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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

Commission File Number 0-24424

CIMA LABS INC.

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, 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 by Rule 12b-2 of the Exchange Act).

	Yes   X		No

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practical date.

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INDEX
CIMA LABS INC.

     We have registered “CIMA®,” “CIMA LABS INC.®,” “OraSolv®,” “OraVescent®,” “DuraSolv®” and “PakSolv®” as trademarks with the U.S. Patent and Trademark Office. We also use the trademarks “OraSolv®SR/CR,” “OraVescent®SL/BL” and “OraVescent®SS.” All other trademarks used in this report are the property of their respective owners. “Triaminic®” and “Softchews®” are trademarks of Novartis. “Zomig®,” “Zomig-ZMT®” and “Rapimelt™” are trademarks of AstraZeneca. “Remeron®” and “SolTab™” are trademarks of Organon. “Tempra®” is a registered trademark of a Canadian affiliate of Bristol-Myers Squibb. “FirsTabs™” is a trademark of Bristol-Myers Squibb. “NuLev™” is a trademark of Schwarz Pharma. “Alavert™” is a trademark of Wyeth. “Allegra®” is a registered trademark of Aventis Pharmaceuticals Inc. “Actiq®” is a registered trademark of Anesta Corporation. “Claritin®” and “Reditabs®” are registered trademarks of Schering Corporation. “Maxalt-MLT®” is a registered trademark of Merck & Co., Inc. “Zyprexa® Zydis” is a registered trademark of Eli Lilly and Company. “Zydis®” is a registered trademark of Cardinal Health, Inc. “FlashDose®” is a registered trademark of Biovail Corporation. “WOWTab®” is a registered trademark of Yamanouchi Pharma Technologies, Inc. “Flashtab®” is a registered trademark of Ethypharm. “OraQuick™” is a trademark of KV Pharmaceutical Company. “Pharmaburst™” is a trademark of SPI Pharma, Inc.

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PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

CIMA LABS INC.
Balance Sheets
(in thousands, except per share data)

Note: The balance sheet at December 31, 2002 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. See accompanying notes.

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CIMA LABS INC.
Income Statements
(Unaudited)
(in thousands, except per share data)

See accompanying notes.

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CIMA LABS INC.
Statements of Cash Flows
(Unaudited)
(in thousands)

See accompanying notes.

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CIMA LABS INC.
Notes to Financial Statements
(Unaudited)
(in thousands, except per share data)

1.     Basis of Presentation

CIMA LABS INC. (the “Company”), a Delaware corporation, develops and manufactures orally disintegrating tablets and enhanced-absorption oral drug delivery systems. The Company operates within a single business segment, the development and manufacture of orally disintegrating tablets and enhanced-absorption oral drug delivery systems. OraSolv and DuraSolv, the Company’s leading proprietary orally disintegrating tablet technologies, allow an active drug ingredient, which is frequently taste-masked, to be formulated into a new, orally disintegrating dosage form that dissolves quickly in the mouth without chewing or the need for water. The Company is also developing enhanced oral drug delivery technologies and independently developing new products based on its oral drug delivery technologies. The Company enters into collaborative agreements with pharmaceutical companies to develop products based on its oral drug delivery technologies. The Company currently manufactures six pharmaceutical brands for its partners incorporating its proprietary orally disintegrating tablet technologies. Revenues are comprised of three components: net sales of products it manufactures for pharmaceutical partners; product development fees and licensing revenues for development activities conducted through collaborative agreements with pharmaceutical companies; and royalties on the sales of products sold by pharmaceutical companies under license from the Company.

The accompanying unaudited financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. These financial statements do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring accruals, which are considered necessary for fair presentation, have been included. Operating results for the three and six month periods ended June 30, 2003 are not necessarily indicative of the results that may be expected for the year ended December 31, 2003. For further information, you should refer to the audited financial statements and accompanying notes contained in our Annual Report on Form 10-K for the year ended December 31, 2002.

2.     Use of Estimates

The preparation of financial statements in conformity with generally accepted accounting principles requires us to make estimates and assumptions that may affect the amounts we report in our financial statements and accompanying notes. Actual results could differ from those estimates.

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3.     Investments

The Company’s investments in available-for-sale securities are carried at fair value, with unrealized gains and losses included in accumulated other comprehensive income as a separate component of stockholders’ equity. As of June 30, 2003 and December 31, 2002, the amortized cost and estimated market value of available-for-sale securities are as follows:

4.     Stock Based Compensation

The Company accounts for its stock plans under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation cost is reflected in net income, 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. Under the requirements of FASB Statement No 148, Accounting for Stock Based Compensation – Transition and Disclosure, the following table illustrates the effect on net income and net income per share if the Company had applied the fair value recognition provisions of that statement to stock based compensation:

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5.     Income Per Share

Income per share for the three and six months ended June 30, 2003 and 2002 are summarized in the following table:

6.     Comprehensive Income

Comprehensive income consists of net income, fair value of forward contracts and net unrealized losses on available-for-sale securities.

