UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

(Mark One)

[X] Quarterly Report pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934

For the quarter ended September 30, 2004

or

[   ] 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 0-27646

Matrixx Initiatives, Inc.

4742 N. 24^th Street, Suite 455
Phoenix, AZ 85016
(Address of principal executive offices)

(602) 385-8888
(Issuer’s telephone number)

Indicate by check mark whether the registrant (1) 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 [   ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). YES [   ]     NO [x]

There were 9,476,701 shares of the registrant’s common stock, $.001 par value, outstanding as of November 1, 2004.

MATRIXX INITIATIVES, INC.
FORM 10-Q
INDEX

Unless otherwise indicated in this quarterly report, “Matrixx,” “us,” “we,” “our”, “the Company” and similar terms refer to Matrixx Initiatives, Inc. and its subsidiaries. “Zicam” is a registered trademark of our subsidiary, Zicam, LLC, and the Matrixx name and logo are trademarks of the Company.

MATRIXX INITIATIVES, INC. AND SUBSIDIARY

ASSETS

The accompanying notes are an integral part of these condensed consolidated financial statements.

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MATRIXX INITIATIVES, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED BALANCE SHEETS
(Continued)
(Unaudited)

LIABILITIES AND STOCKHOLDERS’ EQUITY

The accompanying notes are an integral part of these condensed consolidated financial statements.

2

MATRIXX INITIATIVES, INC. AND SUBSIDIARY

The accompanying notes are an integral part of these condensed consolidated financial statements.

3

MATRIXX INITIATIVES, INC. AND SUBSIDIARY

The accompanying notes are an integral part of these condensed consolidated financial statements.

4

MATRIXX INITIATIVES, INC. AND SUBSIDIARY

The accompanying notes are an integral part of these condensed consolidated financial statements.

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MATRIXX INITIATIVES, INC.

1.		The accompanying financial information of Matrixx Initiatives, Inc. is prepared in accordance with the rules prescribed for filing condensed interim financial statements and, accordingly, does not include all disclosures that may be necessary for complete financial statements prepared in accordance with US generally accepted accounting principles. The disclosures presented are sufficient, in management’s opinion, to make the interim information presented not misleading. All adjustments, consisting of normal recurring adjustments, which are necessary so as to make the interim information not misleading, have been made. Results of operations for the nine months ended September 30, 2004 are not necessarily indicative of results of operations that may be expected for the year ending December 31, 2004. It is recommended that this financial information be read with the complete financial statements included in Matrixx’s Annual Report on Form 10-K for the year ended December 31, 2003 previously filed with the Securities and Exchange Commission.
2.		Stock-Based Compensation

     The Company adopted the disclosure provisions of Statement of Financial Accounting Standard (“SFAS”) No. 123, “Accounting for Stock-Based Compensation”, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure — an Amendment to SFAS 123”. The Company will continue to measure compensation expense for its stock-based employee compensation plans using the intrinsic value method prescribed by Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations in accounting for its stock based compensation plans and does not recognize compensation expense for its stock-based compensation plans other than for options granted to non-employees. If the Company had elected to recognize compensation expense based upon the fair value at the grant date for awards under its stock-based compensation plans consistent with the methodology prescribed by SFAS No. 123, the Company’s net income and net income per share would be reduced to the following pro forma amounts:

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MATRIXX INITIATIVES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

During the quarter ended September 30, 2004, no options were exercised. For the nine months ended September 30, 2004, 35,000 options were exercised for total proceeds to the Company of $392,500.

3.

The Company follows the provisions of Statement of Financial Accounting Standards (SFAS) No. 128, “Earnings Per Share”, which specifies the method of computation, presentation and disclosure of earnings per share. SFAS No. 128 requires the presentation of two earnings per share amounts, basic and diluted. Basic earnings per share is calculated using the average number of common shares outstanding. Diluted earnings per share is computed on the basis of the average number of common shares outstanding plus the effect of dilutive securities. The Company’s stock options are included using the “treasury stock” method.

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MATRIXX INITIATIVES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

     The table below summarizes the elements included in the calculation of basic and diluted net income per common share for the three and nine months ended September 30, 2004 and 2003. Options, warrants and other incremental shares to purchase 391,893 and 215,000 shares of common stock for the three months ended September 30, 2004 and 2003, and 357,963 and 376,300 shares of common stock for the nine months ended September 30, 2004 and 2003, respectively, were not included in the computation of diluted net income per share because their effect would be anti-dilutive.

4.

Inventories consisted of the following at September 30, 2004, and December 31, 2003:

     The increase in inventory is due to the addition of six new Zicam Cough Mist products and the seasonal increase of inventory to meet expected increases in sales during the cough and cold season.

5.

Recently Issued Accounting Standards

     In January 2003, the Financial Accounting Standards Board (“FASB”) issued FIN 46, Consolidation of Variable Interest Entities, which was amended in December 2003, as FIN 46R. In general a variable entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has

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equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN 46R requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or entitled to receive a majority of the entity’s residual returns or both. The consolidation requirements of FIN 46R apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements apply to transactions entered into prior to February 1, 2003 in the first fiscal year or interim period beginning after June 15, 2003, which was subsequently delayed until the fourth quarter of 2003. Certain of the disclosure requirements apply in all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. The Company does not have any variable interest entities and therefore, the adoption of the interpretation did not have any impact on our financial statements.

6.

New Insurance Program

     In April 2004, we established a fully-funded deductible insurance program through a product liability insurance carrier. Under the program, we have agreed to reimburse our insurer for its claims administration expenses and for amounts paid out by it in settlement of product liability claims filed after the initial date of the program and which are not covered by insurance programs from prior years. The terms of the program require us to maintain an irrevocable, evergreen letter of credit issued by a bank or other financial institution to secure our reimbursement obligations to our insurer. We have a $5.0 million letter of credit with Comerica Bank and have reserved an equal amount of cash, presented as restricted cash in the accompanying balance sheet, to secure repayments of amounts that become due under the letter of credit.

7.

Legal Proceedings

          We are subject, from time to time, to legal proceedings and claims regarding adverse reactions to our products. From late 2003 through October 2004, we have been sued by approximately 284 individuals in 19 different lawsuits generally alleging that our Zicam Cold Remedy product caused damage to the sense of smell and/or taste. Two of these lawsuits have been filed as class action lawsuits covering named and unnamed plaintiffs. The lawsuits have been previously disclosed in our Annual Report on Form 10-K for our fiscal year ended December 31, 2003; our Quarterly Reports on Form 10-Q for our first quarter ended March 31, 2004 and our second quarter ended June 30, 2004; and on our Report on Form 8-K filed August 20, 2004. Various defendants in the lawsuits, including manufacturers and retailers, have sought indemnification or other recovery from us for damages related to the lawsuits.

