
for 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

17



---



##### 



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- Goodwill and trademarks totaling
approximately $11.7 million (net of accumulated amortization of $3.7 million)
are related to the Ester-C® group of products. These assets were acquired by
merger in 1997 and are combined for purposes of testing for impairment. We
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.

COMPANY OVERVIEW

We are an innovator in preventative healthcare technologies within
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 plans to
launch Ester-E, an enhanced form of vitamin E, in early 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 Zila® Tolonium
Chloride technologies for cancer and pre-cancer detection and treatment.

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 October 31, 2003 with the three months
ended October 31, 2002

Total Company

Net revenues increased 12.3% to $12.1 million for the three months ended
October 31, 2003, compared to revenues of $10.7 million for the three months
ended October 31, 2002. The increase is due to a 19.1% sales increase in the
Pharmaceuticals Group and a 7.9% sales increase in the Nutraceuticals Group.

Cost of products sold as a percentage of net revenues increased to 41.8%
from 39.7% for the three months ended October 31, 2003. This increase was due
primarily to substantially higher costs for the ascorbic acid raw material used
by the Nutraceuticals Group in its Ester-C® products, a higher percentage of
sales of the lower margin IST product line, increased Zilactin® product costs
related to promotional activities and increased manufacturing costs for
Zilactin®-L.

Marketing and selling expenses for the three months ended October 31, 2003
of $3.0 million were 13.0% higher than the $2.7 million spent in the three
months ended October 31, 2002. This

18



---



##### 



increase was primarily due to heavy brand and media advertising support
for the Nutraceutical Group product, Ester-C®,which offset a decline in
marketing support for certain Pharmaceutical Group products.

General and administrative expenses were $3.7 million, or 30.9% of net
revenues, for the three months ended October 31, 2003, compared to $3.1
million, or 28.6% of net revenue, for the three months ended October 31, 2002.
The increase in general and administrative expenses is primarily attributable
to increased costs for professional services, including $469,000 in legal fees
associated with recently concluded litigation, $106,000 in regulatory
consulting fees for OraTest® and $83,000 in auditing fees.

Severance and related charges of $40,000 in connection with employee
terminations, recruiting fees and relocation expenses were incurred in the
three months ended October 31, 2003, compared to $880,000 incurred in the three
months ended October 31, 2002.

Research and development expenses increased $343,000, or approximately
44.9%, to $1,107,000 for the three months ended October 31, 2003 from $764,000
in the three months ended October 31, 2002. The increase is due primarily to an
increase in the OraTest® phase III clinical trial expenses of 78.7%, offset by
a reduction in Pharmaceutical expenditures.

Depreciation and amortization expenses increased to $626,000, or
approximately 5.9%, for the three months ended October 31, 2003 from $591,000
for the three months ended October 31, 2002. The increase is due to
depreciation of Nutraceuticals capital expenditures and the inclusion of the
amortization related to the ViziLite® product.

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 three months ended October 31, 2003 and 2002,
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
October 31, 2003, all of our deferred tax assets were offset by a valuation
allowance.

Nutraceuticals Group

Net revenues for the Nutraceuticals Group for the three months ended
October 31, 2003 increased 7.9% to $7 million compared to $6.5 million for the
three months ended October 31, 2002. This growth was driven by a 15% increase
in Ester-C® sales for the three months ended October 31, 2003 over the three
months ended October 31, 2002, partially offset by much lower sales of saw
palmetto oil products as we have exited that business. Sales of Ester-C® as a
bulk ingredient rose 39% during the quarter, driven principally by increased
radio and television advertising support for the Ester-C® products in our
continuing strategy of brand development. As previously reported, 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 and exit the saw palmetto business.

Cost of products sold as a percentage of net revenues for the
Nutraceuticals Group increased to 41.0% for the three months ended October 31,
2003 compared to 33.1% for the three months ended October 31, 2002. This
increase was caused primarily by higher costs of ascorbic acid. The
Nutraceuticals Group has obtained stable sources at lower prices than it is
currently paying for a

19



---



##### 



portion of its ascorbic acid needs for fiscal year 2004 and part of fiscal
year 2005 and continues to actively pursue lower cost extended supply
arrangements for its remaining needs.