7.     Inventories

Inventories are stated at the lower of cost (first in, first out) or fair market value.

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8.     Tax Expense

Provisions for income taxes for the six-month period ended June 30, 2003, reflect provisions for U.S. federal and state income taxes. At December 31, 2002, the Company had a valuation reserve of $6,408 resulting in a net deferred tax asset of $11,414. As of June 30, 2003, the Company had a valuation reserve of $5,705 resulting in a net deferred tax asset of $9,695.

9.     Segment Information – Major Customers

The Company operates within a single segment: the development and manufacture of orally disintegrating tablets and enhanced-absorption oral drug delivery systems. Revenues are comprised of three components: net sales of products utilizing the Company’s proprietary fast-dissolve technologies; product development fees and licensing revenues for development activities conducted by the Company through collaborative agreements with pharmaceutical companies; and royalties on the sales of products manufactured by the Company, which are sold by pharmaceutical companies under licenses from the Company

Revenues from major customers are as follows:

Trade accounts receivable at June 30, 2003 of approximately $12,909 were comprised primarily of the following customers: Organon (43%), Wyeth (19%), AstraZeneca (16%) and Schwarz Pharma (10%).

All of the Company’s assets and operations are located in the U.S. While the Company does not directly conduct its activities outside the U.S., it considers international revenues to be those arising from shipments ultimately destined for non-U.S. end-users and revenues from royalties generated by non-U.S. sales by partners.

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10.     Reclassifications

Certain amounts presented in the 2002 financial statements have been reclassified in order to conform to the 2003 presentation. These reclassifications have no impact on the net income or stockholders’ equity as previously reported.

11.     Subsequent Event

On August 5, 2003, the Company announced the signing of a definitive merger agreement with aaiPharma Inc. (“aaiPharma”). Under the terms of the merger agreement, a newly formed holding company will acquire all of the outstanding shares of each company and each company will become a wholly-owned subsidiary of the holding company. Each share of the Company’s common stock will be exchanged for 1.3657 shares of the holding company’s common stock. Each share of aaiPharma common stock will be exchanged for 1.0 shares of the holding company’s common stock. At inception, on a diluted basis, the Company’s stockholders will own 40.6 percent and aaiPharma stockholders will own 59.4 percent of the holding company. If the merger agreement is terminated under certain conditions, the Company may be required to pay aaiPharma termination fees and expenses of up to $11.5 million.

The transaction is subject to approval by the stockholders of both companies, as well as regulatory approvals and satisfaction of other customary closing conditions. Subject to the satisfaction of these conditions, the transaction is expected to close in the fourth quarter of 2003.

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

Forward-Looking Statements

We make many statements in this Quarterly Report on Form 10-Q under the heading Management’s Discussion and Analysis of Financial Condition and Results of Operations and elsewhere, that are forward-looking and are not based on historical facts. These statements relate to our future plans, objectives, expectations and intentions. We may identify these statements by the use of words such as believe, expect, will, anticipate, intend, plan and other similar expressions. These forward-looking statements involve a number of risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those we discuss under the heading “Factors That Could Affect Future Results” and elsewhere in this report. These forward-looking statements speak only as of the date of this report, and we caution you not to rely on these statements without considering the risks and uncertainties associated with these statements and our business that are addressed in this report.

These forward-looking statements include statements relating to the expected growth in operating revenues for 2003 and changes in components of revenues for 2003; the expected increases of gross profits and gross profit margins; the expected decrease in other income; the timing for recognition of our remaining tax benefits; the timing for completion of improvements to our Brooklyn Park R&D center, including the construction and operation of a second site for manufacturing; future expense levels; the timing of availability and expected mix of products; expected demand for products using our technologies; the adequacy of our production capacity, including plans to expand our capacity; the adequacy of our cash and cash reserves; the timing of the closing of the merger transaction with aaiPharma Inc.; and future research and development activities and funding relating to our current or new technologies. We do not undertake any obligation to update any of the forward-looking statements after the date of this report to conform these statements to actual results, except as required by law.