          All of the existing lawsuits have been submitted to our insurance carriers. We cannot predict the outcome of the litigation, but we will defend ourselves vigorously. If any liability were to result from one or more of these or future lawsuits, we believe our financial results could be materially impacted. Our future financial results could also be materially impacted by the adverse publicity that may result from the lawsuits.

          Additionally, there have been two class action lawsuits filed against the Company, our President and Chief Executive Officer, Carl J. Johnson, and our Executive Vice President and Chief Financial Officer, William J. Hemelt, alleging violations of federal securities laws. The

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cases were previously disclosed on our Quarterly Report on Form 10-Q for our second quarter ended June 30, 2004. Among other things, the lawsuits allege that between October 2003 and February 2004, we made materially false and misleading statements regarding our Zicam Cold Remedy product, including failing to adequately disclose to the public the details of certain of the product liability lawsuits described above. We believe the claims made in these lawsuits are without merit and represent the actions of opportunistic plaintiffs’ law firms seeking to take advantage of existing Zicam Cold Remedy litigation. We intend to vigorously defend ourselves in these matters. In accordance with and subject to the provisions of the Company’s Certificate of Incorporation, Messrs. Johnson and Hemelt will be indemnified by the Company for their expenses incurred in defending these lawsuits and for any other losses which they may suffer as a result of these lawsuits. If any liability were to result from these lawsuits, we believe our financial results could be materially impacted.

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

Overview

          Through our 100%-owned subsidiary, Zicam LLC, we are engaged in the development, production and sale of over-the-counter pharmaceutical products. In 2002, we introduced five new Zicam nasal gel products, improved package graphics for our entire Zicam product line and engaged a new sales team to represent our products to retailers. In 2003, we began shipping three new Zicam Cold Remedy products (Oral Mist, Chewables and RapidMelts). In the third quarter of fiscal 2004, we began shipping our six new Zicam Cough Mist products (Cough Mist Adult Cherry, Cough Mist Adult Honey Lemon, Cough Mist Adult Plus Decongestant, Cough Mist Adult Night Time, Cough Mist Kids Cherry, Cough Mist Kids Plus Decongestant).

Executive Summary

          Net sales for the third quarter of fiscal 2004 increased 26% to approximately $16.9 million compared to approximately $13.4 million for the third quarter of 2003. The increased sales in the third quarter of 2004 were due to sales of the new Zicam Cough Mist products. Net income for the third quarter of 2004 increased 33% to approximately $3.7 million compared to $2.8 million in the third quarter of 2003. The increase in net income is primarily related to the increased sales for the quarter.

          Net sales for the first nine months of fiscal 2004 increased 31% to approximately $33.2 million compared to approximately $25.3 million for the first nine months of fiscal 2003. Approximately half of the increase was attributable to sales of our new Zicam Cough Mist products, while sales of our allergy and sinus products increased approximately 37%. The remaining increase in sales is attributable to increased sales of Zicam Cold Remedy oral products that were introduced in the third quarter of 2003. Net income for the first nine months of fiscal 2004 increased 42% to approximately $3.3 million, compared to approximately $2.3 million for the first nine months of 2003.

          We expect net income in future periods will be significantly affected by the level of sales, the timing and amount of our advertising and research and development expenses, and the timing

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and amount of expenses incurred in the defense of product liability and securities litigation matters.

          Since the introduction of our new Zicam Cough Mist products, we now market products in the cold (3 nasal delivery products and 3 oral delivery products), allergy/sinus (4 nasal delivery products), and cough (6 oral delivery products) market categories of the overall cough and cold category. We expect that our mix of products sold will change due to seasonality and varying growth rates within the market categories. For the nine months ending September 30, 2004 our mix of products sold was cold — 56%, allergy/sinus — 27%, and cough — 17%, compared to the nine months ending September 30, 2003 of cold — 72%, and allergy/sinus — 28%.

          Our expected growth in annual sales will depend on our success in securing additional retail distribution of our products, including the six new Zicam Cough Mist products, expanding consumer awareness and acceptance of our entire line of Zicam products, and avoiding additional adverse publicity. Expenditures for advertising, research and development and legal expenses will vary by quarter throughout the year and could be significantly different from amounts incurred in the same periods in prior years. We expect advertising expenses to be heaviest in our first and fourth fiscal quarters in conjunction with the cough and cold season.

          Management reviews several key performance indicators. First, we compare our year to date sales and net income performance against our stated annual goal for each. In fiscal 2004, our goal was to grow sales and net income 30% above the level realized in 2003. For the nine months ended September 30, 2004 net sales have increased 31% and net income is up 42% over the same period in 2003. Second, we monitor our overall share of the cough and cold market. For the 12-week period ended September 5, 2004, retail sales of our products (as measured by three outlet syndicated scanner data, not including our customer Wal-Mart) increased approximately 29% over the comparable period a year ago while the entire cough and cold category experienced a 2% increase over the same period. Third, we measure our ability to maintain strong gross margins on our products. During the nine months ended September 30, 2004, our products averaged a gross margin of 69%, which was slightly below our target of 70% for the full year, but better than the 68% recorded for the first nine months of 2003. Fourth, we evaluate our operating performance by reviewing, over time, our ability to decrease administrative and general costs as a percentage of net sales. For the third quarter of fiscal 2004, our operating expenses were 32% of our net sales compared to 28% for the third quarter of fiscal 2003. Operating expenses have been negatively impacted by an increase in legal expense primarily related to the product liability lawsuits which have been filed against the Company (see Part II, Item 1- “Legal Proceedings”, in this Report on Form 10-Q). Fifth, we review the distribution of our products by key national customers. We expect to expand the distribution of our existing products and add distribution of our new products among our top 10 retailers and anticipate them carrying, on average, 12 of our 16 products for the 2004-2005 cough and cold season compared to carrying, on average, seven of our products during the prior year’s cough and cold season.

          The legal challenges facing the Company have, as previously reported, slowed new product development activity. We expect that slowness, coupled with the high level of legal expenses, may slow the rate of net income growth in 2005 compared to that achieved in recent years.

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Critical Accounting Policies and Estimates

          Our consolidated financial statements and accompanying notes have been prepared in accordance with U.S. generally accepted accounting principles applied on a consistent basis. The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods.

          We regularly evaluate the accounting policies and estimates that we use to prepare our consolidated financial statements. In general, management’s estimates are based on historical experience, on information from third party professionals and on various other assumptions that are believed to be reasonable under the facts and circumstances. Actual results could differ from those estimates made by management.

          We believe that our critical accounting policies and estimates include the accounting for intangible assets and goodwill, accounting for income taxes, accounting for returns and allowances associated with our products, and accounting for legal contingencies.