Ascorbic acid is the major raw material in our Ester-C® products and is
subject to periodic price fluctuations. While ascorbic acid prices have risen
dramatically during fiscal year 2003, we believe that our costs will be less
variable through fiscal year 2004 although no assurances can be provided in
this regard. 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 Group

Net revenues for the Pharmaceuticals Group for the three months ended
October 31, 2003 increased 19.1% to $5.1 million compared to $4.2 million from
the three months ended October 31, 2002. Net revenues of the Zilactin® line of
products were $2.0 million for the three months ended October 31, 2003, an
increase of $0.1 million from the same three months in 2002. Net revenues of the
Peridex® product were $1.4 million in the three months ended October 31, 2003,
matching net revenues for the three months ended October 31, 2002. However, the
customer mix changed significantly, with an 86% increase in sales to Omnii Oral
Pharmaceuticals (Omnii), which offset a 67% decrease in sales to U.S.
wholesalers for sales that were not repeated in the three months ended October
31, 2003 due to seasonal sales pattern fluctuations. Sales for IST (net of
intercompany sales) were $1.6 million, compared to $892,000 last year, as we
increased production to match the needs of our major customer, Matrixx
Initiatives, Inc. (Matrixx), a US-based healthcare company. However, we will
lose this customer in March 2004 when our current contract expires.

Cost of products sold as a percentage of net revenues for the
Pharmaceuticals segment decreased to 42.1% during the three months ended
October 31, 2003 from 44.8% for the three months ended October 31, 2002,
primarily due to the lower cost of product at IST. The lower cost of product at
IST resulted from a March 2003 price increase for products made for Matrixx and
to a lesser extent from improvement in manufacturing efficiencies due to the
full utilization of new machinery installed in fiscal 2003. The IST improvement
was partially offset by a 16% increase in Zilactin® product costs, which rose
to 47.9% for the quarter ended October 31, 2003 from 41.6% in the quarter ended
October 31, 2002. The increased cost of product was due primarily to the higher
cost of promotional events, along with increased production costs of
Zilactin®-L.

Biotechnology Group

Revenues from sales of the OraTest® product in the United Kingdom and the
Pacific Rim area were nominal during the three months ended October 31, 2003
and 2002, as we deemphasized international sales efforts and spending in favor
of focusing on obtaining FDA approval in the United States.

Total operating expenses for the Biotechnology segment were $1.6 million
for the three months ended October 31, 2003, a 64.3 % increase over the $1.0
million for the three months ended October 31, 2002. This was driven by a 78.7%
increase in the phase III clinical trial expenses related to the OraTest®
product, an increase of approximately $440,000.

LIQUIDITY AND CAPITAL RESOURCES

At October 31, 2003, our primary sources of liquidity included cash and
cash equivalents of $12.9 million and the line of credit discussed below.
Working capital decreased to $20.6 million at October 31, 2003 from $22 million
at July 31, 2003, while the current ratio increased to 3.0 at October

20



---



##### 



31, 2003 from 2.9 at July 31, 2003. This decrease in working capital is due to
cash payments to pay down accounts payable, an increase in short-term
borrowings and the need to fund the first quarter operating loss.

Net cash used in operating activities was $3.1 million during the three
months ended October 31, 2003 and was attributable to the net loss of $1.6
million offset by non-cash items of $626,000. Significant changes in operating
assets and liabilities were primarily comprised of (i) a decrease in accounts
receivable of $661,000 related to collection of receivables from extended term
customers; (ii) an increase in inventory of $631,000 related primarily to the
buildup of Zila Nutraceuticals inventory as we attempt to better balance our
production capacity with customer orders and (iii) a decrease in accounts
payable and accrued expenses of $1.7 million primarily in the Nutraceuticals
and Pharmaceuticals groups to be more in line with industry standards.

Net cash used in investing activities was $473,000, related primarily to
equipment purchases at Zila Nutraceuticals and patent filings for Zila
Nutraceuticals and the OraTest® product.

Net cash provided by financing activities during the three months ended
October 31, 2003 was $285,000. The most significant component of this change
was the increase in short-term borrowings of $284,000 related primarily to the
financing of insurance policies.

Bank Financing

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. The amount of funds
available to us from the line of credit is based upon a percentage of the value
of eligible receivables and inventory was $8.0 million as of October 31, 2003.
The obligations under the Congress Agreement are collateralized by various
assets, including, but not limited to, our 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. The Congress Agreement
expires August 17, 2004. There are no borrowings outstanding under this line of
credit as of October 31, 2003.

Under the Congress Agreement, we are required to maintain adjusted
tangible net worth (as defined) of $12 million. At October 31, 2003, our
adjusted tangible net worth, as defined, was $27.8 million compared to the
required amount of $12.0 million. If we continue to incur additional operating
losses, reduce the value of our tangible assets, or incur additional debt, we
may become out of compliance with the covenant. We are currently negotiating
with several local asset based lenders who we believe can provide terms and
conditions better than Congress based on our current financial position.

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.