Overview

We enter into collaborative agreements with pharmaceutical companies to develop and manufacture products based on our proprietary OraSolv and DuraSolv orally disintegrating tablet technologies. We currently manufacture six pharmaceutical brands utilizing our orally disintegrating tablet technologies: three prescription and three over-the-counter (“OTC”) brands. The three prescription products are AstraZeneca’s Zomig-ZMT and its equivalent for non-U.S. markets, Remeron SolTab for Organon, and NuLev for Schwarz Pharma. The OTC products are Triaminic Softchews for Novartis, Tempra FirsTabs for a Canadian affiliate of Bristol-Myers Squibb, and Alavert for Wyeth. We are also currently developing other oral drug delivery technologies for ourselves and for others. We operate within a single business segment, the development and manufacture of orally disintegrating tablets and enhanced-absorption oral drug delivery systems. Our revenues are comprised of three components, including net sales of products we manufacture for pharmaceutical companies using our proprietary orally disintegrating tablet technologies, product development fees and licensing revenues for development activities we conduct through collaborative agreements with pharmaceutical companies, and royalties on the sales of products we manufacture which are sold by pharmaceutical companies under licenses from us.

Revenues from product sales and from royalties will fluctuate from quarter to quarter and from year to year depending on, among other factors, demand by consumers for the products we produce for our partners, new product introductions, the seasonal nature of some of the products we produce to treat seasonal ailments, pharmaceutical company ordering patterns and our production schedules. Revenues from product development fees and licensing revenue will fluctuate depending on, among other factors, the number of new collaborative agreements that we enter into, the number and timing of product development milestones that we achieve under our collaborative agreements, and the level of our development activity conducted for pharmaceutical companies.

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Recent Event

On August 5, 2003, the Company, aaiPharma Inc., a Delaware corporation (“aaiPharma”), Scarlet Holding Corporation, a Delaware corporation and a direct, wholly-owned subsidiary of aaiPharma (“Holding Company”), Scarlet Mergerco, Inc., a Delaware corporation and a direct, wholly-owned subsidiary of Holding Company (“S MergerCo”), and Crimson Mergerco, Inc., a Delaware corporation and a direct, wholly-owned subsidiary of Holding Company (“C MergerCo”), entered into an Agreement and Plan of Merger (the “Merger Agreement”). Pursuant to the Merger Agreement, Holding Company will acquire all of the capital stock of each of the Company and aaiPharma through the merger of S MergerCo with and into aaiPharma and the merger of C MergerCo with and into the Company, with aaiPharma and the Company surviving as wholly owned subsidiaries of Holding Company (together, the “Transaction”). The completion of the Transaction is subject to several conditions, including the approval of the Transaction by the stockholders of the Company and aaiPharma and the expiration or termination of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976.

In connection with the Transaction, each outstanding share of the Company’s common stock will be converted into the right to receive 1.3657 shares of Holding Company common stock, and each share of aaiPharma common stock will be converted into the right to receive one share of Holding Company common stock. Holding Company will assume all options under the respective existing stock option plans of the Company and aaiPharma, and each outstanding option to purchase the Company’s common stock or aaiPharma common stock will be converted into an option to purchase Holding Company common stock, each as adjusted to account for the appropriate exchange ratio. At inception, on a diluted basis, the Company’s stockholders will own approximately 40.6 percent of the combined company and aaiPharma stockholders will own approximately 59.4 percent.

Both the merger of C MergerCo with and into the Company and the merger of S MergerCo with and into aaiPharma are intended to qualify as tax-free reorganizations under Section 368(a) of the Internal Revenue Code of 1986, as amended (the “Code”), and the Transaction, taken as a whole, is intended to qualify as a tax-free exchange under Section 351 of the Code. In connection with the Transaction, the Company entered into Stockholder Voting Agreements (the “aaiPharma Voting Agreements”) with Frederick D. Sancilio and Philip S. Tabbiner (together, the “aaiPharma Stockholders”), pursuant to which the aaiPharma Stockholders have, among other matters, agreed to vote in favor of the Transaction and the Merger Agreement and have granted to the Company an irrevocable proxy to vote their shares of aaiPharma common stock in favor of the Transaction. The aaiPharma Stockholders, collectively, beneficially own approximately 23% of the outstanding shares of aaiPharma. In addition, aaiPharma entered into Stockholder Voting Agreements (the “CIMA Voting Agreements” and, together with the aaiPharma Voting Agreements, the “Voting Agreements”) with John M. Siebert and Steven B. Ratoff (together, the “CIMA Stockholders”), pursuant to which the CIMA Stockholders have, among other matters, agreed to vote in favor of the Transaction and the Merger Agreement and have granted to aaiPharma an irrevocable proxy to vote their shares of the Company’s common stock in favor of the Transaction. The CIMA Stockholders, collectively, beneficially own approximately 3% of the outstanding shares of the Company’s common stock.

In connection with the Merger Agreement, the Company entered into an amendment (the “Rights Agreement Amendment”) to its Amended and Restated Rights Agreement dated as of June 26, 2001 (the “Rights Agreement”). The Rights Agreement Amendment clarifies that, prior to the effectiveness of the Merger Agreement and the CIMA Voting Agreements, aaiPharma, Holding Company, Crimson MergerCo and their affiliates will not be deemed to beneficially own shares of the Company’s common stock issuable in connection with the mergers (under the Rights Agreement generally, the rights will become exercisable if a person acquires more than a certain percentage of beneficial ownership of the Company’s then outstanding common stock).