          Intangible Assets and Goodwill: We recorded approximately $15.0 million in goodwill in connection with the 40% Zicam, LLC interest that we acquired from Zensano, Inc. in December 2001. Under SFAS No. 142, goodwill must be tested when a triggering event occurs or at least annually to identify a potential impairment and the amount of any impairment loss. Factors that could affect this analysis would be significant loss of market share, a general decline in Zicam product sales, higher than expected increases in expenses and various other matters. Any change in key assumptions about the business or prospects of Zicam, LLC, or any change in market conditions or other externalities affecting Zicam, LLC, could result in an impairment charge, and such a charge could have a material adverse effect on our financial condition and results of operations. Our annual evaluation of goodwill was completed in the third quarter of 2004 by an independent valuation firm and no impairment was found.

          Income Taxes: Due to our significant operating losses prior to 2001, we possess a sizeable tax loss carry-forward which can be used to reduce our taxable income in future periods. Due to our history of operating losses, we recorded a deferred tax valuation allowance in 2001 and prior years to offset the entire deferred tax asset arising from our tax loss carry-forward. However, due to the significant improvement in our net income in 2002, together with our expectation of continuing profitability in future years, we determined that we are more likely than not to realize the tax benefit associated with our tax loss carry-forward. Consequently, we reduced the deferred tax valuation allowance and recorded a large portion of the deferred tax asset in 2002. The effect of this change was a decrease in our income tax expense of approximately $3.4 million in 2002.

          In 2003 and the first nine months of 2004, we recorded income tax expense based on our estimated effective income tax rate for the year and will continue to do so in future periods. In addition, we will continue to evaluate the deferred tax valuation allowance regularly and adjust the amount to reflect our expectation of our ability to realize the tax benefit arising from our tax

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loss carry-forward on a quarterly basis. Should there be a significant change in our expectations of future income, the impact of increasing the deferred tax valuation allowance could be significant which would negatively impact our earnings.

          Customer Returns and Allowances: We recognize revenues on the sale of our products when they are shipped from our warehouse facilities, and at that time record a provision for estimated product returns. The estimate for product returns is based on our historical experience of sales to retailers and is reviewed regularly to ensure that it reflects the liability associated with product returns. To date, our sales returns experience has been consistent with our estimate for returns, except for returns of outdated products arising from excess production during the introduction of Zicam Cold Remedy in the 1999-2000 cough and cold season, which resulted in out-of-date product two years later. In July 2004, we reviewed the return provision for the three oral delivery Cold Remedy products that were introduced in the third quarter of 2003. Based on our product return experience we reduced the return provision from 7% to 3% on sales of these three products in mid 2004. Currently, we are recording a provision of 3% of gross sales for the 10 Zicam products introduced in 2003 or earlier for potential returns and allowances. In establishing the appropriate reserve level for the six new Zicam Cough Mist products, that began shipping in July 2004, we reviewed the similarities and differences of the six products relative to the 10 Zicam products for which we now have several years of product return experience. Based on that review, we are recording a provision of 7% of gross sales for these products. We will review the return provision at least quarterly and adjust these reserve amounts as actual product return experience continues to develop. Should the actual level of product returns vary significantly from our estimates, our operating and financial results would be materially affected. In addition, we expect that a higher sales returns allowance will be recorded for any other new products that we introduce until such products achieve market acceptance.

          Legal Contingencies: We are subject to lawsuits, investigations and claims arising out of the normal conduct of our business. We are being sued by approximately 284 individuals in 19 different lawsuits generally alleging that our Zicam Cold Remedy product caused damage to their sense of smell and/or taste. Two of these lawsuits have been filed as class action lawsuits. Various defendants in the lawsuits, including manufacturers and retailers, have sought indemnification or other recovery from us for damages related to the lawsuits. In addition, two class action lawsuits have been filed against Matrixx, our President and Chief Executive Officer, Carl J. Johnson, and our Executive Vice President and Chief Financial Officer, William J. Hemelt, alleging violation of federal securities laws (see Part II, Item 1- “Legal Proceedings”, in this Report on Form 10-Q). While we intend to defend ourselves vigorously in each of these proceedings, the outcome of these and any other proceedings that may arise cannot be predicted with certainty. Therefore, loss provisions arising from such matters will be recorded when a loss outcome is probable and can be reasonably estimated, to the extent not provided for through insurance or otherwise. At present, we have not been able to determine the probability of a loss outcome in any of the litigation to which we are currently subject. Accordingly, we have not recorded any loss provisions related to such litigation.

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Results of Operations for the Three Months Ended September 30, 2004 Compared to the Three Months Ended September 30, 2003

          Certain information is set forth below for our Zicam operations expressed in dollars and as a percentage of net sales for the periods indicated:

          Net Sales. Net sales for the three months ended September 30, 2004 increased approximately $3.5 million to $16.9 million, or almost 26% above net sales in the third quarter of the prior year. For the quarter ended September 30, 2004, the increase in net sales was due to sales of the new Zicam Cough Mist products which began shipping in July 2004.

          Generally, sales in the third quarter are significantly higher than the prior quarter due to retailers purchasing products for the cough and cold season which usually begins at the end of the third quarter. We expect further increases in sales of our cough and cold products in the fourth quarter of 2004 as the incidence of illness increases during the cough and cold season. We continue to expect sales growth of 30% above our 2003 sales level for the full 2004 fiscal year, subject to a number of assumptions including the intensity and timing of the 2004-2005 cough and cold season and no additional adverse publicity.

          Cost of Sales. For the third quarter of fiscal 2004, our cost of sales increased approximately $1 million to approximately $5.2 million, or 24% above the third quarter 2003 cost of sales. The increase in cost of sales is due to the higher sales volume that we experienced during the 2004 third quarter compared to the prior year’s third quarter.

          Gross Profit. Gross profit for the third quarter of 2004 increased to approximately $11.7 million, or 27% greater than the third quarter of 2003, due to the increase in sales. The gross margin increased from 68% in the third quarter 2003, to 69% in the third quarter 2004, due to the phase-out of an older, more expensive swab design and the relative mix of products sold. The gross margin on our current products varies between 65% and 80%. Gross margin will continue to be affected by the relative mix of products sold.

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          Operating Expenses. Operating expenses for the third quarter of 2004 increased to approximately $5.4 million, approximately $1.7 million above the third quarter of 2003. The increase is primarily due to a $1.6 million increase in legal expense ($1.8 million for the quarter ended September 30, 2004 versus $208,000 for the quarter ended September 30, 2003). Also contributing to increased expenses were increases in insurance ($165,000), sales expense ($101,000), and non-advertising marketing expense ($674,000), which offset a $510,000 decrease in advertising expense ($338,000 in the third quarter of 2004 compared to $848,000 in the third quarter 2003), and labor expense ($494,000). The decrease in labor expense reflects the accrual of a portion of year end incentive compensation ($675,000) in the third quarter of 2003, which was not accrued in the third quarter of 2004.

          Expenses in future periods will vary largely in relation to the level of our advertising expenditures, which are heaviest in the first and fourth quarters. We anticipate that we will continue to incur approximately $1.0 to $1.5 million in higher legal expense each quarter as a result of the Zicam Cold Remedy product liability and securities litigation in which we are engaged (see Part II, Item 1 — “Legal Proceedings”, in this Report on Form 10-Q).