21



---



##### 



Long-Term Debt Financing

In April 1999, Oxycal entered into a transaction with The Industrial
Development Authority of the County of Yavapai (the Authority) in which the
Authority issued $5.0 million in Industrial Development Revenue Bonds (the
Bonds). The proceeds were loaned to Oxycal for the construction of a new
manufacturing and laboratory facility. As of October 31, 2003, the Bonds
outstanding consisted of $3.5 million Series A bonds, which bear a variable
interest rate that was 1.3% at October 31, 2003. The Bonds mature in 2019. In
connection with the issuance of the Bonds, the Authority required that Oxycal
obtain, for the benefit of the Bondholders, an irrevocable direct-pay letter of
credit to secure payment of principal and interest. Zila, Inc. guaranteed the
letter of credit. The letter of credit expires on March 15, 2004, and the Bond
Trustee must be notified by February 1, 2004 that a replacement letter of
credit has been obtained. We are in the process of evaluating financial
institutions to secure a replacement letter of credit for these bonds. If,
however, we are unable to replace this letter of credit, we would have to seek
an alternative debt financing source to fund the repayment of these bonds or
pay off the bonds from our available cash resources. There can be no assurance
that any new financing, if available, will be on terms and conditions as
favorable as our current financing or will be otherwise acceptable to us.

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 three months ended October 31, 2002, we repurchased 30,100 shares of
our common stock for $36,253. No shares were repurchased during the three
months ended October 31, 2003. As of October 31, 2003, we had repurchased
225,100 shares of common stock at an aggregate cost of $571,000.

Preferred Stock Financing

On February 5, 2001, we issued 100,000 shares of Series B Convertible
Preferred Stock as part of the IST acquisition. The holders of the Preferred
Stock are entitled to receive cumulative quarterly dividends at a rate of
$0.0975 per share per fiscal quarter, payable in arrears. During the three
months ended October 31, 2003, we paid dividends of $9,750 and we have
accumulated accrued dividends of $19,500 as of October 31, 2003.

Future Contractual Obligations

The table below summarizes our future cash contractual obligations:

Short-Term
    
    Operating
    
    Capital Lease
    
    PurchaseLong-Term Debt
    
    Debt
    
    Leases
    
    Obligations
    
    Obligations
    
    TotalRemaining 2004
    
    $
    367,522
    
    
    $
    438,797
    
    
    $
    302,759
    
    
    $
    11,983
    
    
    $
    5,158,923
    
    
    $
    6,279,9842005 & 2006
    
    
    925,020
    
    
    
    
    
    
    
    382,710
    
    
    
    31,955
    
    
    
    
    
    
    
    1,339,6852007 & 2008
    
    
    851,568
    
    
    
    
    
    
    
    103,951
    
    
    
    31,955
    
    
    
    
    
    
    
    987,474Thereafter
    
    
    1,951,552
    
    
    
    
    
    
    
    
    
    
    
    20,576
    
    
    
    
    
    
    
    1,972,128Total
    
    $
    4,095,662
    
    
    $
    438,797
    
    
    $
    789,420
    
    
    $
    96,469
    
    
    $
    5,158,923
    
    
 $
    10,579,271


Purchase obligations include commitments for advertising.

22



---



##### 



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 CROs
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 October 31, 2003, we have approximately $359,000 of ZTC, the active
ingredient in the OraTest® product, at our manufacturing facility in Phoenix,
AZ. We intend to realize the value of this active ingredient through sales in
the U.S., if we obtain final approval for the OraTest® products from the FDA,
and through sales in Europe and Asia prior to the date we expect sales in the
United States. The drug substance currently has expiration dates in 2004, 2005
and 2006. Previous testing indicates that the drug substance is stable and we
expect to be able to extend the expiration dates of the entire drug substance
inventory through the date we expect sales in the United States. However, no
assurance can be given in this regard. In addition, should FDA approval not be
granted or be significantly delayed, it may not be possible for us to recover
the value of this drug substance.

ViziLite®

On October 15, 2003, we entered into a mediated settlement with Trylon of
various issues. As part of the settlement, we agreed to eliminate the
contractual restrictions relating to sales milestones associated with 500,000
shares of the previously issued 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 payment
ends.

We have $415,000 of ViziLite® product in inventory as of October 31, 2003.
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 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 State 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

23



---



##### 



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. We anticipate that we will
launch the Ester-E product in early 2004. Under the agreement, Zila is
required to make royalty payments based on certain levels of sale volume. We
are also required to pay certain upfront fees upon the completion of certain
market launch milestones, as defined in the agreement, and minimum annual
royalty fees on sales. We believe that our current cash position and operating
cash flow are sufficient to fund the Ester-E product launch.

We believe that cash generated from our operations, our investing
activities and the availability of cash under our line of credit are sufficient
to finance our level of operations, the OraTest® clinical trial, anticipated
capital expenditures, and the stock repurchase program through the next 12
months.