Critical Accounting Policies and Estimates

General

The following discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of our financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to bad debts, inventories, income taxes, and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values

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of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our financial statements.

Revenue Recognition

We recognize revenue in accordance with the Securities and Exchange Commission’s Staff Accounting Bulletin No. 101, or SAB 101, “Revenue Recognition in Financial Statements.” SAB 101 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an agreement exists; (2) delivery has occurred or services rendered; (3) the fee is fixed and determinable; and (4) collectibility is reasonably assured. Revenues from our business activities are recognized from net sales of manufactured products upon shipment; from product development fees as the contracted services are rendered; from product development milestones upon completion of milestones; from up-front product development license fees as fees are recognized ratably over the expected development term of the proposed products; and from royalties on the sales of products that we manufacture, which are sold by pharmaceutical companies under license from us. The determination of SAB 101 criteria (3) and (4) for each source of revenue is based on our judgments regarding the fixed nature and collectibility of each source of revenue. Revenue recognized for any reporting period could be adversely affected should changes in conditions cause us to determine that these criteria are not met for certain future transactions.

Deferred Taxes

The carrying value of our net deferred tax assets assumes that we will be able to generate sufficient taxable income in the United States, based on estimates and assumptions. We record a valuation allowance to reduce the carrying value of our net deferred tax assets to the amount that is more likely than not to be realized. While we have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the requirements for the valuation allowance, in the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of our net recorded amount, an adjustment to the deferred tax asset would increase net income in the period such determination is made. Likewise, should we determine that we would not be able to realize all or part of our net deferred tax asset in the future, an adjustment to the net deferred tax asset would decrease net income in the period such determination is made. On a quarterly basis, we evaluate the realizability of our deferred tax assets and assess the requirements for a valuation allowance. At December 31, 2002, the Company had a valuation reserve of $6.4 million resulting in a net deferred tax asset of $11.4 million. As of June 30, 2003, the Company had a valuation reserve of $5.7 million resulting in a net deferred tax asset of $9.7 million.

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Results of Operations

Three and Six Month Periods Ended June 30, 2003 and 2002

Components of revenue, expenses, and net income as a percentage of total operating revenue for the three and six month periods ended June 30 were as follows:

*     Net income for the three and six months ended June 30, 2003 reflected tax expense provisions of $1.4 million and $3.2 million, respectively; whereas net income for the three and six months ended June 30, 2002 reflected tax benefit of $272,000 and $440,000, respectively.

Operating Revenues. Total operating revenues for the second quarter ended June 30, 2003 were $18.3 million, an increase of $8.1 million, or 79%, over the same period in 2002. The second quarter increases in total operating revenues resulted from increases in two out of three of our revenue components: revenues from the sales of products we manufacture and sell to our pharmaceutical company partners and royalties on the sales of products we manufacture which are sold by pharmaceutical companies under licenses from us. The third source of our revenues, product development fees and licensing revenue, declined from the second quarter of 2002. For the six months ended June 30, 2003, total operating revenues were $34.9 million, an increase of $16.4 million, or 88%, over the same period of 2002. The increases for the six-month period by revenue component followed the same pattern as the quarter. That is, increases in product sales and royalties and a decrease in product development fees and licensing revenues.

In the second quarter of 2003, revenues from net sales of products we manufacture for our pharmaceutical partners were $12.3 million, an increase of $7.6 million, or 164%, over the same period of 2002. The increase was primarily due to production of Alavert for Wyeth which was launched in December 2002, higher manufacturing volumes of Remeron SolTab for Organon and Zomig for AstraZeneca, partially offset by lower sales of Triaminic Softchews for Novartis and NuLev for Schwarz Pharma. For the six months ended June 30, 2003, revenues from net sales of products we manufacture for our pharmaceutical partners were $22.3 million, an increase of $13.4 million, or 151%, versus the first six months of 2002. The increase was due to sales of Alavert for Wyeth, and increased volumes of Remeron SolTabs for Organon, Zomig for AstraZeneca and NuLev for Schwarz offset in part by declines in volume of Triaminic Softchews for Novartis. For the full year 2003, we expect revenues from net sales of products we manufacture for our pharmaceutical partners to increase more than 80%. Sales of branded prescription products to our pharmaceutical company partners increased over $7.6 million and represented 65% of our total product sales in the first six months of 2003, compared with 77% the first half of 2002. Over-the-counter product sales to our pharmaceutical company partners increased nearly $5.8 million and accounted for 35% of total product sales compared with 23% in the first six months of last year. We expect lower contributions to our revenues from prescription products and higher contributions from over-the-counter products for the full year 2003, although the contributions may vary by quarter.