          Research and Development. Research and development expenses decreased from approximately $795,000 in the third quarter of 2003 to approximately $353,000 in the third quarter of 2004. We had previously announced our intention to spend 6% of net sales annually on research and development efforts; however, due to research and development efforts being diverted as a result of product liability litigation matters, we do not anticipate spending at that level in 2004. We continue to maintain research and development efforts and remain focused on developing new products.

          Interest & Other Income. Other income increased to $271,000 in the third quarter 2004, approximately $227,000 higher than the third quarter of 2003. The increase is attributable to royalty income associated with a gum product marketed by the Wm. Wrigley Jr. Company. We do not anticipate any future royalty income under this agreement.

          Interest Expense. Interest expense for the third quarter of 2004 was approximately $23,000, $21,000 below the level of the third quarter of 2003. The decrease is attributable to the repayment of the debt that we incurred in connection with the acquisition of the 40% interest in Zicam, LLC in December 2001. This debt was fully repaid in November 2003. In July 2004, we borrowed $2 million against our credit facility with Comerica Bank. We anticipate repaying the borrowing in the fourth quarter of 2004 and ending the year with no debt outstanding.

          Income (Loss) Before Income Tax. Income before income tax in the third quarter of 2004 increased to approximately $6.1 million, or 33%, from $4.6 million in the third quarter of 2003, as a result of higher sales which were partially offset by higher operating expenses. We expect that earnings in future periods will continue to be significantly impacted by the seasonality of our sales, the severity of the cold season, the revenues and expenses associated with new products, and the timing and amount of advertising, research and development, and legal expenses. Based on our expectation of increased sales in the fourth quarter of fiscal 2004, we expect to be profitable in the fourth quarter of fiscal 2004 and for the full 2004 fiscal year.

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          Provision for Income Tax Expense. In 2004, we are recording a provision for income tax expense based on an estimate of our effective income tax rate for the full year. Due to operating income recorded in the third quarter of 2004, we recognized income tax expense of approximately $2.5 million.

          Net Income. Net income increased $914,000, or 33%, to approximately $3.7 million for the quarter ended September 30, 2004, compared to net income for the third quarter of 2003 of approximately $2.8 million. Based on our expectation of seasonally increased sales in the fourth quarter of fiscal 2004, we continue to expect 30% net income growth for the full 2004 fiscal year compared to fiscal 2003, subject to a number of assumptions including the intensity and timing of this year’s cough and cold season and no additional adverse publicity.

Results of Operations for the Nine Months Ended September 30, 2004 Compared to the Nine Months Ended September 30, 2003

     Certain information is set forth below for our Zicam operations expressed in dollars and as a percentage of net sales for the periods indicated:

          Net Sales. Net sales for the nine months ended September 30, 2004 increased to approximately $33.2 million, or 31% above net sales in the first nine months of the prior year. Approximately half of the increase in net sales was attributable to sales of our new Zicam Cough Mist products. Sales of Zicam products within the allergy & sinus segment of our business increased almost 42% in the first nine months of 2004 compared to the same period in the prior year, and accounted for approximately 37% of the increase in net sales for the nine months ended September 30, 2004 compared to the same period in 2003. The remaining increase in sales stemmed from sales growth within our cold remedy line of products. We continue to expect sales growth for the full 2004 fiscal year to be 30% above our 2003 sales, subject to a number of assumptions including the intensity and timing of the 2004-2005 cough and cold season and no additional adverse publicity.

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          Cost of Sales. Our cost of sales increased to approximately $10.4 million, or 30% above the cost of sales for the first nine months of 2003 of approximately $8.0 million. The increase is due to the higher product sales that have occurred year to date.

          Gross Profit. Gross profit for the first nine months of 2004 increased to approximately $22.8 million, or 32% greater than the first nine months of 2003, due to the substantial increase in sales. The gross margin increased 1%, to 69% for the first nine months of 2004 compared to 68% for the same period in 2003. We experienced higher margins in the first nine months of 2004 due to the phase-out of an older, more expensive swab design and the relative mix of products sold. The gross margin on our current products varies between 65% and 80%. Gross margin will continue to be affected by the relative mix of products sold. We anticipate achieving a 70% gross margin for the full year due to the relative mix of products we anticipate selling.

          Operating Expenses. Operating expenses for the nine months ended September 30, 2004 increased to approximately $16.3 million, or approximately $4.7 million above the first nine months of 2003. The increase is due to approximately $2.8 million in increased legal expense compared to the first nine months of 2003 ($3.3 million for the nine months ended September 30, 2004 versus $564,000 for the nine months ended September 30, 2003). Also contributing to increased expenses were increases in non-advertising marketing expense ($1.3 million), insurance expense ($265,000), advertising expense of $169,000 ($5.2 million for the first nine months in 2004 versus $5.0 million in 2003), quality control expense ($271,000), and sales expense ($95,000), which offset a decrease in labor expense ($211,000). The decrease in labor expense reflects the accrual of a portion of year end incentive compensation ($675,000) in the third quarter of 2003, which was not accrued in the third quarter of 2004.

          Expenses in future periods will vary largely in relation to the level of our advertising expenditures, which are heaviest in the first and fourth quarters. We anticipate that we will continue to incur approximately $1.0 to $1.5 million in higher legal expense each quarter as a result of the Zicam Cold Remedy product liability and securities litigation in which we are engaged (see Part II, Item 1 — “Legal Proceedings”, in this Report on Form 10-Q).

          Research and Development. Research and development expenses decreased from approximately $1.7 million in the first nine months of 2003 to approximately $1.3 million in the first nine months of 2004. We had previously announced our intention to spend 6% of net sales annually on research and development efforts; however, due to research and development efforts being diverted as a result of product liability matters, we do not anticipate spending at that level in 2004. We continue to maintain research and development efforts and remain focused on developing new products.

          Interest & Other Income. Interest and other income increased to $346,000 in the first nine months of 2004, approximately $206,000 higher than the same period of 2003. The increase is attributable to royalty income associated with a gum product marketed by the Wm. Wrigley Jr. Company. We do not anticipate any future royalty income under this agreement.

          Interest Expense. Interest expense for the nine months ended September 30, 2004 decreased to $23,000, which is $194,000 below the amount incurred for the first nine months of 2003. The decrease is attributable to the repayment of the debt that we incurred in connection

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with the acquisition of the 40% interest in Zicam, LLC in December 2001. This debt was fully repaid in November 2003. In July 2004, we borrowed $2 million against our credit facility with Comerica Bank. We anticipate repaying the borrowing in the fourth quarter of 2004 and ending the year with no debt.