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 a variable interest rate equal to
three-quarters of one (0.75%) percent per annum in excess of the prime rate
announced by First Union Bank (4.75% at October 31, 2003). At October 31, 2003,
we had no borrowings outstanding under this line of credit. The impact of a 10%
proportional increase in average interest rates would not be expected to have a
material effect on us since average outstanding balances on the line are not
expected to be significant. We also have long-term debt associated with the
Industrial Development Revenue Bonds that carry a variable interest rate. The
rates are set weekly by Bank One Capital Markets and fluctuate based on market
conditions and our rate was 1.3% at October 31, 2003. A 10% proportional
increase in the average interest rate on the bonds 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 Control 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 (i) in general computer controls at our corporate headquarters and at
Zila Nutraceuticals and (ii) in the application of our revenue recognition
policy at one of our divisions. For the period covered by this Report, we have
developed a strategic plan to improve general computer controls and have
developed and implemented several policies and procedures in certain risk
areas. With respect to the revenue recognition issue, we refined revenue
cut-off procedures and performed an extensive review at the division level for
this quarter to ensure compliance with our revenue recognition policy.

24



---



##### 



Except as set forth 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 entered into a mediated settlement with Trylon of
various issues. As part of the settlement, we agreed to eliminate the
contractual restrictions relating to sales milestones associated with 500,000
shares of the previously issued 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 payment
ends.

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 furthermore 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. However, one of Tinnells counterclaims is
still outstanding for breach of contract. Furthermore, the court has not ruled
on our request for reimbursement of overpaid royalties. We intend to request
the Court to rule on our claim for reimbursement and prepare for trial on the
remaining breach of contract issue.

In November 2001, we filed a suit for trademark infringement and trade
secret misappropriation against Darrel Van Dyke and GMP Products, LLC relating
to ISTs patented swab technology. Subsequent to 2001, GMP Products changed its
name to Viridian Packaging Solutions, LLC (Viridian). In December 2002, the
court entered a final judgment against us and the defendants brought a motion
to recover their attorneys fees and other costs incurred in defending the
action. On September 29, 2003, the court awarded $131,700 to the defendants.

In January 2003, we filed a suit for patent infringement against Beutlich
Pharmaceuticals, LP (Beutlich) alleging that it sold dry-handle swabs that
infringe upon our IST product swab patent. In February 2003, the Arizona court
issued a temporary restraining order in our favor that stopped Beutlich from
selling its swabs. In May 2003, Viridian filed a declaratory judgment action in
the Northern District of Illinois that sought a declaration of non-infringement
and patent invalidity.

In November 2003, we settled of both of these matters. Under the
settlement agreement we permitted Beutlich and Viridian to sell their products
to certain prospective customers. In addition, we paid Viridian $29,000 of the
$131,700 that the court had awarded and Viridian waived the balance.

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.

25



---



##### 



ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

Not Applicable.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES.

Not Applicable

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

Not Applicable

ITEM 5. OTHER INFORMATION

Not Applicable

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K



| | (a) |  | Exhibits
| | --- |  | --------

Exhibit Number
    
    Description31.1
    
    Certification of the Chief Executive Officer as required
by Rule 13a-14(a) of the Securities Exchange Act of 1934, as
amended31.2
    
    Certification of the Chief Financial Officer as required
by Rule 13a-14(a) of the Securities Exchange Act of 1934, as
amended32.1
    
    Certification of the Chief Executive Officer as required
by Rule 13a-149(b) of the Securities Exchange Act of 1934, as
amended*32.2
    
    Certification of the Chief Financial Officer as required
by Rule 13a-149(b) of the Securities Exchange Act of 1934, as
amended*




| | (b) |  | Reports on Form 8-K
| | --- |  | -------------------



| |  |  | During the quarter ended October 31, 2003, we filed one Current
Report on Form 8-K dated July 30, 2003.
| |  |  | -------------------------------------------------------------------------------------------------------

26



---



##### 



SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.

Date: December 15, 2003
    
    By:/s/Douglas D. Burkett, Ph.D.Douglas D. Burkett, Ph.D.President, Chairman of the Board(Principal Executive Officer)By:/s/Lawrence J. BatinaLawrence J. BatinaVice President and Chief Financial Officer(Principal Financial & Accounting Officer)


27



---



##### 



INDEX TO EXHIBITS

Exhibit Number
    
    Description31.1
    
    Certification of the Chief Executive Officer as required
by Rule 13a-14(a) of the Securities Exchange Act of 1934, as
amended31.2
    
    Certification of the Chief Financial Officer as required
by Rule 13a-14(a) of the Securities Exchange Act of 1934, as
amended32.1
    
    Certification of the Chief Executive Officer as required
by Rule 13a-149(b) of the Securities Exchange Act of 1934, as
amended*32.2
    
    Certification of the Chief Financial Officer as required
by Rule 13a-149(b) of the Securities Exchange Act of 1934, as
amended*


28