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Revenues from product development fees and licensing were $1.6 million in the second quarter of 2003, a decrease of $1.5 million, or 48%, from the same period of 2002. This decrease resulted from a maturing of certain agreements for proposed new products, including our achievement of certain milestones under existing agreements. The timing of product development fees and licensing revenues can vary based on the nature and scope of the activities being performed. We are actively pursuing new development agreements while increasing efforts in support of our proprietary compounds. For the first half of 2003, revenues from product development fees and licensing were $3.2 million, a decrease of $2.2 million, or 40%, from the first half of 2002. The decrease for the first half was caused by the same factors as the second quarter. For 2003, we expect combined revenues attributable to product development fees and licensing to range from somewhat less than to approximating full-year 2002 levels.

Revenues from royalties were $4.4 million in the second quarter of 2003, an increase of $1.9 million or 77% over the same quarter of 2002. The increase was due primarily to increased end-customer sales by Organon of Remeron SolTab, AstraZeneca of Zomig Rapimelt (the non-U.S. equivalent of Zomig-ZMT) in Europe and Zomig-ZMT in the United States, and the introduction by Wyeth of Alavert in the fourth quarter of 2002. For the six months ended June 30, 2003, revenues from royalties were $9.4 million, an increase of $5.1 million, or 117% versus the first six months of 2002. The increase for the first half was caused by the same factors as the second quarter. For 2003, we expect royalties to increase by 60% to 90% from 2002 levels.

Cost of goods sold. Cost of goods sold was $7.4 million and $15.2 million in the second quarter and first half of 2003, respectively, compared with $3.7 million and $7.0 million, respectively for the same periods of 2002. These increases were primarily due to additional labor and materials related to higher production volumes over the same periods in 2002. In the first half of the year, material costs increased by approximately $5.2 million, or about 158%, largely in line with the 151% increase in net sales revenue, but marginally higher due to the cost of the active ingredient (loratadine) in the Alavert product manufactured for Wyeth. Labor costs were up approximately $750,000, or about 113%, reflecting better efficiencies on the higher net sales volume. Overhead was up approximately $2.2 million, or about 72%, reflecting the high overhead absorption from running at nearly full capacity in the first half of 2003. For 2003, we expect cost of goods sold to increase from 2002 levels in terms of dollar amount, but decrease as a percentage of net sales as we continue to run at full capacity for the balance of the year.

Gross profit on product sales was $4.8 million and $7.1 million in the second quarter and first six months of 2003, compared to $896,000 and $1.8 million in the same periods of 2002. Gross margins on product sales were 39.3% and 31.9% of total product sales in the second quarter and first six months of 2003 compared with 19.3% and 20.8% for the same periods of 2002, respectively. For the first half of 2003, nearly all of this improvement is due to higher manufacturing efficiencies from full capacity utilization, as manufacturing volume has increased by over 110% while overhead spending has risen only 37%. For the full year of 2003, we expect gross profits on product sales to increase from 2002 levels in terms of dollar amounts and as a percentage of product sales.

Research and product development expenses. Research and product development expenses were $2.7 million in the second quarter of 2003, an increase of $258,000, or 10.6%, over the same period of 2002. For the first six months of 2003, research and product development expenses were $5.2 million, an increase of $755,000, or 16.9% over the first half of 2002. The increase in the first six months was due primarily to additional staffing (approximately $600,000) and infrastructure investments (approximately $300,000), offset partly by reduced external spending on development projects (approximately $225,000). For 2003, we expect research and product development expenses to increase by 20% to 25% from 2002 levels due to increased development efforts and clinical trial costs related to our proprietary products, increased staffing costs, and higher infrastructure costs.

Selling, general and administrative expenses. Selling, general and administrative expenses were $3.9 million in the second quarter of 2003, an increase of $1.8 million, or 89.6%, over the second quarter of 2002. For the first half of 2003, selling, general and administrative expenses were $6.4 million, an increase of $2.8 million, or 76.4% over the first six months of 2002. The increase in the first six months was due primarily to costs associated with increased legal fees (approximately $850,000), increased professional staffing and payroll related costs (approximately $550,000), management transition costs (approximately $350,000), merger related costs (approximately $250,000), outside consulting costs (approximately $250,000) and efforts to comply with the Sarbanes-Oxley Act (approximately $100,000). For 2003, we expect selling, general and administrative expenses to increase by more than 50% from 2002 levels due to merger related costs, legal fees, increased professional staffing, management transition costs, outside consulting costs and efforts to comply with the Sarbanes-Oxley Act.