          Income Before Income Tax. Income before income tax in the first nine months of 2004 increased to approximately $5.5 million, or 42%, from approximately $3.9 million in the first nine months of 2003, due to higher sales which were partially offset by higher operating expenses. We expect that earnings in future periods will continue to be significantly impacted by the seasonality of our sales, the severity of the cold season, the revenues and expenses associated with new products, and the timing and amount of advertising, research and development, and legal expenses. Based on our expectation of increased sales in the fourth quarter, we expect to be profitable in the fourth quarter of fiscal 2004 and for the full 2004 fiscal year.

          Provision for Income Tax Expense. In 2004, we are recording a provision for income tax expense based on an estimate of our effective income tax rate for the full year. We recognized tax expense of almost $2.2 million for the first nine months of 2004.

          Net Income. Net income increased $971,000 to approximately $3.3 million for the nine months ended September 30, 2004, compared to net income for the first nine months in 2003 of $2.3 million. Based on our expectation of seasonally higher sales in the fourth fiscal quarter, we continue to expect 30% net income growth for the full 2004 fiscal year compared to fiscal 2003, subject to a number of assumptions including the intensity and timing of the 2004-2005 cough and cold season and no additional adverse publicity.

Liquidity and Capital Resources

          Our working capital remained unchanged from the $17.6 million level recorded on December 31, 2003. During the nine-month period ended September 30, 2004, we experienced a decrease in cash from operating activities of approximately $3.1 million. The decrease in cash from operations is due to increases in cash of $3.3 million from net income and $2.6 million for non-cash items being offset by decreases in cash of approximately $5.6 million due to increases in inventory levels (the increase in inventory is due to the addition of six new Zicam Cough Mist products and the seasonal increase in inventory to meet expected increases in sales during the cough and cold season). Also contributing to the decrease in cash from operations was a decrease in accounts payable ($1.9 million), an increase in accounts receivable ($801,000), and an increase in prepaid expenses ($682,000).

          Investing activities used cash of approximately $5.1 million. The decrease in cash was primarily due to $5 million of cash being restricted to secure a $5 million letter of credit related to the new insurance program, as discussed below. Cash flow from financing activities provided approximately $2.2 million which includes $2 million borrowed under our credit facility with Comerica Bank in July 2004.

          In April 2004, we established a fully-funded deductible insurance program through a product liability insurance carrier. Under the program, we have agreed to reimburse our insurer for its claims administration expenses and for amounts paid out by it in settlement of product

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liability claims filed after the initial date of the program and which are not covered by insurance programs from prior years. The terms of the program require us to maintain an irrevocable, evergreen letter of credit issued by a bank or other financial institution to secure our reimbursement obligations to our insurer. We have a $5.0 million letter of credit with Comerica Bank and have reserved an equal amount of cash to secure repayments of amounts that become due under the letter of credit. The $5 million reserve is noted as Restricted Cash on the balance sheet and has been placed in an interest earning certificate of deposit.

          We have a $2.5 million credit facility with Comerica Bank which was renewed for a two-year term in May 2003. In July 2004, we borrowed $2 million under the facility to meet our working capital needs in the third quarter. We anticipate repaying the debt in the fourth quarter of 2004 and ending fiscal 2004 with no debt. We are in compliance with the earnings and financial covenants contained in our credit agreement. We believe that our existing capital resources and our credit line will be sufficient to fund our operations and capital requirements for the next 12 months.

Contractual Obligations

          We have entered into certain long-term contractual obligations that will require various payments over future periods as follows:

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS AND RISK FACTORS

Forward Looking Statements

          This Report on Form 10-Q, including documents incorporated herein by reference, contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The words “believe”, “expect”, “estimate”, “anticipate”, “intend”, “may”, “might”, “will”, “would”, “could”, “project” and “predict”, or similar words and phrases generally identify forward-looking statements. Forward looking statements contained herein and in documents incorporated by reference herein include, but are not limited to statements regarding:

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•		our belief that expected growth in sales will depend on our success in securing additional retail distribution of our products, including the six new Cough Mist products that we began shipping in the third quarter of 2004;
•		our belief that growth in sales in future periods will be affected by expanding consumer awareness and acceptance of our entire Zicam brand line of products and upon avoiding additional adverse publicity;
•		our belief that expenditures for advertising and research and development will vary by quarter throughout the year, and our expectation that advertising expenses will be heaviest in our first and fourth fiscal quarters;
•		our expectation that our mix of products sold will change due to seasonality and varying growth rates within our three market categories;
•		our expectation of expanding distribution of our products among our largest 10 retailers such that they will carry, on average, 12 of our 16 products for the 2004-2005 cough and cold season;
•		our expectation that slower product development activity coupled with high legal expenses may slow the rate of net income growth in 2005;
•		our expectation of continuing profitability in future years, and profitability in the fourth quarter of fiscal 2004 and the full 2004 fiscal year;
•		our intention to review our product return reserve provision regularly and adjust the reserve amounts as actual product return experience continues to develop, and our expectation that a higher sales returns allowance will be recorded in the future for new products that we introduce until such products achieve market acceptance;
•		our intention to evaluate and adjust as appropriate the deferred tax valuation allowance;
•		our expectation that sales growth and net income for the full 2004 fiscal year will be 30% above our 2003 sales and net income levels subject to a number of assumptions;
•		our anticipation that we will not receive any future royalty income under our agreement with the Wm. Wrigley Jr. Company.
•		our expectation that our Cough Mist product manufacturer will have inventory available for sales of the Cough Mist products through the 2004-2005 cough and cold season;
•		our expectation that the average unit cost of goods sold and gross margin will continue to be affected by the relative mix of products sold;
•		our expectation of achieving a 70% gross margin for the year;

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•		our expectation that our net income and operating expenses in future periods will vary largely in connection with the level of our advertising, research and development, and legal expenses expenditures;
•		our belief that research and development spending will be below 6% of net sales for 2004;
•		our expectation regarding increases in sales in the fourth quarter of 2004;
•		our expectation that earnings in future periods will be significantly impacted by the seasonality of our sales, the severity of the cold season, the revenues and expenses associated with new products, and the timing and amount of advertising, research and development, and legal expenses;
•		our intention to vigorously defend the Zicam Cold Remedy product liability and securities violation claims that have been filed against us, our expectation that additional product liability lawsuits will be filed against us, and our belief that any liability resulting from these or other lawsuits, including any adverse publicity, could materially impact our financial results;
•		our anticipation that we will continue to incur approximately $1.0 to $1.5 million in higher legal expense each quarter as a result of the Zicam Cold Remedy product liability and securities litigation in which we are engaged;
•		our Scientific Advisory Board’s plan to do further testing of the zinc gluconate nasal gel on human volunteers and animal models, and our expectation that members of the Scientific Advisory Board will reconvene in approximately six months to review the findings of such research;
•		our expectation that we will repay the $2 million borrowed from our credit facility by the end of 2004 and have no debt at the end of fiscal 2004;
•		our belief that our existing capital resources and our credit line will be sufficient to fund our operations and capital requirements for the next 12 months;
•		our having no plans to directly manufacture and store our products; and
•		our belief that moderate interest rate increases will not have a material adverse impact on our results of operations or financial position in the foreseeable future.

          We may make additional written or oral forward-looking statements from time to time in filings with the Securities and Exchange Commission or in public news releases. Such additional statements may include, but not be limited to, projections of revenues, income or loss, capital expenditures, acquisitions, plans for future operations, financing needs or plans, the impact of inflation and plans relating to our products or services, as well as assumptions relating to the foregoing. Forward-looking statements are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified. Future events and actual results could differ

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materially from those set forth in, contemplated by, or underlying our forward-looking statements.

          Statements in this Report on Form 10-Q, including those set forth in the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, and under the subheading below entitled “Risk Factors”, describe factors that could contribute to or cause actual results to differ materially from our expectations. Other such factors include (i) less than anticipated demand for our current and future products, (ii) a weak cough and cold season, (iii) lack of market acceptance for or uncertainties concerning the efficacy or safety of our current and future products or regulatory actions involving our products, (iv) difficulties in increasing production or maintaining sufficient inventories to meet unexpectedly high demand in the short term, (v) financial difficulties encountered by one or more of our principal customers, (vi) difficulties in obtaining additional capital for marketing, research and development, and other expenses, (vii) material litigation involving patent and contractual claims, product liability claims, consumer issues and securities violation claims, and (viii) adverse publicity regarding our products or advertising restrictions.

          Forward-looking statements contained in this Report on Form 10-Q speak only as of the date of this Report on Form 10-Q or, in the case of any document incorporated by reference, the date of that document. We do not undertake, and we specifically disclaim any obligation, to publicly update or revise any forward-looking statement contained in this Report on Form 10-Q or in any document incorporated herein by reference to reflect changed assumptions, the occurrence of unanticipated events or changes to future operating results over time.

Risk Factors

Our new business focus means we have a limited operating history on which to assess our current and prospective performance

          Although we have been in operations for a number of years, the significant change of direction and focus in our business that we made in 2001 by exiting the chewing gum business and refocusing entirely on the development, production and sale of over-the-counter pharmaceutical products presents a limited operating history upon which you may evaluate our current and prospective performance. The possibility of our future success must be considered relative to the problems, challenges, complications and delays frequently encountered in connection with the development and operation of a new business, and the development and marketing of relatively new products such as the Zicam products.

If our Zicam products do not gain widespread market acceptance or receive additional adverse publicity, our anticipated sales and results of operations will suffer

          Although we believe that each of our products, and in particular our Zicam Cold Remedy nasal products, offer unique benefits to consumers, we cannot be certain that any of these products will achieve widespread acceptance by the market. In addition, given their recent introduction in late 2003, our three new oral Zicam products have not yet reached the level of market recognition achieved by the original Zicam Cold Remedy nasal gel pump or swab products. While we are working to increase the market presence of all of our products, including our new Cough Mist products, we cannot be certain that demand for these products will grow. If

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problems arise concerning the efficacy or safety of any of our products, or if any of our products receives additional adverse publicity, or if any of our products fails to achieve widespread market acceptance for any other reason, our operating results and prospects would be materially adversely affected. Our results could also be affected by fluctuations in buying patterns and inventory levels of major customers.

Unanticipated problems associated with product development and commercialization could adversely affect our operating results

          Our successful development of existing and new products is subject to the risks of failure and delay inherent in the development and commercialization of products based on innovative technologies. These risks include the possibilities that:

•		we may experience unanticipated or otherwise negative research and development results;
•		existing or proposed products may be found to be ineffective or unsafe, or may otherwise fail to receive required regulatory clearances or approvals;
•		we may find that existing or proposed products, while effective, are uneconomical to commercialize or market;
•		we may be unable to produce sufficient product inventories to meet customer demand;
•		existing or proposed products do not achieve broad market acceptance; or
•		proprietary rights held by third parties preclude us from developing or marketing existing or proposed products.

          Our inability to develop and commercialize our existing products or any new products on a timely basis and within our financial budgets could have a material adverse effect on our operating results and future prospects.

Our inability to provide scientific proof for product claims may adversely affect our sales

          The marketing of our Zicam products involves claims that these products assist in reducing the duration and severity of the common cold (in the case of Zicam Cold Remedy products) and controlling allergy symptoms (in the case of Zicam Allergy Relief). Under Food and Drug Administration (“FDA”) and Federal Trade Commission (“FTC”) rules, we are required to obtain scientific data to support any health claims we make concerning our products. We have obtained scientific data for our product claims, however, we cannot be certain that the scientific data we have obtained in support of our claims will be deemed acceptable to the FDA, FTC or other regulatory bodies. If any regulatory body requests supporting information and we are unable to provide support that is acceptable, either the FDA or FTC could force us to stop making the claims in question or restrict us from selling the affected products.

FDA and other government regulation may restrict our ability to sell our products

          We are subject to various federal, state and local laws and regulations affecting our business. Our Zicam products are subject to regulation by the FDA, including regulations with respect to labeling of products, approval of ingredients in products, claims made regarding the

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products, and disclosure of product ingredients. If we do not comply with these regulations or if these regulations change in the future, the FDA could force us to stop selling the affected products or require us to incur substantial costs in adopting measures to maintain compliance with these regulations. If the FDA came to believe that any of our products caused harm to consumers, we could be required to stop selling that product or subject the product to a recall. Our advertising claims regarding our products are subject to the jurisdiction of the FTC as well as the FDA. In both cases we are required to obtain scientific data to support any advertising or labeling health claims we make concerning our products, although no pre-clearance or filing is required to be made with either agency. If we are unable to provide the required support for such claims, the FTC may stop us from making such claims or require us to stop selling the affected products.

We may fail to compete effectively, particularly against larger, more established pharmaceutical and health products companies, causing our business and operating results to suffer

          The consumer health products industry is highly competitive. We compete with companies with sales in the United States that are engaged in the development of both traditional and innovative healthcare products. Many of these companies have much greater financial and technical resources and production and marketing capabilities than we do. As well, many of these companies have already achieved significant product acceptance and brand recognition with respect to products that compete directly with our Zicam products. Our competitors may successfully develop and market superior or less expensive products which could render our Zicam and other future products less valuable or unmarketable.