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Other income (expense). Other income was $849,000 and $1.9 million in the second quarter and first half of 2003, respectively, a decrease of $1.1 million and $1.8 million from the comparable periods of 2002, respectively. Other income consists primarily of investment income comprised of interest earned on securities and gains realized on the sale of securities. The decrease from 2002 levels was due primarily to lower interest rates on our investments and lower levels of cash available for investment. For 2003, we expect other income to decrease by 40% to 50% from 2002 levels due to lower interest rates and expected capital expenditures which will reduce the level of cash available for investment.

Provision for income taxes. 2003 is the first year since turning profitable in the fourth quarter of 1999 that we have reported a provision for income tax expense on our income statement. The provision for income tax expense for the quarter ended June 30, 2003 was $1.4 million, compared with a tax benefit of $272,000 recognized in the second quarter of 2002. For the six months ended June 30, 2003, the tax provision recorded was $3.2 million, compared to a tax benefit of $440,000 for the first half of 2002. We have recognized approximately $500,000 of U.S. tax credits related to the utilization of net operating loss carryforwards in the second quarter of 2003 and $700,000 in the first six months of 2003 from the years when we were not profitable. Without these credits, our cumulative tax expense since turning profitable would have been approximately $18.1 million, based on an effective tax rate of 37.5%. We expect to recognize our remaining tax benefits of approximately $1.3 million during 2003.

Liquidity and Capital Resources

We have financed our operations to date primarily through private and public sales of equity securities, other income, and from operating revenues consisting of product sales, product development fees and licensing, and royalties.

Working capital increased from $83.7 million at December 31, 2002 to $89.1 million at June 30, 2003, primarily due to an increase in cash and the current portion of available-for-sale securities. Cash and available-for-sale securities, including both current and non-current securities, were $133.7 million at June 30, 2003, up from $131.7 million at December 31, 2002. Capital expenditures during the first half of 2003 totaled $11.5 million. These expenditures were essentially funded by cash generated from operating activities. We invest excess cash in interest-bearing money market accounts and investment grade securities.

During 2003, we plan to spend approximately $25 to $30 million, exclusive of potential capital expenditures to add capacity for the manufacture of products containing potent substances, to complete various improvement projects at our Eden Prairie manufacturing facility and our Brooklyn Park R&D center. These projects include: the addition of a production line in Eden Prairie for products requiring blister packaging in response to the increased demand by our pharmaceutical company partners for manufactured products; and the establishment of a second manufacturing site in our Brooklyn Park facility to provide bottling production capabilities. We expect the Brooklyn Park manufacturing site to be operational in late 2003. In addition, we expect to fund additional product development activities related to our OraVescent technology, which may include adding capacity for the manufacture of products containing potent substances, and to develop proprietary products using our OraSolv and DuraSolv technologies. We may also acquire technologies that complement our current portfolio of oral drug delivery technologies. We believe that our cash and cash equivalents and available-for-sale securities, together with expected revenues from operations, will be sufficient to meet our anticipated capital requirements for the foreseeable future. However, we may require additional funds to support our working capital requirements or for other purposes and may seek to raise such additional funds through public or private equity financings or from other sources. We cannot be certain that additional financing will be available on terms favorable to us, or at all, or that any additional financing will not be dilutive.

Factors That Could Affect Future Results

Certain statements made in this Quarterly Report on Form 10-Q are forward-looking statements based on our current expectations, assumptions, estimates and projections about our business and our industry. These forward-looking statements involve risks and uncertainties. Our business, financial condition and results of operations could differ materially from those anticipated in these forward-looking statements as a result of certain factors, as more fully described below and elsewhere in this Form 10-Q. You should also consider carefully the joint proxy statement/prospectus regarding our proposed transaction with aaiPharma when it becomes available because it will contain important

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information about the transaction. You should consider carefully the risks and uncertainties described below, which are not the only ones facing our company. Additional risks and uncertainties also may impair our business operations.

Our Business And Stock Price May Suffer If We Do Not Complete The Proposed Transaction With aaiPharma.

     If the transaction with aaiPharma is not completed, we could be subject to a number of risks that may adversely affect our business and stock price, including:

•		our day-to-day operations may be disrupted due to the substantial time and effort our management must devote to seeking to complete the transaction;
•		if the merger agreement is terminated under certain conditions, we may be required to pay aaiPharma termination fees and expenses of up to $11.5 million;
•		the market price of our common stock may decline to the extent that the current market price of such shares reflects a market assumption that the transaction will be completed;
•		benefits that we expect to realize from the transaction would not be realized;
•		we must pay various costs related to the transactions, such as our legal, investment advisor and accounting fees; and
•		if our board of directors determines to seek another merger or business combination, we may not be able to find a partner willing to enter into a transaction with more favorable terms and conditions than that agreed to by aaiPharma.