If we are unable to protect our intellectual property or if we infringe the intellectual property of others, our financial condition and future prospects could be materially harmed

          We rely significantly on the protections afforded by patent and trademark registrations that we routinely seek from the U.S. Patent and Trademark Office (“USPTO”) and from similar agencies in foreign countries. We cannot be certain that any patent or trademark application that we file will be approved by the USPTO or other foreign agencies. In addition, we cannot be certain that we will be able to successfully defend any trademark, trade name or patent that we hold against claims from, or use by, competitors or other third parties. No consistent policy has emerged from the USPTO or the courts regarding the breadth of claims allowed or the degree of protection afforded under biotechnology and similar patents. Our future success will depend on our ability to prevent others from infringing on our proprietary rights, as well as our ability to operate without infringing upon the proprietary rights of others. We may be required at times to take legal action to protect our proprietary rights and, despite our best efforts, we may be sued for infringing on the patent rights of others. Patent litigation is costly and, even if we prevail, the cost of such litigation could adversely affect our financial condition. If we do not prevail, in addition to any damages we might have to pay, we could be required to stop the infringing activity or obtain a license. We cannot be certain that any required license would be available to us on acceptable terms, or at all. If we fail to obtain a license, our business might be materially adversely affected. In addition to seeking patent protection, we rely upon a combination of non-disclosure agreements, other contractual restrictions and trade secrecy laws to protect proprietary information. There can be no assurance that these steps will be adequate to prevent misappropriation of our proprietary information or that our competitors will not independently develop technology or trade secrets that compete with our proprietary information.

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We may incur significant costs resulting from product liability claims or securities litigation

          We are subject to significant liability should use or consumption of our products cause injury, illness or death. Presently, we are being sued by approximately 284 individuals in 19 different product liability lawsuits (two of which have been filed as class action lawsuits) relating to our Zicam Cold Remedy product. Various defendants in the lawsuits, including manufacturers and retailers, have sought indemnification or other recovery from us for damages related to the lawsuits. Although we carry product liability insurance, we cannot be sure that our insurance will be adequate to protect us against product liability claims or that insurance coverage will continue to be available. Product liability claims, such as those described in our Report on Form 10-K for our 2003 fiscal year and in our subsequent Reports on Form 10-Q and 8-K, even if without merit or for which we have substantial coverage, could result in significant legal defense costs, thereby increasing our expenses and lowering our earnings. Such claims, whether or not proven to be valid, could have a material adverse effect on our product branding and goodwill, resulting in reduced market acceptance of our products. In addition, any adverse decision in such litigation could require significant damages to be paid or result in adverse publicity, either of which could materially adversely affect our results of operations and financial condition. The Company and its Chief Executive and Chief Financial Officers are also subject to two class action lawsuits alleging violations of securities laws. Any adverse decision in such litigation could materially adversely affect our results of operations and financial condition.

We do not have manufacturing capabilities of our own

          We currently do not have the physical or human resources to independently manufacture our Zicam products or any other products that we may develop. We currently outsource all of our product manufacturing and packaging operations and intend to continue this outsourcing for the foreseeable future. If we are unable to enter into cost-effective or otherwise suitable arrangements for manufacturing of our Zicam products or any other products, or if our third-party contractors fail to adequately perform their manufacturing operations (as occurred with our old swab products), our sales and related financial results could be materially adversely affected. If, in the future, we decide to establish our own manufacturing facilities, we will require substantial additional funds and significant additional personnel to undertake such operations. We cannot be certain that such funding or a sufficient number of such qualified persons will be available for such an undertaking.

We may continue to experience product backlogs

          At the end of fiscal 2003, we had approximately $0.4 million in backlog of swab orders. This backlog continued into the first half of the first quarter of fiscal 2004. We have undertaken significant measures to remedy the manufacturing problems that led to this backlog, including replacing our swab manufacturer and redesigning our swab product to permit higher volume production. We have built a substantial inventory of swab products to reduce the likelihood of any backlog occurring in the 2004-2005 cough and cold season. We have increased the inventory of our other products in preparation of anticipated sell-in during the third quarter of 2004, and we have established inventory plans to support sales through the 2004-2005 cough and cold season. We introduced six new Zicam Cough Mist products which began shipping to customers in July 2004. Our Cough Mist manufacturer is producing according to our forecast and we expect to have inventory available for sales of the new products through the 2004-2005

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cough and cold season. However, we cannot be certain that these measures will be sufficient to prevent future backlog of these products or that other product backlogs will not occur in the future. Any such future backlogs will potentially result in higher production costs, higher freight costs to expedite shipment of raw materials and finished goods, fines from certain retailers, cancelled orders and lost opportunity costs. These in turn could materially affect our results of operations and financial condition.

Our board of directors is authorized to issue shares of preferred stock that could have rights superior to our outstanding shares of common stock, and, if issued, could adversely impact the value of our common stock

          Our certificate of incorporation permits our board of directors, in its sole discretion, to issue up to 2,000,000 shares of authorized but unissued preferred stock. These shares may be issued by our board without further action by our shareholders, and may include any of the following rights (among others) as our board may determine, which rights may be superior to the rights of our outstanding common stock:

•		voting rights, including the right to vote as a class on particular matters;
•		preferences as to dividends and liquidation rights;
•		conversion rights;
•		anti-dilution protections; and
•		redemption rights

          Since our board of directors has the authority to determine, from time to time, the terms of our authorized preferred stock, there is no limit on the amount of common stock that could be issuable upon conversion of any future series of preferred stock that may be issued. The rights of holders of our common stock will be subject to, and may be adversely affected by, the rights of the holders of any series of preferred stock that may be issued in the future. In addition, the market price of our common stock may be adversely affected by the issuance of any series of preferred stock with voting or other rights superior to those of our common stock. The issuance of any series of preferred stock could also have the effect of making it more difficult for a third party to acquire a majority of our outstanding common stock.

The price of our stock may continue to be volatile

          The market price of our common stock, which is quoted for trading on the Nasdaq National Market, has been highly volatile and may continue to be volatile in the future. Any or a combination of the following factors could cause the market value of our common stock to decline quickly: operating results that differ from market expectations, negative or other unanticipated results of clinical trials or other testing, delays in product development, technological innovations or commercial product introductions by our competitors, changes in government regulations or advertising restrictions, developments concerning proprietary rights, including pending or threatened patent litigation, adverse publicity or public concerns regarding the safety of any of our products, litigation against the Company, and general economic and stock market conditions. Since the Spring of 2000, the stock market has experienced, and it may continue to experience, significant price and volume fluctuations. These fluctuations have particularly affected the market prices of equity

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securities of small capitalization companies, like Matrixx. Often, the effect on the price of such securities is disproportionate to the operating performance of such companies. In our case, such fluctuations may adversely affect our stockholders’ ability to dispose of their shares of Matrixx at a price equal to or above the price at which they purchased such shares. In addition, we believe our stock price has been impacted by a sizeable short position and resulting covering by investors holding short positions in our stock.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

          Our primary market risk exposure relates to our variable rate revolving line of credit with Comerica Bank. At no time during fiscal 2003 or the first six months of fiscal 2004 did we have any outstanding balance against this line of credit. In July 2004, we borrowed $2 million against our credit facility with Comerica Bank. The primary purpose for the borrowing was to provide additional liquidity as we built inventory for expected increases in sales during the second half of 2004. We generally extend payment terms for customers during the third quarter as customers purchase new products and build inventory for the upcoming cough and cold season. We anticipate repaying the debt in the fourth quarter of 2004 and ending fiscal 2004 with no debt. Consequently, we believe that moderate interest rate increases will not have a material adverse impact on our results of operations or financial position in the foreseeable future.

          As of September 30, 2004 and December 31, 2003, we did not participate in any market risk-sensitive commodity instruments for which fair value disclosure would be required under Statement of Financial Accounting Standards No. 107. We believe that we are not subject in any material way to other forms of market risk, such as foreign currency exchange risk or foreign customer purchases (of which there were none in the first nine months of fiscal 2004 or in any of 2003) or commodity price risk.

Item 4. Controls and Procedures

          We carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rules 13a-15 and 15d-15 of the Securities Exchange Act of 1934. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures are effective in timely alerting them to material information relating to the Company and required to be included in our periodic SEC filings. There were no significant changes in our internal controls over financial reporting during our most recently completed quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting, or other factors that could significantly affect these controls subsequent to the date of their evaluation, and there were no corrective actions taken with regard to significant deficiencies or material weaknesses in our controls.

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PART II
OTHER INFORMATION

Item 1. Legal Proceedings

          We are subject, from time to time, to legal proceedings and claims regarding adverse reactions to our products. From late 2003 through October 2004, we have been sued by approximately 284 individuals in 19 different lawsuits generally alleging that our Zicam Cold Remedy product caused damage to the sense of smell and/or taste. Two of these lawsuits have been filed as class action lawsuits covering named and unnamed plaintiffs. The lawsuits have been previously disclosed in our Annual Report on Form 10-K for our fiscal year ended December 31, 2003, our Quarterly Reports on Form 10-Q for our first quarter ended March 31, 2004 and our second quarter ended June 30, 2004, and on our Report on Form 8-K filed August 20, 2004. Various defendants in the lawsuits, including manufacturers and retailers, have sought indemnification or other recovery from us for damages related to the lawsuits.

          An investigative news report by a national network program that was subsequently featured by several local stations across the country, which suggested the possibility of Zicam Cold Remedy negatively impacting a person’s sense of smell and/or taste appears to be related to the filing of the lawsuits. Also, we are aware that plaintiffs’ law firms are actively soliciting potential claimants through the Internet and other media. As a result, we expect additional lawsuits to be filed against us. It is very early in the discovery phase of the lawsuits. It appears that the lawsuits, as well as the above-noted news media reports, are based on research and allegations regarding a connection between zinc sulfate and loss of sense of smell. Zicam Cold Remedy contains zinc gluconate, not zinc sulfate, which has very different properties than zinc sulfate.

          We believe the allegations relating to Zicam Cold Remedy are inappropriate and misleading. Zicam Cold Remedy has been studied in two independent, placebo-control studies. In those studies, there was no statistically significant difference in adverse events between the placebo and non-placebo group, and there was no indication in either group of impairment to the sense of smell. Further, the incidence of smell disorders is reported at 1-2% of the population on average, and is very common in those over age 50. Upper respiratory infections are among the most common causes of impairment to sense of smell. Therefore, any product such as Zicam Cold Remedy designed to treat upper respiratory illnesses may be mistakenly associated with distortion of sense of smell. The rate of reported complaints of distortion of sense of smell associated with Zicam Cold Remedy is well below these national incidence levels.

          In September 2004, we convened a two-day meeting of our Scientific Advisory Board to review the findings of studies initiated in the first quarter of fiscal 2004. Members of the Scientific Advisory Board presented the results of their studies on the epidemiology, anatomy, and physiology of smell disorders. It was the unanimous opinion of the Scientific Advisory Board that the cumulative scientific evidence does not support the contention that Zicam® Cold Remedy zinc gluconate nasal gel is associated with disorders of smell. The Scientific Advisory Board plans to do further testing of the zinc gluconate nasal gel on human volunteers and animal models. Panel members are expected to reconvene in approximately six months to review the findings of the additional research.

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          We have submitted all of the existing lawsuits to our insurance carriers. We cannot predict the outcome of the litigation, but we will defend ourselves vigorously. If any liability were to result from one or more of these or future lawsuits, we believe our financial results could be materially impacted. Our financial results could also be materially impacted by the adverse publicity that may result from the lawsuits.

          Additionally, there have been two class action lawsuits filed against the Company, our President and Chief Executive Officer, Carl J. Johnson, and our Executive Vice President and Chief Financial Officer, William J. Hemelt, alleging violations of federal securities laws. These cases were previously disclosed in our Quarterly Report on Form 10-Q for our second quarter ended June 30, 2004. Among other things, the lawsuits allege that between October 2003 and February 2004, we made materially false and misleading statements regarding our Zicam Cold Remedy product, including failing to adequately disclose to the public the details of certain of the product liability lawsuits described above. We believe the claims made in these lawsuits are without merit and represent the actions of opportunistic plaintiffs’ law firms seeking to take advantage of existing Zicam Cold Remedy litigation. We intend to vigorously defend ourselves in these matters. In accordance with and subject to the provisions of the Company’s Certificate of Incorporation, Messrs. Johnson and Hemelt will be indemnified by the Company for their expenses incurred in defending these lawsuits and for any other losses which they may suffer as a result of these lawsuits. If any liability were to result from these lawsuits, we believe our financial results could be materially impacted.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

          During the quarter ended September 30, 2004, there were no sales of equity securities by the Company that were not registered under the Securities Act and no purchases by the Company (and its affiliated purchasers) of the Company’s equity securities.

          The board of directors previously approved the repurchase by the Company of up to one million shares of the Company’s common stock through a stock repurchase program that we publicly announced on April 1, 2004 (the “Program”). Unless terminated earlier by resolution of our board of directors, the Program will expire when we have repurchased all shares authorized for repurchase through the Program. There are 982,100 shares remaining for repurchase under the Program.

Item 4. Submission of Matters to a Vote of Security Holders

          There were no matters subject to a vote of security holders during the third quarter of 2004.

Item 6. Exhibits

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*

Filed with this Report on Form 10-Q.

(1)		Incorporated by reference to the registrant’s Amendment No. 1 to Form 8-A, filed June 18, 2002, file number 000-27646.
(2)		Incorporated by reference to the registrant’s registration statement on Form 8-A, filed July 23, 2002, file number 000-27646.
(3)		Incorporated by reference to the registrant’s Report on Form 8-K filed October 28, 2004; file number 001-31404.

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SIGNATURES

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

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EXHIBIT INDEX

*

Filed with this Report on Form 10-Q.

(1)		Incorporated by reference to the registrant’s Amendment No. 1 to Form 8-A, filed June 18, 2002, file number 000-27646.
(2)		Incorporated by reference to the registrant’s registration statement on Form 8-A, filed July 23, 2002, file number 000-27646.
(3)		Incorporated by reference to the registrant’s Report on Form 8-K filed October 28, 2004; file number 001-31404.