     The announcement of the planned transaction with aaiPharma, and related uncertainty concerning our future, may make it more difficult for us to enter into long-term relationships with certain pharmaceutical company partners and other third parties, which could have an adverse effect on our revenues. Speculation regarding the likelihood of the closing of the transaction with aaiPharma could increase the volatility of the price of our common stock.

     Prior to the completion of the transaction with aaiPharma and unless the merger agreement is terminated, we believe that the price of our common stock may be determined in part by the expectation that the merger will be completed and that our stockholders will become stockholders of a combined company with aaiPharma. As a result, the price of our common stock may be affected by the price of aaiPharma’s common stock. aaiPharma’s business differs from our business, and aaiPharma’s results of operations and the price of its common stock may be affected by factors different from those that affect our results of operations and the price of our common stock before the completion of the transaction.

     We have contracts with some of our suppliers, distributors, customers, licensors and other business partners. Some of these contracts require us to obtain consent from these other parties in connection with the proposed transaction with aaiPharma. If these consents cannot be obtained, we may suffer a loss of potential future revenue and may lose rights that are material to our business and the business of the combined company. In addition, third parties with whom we currently have relationships may terminate or otherwise reduce the scope of their relationship with us in anticipation or as a result of the transaction. aaiPharma recently filed a lawsuit against Schwarz Pharma, which resulted in Schwarz Pharma notifying aaiPharma that it intends to terminate its business relationship with aaiPharma. Schwarz Pharma is currently one of our top four revenue generating pharmaceutical partners. If Schwarz Pharma were to reduce its relationship with us in whole or in part, it could have a material adverse effect on our revenues and profitability.

     We intend to comply with the securities and antitrust laws of the United States and any other jurisdiction in which the proposed transaction is subject to review. The reviewing authorities may seek to impose conditions before giving their approval or consent to the transaction, and those conditions could harm the combined companies’ business. In addition, a delay in obtaining the necessary regulatory approvals will delay the completion of the transaction. We have not yet obtained any governmental or regulatory approvals required to complete the transaction. We may be unable to obtain these approvals or to obtain them within the timeframe contemplated by the merger agreement.

The completion of the proposed merger with aaiPharma could affect adversely our business.

     Our proposed merger with aaiPharma presents additional risks, including the combined company’s ability to successfully integrate the businesses of the two companies, and unexpected costs involved in the merger or the combined company’s ability to achieve cost-cutting synergies.

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The Loss Of One Of Our Top Four Major Customers Could Reduce Our Revenues Significantly.

     Revenues from AstraZeneca, Organon, Schwarz Pharma, and Wyeth together represented approximately 92% and 75% for the first half of 2003 and 2002, respectively. The loss of any one of these customers could cause our revenues to decrease significantly, resulting in losses from our operations. If we cannot broaden our customer base, we will continue to depend on a few customers for a significant portion of our revenues. We may be unable to negotiate favorable business terms with customers that represent a significant portion of our revenues. If we cannot, our revenues and gross profits may not grow as expected and may be insufficient to allow us to achieve sustained profitability.

We Rely On Third Parties To Market, Distribute And Sell The Products Incorporating Our Drug Delivery Technologies, And Those Third Parties May Not Perform, Or The Sales Of Those Products May Be Affected By Factors Beyond The Control Of Those Third Parties.

     Our pharmaceutical company partners market and sell the products we develop and manufacture for them. If one or more of our pharmaceutical company partners fails to pursue the marketing of products incorporating our technology as planned, our revenues and gross profits may not reach our expectations, or may decline. We often cannot control the timing and other aspects of the development of products incorporating our technologies because our pharmaceutical company partners may have priorities that differ from ours. Therefore, commercialization of products under development may be delayed unexpectedly. Because we incorporate our drug delivery technologies into the oral dosage forms of products marketed and sold by our pharmaceutical company partners, we do not have a direct marketing channel to consumers for our drug delivery technologies. The marketing organizations of our pharmaceutical company partners may be unsuccessful or they may assign a low level of priority to the marketing of our products. Further, they may discontinue marketing the products that incorporate our drug delivery technologies. If marketing efforts for our products are not successful, our revenues may fail to grow as expected or may decline.

     For the year ended December 31, 2002, net sales from manufacturing and royalties from our partners’ sales of our top four products accounted for approximately 71% of our operating revenues. For the six months ended June 30, 2003, net sales from manufacturing and royalties from our partners’ sales of our top four products accounted for approximately 87% of our total operating revenues. Our top four products are AstraZeneca’s Zomig-ZMT and its equivalent for markets outside the U.S., Organon’s Remeron SolTab and its equivalent for markets outside the U.S., Wyeth’s Alavert and Novartis’ Triaminic Softchews. We cannot be certain that these products will continue to be accepted in their markets. Specifically, the following factors, among others, could affect the level of market acceptance of Remeron SolTab and its non-U.S. equivalents, Zomig-ZMT and its non-U.S. equivalents, and Alavert:

	•		the perception of the healthcare community of their safety and efficacy, both in an absolute sense and relative to that of competing products;
	•		unfavorable publicity regarding these products or similar products;
	•		product price relative to other competing products or treatments;
	•		changes in government and third-party payor reimbursement policies and practices; and
	•		regulatory developments affecting the manufacture, marketing or use of these products.

If We Do Not Enter Into Additional Collaborative Agreements With Pharmaceutical Companies, We May Not Be Able To Achieve Sustained Profitability.

     We primarily depend upon collaborative agreements with pharmaceutical companies to develop, test and obtain regulatory approval for, and commercialize oral dosage forms of, active pharmaceutical ingredients using our drug delivery technologies. The number of products that we successfully develop under these collaborative agreements will affect our revenues. If we do not enter into additional agreements in the future, or if our current or future agreements do not result in successful marketing of products incorporating our technology, our revenues and gross profits may be insufficient to allow us to achieve sustained profitability.

     We face additional risks related to our collaborative agreements, including the risks that:

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	•		any existing or future collaborative agreements may not result in additional commercial products;
	•		additional commercial products that we develop with our pharmaceutical company partner may not be successful;
	•		we may not be able to meet the milestones established in our current or future collaborative agreements;
	•		we may not be able to successfully develop new drug delivery technologies that will be attractive in the future to potential pharmaceutical company partners; and
	•		our pharmaceutical company partners may exercise their rights to terminate their collaborative agreements with us.

If We Cannot Increase Our Production Capacity, We May Be Unable To Meet Expected Demand For Our Products, And We May Lose Revenues.

     We must increase our production capacity to meet expected demand for our products. We currently have two production lines for product requiring blister packaging, which collectively have an estimated annualized production capacity in excess of 500 million tablets. In 2003, we plan to add a third production line, which is expected to be completed and commissioned in the first half of 2004. We also are installing a production line for bottled product at our Brooklyn Park facility, which is expected to be completed and commissioned in the fourth quarter of 2003. We estimate that our total annualized capacity for the two production lines in Eden Prairie will increase from approximately 500 million to approximately 1.0 billion tablets. The estimated total annualized capacity of the production line in Brooklyn Park will be approximately 700 million bottled tablets. If we are unable to increase our production capacity as scheduled or if our partners significantly increase their requirements for product deliveries prior to completing the scheduled increases in capacity, we may be required to allocate our production capacity until we have completed these capacity improvements. If this should happen, we may lose revenues and we may not be able to maintain our relationships with our pharmaceutical company partners. Production lines in the pharmaceutical industry generally take 16 to 24 months to complete due to the long lead times required for precision production equipment to be manufactured and installed, as well as the required testing and validation process that must be completed once the equipment is installed. We may not be able to increase our production capacity quickly enough to meet the requirements of our pharmaceutical company partners.

If We Do Not Properly Manage Our Growth, We May Be Unable To Sustain The Level Of Revenues We Have Attained Or Effectively Pursue Additional Business Opportunities.

     Our operating revenues increased 88% in the first half of 2003, 46% in the year ended December 31, 2002, and 34% in the year ended December 31, 2001, placing significant strain on our management, administrative and operational resources. If we do not properly manage the growth we have recently experienced and expect in the future, our revenues may decline or we may be unable to pursue sources of additional revenues. To properly manage our growth, we must, among other things, implement additional (and improve existing) administrative, financial and operational systems, procedures and controls on a timely basis. We also need to expand our finance, administrative and operations staff. We may not be able to complete the improvements to our systems, procedures and controls necessary to support our future operations in a timely manner. We may not be able to hire, train, integrate, retain, motivate and manage required personnel and may not be able to successfully identify, manage and pursue existing and potential market opportunities. Improving our systems and increasing our staff will increase our operating expenses. If we fail to generate additional revenue in excess of increased operating expenses in any fiscal period we may incur losses, or our losses may increase in that period.

Sales Of Our Pharmaceutical Company Partners’ Products May Decline As A Result Of Competition From Generic Prescription Products And Regulatory Actions That Could Switch A Prescription Product To An Over-The-Counter Product, Which May Result In A Decline In Our Revenues And Profitability.

     Many of our pharmaceutical company partners face intense competition from manufacturers of generic drugs. Generic competition may reduce the demand and/or price for our partners’ products. Products that our pharmaceutical company partners produce may also be subject to regulatory actions that result in prescription products becoming available to consumers over-the-counter. Such a change could also reduce the demand and/or price for our partners’ products. Because we derive a significant portion of our revenue from manufacturing products for and receipt of royalties from our pharmaceutical company partners, a decline in the sales of products that we produce for our partners, whether as a result of the introduction of competitive generic products or other competitive factors, could have a material adverse effect on our revenues and profitability.

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